First published in June 2021. This guide explores some of the biggest red flags hidden in annual reports. Many of the most important risks and opportunities are hidden in the footnotes or buried in legalese. This guide will hope you find what matters. This guide should be read in conjunction with Red Flag Guide Part II.
Introduction: Adventures in Revenue Targets
Pretend for a second that you are the CEO of a widget company and you know your company isn’t going to meet its revenue and earnings targets. You were once the cool new high growth company, but now revenue is stagnating.
You have a choice. You can be completely honest that business has slowed (and your stock price and options will take a hit), or…
- Certain customers make regular purchases, and a friend works at one that is scheduled to make a purchase in the next few months anyway. You call them up and ask if they can put a big order in before year-end, offering a discount to buy early.
Now stagnating revenues are next quarter’s problem. - You’ve been recording sales when customers receive items. You could change your accounting policy to instead record sales when the product is shipped from your warehouse.
Increase current period revenues without any changes to actual sales. - You can make up fake customers and ship products to secret warehouses to trick your auditors.
This is plain old fraud.
You can meet your targets without actually fixing the issues with the business. You have a few ways you can do this without actually committing fraud (along-side some fraudulent ones). The numbers will look fine. However there will be signals in the disclosures: in related party transactions, accounting policy changes, or internal control issues. But who reads those anyway?
We believe in corporate accountability through information transparency. We believe reading and understanding disclosures is imperative to holding companies accountable.
Welcome to our guide.
The Hudson Labs Red Flag Guide (Part I)
- Transactions and Accounting policy -
Related parties
Related parties are people or organizations that are affiliated with the corporation or management team in some way. For instance, a company controlled by the husband of the CEO would be considered to be a related party.
Because related parties have different motivations, related party transactions should be viewed with skepticism.
Related party transactions can and are used to facilitate a multitude of corporate misdeeds from booking sham revenue transactions (Luckin Coffee) to enriching the management team at the expense of shareholders (InfoUSA). Strange and/or significant related party transactions should be reviewed in detail.
CLNN is a recent SPAC graduate. In their first quarter of 2021 they had about $0.2M in revenues, all from related parties. They paid related parties about $0.2M as a cost of product. It’s not clear why they needed to be involved in the transaction.
CLNN | 10-Q | March 2021 “Product revenue of $0.2 million and $70 thousand was recognized in our dietary supplement segment under a supply agreement with 4Life Research, LLC, a related party, for KHC46 and a low dose zinc-silver solution, two dietary (mineral) supplements that we began supplying during those periods.”
CLNN | 10-Q | March 2021 “We incurred cost of sales of $0.2 million and $58 thousand for the three months ended March 31, 2021 and 2020, respectively, relating to production and distribution costs for the sales of our KHC46 and low dose zinc-silver solution dietary supplement products through supply agreements we have entered into with a related party.”
Accounting policy
Accounting requirements are more flexible than most people realize.
Even where there are specific rules, a company may have a choice between accounting treatments, implementation methods, or even a choice of early adoption. Many areas rely on estimates, and estimates involve significant management judgment. The management judgment involved in accounting decisions makes it challenging to evaluate and compare corporate entities. However all is not lost, there is signal in choice. Companies that choose more aggressive accounting policies are also more likely to be more aggressive in managing their earnings.
Accounting policy changes should be regarded with skepticism unless there has been a fundamental change in the underlying business. Watch out for companies that cherry pick accounting policies after a merger or acquisition.
Changes in estimates: Instead of changing an accounting policy, management can manage their earnings by making seemingly minor changes to the assumptions underlying their estimates. For instance, instead of booking a pension expense, a company can simply assume that their pension assets will accrue greater returns in the future. Problem solved.
Areas of accounting that involve significant management judgment: Valuation of intangible assets, when to stop/start capitalizing expenses (e.g. R&D, mine development, software development), tax valuation allowances, reserves, provisions and allowances of all types, impairment decisions, pension accounting, acquisition accounting etc.
This interesting change in estimate was extracted by our Bedrock AI algorithms:
BOMN | 10-K | 2020 “Amortization expense decreased by 61.9% from fiscal 2019 to fiscal 2020 as we extended the amortization period from three years to ten years to better reflect the estimated economic lives of our customer relationships within our billboard segment.”
Boston Omaha (BOMN) is saying that they expect a new billboard customer to still be a customer 10 years from now, when previously this was 3 years. Even if you accept 10 years as reasonable, you should question what changed in 2020 to make them expect customers to stick around for an additional 7 years.
- Audits and Internal controls -
Audit opinion
Look out for qualified and adverse opinions from auditors on both the internal controls and the financial statements. Be aware of whether or not the auditor is required to give an opinion on the internal controls over financial reporting.
Internal controls
Internal controls over financial reporting (ICOFR) are the checks and balances put in place to ensure financial information is recorded completely and accurately. ICOFR not functioning properly means more opportunities for errors or intentional manipulation of earnings. Strong or weak ICOFR may reflect the attitudes of management towards the importance of transparency and compliance.
If the auditors discover a material weakness in internal controls, it’s a bad sign. Adverse internal control opinions are often the result of an auditor discovering an error or omission in the financial statements, which, if not caught by them, would not have been corrected in the company’s financial statements. A strong management team and strong accounting department should be able to catch their own errors.
Companies with material weaknesses in internal controls need to disclose the issues that arose.
Some material weaknesses in internal controls extracted by our algorithms:
AHCO | 10-K | 2020 “[W]e lacked a sufficient number of professionals with an appropriate level of accounting knowledge, training, and experience to appropriately analyze, record and disclose accounting matters timely and accurately.”
EBIX | 10-K | 2020 “Specifically, management did not design or implement the necessary procedures and controls over the gift or prepaid card revenue transaction cycle sufficient to prevent or detect a material misstatement.”
Management teams are required to assess whether ICOFR is operating effectively at their company and disclose their conclusion in the 10-K. Many U.S. companies are also required to get an audit of ICOFR from their auditor who will also provide a formal opinion. In certain circumstances an auditor will not be required to provide an opinion on internal controls. In these cases the only information is management’s assessment of their own controls. Like a student grading their own exams, results should be approached with a higher level of skepticism. It is not uncommon for auditors to find internal control issues the first time they are required to provide an opinion, even where management has given themselves a positive assessment in prior years.
- Governance, Executive Team, and Resignations -
Resignations & dismissals
Companies that commit fraud or engage in other shady dealings often have high turnover in their executive ranks. Most people are afraid of going to jail which makes fraud stressful. Famously, Jeffrey Skilling left Enron just before the company’s dramatic collapse.
Turnover in the company’s external auditor may also be a red flag. Some companies rotate auditors regularly, but irregular changes are often preempted by other issues. Watch for companies changing their auditors after the auditor issues a qualified or adverse opinion. Another red-flag is auditors resigning. There may be some innocuous explanation (perhaps a recent acquisition created an independence issue), but typically auditors don’t give up recurring revenues without a reason to do so.
EBIX | 10-K | 2020 “On February 15, 2021, RSM told the Chairman of the Company’s Audit Committee during a telephone call that RSM was resigning as the Company’s independent registered public accounting firm, effective immediately.”
“RSM then advised the Chairman on the call that it was resigning as a result of being unable, despite repeated inquiries, to obtain sufficient appropriate audit evidence that would allow it to evaluate the business purpose of significant unusual transactions that occurred in the fourth quarter of 2020, including whether such transactions have been properly accounted for and disclosed in the financial statements subject to the Audit.”
In this case, Ebix’s auditors resigned mid-audit citing an inability to complete their audit and issue an audit opinion. Most signals are more subtle.
Governance
If you want to understand a company’s governance structure, their proxy circular is the best source. But some key governance risks are included in 10-K filings.
Companies should have strong oversight and accountability at the board level. A strong, independent board can act as a check on an aggressive management team. Here are a few things that are indicative of a strong governance structure:
- Separation between the role of CEO and the Chair of the board
- The board members are majority independent
- The audit committee exists, consists of independent directors and boasts one or more financial experts
- Related party transactions outside the corporate group are rare and when they do happen they have strong economic substance
If a few minority shareholders or members of the management team control the company through a majority of voting shares, it is less likely that the board will be able to hold management to account. Controlling shareholders may not always have your best interests in mind.
Th lawsuit surrounding Tesla’s 2016 purchase of SolarCity provides an interesting look into governance. Shareholders have alleged that Tesla overpaid for the Company, squandering company assets and unjustly enriching Elon Musk as the majority owner of SolarCity. One issue in the case is whether Musk was able to influence Tesla’s other board members in their acquisition decision. This case is still ongoing.
Corporate perks
Corporate perks are associated with bad actors. Filings that were later the subject of SEC investigat
GOEV | 10-K | 2020 “The total aircraft reimbursement to Mr. Aquila for the use of an aircraft owned by Aquila Family Ventures, LLC (“AFV”), an entity controlled by Mr. Aquila, for the purposes related to the business of the Company for year ended December 31, 2020 was $541,000”
Canoo Inc went public via SPAC in December 2020, and has been reimbursing their Executive Chairman and CEO for use of aircraft owned by their family business. In April 2021, the SEC announced an investigation into the company, confirming the trend.
Read more at Annual Report (10-K) Red Flag Guide: Part II
