The Financial Numbers Game: Detecting Creative Accounting Practices
416
The Financial Numbers Game: Detecting Creative Accounting Practices
416Overview
"So much for the notion 'those who can, do-those who can't, teach.' Mulford and Comiskey function successfully both as college professors and real-world financial mercenaries. These guys know their balance sheets. The Financial Numbers Game should serve as a survival manual for both serious individual investors and industry pros who study and act upon the interpretation of financial statements. This unique blend of battle-earned scholarship and quality writing is a must-read/must-have reference for serious financial statement analysis." —Bob Acker, Editor/Publisher, The Acker Letter
"Wall Street's unforgiving attention to quarterly earnings presents ever increasing pressure on CFOs to manage earnings and expectations. The Financial Numbers Game provides a clear explanation of the ways in which management can stretch, bend, and break accounting rules to reach the desired bottom line. This arms the serious investor or financial analyst with the healthy skepticism required to drive beyond reported results to a clear understanding of a firm's true performance." —Mark Hurley, Managing Director, Training and Development, Global Corporate and Investment Banking, Bank of America
"After reading The Financial Numbers Game, I feel as though I've taken a master's level course in financial statement analysis. Mulford and Comiskey's latest book should be required reading for anyone who is serious about fundamentally analyzing stocks." —Harry Domash, San Francisco Chronicle investing columnist and investment newsletter publisher
Product Details
| ISBN-13: | 9780470495315 |
|---|---|
| Publisher: | Wiley |
| Publication date: | 03/10/2011 |
| Sold by: | JOHN WILEY & SONS |
| Format: | eBook |
| Pages: | 416 |
| File size: | 8 MB |
About the Author
Read an Excerpt
The Financial Numbers Game
Detecting Creative Accounting PracticesBy Charles W. Mulford Eugene E. Comiskey
John Wiley & Sons
ISBN: 0-471-37008-8Chapter One
Financial Numbers Game
I'd like to talk to you about another widespread, but too little-challenged custom: earnings management. This process has evolved over the years into what can best be characterized as a game among market participants. A game that, if not addressed soon, will have adverse consequences ...
With an all-too-frequent occurrence, users of financial statements are shaken with disclosures by corporate managements that certain "accounting irregularities" have been discovered and, as a result, current- and prior-year financial results will need to be revised downward. Consider these examples:
Sybase's shares dropped an additional 20% when the company reported improper practices at the Japanese subsidiary, which Sybase said included booking revenue for purported sales that were accompanied by side letters allowing customers to return software later without penalty.
Bausch & Lomb oversupplied distributors with contact lenses and sunglasses at the end of 1993 through an aggressive marketing plan.... The company said yesterday that in the fourth quarter of 1993 it "inappropriately recorded as sales" some of the product it sent to distributors.
Nine West Group Inc. said its revenue-booking practices and policies are under investigation by theSecurities and Exchange Commission. The company's shares plunged 18% on the news.
MicroStrategy Inc., the high-flying software company ... announced it would significantly reduce its reported revenue and earnings for the past two years.... Shares of MicroStrategy plummeted 62%, slicing about $11 billion off its market value.
In a long-awaited restatement, Sunbeam Corp. slashed its reported earnings for 1997 by 65%.... Sunbeam said the robust profit reported for 1997 resulted largely from an overly large restructuring charge in 1996, premature booking of revenue, and a variety of other accounting moves that have been reversed.
California Micro Devices Corp., a highflying chip maker, disclosed that it was writing off half of its accounts receivable, mostly because of product returns. Its stock plunged 40% after the announcement on August 4, 1994, and shareholders filed suit alleging financial shenanigans.
Waste Management Inc., undoing years of aggressive and tangled accounting, took $3.54 billion of pretax charges and write-downs, and said more conservative bookkeeping going forward would significantly crimp its earnings.
The once-highflying stock of Cendant Corp. plunged 46.5%, knocking $14 billion off the company's market value, after the marketing and franchising concern said accounting problems would require it to reduce last year's earnings and would hurt this year's results.
Aurora Foods Inc.'s chief executive and three other top officers resigned as the company disclosed an investigation into its accounting practices that it said could entirely wipe out 1999 profit.
Baker Hughes Inc. said it discovered accounting problems at a business unit that will result in pretax charges of $40 million to $50 million, a disclosure that sent its stock falling 15% and revived Wall Street's questions about the company's performance.
Every one of the above examples entails, in one form or another, participation in the financial numbers game. The game itself has many different names and takes on many different forms. Common labels, which depend on the scope of the tactics employed, are summarized in Exhibit 1.1.
While the financial numbers game may have many different labels, participation in it has a singular ultimate objective-creating an altered impression of a firm's business performance. By altering financial statement users' impressions of a firm's business performance, managements that play the financial numbers game seek certain desired real outcomes.
REWARDS OF THE GAME
Expected rewards earned by those who play the financial numbers game may be many and varied. Often the desired reward is an upward move in a firm's share price. For others, the incentive may be a desire to improve debt ratings and reduce interest costs on borrowed amounts or create additional slack and reduce restrictions from debt covenants. An interest in boosting a profit-based bonus may drive some. Finally, for high-profile firms, the motivation may be lower political costs, including avoiding more regulation or higher taxes. These rewards are summarized in Exhibit 1.2 and discussed below.
Share Price Effects
Investors seek out and ultimately pay higher prices for corporate earning power-a company's ability to generate a sustainable and likely growing stream of earnings that provides cash flow. That cash flow either must be provided currently, or there must be an expectation among investors that it will be provided in future years.
Firms that communicate higher earning power to investors will tend to see a favorable effect on their share prices. For the firm, a higher share price increases market valuation and reduces its cost of capital. For managers of the firm with outright equity stakes or options on equity stakes, a higher share price increases personal wealth. Playing the financial numbers game may be one way to communicate to investors that a firm has higher earning power, helping to foster a higher share price.
Strong earning power and higher earnings were expected from Centennial Technologies, Inc., in the quarters and months leading up to a peak share price of $58.25 on December 30, 1996. However, playing a role in the company's supposedly bright future were many creative and fictitious accounting practices that boosted the company's prospects. Among the accounting practices employed were the overstatement of revenue and such assets as accounts receivable, inventory, and investments. As the company's true financial position came to light over a two-month period following its share-price peak, investors bid the share price down 95%.
During 1997 and early 1998, Twinlab Corp. saw a dramatic increase in its share price. From just under $12 per share at the beginning of 1997, the company's share price increased to the high $40s per share in July 1998. However, during that time period, the stellar results that investors grew to expect from the company were not entirely real. The company later announced that it would restate its results for 1997 and for the first three quarters of 1998 because "some sales orders were booked but not 'completely shipped' in the same quarter." By the end of 1998, the company's share price had declined back to $12.
In 1997 Sylvan Learning Systems, Inc., received a $28.5 million breakup fee when it was outbid for National Education Corp. The company established two not-for-profit organizations with the proceeds of the breakup fee to avoid paying income taxes on it. That is, the taxable income associated with the proceeds was offset with a contribution to the newly established not-for-profits. The not-for-profits, however, had a link to Sylvan Learning. They contributed to marketing efforts of Sylvan Learning, doing advertising for the company and promoting Sylvan's software training and licensing programs. Had these promotional costs been borne by Sylvan Learning, they would have been reported as expenses on Sylvan's income statement. Under the current arrangement, however, Sylvan was able to keep the marketing and promotion costs off of its income statement, boosting pretax income.
Between January and July 1998, Sylvan Learning's share price rose from the low $20s per share to the high $30s per share. The unusual reporting scheme may have played a role in this share price rise. However, when knowledge of the arrangements made with the not-for-profits became widely known, the company's share price declined rather abruptly to around $20 per share.
The financial numbers game was being played, although to different degrees, at Centennial Technologies, Inc., Twinlab Corp., and Sylvan Learning Systems, Inc. While the game was being played, and before it became evident, all three companies enjoyed higher and rising share prices. Those higher share-price rises may be attributed, at least in part, to the higher earning power implied by the financial results reported by the companies. An interesting aside from the examples provided is just how punishing the markets can be when news of accounting gimmickry becomes widely known.
Investors also seek and ultimately pay higher prices for the shares of firms whose earnings are less volatile. Reduced volatility implies less uncertainty about the direction of earnings, fostering an impression of reduced risk. The financial numbers game can be used to reduce earnings volatility and, in the process, encourage a higher share price.
Borrowing Cost Effects
Higher reported earnings, and the higher assets, lower liabilities, and higher shareholders' equity amounts that accompany higher earnings, can convey an impression of improved credit quality and a higher debt rating to a lender or bond investor. As a result, the use of creative accounting practices to improve reported financial measures may lead to lower corporate borrowing costs.
Sales at Miniscribe Corp. grew from just over $5 million in 1982 to approximately $114 million in its fiscal year ended in 1985. Profits, however, were elusive as the company continued to report losses from operations. In 1986 the company's financial fortunes changed for the better as sales grew to $185 million and the company reported a profit from operations of $24 million. The timing was perfect as the company was able to use the strength of its latest financial statements to successfully issue $98 million in bonds.
Unfortunately for bond investors, the improved financial results of the company were mostly fabricated, including fictitious shipments to boost revenue and manipulated reserves to reduce expenses. Reported net income for 1986 of $22.7 million was later restated to a greatly reduced $12.2 million. Without the altered financial results, it is unlikely that the company would have been able to sell its bonds as successfully as it did, if at all. Unable to recover from the debacle, the company sought bankruptcy protection and sold its assets in 1990.
Miniscribe Corp. was a public company issuing publicly traded debt. The temporary benefit derived from its use of creative accounting practices, including an ability to secure lower interest rates on the debt issued, was clearly evident from the example. Another potential benefit for borrowers derived from playing the financial numbers game is less stringent financial covenants. This benefit can accrue to borrowers whether they are public companies or privately held.
Debt agreements typically carry loan covenants-express stipulations included in the loan agreement, which are designed to monitor corporate performance and restrict corporate acts-that afford added protection to the lender. Positive loan covenants typically express minimum and maximum financial measures that must be met. For example, a positive loan covenant might call for a minimum current ratio (current assets divided by current liabilities) of 2, or a maximum total liabilities to equity ratio of 1, or a times-interest-earned ratio (typically, earnings before interest, taxes, depreciation, and amortization divided by interest) of 5. Failure on the part of a borrower to meet these covenants is a covenant violation. Such violations may be cured with a simple waiver, either temporary or permanent, from the lender. However, they also may give the lender the opportunity to increase the loan's interest rate, to seek loan security or guarantees, or even in extreme cases, to call the loan due.
Negative loan covenants are designed to limit corporate behavior in favor of the lender. For example, a negative covenant might restrict a company's ability to borrow additional amounts, pay cash dividends, or make acquisitions.
Creative accounting practices can play a very direct role in relaxing the restrictive nature of financial covenants. Steps taken to boost revenue will increase earnings, current assets, and shareholders' equity and, in some instances, reduce liabilities. Such changes in a company's financial results and position improve its ability to meet or exceed financial ratios such as the current ratio, liabilities-to-equity ratio, and times interest earned ratio mentioned above. Steps taken to reduce expenses have a similar effect. As creative accounting is used to improve a company's apparent financial position and build a cushion above its existing financial covenants, those covenants become less restrictive.
Bonus Plan Effects
Incentive compensation plans for corporate officers and key employees are typically stock option and/or stock appreciation rights plans. With such plans, employees receive stock or the right to obtain stock, or cash, tied to the company's share price. When properly structured, such plans successfully link the officers' and employees' interests with those of other shareholders'. Occasionally companies use a measure of earnings-for example, pretax income-in calculating a cash or stock bonus. When such bonus schemes are tied to reported earnings, officers and employees have an incentive to employ creative accounting practices in an effort to maximize the bonuses received.
Few bonus plans were as lucrative as the plan in place for Lawrence Coss, chairman of Green Tree Financial Corp., a subprime lender. Mr. Coss's bonus was calculated at 2.5% of Green Tree's pretax profit-a significant amount being paid to a single person. The bonus was paid in shares of stock as opposed to cash. However, helping to increase the amount of the payout, the price used in determining the number of shares of stock to issue to Mr. Coss was set at a much lower, and fixed, historical amount of approximately $3 per share. For example, during 1996, Green Tree's shares traded between the low $20s and low $40s per share. That year, a $3,000 bonus would effectively buy 1,000 shares of Green Tree stock at the fixed price of $3 per share. If the stock were selling at $30 per share, that $3,000 bonus actually would be worth $30,000 (1,000 shares times the current market value of $30 per share).
In the years ended 1994, 1995, and 1996, Green Tree Financial's pretax earnings were $302,131,000, $409,628,000, and $497,961,000, respectively. A bonus computed at 2.5% of this amount would be $7,553,000, $10,241,000, and $12,449,000, respectively, for that three-year period. Yet Mr. Coss received an annual bonus in stock worth $28.5 million in 1994, $65.1 million in 1995, and $102.0 million in 1996. Clearly, with amounts such as these involved, there is considerable motivation to use creative accounting practices in an effort to boost the company's pretax earnings.
Continues...
Excerpted from The Financial Numbers Game by Charles W. Mulford Eugene E. Comiskey Excerpted by permission.
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Table of Contents
1 Financial Numbers Game 1Rewards of the Game 2
Classifying Creative Accounting Practices 8
Plan of This Book 13
Summary 14
Glossary 15
Notes 16
2 How the Game Is Played 19
Accounting Policy Choice and Application 19
Fraudulent Financial Reporting 39
Cleaning Up after the Game 44
Clarifying Terminology 49
Summary 50
Glossary 50
Notes 52
3 Earnings Management: A Closer Look 57
What Is Earnings Management? 58
Incentives and Conditions for Earnings Management 60
Earnings Management Techniques 62
Evidence of Earnings Management 68
Effectiveness of Earnings Management 74
Is Earnings Management Good or Bad? 82
Summary 84
Glossary 86
Notes 88
4 The SEC Responds 93
The Chairman’s Speech 93
The Action Plan 96
Subsequent Developments 99
Enforcing the Securities Laws 108
Summary 120
Glossary 122
Notes 123
5 Financial Professionals Speak Out 127
Survey of Financial Professionals 129
Survey Results 133
Summary 156
Glossary 157
Notes 158
6 Recognizing Premature or Fictitious Revenue 159
Is It Premature or Fictitious Revenue? 160
When Should Revenue Be Recognized? 165
Detecting Premature or Fictitious Revenue 185
Checklist to Detect Premature or Fictitious Revenue 191
Summary 193
Glossary 194
Notes 196
7 Aggressive Capitalization and Extended Amortization Policies 201
Cost Capitalization 202
Detecting Aggressive Cost Capitalization Policies 214
Amortizing Capitalized Costs 220
Detecting Extended Amortization Periods 226
Checklist to Detect Aggressive Capitalization and Extended Amortization Policies 229
Summary 231
Glossary 231
Notes 233
8 Misreported Assets and Liabilities 237
Link with Reported Earnings 238
Boosting Shareholders’ Equity 239
Overvalued Assets 240
Undervalued Liabilities 259
Checklist to Detect Misreported Assets and Liabilities 268
Summary 271
Glossary 272
Notes 275
9 Getting Creative with the Income Statement: Classification and Disclosure 279
Current Income Statement Requirements and Practices 280
Reporting Comprehensive Income 292
Creative Income Statement Classifications 295
Creativity with Other Aspects of the Income Statement 304
Summary 311
Glossary 312
Notes 313
10 Getting Creative with the Income Statement: Pro-Forma Measures of Earnings 317
Recasting the Bottom Line: Pro-Forma Earnings Measures 318
Summary 339
Glossary 340
Notes 341
11 Problems with Cash Flow Reporting 345
Reporting Cash Flow 347
Problems with Reported Operating Cash Flow 354
Using Operating Cash Flow to Detect Creative Accounting Practices 370
Checklist for Using Operating Cash Flow to Detect Creative Accounting Practices 373
Summary 373
Glossary 375
Notes 377
Subject Index 379
Company Index 391