Beware Of Creative Accounting: The Bankruptcy Watch List
By Eben Esterhuizen, CFA: Contrary to popular belief, financial accounting is not an exact science; rather, it's something more like educated guesswork. Inputs to an income statement or balance sheet are often just estimates, and not hard and fast quantities--which means that there's always the opportunity for selective interpretation by company management. Thankfully, most companies don't abuse this latitude--but beware of the few that do.
Over the years, accounting wizards have developed novel ways to put a positive spin on financial statements, by changing the way income, assets and liabilities are characterized. These practices, called "Creative Accounting," have led to several high-profile corporate collapses, among them Enron, Worldcom and Global Crossing, to name just a few.
As a result, several companies have arisen that specialize in detecting accounting manipulation. These firms employ hundreds of forensic accountants to dig through SEC filings, and use statistical analysis to identify red flags in financial statements.
One of those firms is Audit Integrity, a Los Angeles based firm founded in 2002.
The company takes a fine tooth comb to corporate behavior in order to ferret out the inconsistencies, identifying patterns in governance and accounting practice that culminate in negative events such as SEC enforcement action, litigation, fraud, and earnings restatements.
After looking at hundreds of indictments and examining thousands of combinations of factors, a pattern emerged--it appeared that corporate integrity could, in fact, be quantified in a statistical model.
To summarize the results of this model, they developed the Accounting and Governance Risk rating (AGR) system.
Recently, Audit Integrity released a bankruptcy watch list--a group of companies that run the greatest risk from financial distress, according to the AGR system.
"The highest risk companies from a bankruptcy standpoint have about a 10% to 15% chance of going bankrupt, based on our current ratings," explained Jack Zwingli, the company's chief executive. "This is the intent of the Risk List--to identify companies that have the greatest risk to investors and other stakeholders based on weakened financial condition."
Wondering which stocks you might want to avoid? Here are few highlights from the list, compiled by Audit Integrity.The complete list can be accessed here.
1. Ambassadors International (AMIE): According to Audit Integrity's model, there is a 16.8% probability that the company might go bankrupt over the next year. They cite the company's aggressive accounting practices.2. RHI Entertainment (RHIE): RHI is an entertainment company that have seen a significant price drop over recent weeks. Audit Integrity ranks the company in the lowest 1% of all the stocks in their research universe.
3. Arise Technologies Corporation (APV): Audit Integrity's bankruptcy model projects a 15.3% probability of bankruptcy. The company is involved in the semiconductor industry.
4. Jackson Hewitt Tax Service Inc. (JTX): The tax preparation company has a 13.7% probability of bankruptcy, according to the list.
5. YRC Worldwide (YRCW): The company's aggressive accounting policies place them in the bottom 7% of all companies tracked by Audit Integrity.
Other notable companies in the list, with their associated bankruptcy probability:
6. NexCen Brands (NEXC): 9.1%
7. Cell Therapeutics (CTIC): 7.1%
8. Eastman Kodak (EK): 5.7%
9. Evergreen Solar (ESLR): 5.6%
10. Genta Inc. (GETA): 5.4%
Disclosure: At time of writing, Eben Esterhuizen did not own any of the securities mentioned above.
(Edited by Alicia Sellitti)
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