Forensic Accounting.

Forensic Accounting.

Source – Bear Essentials by Simon Cawkwell

1. A change in accounting policy is usually bad.
2. Directors. Avoid companies whose directors have disproportionate salaries and
large expense accounts. Look for directors who have a significant equity
exposure.
3. Options. Share options should be treated as a cost. Option purchases are not tax-
deductible and dilute Shareholders’ Equity. Watch out for cancellation of existing
options and the award of new ones on more favourable terms.
4. Cash. Watch out for switching money in at year end. Check the cash over two
year-ends; if there is a lot of cash there should be a matching amount of interest;
be suspicious if the interest is not there.
5. Capitalising Costs boosts profits in the short term, flattering the P & L and the
Balance Sheet. The usual justification is that an asset is being built up, but it is not
a good practice. Check the P & L, Cashflow Statement and Notes to see if any
interest has been capitalised.
6. Goodwill Amortisation. Evil would write it off immediately to Shareholders’
Funds.
7. Depreciation over a lengthy period flatters profits. Need to check if the company
is generating enough cash to replenish its capital reserves (replace machinery etc).
8. Debt. Check out the cost of servicing debt. View Preference Shares as debt;
dividends are really interest costs. Divide Total Net Debt by Free Cash Flow to
get an idea of the number of years needed to clear the debt. Companies are in
difficulty if their long-term finance comes from an overdraft facility.
9. Exceptional Items. Check to see if they have been recurring. Usually a credit is
established on the books, which provides a pot to be drawn on; done in
acquisition accounting.
10. Tax Rates. Be suspicious of a low tax rate, which probably means that profits are
lower than stated.
11. Working Capital should move roughly in line with the growth of the business e.g.
if Turnover is up 10%, so should Working Capital.
12. Assets. Look for a strong NAV. ROCE is a key figure. Dividend Cover should be
2*.