watch for disclosures about debt, stock options, loans to customers,
reserves against losses, and other “risk factors” that can take a big
chomp out of earnings. Among the things that should make your
antennae twitch are technical terms like “capitalized,” “deferred,” and
“restructuring”—and plain-English words signaling that the company
has altered its accounting practices, like “began,” “change,” and “how-
ever.” None of those words mean you should not buy the stock, but all
mean that you need to investigate further. Be sure to compare the
footnotes with those in the financial statements of at least one firm
that’s a close competitor, to see how aggressive your company’s
accountants are.
Read more.If you are an enterprising investor willing to put plenty
of time and energy into your portfolio, then you owe it to yourself to
learn more about financial reporting. That’s the only way to minimize
your odds of being misled by a shifty earnings statement. Three solid
books full of timely and specific examples are Martin Fridson and Fer-
nando Alvarez’s Financial Statement Analysis,Charles Mulford and
Eugene Comiskey’s The Financial Numbers Game, and Howard
Schilit’s Financial Shenanigans.^8Commentary on Chapter 12 329Exchange Commission that Informix had committed accounting fraud, the
company later restated its revenues, wiping away $244 million in such
“sales.” This case is a keen reminder of the importance of reading the fine
print with a skeptical eye. I am indebted to Martin Fridson for suggesting this
example.(^8) Martin Fridson and Fernando Alvarez, Financial Statement Analysis: A
Practitioner’s Guide(John Wiley & Sons, New York, 2002); Charles W. Mul-
ford and Eugene E. Comiskey, The Financial Numbers Game: Detecting
Creative Accounting Practices (John Wiley & Sons, New York, 2002);
Howard Schilit, Financial Shenanigans(McGraw-Hill, New York, 2002).
Benjamin Graham’s own book, The Interpretation of Financial Statements
(HarperBusiness, New York, 1998 reprint of 1937 edition), remains an
excellent brief introduction to the basic principles of earnings and expenses,
assets and liabilities.