How To Profit From Accounting Shenanigans -- Legally

StreetAuthority Network

When it comes to quarterly results, too many companies try to game the system.

They tell analysts what they expect to earn in the quarter, and then magically meet or exceed earnings per share (EPS) forecasts every time. Do they have a crystal ball at the start of the quarter and know how results will turn out? Nope. 

They simply make a series of accounting adjustments -- a booked order turned into a sale here, an expense deferred there -- and are able to come up with whatever net income figure they like. (Here are some examples of financial trickery.)

Of course, such accounting shenanigans can come back to bite them. You can only manipulate the books for so long until your balance sheet, income statement and cash flow statement become harder to reconcile. Eventually, these companies will have to deliver more realistic financial figures, usually after management has had a chance to cash out of their stock options.

Nobody's forcing you to own such companies. In fact, a pair of exchange-traded funds (ETFs) can help you avoid them -- and since accounting tricks never going out of style, these funds are worth a closer look.

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The Forensic Accounting ETF (Nasdaq: FLAG) was developed by John Del Vecchio, a forensic accountant who co-wrote a book on the subject. Del Vecchio established a set of criteria that helped establish which companies adhere to conservative accounting practices. The ETF provides a strong weighting to companies with the best practices and shuns companies that play fast and loose with the numbers. (As with any ETF, I encourage you to read the fund's fact sheet and any other relevant materials.)

To be sure, this conservative approach hasn't yet shown its mettle in an ever-rising bull market. Since it was launched in early 2013, it has risen 27% while the S&P 500 is up 35% in that time. Presumably, the real proof of this approach will be borne out when the rising market is no longer lifting all boats and companies with the best accounting practices are in greater focus than some of today's riskier high-fliers.

As is the case with some new ETFs, this ETF has yet to build up a meaningful asset base: Only $16 million is being managed right now, according to Morningstar. And that is leading to still-weak daily trading volumes. Still, this is an ETF that more investors should know about, and I hope it succeeds.

The Vident Core US Equity ETF (Nasdaq: VUSE) is a similar earnings-quality-focused ETF, but it has clearly resonated more with investors. It has been around less than six months and already has more than $100 million in assets under management (AUM) and trades more than 100,000 shares on certain days -- a key liquidity threshold. Though the fund owns some large company stocks, two-thirds of the portfolio is invested in companies that qualify as small and mid caps ($500 million to $10 billion in market value).

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This ETF is focused on companies with conservative accounting practices and good governance measures, such as reasonable -- not excessive -- executive compensation. Since its launch in early 2014, the fund is merely keeping pace with the S&P 500, rising about 5%. As is the case with the Forensic Accounting ETF, a focus on earnings quality should portend a smoother path to upside over the long haul, as potential stock blow-ups are unlikely to appear in these portfolios.

In terms of costs, the Vident fund gets a slight edge with a 0.55% expense ratio, while the FLAG ETF carries a more onerous 0.85% expense ratio (which will presumably come down as AUM grows).

Risks to Consider: The biggest risk for these ETFs is that they tend to eschew the kind of fast-growing, high-risk stocks that tend to outperform in this kind of market. Controversial printing firm 3D Systems (NYSE: DDD), for example, has been subject to many concerns about its accounting practices, yet its shares are up 2,000% over the past five years. So these ETFs hold greater appeal for more conservative investors.

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Action to Take --> Both of these funds hold great appeal, but the nod goes to the Vident Core US Equity ETF, simply because it sees higher trading volumes (and resulting smaller bid/ask spreads) and also carries a lower expense ratio.

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