First and foremost, nobody should think that the accounting scandals are over or ever will be. Accounting scandals have existed almost as long as financial statements themselves and will continue to do so because there's always some guy who wants to get ahead at everybody else's expense. What we want to focus on instead is their frequency and the extent of their consequences. Since neither corporate America nor Congress has dealt with the underlying causes of the accounting scandals of 2001-2002, I remain less sanguine about the presumed cleanup. Maybe the proverbial dust remains hidden under the carpet.

This matter feeds directly into the next issue: how much risk the investor is willing to accept. If the individual desires never again to face ruination from an accounting scandal, then he or she should forget about equities. But, if the person will accept at least some degree of risk, then the problem becomes knowing and understanding which firms have more financial reporting risk than others, where financial reporting risk refers to the probability of managers not presenting truthful financial statements and to the effects of any untruths, whether large or small.

My general advice to those willing to accept some risk is to look only at those business enterprises that have low financial reporting risk. In other words, forget about any company that has very aggressive accounting methods and accounting policies, regardless of the merits of their business model, because one is apt to get caught in the jaws of some future accounting vice.

Since this principle is a bit vague, let me add flesh to the skeleton. Below is a list of some areas in which corporate managers have choices. If they opt for aggressive methods clearly to benefit primarily themselves, then I would pass over them. If they select conservative methods, then I would trust management, for it appears that they are actually trying to communicate good information to the investment community. While a longer and more detailed list is possible, I shall limit myself to three major areas that provide evidence about the corporate financial reporting risk.

The most important footnote to read is the one on management stock options, and in this footnote one must ascertain three things. First, does the firm expense these stock options in the income statement? If not, the firm is not investor-friendly and one should espy managers' intentions very carefully. Second, does the firm over-employ stock options to pay their managers? To assess this factor, examine the impact of stock options on the firm's earnings per share. My rule of thumb is not to invest in any business entity in which the stock option expense causes a drop in earnings per share by five percent or more. The reason for this is that that amount constitutes a huge amount of stock options that generate perverse incentives for managers to cook the accounting books. Third, use this footnote to examine the assumptions managers use to estimate the stock option expense. While several exist, I prefer to concentrate on the stock volatility assumption over the past (say) three years. Given the madcap nature of stock prices during recent times, stock prices seem to have become more volatile than in the past. Any firm that decreases the assumed stock volatility may be lying to you. I wouldn't trust them.

The next most important footnote to read is the pension footnote. While these disclosures are quite valuable, the nonprofessional investor need only look at the presumed rate of return on pension assets. (Why the FASB or the SEC allows corporations to apply such fantasyland accounting instead of reporting the actual gains or losses on pension assets is beyond me.) I would estimate the proper return on these assets to be in the neighborhood of five or six percent. Any manager that chooses a much higher return is trying to pull the wool over your eyes, while trying to sell you lamb chops. My rule of thumb: I would definitely not invest in any firm that assumes a return of nine percent or more. And I take a hard look at those in the eight to nine percent range.

The third thing I recommend is to compute free cash flow. This number is not well defined and may be measured in many ways. One of the easiest and best ways for the dilettante to estimate free cash flow is to go to the statement of cash flows and notice that the statement is broken into three parts, cash flows by operating, investing, and financing activities. I would estimate free cash flow as cash flows generated by operating activities minus cash flows paid out for investing activities. Not only is this a quick and dirty way to gauge free cash flow, it reduces manager's abilities to manipulate this by categorizing a cash flow in the wrong section. Once these estimates are obtained, I would discard from my opportunity set any firm with negative free cash flows. Yes, some might be investing for the long haul, but chances are the firm is in trouble. This is a far better metric than accounting earnings if only because it is less susceptible to fraud.

So there's my investment advice. Choose firms with realistic computations of its stock-based compensation expense that is not too large and is found on the income statement, reasonable, down-to-earth assumptions about their pension returns, and positive free cash flows. Any other business enterprise is too much like the lottery for my tastes.

J. EDWARD KETZ is accounting professor at The Pennsylvania State University. Dr. Ketz's teaching and research interests focus on financial accounting, accounting information systems, and accounting ethics. He is the author of Hidden Financial Risk, which explores the causes of recent accounting scandals, and columnist of The Accounting Cycle for SmartPros.com.