Leases as Liabilities

• An understanding of accounting may prove critical for an analyst when, for example, considering the underlying value of a company that leases its land, buildings or equipment.
  
  He will want to ask himself whether the company treats these as "capital" or as "operating" leases. Operating leases are generally kept off-balance sheet; for example, rent is not treated as a liability. An analyst who is not aware of this may overvalue the company.
  
  As reporter Rob Roberts observed in a story in the "Kansas City Business Journal" in July 2010, lessees employ operating-lease treatment because they believe it maximizes "their borrowing capacity by minimizing balance-sheet liabilities."
  
  

Sales Figures

• Another accounting issue of importance to an analyst: sales figures. A company that complies with Generally Accepted Accounting Principles will account for that percentage of its product that is returned pursuant to a refund policy.
  
  On the company's income statement, returns should not be treated as a debit to sales, but rather as a contra-revenue account. Increases in this account over time can suggest important problems. Jerry Weygandt, in "Financial Accounting," lists them as: "inferior merchandise, inefficiencies in filling orders, errors in billing customers, or delivery or shipment mistakes."
  
  

Channel Stuffing

• In the extreme, sales figures can be fraudulently inflated through "channel stuffing," a scheme in which a manufacturer offers distributors or retailers special incentives for purchasing more goods than they need within a particular year or quarter. (The recipients may return these goods in the next quarter, but in the meantime the earlier quarter's results have been successfully inflated.)
  
  In 2001, the Securities and Exchange Commission alleged that channel stuffing had been the means by which Chief Executive Officer Al Dunlap produced an apparently miraculous turnaround at the appliance maker Sunbeam. In September 2002, Dunlap settled with the SEC. Although he did not admit guilt, he paid a $500,000 fine and agreed that he would never again serve as officer or director of a public company.
  
  

Expert Insight

• Accounting chicanery is not always blatant. It can be quite subtle, so financial analysts will have to keep on their toes to keep up. "The difference between channel stuffing and fancier methods of prematurely recognizing revenue is one of degree, not of kind. At bottom, most revenue-recognition games are variations on a few simple themes," according to Harris Collingwood, David Sherman and David Young, "Revenue Recognition: What is a Sale, and When Do You Book It?" in "FT Press" (2003).