Red flags that can warn of shaky books

By Harry Domash

These days, investors have plenty of reasons not to trust Wall Street. So it's good to know that you can learn a lot about the quality of management by taking a quick look at the books.

No, the reports won't list things like "sank billions into risky mortgage assets." But you can still gain insights into the quality of management by looking at just a couple of easily found numbers.

Many market pros consider clean and straightforward accounting a hallmark of good management. For them, repeated nonrecurring and extraordinary charges are red flags that can signal questionable accounting practices -- warning signs that should be checked out.

The reason some corporate executives like nonrecurring expenses is that the company's number crunchers don't have to count them when they tabulate pro forma earnings. And those earnings figures are the ones pundits use to determine whether a company met, beat or fell short of forecasts. Analysts also use them to gauge a company's future prospects. The more expenses that can be defined as nonrecurring, the higher the reported pro forma earnings. Of course, that often translates to a higher stock price.

There's nothing wrong with pro forma earnings when used appropriately, such as to present the results of recently merged companies as if they had always been a single company or to exclude the effects of one-time events such as income tax refunds or legal expenses.

The problem comes in when managers use nonrecurring charges inappropriately and repeatedly to boost pro forma earnings. Unfortunately, analysts often accept managers' definitions of what's appropriate without questioning them. Investors thus end up relying on numbers a company may not be able to deliver.

What to watch for

It's easy to spot nonrecurring charges because MSN Money lists them separately on each company's income statement. (You can find the statement for Microsoft, which owns MSN Money, here. Just change the ticker symbol in the URL to see other companies.)

Microsoft groups most nonrecurring items on the line labeled Unusual Expense (Income). However, it lists some one-time items as Total Extraordinary Items. So you have to add the Unusual Expense (Income) and Total Extraordinary Items figures to get the total nonrecurring figure for each reporting period.

That total, by itself, doesn't mean much. What's significant for a small company wouldn't move the needle for a larger company. Thus, you have to express the nonrecurring figures as a percentage of something reflecting the company's size -- and hopefully, something found on the same income statement, so you can do it quickly.

The right numbers to track

I tried using earnings, but that didn't work because those numbers are too volatile. Revenues (i.e., sales), which we hope are growing, are more consistent than earnings. Consequently, I compared nonrecurring expenses with total revenue, which is also shown on the income statement. You could use the quarterly figures, but I've found that annual numbers work best.

To get the numbers for nonrecurring charges as a percentage of sales, first add the unusual and total extraordinary expenses together. Then divide that total by revenue and express the result as a percentage. For example, the result would be 10% if a company recorded revenue of $1,000 and listed nonrecurring charges totaling $100 (that's 100 divided by 1,000).

Continued: Examining expenses

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