It is hard to say exactly when the topic of financial warnings initially captured our interest and began to consume our attention. Certainly by the time the last recession was painfully present, it was very much in our consciousness. Leading up to that difficult time in 1991, and continuing thereafter to the present, certain corporate acts, such as the recording of restructuring charges and asset write-offs, the accrual of unrecorded liabilities, and earnings restatements for accounting irregularities or inflated profits, have been an all too familiar occurrence. Moreover, rather than slowing with better economic times, their pace is accelerating as more and more companies announce special charges for restructurings, asset write-offs and liability accruals. These special charges and restatements are taken in response to circumstances that often have been unanticipated and have led to unexpected reductions in corporate earnings and forecast cash flow. Affecting lenders and equity investors, unexpected reductions in corporate earnings and forecast cash flow can be linked to reduced debt-service capacity and lower share prices.
As we took notice of these earnings surprises, so did the bankers across the country with whom we worked. Striving to stay on top of debt-service capacity, the pervading question among them was - how could we have anticipated these surprises? It is in search of an answer to that question that brought this book to life.
Financial Warnings identifies the financial characteristics of firms that typically precede such special charges and restatements, helping the informed financial statement reader anticipate their occurrence and their accompanying negative earnings surprise. We developed these characteristics from two primary sources. The first was through the examination of the financial statements and footnotes of firms reporting earnings surprises in the years preceding and leading up to those surprises. We looked for financial statement clues that helped to indicate that something was amiss. Some of the clues that we found to be effective, measures such as a declining gross margin, or a lengthy collection period for accounts receivable, are commonly used by lenders and equity investors. Our experience indicates that others are less popular. For example, the company??s revenue recognition policy, its capitalization policy for costs incurred, or its reported investments in property and equipment relative to the level of sales, are less commonly employed and can be useful in anticipating earnings surprises. The second source involved in-person questioning of a large cross-section of experienced lenders. We wanted to learn from persons whom have been surprised by earnings developments what they consider to be clues of those problems. These lenders provided us with many useful insights and complemented well our early warnings developed from the financial statements and footnotes. We did not, however, limit our research to earnings surprises from a lender??s viewpoint. Also included in our work were developments that posed surprises for equity analysts in their forecasts of earnings per share.
Thus, we wrote Financial Warnings for both lenders and equity investors. Both groups rely on financial statements to formulate earnings and cash flow expectations as part of their decision processes. By raising their awareness to the financial characteristics that often precede earnings surprises, more timely and profitable action can be taken.
It is our belief that the targeted reader will not only find the book to be interesting and informative reading, but also a useful reference source. To this end, checklists designed to focus attention on developing problems are provided as exhibits in several of the chapters. In addition, a sustainable earnings worksheet is provided and its use is demonstrated to help the reader uncover nonrecurring items of income and expense and derive an earnings base from which to begin formulation of an accurate earnings forecast. Finally, a collection of key accounting guidelines providing background that some readers may be missing is provided in an appendix.
We strongly believe that Financial Warnings will provide serious help for those who rely on financial statements and footnote disclosures in their decision making.