Let’s face it — the last thing most investors want to do is read a bulky 200-page annual report. Sure, you might flip through a few pages, but most shareholders have never read a report from front to back. However, a new study shows that certain phrases in corporate filings can provide important warnings about trouble ahead. Looking for these phrases — something that is much easier to do these days, thanks to searchable PDFs — can help you avoid losing big bucks.

The study, by University of Notre Dame business professors Tim Loughran and Bill McDonald, reveals that certain innocuous-sounding phrases such as “related party transaction” and “unbilled receivables” that appear in corporate filings could signal fraud or, at the very least, problems with the business. The academics studied more than 50,000 10-Ks (like an annual report but more detailed) that were filed to the U.S. Securities and Exchange Commission, and searched for 13 specific words that investment magazine Barron’s identified, in an August article, as red-flag phrases.

The phrase that popped up the most was “related party transactions,” which appeared in 16,524 reports. The term, which means a deal between two parties who have a prior relationship, is worrisome, write Loughran and McDonald in their study, as it “could be an indication that a board of directors is not independent.” The study found that the more the phrase appears, the greater the company’s volatility in the following year. There is also an increased chance that shareholders will accuse the firm of material omissions.

The authors found as well that the more companies used the words “materially and adversely affected,” which usually refers to a negative event affecting earnings, the more the stock value dropped after the report was submitted to the SEC. Another term to watch for is “unbilled receivables.” The study reveals that the more times that term is used, “the more likely it is that someone will subsequently file a class action lawsuit against the company.” The phrase, which means services have been rendered, but a bill hasn’t been issued, is often a sign of accounting problems.

John Parkinson, an accounting professor at Toronto’s York University who’s written extensively on analyzing financial statements, isn’t surprised by the Notre Dame study. He says companies have a history of masking problems by creatively inserting troubling items into reports. In Canadian annual reports, it’s in the notes — often located at back of the document — where investors can find red flags. That’s where impending lawsuits are revealed and you can see when liabilities are due, exact inventory numbers, social responsibility practices and a host of other vital details. “Everything people need to know is in the statements or the notes,” Parkinson says.

Ilana Singer, associate director with the Canadian Foundation for Advancement of Investor Rights, admits investors’ lack of enthusiasm for reading annual reports is a problem. But, at the very least, shareholders should look at the sections that discuss company objectives, risk factors, who sits on the board of directors (to make sure there aren’t any conflicts of interest) and who is auditing the business. That last point, she says, is crucial. If the SEC looked into who was auditing Bernie Madoff, they would have realized it was a virtually unknown three-person firm.

In a 2008 study, researchers found that deciphering corporate documents is made even more difficult if a company has a charismatic CEO. The authors, HEC School of Management’s Angelo Fanelli, Penn State University’s Vilmos Misangyi and the University of Florida’s Henry Tosi, found that charismatic language, including words such as “we,” “our,” “new” and “believe,” makes it difficult to predict a company’s performance. Securities analysts either overestimated or underestimated the performance of companies led by captivating leaders, while they were more accurate when it came to forecasting organizations with less inspiring people at the helm. While the study didn’t look at whether or not these phrases should raise alarm bells, Misangyi says investors can be easily swayed by strong, confident CEOs. “Be wary of romanticizing leadership,” he cautions.

Sadly, even digging through an annual report isn’t foolproof these days. Enron’s financial statements were mostly made up, and Bernie Madoff’s documents were complete forgeries. Still, keep dumping those reports in the garbage and there will be only one person to blame if your investment tanks — yourself.

Appeared in March 15, 2010 issue of Canadian Business magazine.

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