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The startling revelation in the recent Congressional hearings on the Bear Stearns situation was not simply that the SEC and its Chairman Christopher Cox failed to foresee the impending failure of Bear Stearns.

Rather, the remarkable news was that at all times leading up to its failure, Bear Stearns was in compliance with each of the following regulatory rules:

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  • It had adequate liquidity in the sense of having full-faith-and-credit (FFC) government securities, and similar assets, sufficient to cover all customers’ accounts;
  • It had adequate liquidity by maturity to cover customers’ accounts for one year assuming an inability to borrow new funds on the general credit of the firm;
  • It would have met the standards to be rated “well-capitalized” under Basel I rules if it were classified as a bank.

In other words, the customers of Bear Stearns seemed to be exposed to minimal risks of being wiped out. It would be difficult not to conclude that the Fed’s intervention in the sale of Bear Stearns to J.P. Morgan Chase was intended to secure non-customer interests of Bear Stearns – its general creditors and derivatives counterparties.

Bear Stearns’ shareholders were nearly wiped out and taxpayers could be on the hook for billions if the deal turns sour. Is there anything investors or interested citizens could look for to anticipate similar trouble in the future?

Only the vigilance of a company’s auditors can protect stockholders from outright fraud on the part of management (such as phantom assets or unreported liabilities). Yet even where revenues and expenses are stated accurately and assets are fairly valued, a company’s financial results can vary greatly. This is because there is considerable flexibility in applying Generally Accepted Accounting Principles (GAAP) to a company’s books, as certified by the auditors. These variations generally reflect the “spin” that management wants to give its reports.

There may be accounting decisions that boost earnings or inflate assets too subtle for outside investors to detect, but some of the most common ways of “stretching things” can be determined with only a little digging in a company’s financial statements. These include:

Re-statements and Extraordinary Items:

“pro forma” earnings statements that exclude losses from “discontinued operations” or the segregation of extraordinary items (especially losses) may be appropriate at the time of a major merger or corporate re-organization. But when they are a regular feature of a company’s reports, such reports are questionable.

Change in Accounting Methods:

if a company switches to straight line from accelerated depreciation, lengthens the time over which assets are written off, or decreases its reserve accounts (for bad debts, say), earnings and asset values may be artificially boosted.

Deferred Taxes:

because of various tax incentives built into the tax code, income subject to corporate taxes is generally less than that reported under GAAP—most companies show deferred income taxes as a liability. If this item is stable, or decreasing, when a company is reporting increased earnings, it can mean that the difference between reported and taxable incomes may be widening. Guess which figure is more likely to reflect the company’s fortunes?

A more general indication that management is “massaging” its financial reporting may be when, almost miraculously, every quarter’s earnings per share comes in $0.01 over the “street estimate.” Given the uncertainties of life, this should be seen as incredible. It was a widely accepted happening with “hot stocks” during past years, but it probably should have been seen as an indication of questionable accounting.

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