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This chapter is from the book

Accounting Problems and Stock Selection

We constantly struggle with the question, What is a dependable method for consistently selecting stocks? We have come to depend on audited financial statements as the basis for finding fundamental trends. The Enron age has reminded us that this basic assumption may not be dependable after all and that making decisions based on audited financial statements could place us at risk.

It has always been the unspoken rule that pointing out the inaccuracies in accounting practice was off limits. Everyone knew, or at least suspected, that a lot of manipulation was done as a matter of course; and those familiar with GAAP further understood that the rules allowed flexibility in interpretation and reporting. But we have also assumed for many years that to the extent the numbers were manipulated, at least the auditors were ensuring that the financial reports were accurate within an acceptable range. It has become clear that as part of the fundamental approach, we have to look at ratios not only to spot future trends but also to uncover questionable current and past financial relationships—if only to raise questions about the reliability of the numbers. Investors must police the accounting industry, because it is clear that even the audited financial statement is not above suspicion.

That is where core earnings adjustments are valuable; these adjustments eliminate many of the areas where past abuses have distorted financial statements, such as in pro forma earnings from invested pension assets, for example. So, while core earnings adjustments do not address all of the problems associated with the accounting industry, they do address many of the areas where subjective interpretations have become a problem in the past.

Key Point: It is the very flexibility of GAAP that has led to so many accounting problems in the past. Abuse occurs, though, when isolated cases of questionable interpretation become recurring annual policy, and distortion in accurate reporting results.

Investors want and deserve realistic reports, and defining core earnings is the most reliable and consistent way to achieve that reality. In order to judge the likely earnings and, by association, future investment value, investors must be able to judge how core earnings growth will occur in the future.

The first problem in stock selection has been reliability in the very numbers we depend on for fundamental analysis. As we move through a period of reform, we need to rely not only on better policies and stricter enforcement, but also on our own sense of how trends are changing (see Chapter 2). We must use fundamental analysis to verify, rather than merely accept, the numbers presented by corporations and auditors.

Core earnings adjustments are, in effect, a return to simplicity. Corporations will continue to take tax write-offs for noncore expenses and will continue to enact changes in accounting methods. In part, much of the creative accounting practice that invaded the corporate culture grew from the complexities of federal taxation. However, to the extent that it crossed over into what was reported to shareholders, it got out of hand, to say the least. Deception and liberal interpretation became the rule in an environment in which the expectation had been disclosure and conservative reporting.

By applying core earnings adjustments, corporate reports will be simplified and noncore transactions discarded for the purpose of analysis. Once this idea is clarified and applied universally, investors will be better able to use fundamental analysis to identify growth potential with a clear field in view. The development of core earnings may create a third form of accounting convention. We currently have statutory-basis reporting (the form allowed under the tax rules) and GAAP reporting (the loosely organized but broadly applied series of conventions and standards aimed at improving overall accuracy and consistency), which also includes possible adjustments under EBITDA and the use of pro forma methods to set income valuation. The third form of accounting may be called CEA, or Core Earnings Accounting. As S&P continues to revise its proposed standards, and as the company uses its core earnings adjustments to rate those corporations it tracks, it is likely that other organizations (such as ValueLine, for example) are likely to follow suit. A trend has already begun in which some corporations are making core earnings adjustments voluntarily, recognizing the validity of reflecting core-earnings-based reports to shareholders, even when accounting rules do not require such adjustments.

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