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Mind The GAAP- How to Avoid Financial Shenanigans

By Linda McDonough on May 24, 2017

Investing is a tough business. There are hundreds of trends to keep track of, numbers to analyze and assumptions to make.

With so many uncertain data points, most investors take solace in SEC mandated GAAP financial standards and the auditors that sign off on them. Yet the news this week that employees at solar company Sunrun (NSDQ: RUN) were encouraged to delay booking contract cancellations to boost the company’s revenue before its IPO illustrates the level of cynicism required to be an intelligent investor.

Sunrun went public in August 2015, fairly late in the solar cycle. As with most solar companies at the time, Sunrun was unprofitable so investors focused on revenue growth and the number of megawatts “booked”, a metric highlighted by Sunrun management. If the growth in megawatts booked was less than presented in the company’s prospectus, investors might have hesitated to pay the proposed IPO price.

The SEC is investigating claims by Sunrun employees that they were instructed by superiors to delay booking cancellations. Sunrun reports net sales in its financial reports, so the effect of delaying cancellations would be a boost to revenue and megawatts growth.

Employees claim that the booking of almost 200 cancellations was delayed in the six month period leading into the IPO. Once the deal was priced, employees were supposedly told to enter the cancellations in “a slow drip” so as not to cause a dramatic jump in the cancellation rate.

While I recommend long and short ideas in my Profit Catalyst Alert service, the bulk of my 27 years as a stock analyst have been spent researching short ideas. Bearish analysts love nothing more than footnotes and the dissection of numbers that produce the final results in financial statements. This is a critical skill in finding stocks that are doomed to fall.

Just because the SEC or an auditor has signed off on a company’s financials does not ensure the absence of shenanigans. The perusal of any SEC document illustrates the weight that corporate assumptions have in determining reported numbers.

Investors need to be aware of any non-GAAP metric or one that includes significant assumptions by management.  Booked revenue, also known as backlog, is a quagmire of swampy assumptions. Although the SEC has fairly clear and strict standards for revenue recognition, there are few guidelines for backlog, which is a non-GAAP term.

The determination of when an order is considered booked or part of backlog varies from company to company. The CRO industry, which provides outsourced research services for drug and biotech companies, recently tightened its definition of backlog.

Prior definitions were pretty lax. An indication of interest in a contract could be considered part of backlog. As with any non-GAAP metric, policies for backlog inclusion differed from company to company. Due to pressure from shareholders and peers, the CRO industry is shifting towards a more consistent and conservative standard, a good thing for investors.

Shady players who once booked backlog on a handshake must now wait until a signed contract is in hand. Sunrun’s issue dealt with the assumptions behind what qualified as a cancellation. CEO Lynn Jurich responded to the allegations with this description of its policy,

“There is some judgment in determining when an installation might not proceed- my direction to employees is to make these calls with integrity and always focused on the customer.”

This policy is clear as mud. As an analyst, I’d steer clear of any company who leaves wiggle room for determining when a cancellation is valid or not up to its sales team, who is likely getting paid commission on closed contracts.

The bottom line for investors is to read financial statements with a critical eye and to avoid companies whose GAAP and non-GAAP numbers differ dramatically. It takes some time, but I’m especially fond of looking for companies where the gap between GAAP and non-GAAP numbers is widening. These companies can be great short candidates.

Although the SEC is attempting to crack down on non-GAAP abusers, aggressive companies will always be pushing the envelope, especially when the GAAP numbers don’t tell the story they’d like.

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