Rule #1 Finance Blog

With Investor Phil Town

ACCOUNTING IRREGULARITIES & THE 10-K

Here’s an email submitted recently by someone who’s really digging in on his research. A good refresher on reading a 10-K.  My comments are at the bottom.

Phil,

I have recently began searching for the stocks that I believe are true Rule #1 investments.  I have about 15 at this point, 4 of which are at the MOS price in which I am waiting for the three green arrows to buy.  I am still in the paper trading part to learn the market and understand the fluctuations.  One of the companies I have researched and believe is a good Rule #1 investment.  That company is Netflix.  To continue my research of Netflix I pulled the 10K and read through the auditor’s piece at the end.  Here is that part of the 10K:

CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors

Netflix, Inc.:

We consent to the incorporation by reference in the
Registration Statements on Form S-8 (Nos. 333-89024, 333-104250,
333-113198 and 333-123501) of Netflix, Inc. of our reports dated March
14, 2006, relating to the consolidated balance sheets of Netflix, Inc.
and subsidiary as of December 31, 2004 and 2005, and the related
consolidated statements of income, stockholders’ equity and
comprehensive income, and cash flows for each of the years in the
three-year period ended December 31, 2005, management’s assessment of
the effectiveness of internal control over financial reporting as of
December 31, 2005, and the effectiveness of internal control over
financial reporting as of December 31, 2005, which reports appear in
this December 31, 2005 annual report on Form 10-K of Netflix, Inc.

Our report, dated March 14, 2006, on management’s assessment of
the effectiveness of internal control over financial reporting and the
effectiveness of internal control over financial reporting as of
December 31, 2005, expresses our opinion that Netflix, Inc. did not
maintain effective internal control over financial reporting as of
December 31, 2005 because of the effect of a material weakness on the
achievement of the objectives of the control criteria and contains an
explanatory paragraph that states that the Company identified a
material weakness related to their accounting for income taxes.

I have bold and italicized the part in the statement made by the
public accounting firm which states that they can not support the
financial reporting due to ineffective internal control over the
financial reporting.  [His bolding didn’t show up over email.] To me this means that the entire 10K is
irrelevant and does not contain financial data that can be supported.

What are your thoughts on the auditor’s comments in the 10K reports?
Should they be read and in situations such as this should we avoid this
company?  What are your suggestions?

By the way… love the investing book and all the additional advice found on your web site.  Great stuff.

Scott

My comments:

Hi Scott,

Any irregularities found by auditors raise a huge red flag for any
business.  Having said that, businesses that are relatively new like
Netflix can have screwed up accounting from their formative years that
the auditors cannot decipher.  I haven’t looked into this but a quick
call to the Investor Relations people will get you an answer.  It may
be a BS answer but it will be an answer.  From that you can begin
digging until you are satisfied that Netflix is either screwed up or
that the issue isn’t particularly important.

Let us know.

Now go play.

Phil

P.S.

GREAT JOB digging into the 10K.  I LOVE this because it demonstrates
that you are taking the idea of understanding the business seriously
before you commit your capital.  This is great!

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