Magic Tricks on the Corporate Books

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More companies may run into problems. An Audit Integrity report found that of the 5,514 companies with a market value of more than $100 million, 668 have goodwill assets above the 20% mark. The list includes such debt-burdened businesses as Virgin Media (VMED) and TicketMaster Entertainment (TKTM). Both declined to comment.

Accrual Accounting

Another warning sign may be a growing pile of "accrued" assets. In so-called accrual accounting, companies recognize a sale or expense when the transaction is made rather than when the cash is exchanged. As a result, cash flows and profits don't always match up. "If it's not cash, there's a high level of uncertainty and subjectivity," says Brent Miller, a forensic analyst at Gradient Analytics.

The concern is that companies are dressing up results by using these tactics. Take Amazon.com (AMZN). Its mainstay business of selling books, DVDs, and CDs was flat in the second quarter. But cash flow looked healthy. (Amazon was set to report third-quarter earnings after BusinessWeek went to press.)

Why weren't profits and cash flow in sync? Some analysts speculate that Amazon may be managing its accounts payable, the money it owes suppliers. Analyst Jeffrey B. Middleswart of Behind the Numbers, a research firm for short-sellers, figures that accounts payable amount to 195% of Amazon's inventory—meaning the company is selling the goods to customers long before it pays suppliers. As of the second quarter, Amazon was taking 65 days to pay bills, vs. 58 at the start of the year. Says Colin W. Gillis of research firm Brigantine Advisors: "They make money on the backs of suppliers."

Such moves, Middleswart estimates, accounted for 70% of Amazon's cash flow in the most recent 12 months. "Think of this as a rubber band being stretched," he says. "[The company] cannot maintain the situation." Eventually the company has to pay up, which could crimp cash flow. One analyst said Amazon doesn't have any accounting problems, and "there's some aggressive shorts out there who want to knock it down." Amazon declined to comment.

"Doubtful" Revenues

On the flip side, some companies may be too optimistic about their delinquent customers. Managers classify those accounts receivables as "doubtful" if they think they won't get paid. They then take a related loss to build reserves. But analysts say some companies are pushing off the day of reckoning by extending the number of days the accounts are considered current.

First Solar (FSLR), an energy equipment manufacturer, may be among those doing so. Roughly one-fifth of its clients are renegotiating contracts to get lower prices, says Middleswart. But First Solar doesn't seem to be recording those accounts as doubtful. The company didn't set aside any reserves for the contracts until the second quarter, when it took a tiny $7 million charge related to accounts receivables. "There is not that much transparency about how they book revenues," says analyst Ben Pang of research firm Caris & Co. "We're concerned if [First Solar] is making the pricing look better near term." First Solar declined to comment.

Pundits can't decide whether the recession is prompting such games or whether these are longtime transgressions just coming to light during tough times. Either way, the problems raise questions about the quality of corporate profits—a situation regulators likely will watch closely. "One of the things people misunderstand is that manipulating accounts doesn't have to be complicated," says Toby J.F. Bishop, director of the Deloitte Forensic Center, an arm of the accounting firm. "It can be done simply with the stroke of a pen."

Der Hovanesian is Banking editor for BusinessWeek in New York.

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