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Four common 10-K red flags

March 23, 2017

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Don't miss these red flags when read a company's financial reports. ("Red Flags" image by Rutger van Waveren via flickr, CC BY-SA 2.0)
Don't miss these red flags when read a company's financial reports. ("Red Flags" image by Rutger van Waveren via flickr, CC BY-SA 2.0)

Public companies have many ways of making themselves look more stable and successful than might be the case. Pro-forma financial reports are one tactic that present a challenge to reporters. These reports often include metrics and presentations that don’t adhere to generally accepted accounting principles (GAAP), the gold-standard for interpreting financial results.

Pro-forma metrics aren’t the only way executives can distract from the real conditions of their companies. Here are some other common methods used in a company’s 10-K filing with the SEC.

Underfunding pensions

Many companies have completely dropped offering traditional defined-benefit pension plans in which employees are guaranteed a future return. The plans are expensive to fund and must stay updated for an aging work force. Those that still have them carry a significant burden on the balance sheet that requires constant financial feeding.

If there is a shortfall in the fund, the company will have to document it in a footnote of its annual 10-K report. The business might assume the pension fund will grow faster than use assumptions as a rationale to minimize how much it needs to contribute. The company could overestimate what return the plan investments will see. If they’re much above the commonly quoted long-term 7 percent investment return on stocks, the estimate may be unrealistic. Another way is to optimistically choose the so-called discount rate, a growth factor that assumes how much a dollar today will be worth at some point in the future. Either approach reduces the amount of money needed to be invested today to cover the pension’s future costs.

Reducing capital investment

Capital equipment loses value over time through the accounting procedure of depreciation. Accountants do this because those investments will eventually need replacement and so effectively are worth less. If a company begins to drop its rate of capital investment but there is no corresponding change in operations, like closing facilities, they may be trying to improve the picture in the short run. Check the balance sheet for the percentage of total assets that property, plant and equipment represent. If the number suddenly begins to drop, there is a good chance that capital investment has been cut. On the other hand, if the amount starts increasing, it might indicate that the company is treating maintenance costs as capital investment.

Cutting R&D spending

Research and development spending doesn’t necessarily translate proportionately into innovation and improved competition, but if a company keeps cutting the amounts it puts into R&D (whether in absolute dollars or as a percentage of revenue), it’s a warning sign that something might be up.

Pumping revenue

When you see brisk company sales but reports of sales of products through retailers and resellers (known as sell-through) doesn’t increase accordingly, the company may be pushing its business partners to take more product than they really need. The tactic is called channel stuffing. One sign is to calculate days sales outstanding (DSO), a measure of how long it takes to collect for products sold on credit. You could also see if accounts receivable growth is higher than sales growth over the period.

Reporter’s Takeaway

• The method public companies most commonly use to obscure bad news is a pro-forma financial report. But even the 10-K report filed with the SEC has places to hide underperformance.

• Underfunded pensions as well as a drop in the percentage of total assets that PP+E represent should raise a reporter’s antennae.

• A cut in R+D spending, as well as the tactic of channel stuffing are other red flags.

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