How Audit Taught Me to Be a Better Investor #investorrelations #audit #capitalmarkets #steverubis
Published 2024-04-03
Capital Markets / Investor Relations in Two Minutes or Less
How ACCY 504 – Audit Taught Me to Be a Better Investor
ACCY 504 is the auditing class taught by Professors Mark Peecher and Angel Chatterton in the University of Illinois Masters of Accounting program.
Taking an auditing class will make anyone a better investor.
Investors dread accounting scandals because they usually land as a surprise.
We do not have the time or competency to ferret out an accounting scandal.
An audit class, and basic accounting, uncover some simple tools for a strong defense when you find yourself owning a stock with an accounting issue.
Three Key Tools of Defense
1. Accounting Standards Codification (ASC) Standards, and
2. Audit Risk Model, and
3. Non-GAAP Adjustments and Reconciliations
ASC Standards
Accountants always justify the accounting treatments applied in a given situation. The process involves researching the ASC standards database created by FASB. These are detailed memos that explain and offer support as to why a company does X or Y in an accounting situation.
Audit Risk Model
Audit risk represents a function of Risk of Material Misstatement (RMM) and Detection Risk. The variable RMM is a combination of Inherent Risk and Control Risk.
Management teams are responsible for Inherent and Control risk, or RMM. In most cases, the management team has solid internal controls and likely significant amounts of ASC memos justifying given accounting treatments.
The Auditor is responsible for Detection Risk. Auditors undertake detailed statistical sampling plans to mitigate the risk of a material misstatement. If the auditor is calling out Critical Audit Matters (CAMs) in the 10-K it is hard to argue they messed up their Tolerable Deviation Rate (TDR) and missed something nefarious.
Non-GAAP Reconciliations and Adjustments
Simply put, do the add-backs actually flow through the financial statements.
A Comparative Example $EQIX versus $CANO
Equinix Issue: CAPEX classification and AFFO.
In my mind, $EQIX is a large enough entity and CAPEX represents a material amount that significant ASC memo justification exists to support the classification.
Cano Health Issue: De Novo Losses
The problem for $CANO involved de novo losses, which seemed to be arbitrarily added back to adjusted EBITDA. Even the definition of de novo losses suggested it was a peculiar add-back, and did not flow through the financial statements.
Key Learnings
ASC provides validation for accounting treatments
Auditors can drive statistical accuracy
Look at Non-GAAP Adjustments!