Olstein Funds: Accounting Alerts Help Avert Trouble

An astute investor should be aware of the types of accounting smokescreens that companies use to disguise problems and to misrepresent the company’s economic reality. The following alerts are sometimes clear indicators of future earnings surprises and have proved valuable to investors:

• Sizable negative divergences between cash flow and net income;
• Questionable accounting for transactions with unconsolidated affiliates or joint ventures;
• Prematurely realizing revenue that may not be sustainable;
• Reversal of past reserves to artificially inflate earnings;
• Realizing nonrecurring gains, and netting these gains to hide past mistakes;
• Lowering discretionary expenditures to meet earnings targets;
• Continual characterization of material expenses as nonrecurring;
• Unrealistic depreciation schedules;
• Capitalizing expenses based on unjustified optimism;
• Serial acquisitions under purchase accounting that overstate internal earnings growth;
• Lower inventory turns or negative inventory divergences;
• Accounts receivable rising faster than sales; and
• Unrealistic pension assumptions.