Unfortunately, corporate malfeasance never goes away, and the next big accounting crisis could strike at any time. The number of ways a company can deceive investors––and its own auditors––could fill up a book. That’s why forensic accountant John Del Vecchio wrote “What’s Behind the Numbers? A Guide to Exposing Financial Chicanery and Avoiding Huge Losses in Your Portfolio,” which was named the number one investment book for 2013 by Stock Trader's Almanac
To help investors avoid accounting shenanigans, he developed the Del Vecchio Earnings Quality Index that underpins the Forensic Accounting ETF (FLAG). The passively managed fund, which launched early this year, bills itself as an investment vehicle where the science of accounting meets the art of investing. Del Vecchio screens 500 large-cap U.S. stocks and does forensic accounting analysis focused on areas including revenue recognition practices, inventory management, material changes to operating expenses or income, and financial ratio adjustments, among others.
He grades those companies quarterly on a sliding scale from “A” to “F.” Companies ranking highest in earnings quality get an “A” grade, while companies that are loose with the numbers and have the lowest earnings quality receive an “F.”
Companies graded “A” comprise 40 percent of the index, while the “B,” “C” and “D” categories each comprise 20 percent of the index. Companies graded “F” are excluded from the index.
Why would he include companies that barely get a passing grade? “If you focus too much on companies with the top grades, you may end up with a portfolio that is skewed heavily towards a particular industry or sector, and we’re trying to avoid the risk of owning an out-of-favor group,” Del Vecchio says.
Parsing The Numbers
Del Vecchio uses a proprietary process to grade each company, and the exact grade––and companies that get them––aren’t divulged. But he cites a few items that all forensic accountants focus upon. “Most of the problems you’ll find are higher up on the income statement,” he says. “There’s a lot more manipulation there.”
For example, some companies overstate revenues by shipping goods to distributors and then counting them as final sales (even if the distributor has the right to return unsold goods). Del Vecchio also notes that companies can underestimate expenses by categorizing them as capital costs.
As far as Del Vecchio is concerned, the problems often stem from the vague wording and lackadaisical enforcement of accounting rules. “Companies can use GAAP (Generally Accepted Accounting Principles) to their advantage without formally breaking any laws,” he says.
To catch them in the act, Del Vecchio looks for changes in areas such as deferred revenue or accounts receivable, and he notes that a sudden drop in backlog or a quick spike in receivables is often a sign that a company has pushed the envelope to meet quarterly targets.