3 ways companies bury their debt

By Michael Brush

As we watch companies blow up almost weekly after running into debt problems exacerbated by today's credit crunch, it's wise to check the health of your stocks.

Good luck.

Because of the way the bean counting works, the financial wizards inside companies can routinely:

• Hide the amount of pension money they've invested in risky debt instruments backed by subprime loans.

• Disguise long-term debt in off-balance-sheet leases.

• Bury the amount of your money they've promised to employees in the form of lavish stock options deep in annual financial reports, making it hard to find.

All of this helps make a company's performance look better than it is and makes stocks look safer and cheaper than they are.

"Companies have lots of hidden liabilities that aren't made available anywhere," says accounting expert David Trainer. You won't find them in news releases. You won't find many references to them in Wall Street analyst reports. They're tough to locate in the financial reports.

Trainer is a Sherlock Holmes among bean counters -- one who regularly roots out evidence of accounting tricks used to disguise sick companies. His research shop, New Constructs, runs a model portfolio of stocks -- picked in part on the basis of earnings-quality analysis -- that was up 17.8% from April 2006 through of the end of last year, compared with a 7.3% gain for the S&P 500 Index ($INX).

Let's be clear, though. Companies don't have to do anything illegal to disguise liabilities from shareholders. They only have to bury what's really going on deep in the fine print. That way, the big picture doesn't surface in the numbers investors find in the commonly used financial databanks. "It takes a lot of work to get to these numbers, and that's deliberate," says Trainer.

Let's take a look at some of the more common techniques and some of the bigger offenders, uncovered recently by New Constructs.

Pension time bombs?

The amount that companies are short on money needed to cover their employee pension obligations is a lot easier to figure out now that companies have to report this clearly on balance sheets.

And the shortfalls are stunning. Ford Motor (F, news, msgs), for example, was short $27.5 billion at the end of last year, more than twice the company's market value. Ford says it will reduce that to $7.5 billion by transferring health-care obligations to a labor-union trust. If the rest of the shortfall persists, the company may have to pump a lot of cash into its pension plan, rather than paying it out in dividends or investing in the company's future.

But we don't know how much worse that shortfall might get because so many debt instruments backed by subprime loans are blowing up these days as homeowners default. Ford, like all companies, isn't obligated to reveal how much of its pension investments are in those kinds of debt.

The long-term lease

Another common way to disguise debt is by keeping long-term leases on assets like store locations off the balance sheet -- which is supposed to be a company's description of all its assets and liabilities. Yes, lease payments are deducted from revenue before profits are calculated, just like rent would be. But the lifetime cost of the lease is buried in footnotes.

This bothers critics because a lease, like debt, is a long-term obligation; a retailer, for example, has to pay on a lease even a store is closed. "It is a trick created by accountants to help companies show less debt on their balance sheets," maintains Trainer.

One way this fools investors is by increasing a company's return on assets, or ROA. This popular performance yardstick is calculated dividing a company's earnings by its assets. Think of it as a measure of how well a company uses its assets to produce profits for you, the shareholder.

Ignoring a big asset such as leased property makes ROA look a lot higher. "Management should be on the hook for generating a return on all the assets, regardless of whether those assets are on or off the balance sheet," says David Zion, an accounting expert with Credit Suisse Group (CS, news, msgs).

Continued: Walgreen's ROA

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