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financial shenanigans

Azra Wakeel Ahmed
Roll no:
Jimmy Hoffa, corrupt boss of the Teamsters Union, left a Detroit restaurant on July 30, 1975,
and vanished without a trace. It is widely believed that he was «whacked» in a mob hit, yet
despite having searched for the past 35 years, the FBI has been unable to locate his remains.
Global Crossing was one of the highest-flying technology companies during the 1990s dot-com
bubble. It was building an undersea fiber-optic cable network that would connect more than 200
cities across four continents, and investors appeared to be absolutely giddy over its prospects.
However, as the project neared completion in 2000 and early 2001, critics began to wonder
whether Global
For the March quarter, $375 in consideration, which is included in the $441 of Recurring
Adjusted EBITDA below and in the $1,613 of cash revenue above, was received from significant
Carrier customers who signed contracts during the quarter to purchase $500 of capacity on the
Global Crossing Network, and to whom the Company made substantial capital commitments
during the quarter.
During the quarter, the Company also entered into several agreements with various Carrier
customers for the purchase of capacity and co-location space. These transactions were
implemented in order to acquire cost-effective local network expansions; to provide for costeffective alternatives to new construction in certain markets in which the Company anticipates
shortages of capacity; and to provide additional levels of physical diversity in the network as the
Company implements its global mesh architecture.
Than as an Expense
Recall our discussion of how WorldCom improperly inflated its earnings by recording its line
costs as an asset rather than as an expense? This simple tactic helped the company portray itself
as a profitable company rather than tell investors that trouble was stirring. This move also
allowed WorldCom to present strong operating cash flow.
Recording the Purchase of Inventory as an Investing Outflow
«Cost of goods sold» is a very apt name for the direct expenses that companies incur to acquire
or produce inventory sold to customers. Consider the case of Netflix Inc., the online movie rental
Subtract: Capital expenditures
Free cash flow 2,289 essentially Netflix’s inventory, and therefore the company recieves DVD
library as an asset on its Balance Sheet. This asset is then amortized , and, as you would expect,
the amortization cost is presented on the Statement of Income as a cost of goods sold.
Consider Differences in Accounting Policies When Comparing Competitors. Any Investing
Outflow That Sounds Like a Normal Cost of Operations. While many analysts claim that reading
the Statement of Cash Flows is an integral part of their analysis, many of them fail to read
carefully below the Operating section.
Purchasing Patents and Newly Developed Technologies
Some professional sports franchises fill their team rosters with players whom they scouted,
drafted, and developed within their own organizations. Some companies report cash paid to
acquire already researched and developed products as an Investing outflow. In certain industries,
acquiring development-stage technologies is considered commonplace. Cephalon presented these
cash payments as «acquisitions» and dumped them into the Investing section of the Statement of
Cash Flows.
I’ll Gladly Pay You Tuesday for a Hamburger Today
«Acquisition» of drug patents, rights, and licenses —Cash flow from operations, as adjusted
200.2 the rights through noncash transactions. Biovail’s noncash purchases of product rights can
be thought of in the same light as Cephalon’s patent purchases and Netflix’s DVD purchases.
The economics suggest that these purchases relate to normal business operations, yet they are
reflected in a very different way on the Statement of Cash Flows.
The Friday after Thanksgiving is generally considered the unofficial start of the holiday
shopping season. Tyco and WorldCom seemed to adhere to the «Shop ‘Til You Drop» mantra
quite literally; however, they were buying entire businesses, and their holiday season ran all year
long for many years. In the late 1990s and early 2000s, both companies went on lavish shopping
sprees, acquiring business after business in order to fuel impressive performance.
The cash flow shifting tricks in this chapter have many similarities to the ones we discussed in
the previous chapter; they represent shifts between the Operating and the Investing sections.
However, in this chapter, we focus solely on shifts that are related specifically to acquisitions
and disposals.
Accounting on CFFO
A quirk in the accounting rules gives many companies a benefit to CFFO just for making an
acquisition. To understand why, realize that cash spent to acquire another business runs through
the Investing section of the Statement of Cash Flows. As a result, when buying another business,
companies inherit a brand new stream of cash flows without having to incur a CFFO outflow.
Serial Acquirers Receive This CFFO Boost Repeatedly
So far, we have established that by their very nature, acquisitions serve to boost CFFO. These
«roll-ups» often reject this criticism and point to their CFFO as proof that they are running the
acquired businesses well and exploiting synergies. Putting the «Con» in Conglomerate
For some companies, these pure boosts to cash flow are just not enough. They want to squeeze
even more juice out of these acquisitions. Consider the following scenario, based on allegations
in legal proceedings of Tyco’s behavior during the acquisition process.
Imagine that you work in the accounting department of a company that just announced that it
was being bought by a serial acquirer.
Tyco: The Mother of All Roll-Ups
This scenario is similar to allegations of what happened behind the scenes when Tyco made its
acquisitions. And Tyco made a lot of acquisitions. From 1999 to 2002, Tyco bought more than
700 companies for a total of approximately $29 billion.
may be difficult to be precise in this analysis; however, you often will be able to make an
assessment that is within the «ballpark» of the potential benefit.
Given how deeply the acquisition mentality was engrained in Tyco’s culture and DNA, you can
almost picture confusion among its executives.
From Aggressive Accounting to Fraud
By turning the Investing section into a hidden dumping ground for customer solicitation costs,
Tyco aggressively and creatively twisted the accounting rules.
Tyco raised the price at which it would purchase new contracts by the same $200—from $800 to
In 2005, Softbank structured an interesting two-way arrangement with a fellow Japanese telecom
company, Gemini BB. $800 — received into two categories: ¥45 million was allocated to the
sale of the business, and ¥40 million was deemed to be an «advance» on the future royalty
revenue stream. The Friday after Thanksgiving is generally considered the unofficial start of the
holiday shopping season.
With local versions in more than 100 countries, the hit game show Who Wants to Be a
Millionaire? is one of the most internationally successful television franchises of all time.
Unsustainable Activities
December bills. If you push your payments out a month, your end of-year bank balance will be
higher, and it will cosmetically seem as if you generated more cash this year. Accounts
payable/cost of goods sold number of days in the period. Investors should analyze payables in
terms of days’ sales, in much the same way that they analyze receivables and inventory .
Net cash provided by operations 4,802 5,963 2,796 ably stretched out its payments to vendors.
This anecdote shows the enormous management discretion available in classifying a fairly
straightforward transaction on the Statement of Cash Flows. In order to properly compare cash
flow generation at these competitors, investors must adjust for this difference in policy. Another
way in which companies can generate a nonrecurring CFFO boost would be to convince
customers to pay them more quickly. This certainly would not be considered a bad thing, and it
may even speak well of a company’s significant leverage over its customers.
Watch for Elaborate Strategies to Influence the Timing of Cash
Subtract: Unusual customer prepayment to show cash on its Balance Sheet at its highest point on
the last day of the quarter. Diligent investors would have noticed these issues and known that
disaster was not far away.
If you recall from our earlier discussion of Home Depot, stretching out vendor payments
produced a large positive «swing» on the Statement of Cash Flows. To be fair, Home Depot was
very clear in its disclosure under the «Liquidity and Capital Resources» section of its 10-K filing,
stating that CFFO growth primarily had been driven by an extension of payables and a decrease
in inventory per store. For fiscal 2002, cash provided by operations decreased to billion from
$6.0 billion in fiscal 2001. Watch for Disclosure about Timing of Inventory Purchases within
Each Quarter.
Shenanigans give a company the misleading appearance of having strong operating and free cash
Avoid Showing Deterioration
Successful investing requires a rigorous analysis of a broad array of financial performance and
economic health metrics for a company.
Investors are increasingly evaluating companies using both performance- and economic health–
related metrics.
Health Metrics
For a given industry or company, start out by learning the very best metrics for evaluating
economic performance and health—both past and expected in the near-term.
Categories of Performance Metrics
Think of our traditional financial performance metrics as being similar to the box score of
yesterday’s baseball game. While the information reflects past performance, it can often provide
very relevant indicators about the strength of the team and in many cases can shed light on what
to expect tomorrow.
Categories of Economic Health Metrics
Continuing our baseball analogy, if analyzing performance metrics can be considered akin to
reviewing yesterday’s box score, then analyzing economic health metrics would be similar to
reviewing today’s baseball standings that show a team’s cumulative performance.
Investors should evaluate accounts receivable to gauge whether the DSO metric provided by
management fairly presents the underlying economics of the business. Remember, distorting
accounts receivable metrics could indeed be an attempt to hide revenue problems.
Newly minted doctors are required to take the Hippocratic oath and pledge their commitment to
practice medicine ethically. Many people consider revenue growth to be an important and
straightforward measure of the overall growth of a business.
Same-Store Sales
Revenue growth at retailers and restaurants is often fueled by the opening of additional stores.
Logically, companies that are in the middle of a rapid store expansion show tremendous revenue
growth, since they have many more stores this year than they had the prior one. This framework
was used by the Center for Financial Research and Analysis to successfully identify problems at
Krispy Kreme Doughnuts Inc. in 2004 and Starbucks Corporation in 2007, and to warn investors
before these companies unraveled.
Watch for Bloated Same-Store Sales Resulting from Company Ac­quisitions. The comp base can
also be influenced by unrelated company activities, such as acquisitions.
March 2005 Earnings Release
Internal revenue growth is measured as total revenue growth less acquired revenue from
acquisitions and revenues from divested operations.
Average Revenue per User
When comparing key non-GAAP metrics across a peer group, it is important to ensure that these
metrics are being calculated in the same way. Let’s go back to our discussion of subscriptionbased businesses in the previous chapter. Adelphia Communications, the Rigas family business
we introduced in Chapter 2 and the sixth largest cable company in the United States at the time,
artificially inflated its subscriber counts by including subscribers of unconsolidated affiliates that
had not previously been included in the count.
Bookings and Backlog
Many companies disclose their quarterly «bookings» or «orders,» which are supposed to
represent the amount of new business booked during the period.
EBITDA and Its Variations
Consider the bull’s-eye drawn by the archers at Global Crossing. The company reported a net
loss of $120 million in the March 2007 quarter.
Pro Forma Earnings/Adjusted Earnings/Non-GAAP Earnings
What’s in a name? That which companies call earnings, by any other name would smell as sweet
. . . or so management would like you to think. Sometimes management insists that a foulsmelling «pro forma» or «adjusted» earnings metric is a sweet and pure measure of earnings.
«Cash Earnings» and EBITDA Are Not Cash Flow Metrics
Companies sometimes present metrics like «cash earnings» or «cash EBITDA». Non-GAAP
Cash Flow Metrics Put There to Confuse Delphi Corp. improperly recorded a loan from the bank
as the sale of inventory, and in doing so boosted cash flow from operations by $200 million in
Funds from Operations
The real estate investment trust industry uses the funds from operations metric as a standard for
measuring company performance.
As well as writing books, we also love reading them. We always make it a point to stop into
bookstores as often as possible, whether it’s megachains like Barnes & Noble or the literary
jewel of Portland, Powell’s Books.
Company managements are well aware that investors review working capital trends carefully to
spot signs of poor earnings quality or operational deterioration. They realize that a surge in
receivables that is out of line with sales will lead investors to question the sustainability of recent
revenue growth. What easier way could there be to keep these questions at bay and give
investors what they cherish than by distorting the numbers? This first section deals with games to
keep the reported accounts receivable lower by selling them, converting them into notes
receivable, or moving them somewhere else on the Balance Sheet.
$43 million the following quarter. By now, it should be abundantly clear that identifying the
reason for such a change is extremely important.
Ending receivables/revenue number of days in the period
While we recommend using this calculation for DSO, you may encounter different calculations
suggested by companies or texts. For example, some people believe that DSO should be
calculated using average receivables over the period, as opposed to the ending balance of
receivables that we suggest. Tip: Alert investors who learn of a change in the calculation of DSO
should immediately become concerned, when management changes how it computes operational
metrics, it is attempting to hide some deterioration from investors. Watch for Inventory That
Moves to Another Part of the Balance Sheet. Companies will sometimes reclassify inventory to a
different account on the Balance Sheet. Pharmaceutical giant Merck & Tween to simply ignore
inventory that it owned and included on its Balance Sheet, but that was not on store shelves.
«Out-of-store» inventory qualifies as inventory and has no less markdown risk than «in-store»
Impairment Problems
Financial assets are significant sources of income for banks and other financial institutions.
Therefore, assessing the «quality» or strength of these assets should be a key part of
understanding the future operating performance of such companies. For example, it is crucial for
investors to understand whether a bank’s investment portfolio consists of risky, illiquid securities
and to know if its loan portfolio is weighted toward dicey subprime borrowers.
September 2006 Earnings Release
At September 30, 2006, the allowance for losses on mortgage loans held for investment and real
estate owned was $239.4 million compared with $236.5 million at June 30, 2006.
Maintaining Debt Covenants
In order to minimize the probability of loan defaults, many lenders lay out rules that require
borrowers to maintain a certain level of economic health .
Europe’s Enron
Parmalat Finanziaria SpA, the Italian-based dairy company and one of the world’s largest
packaged food companies, grew its business rapidly in the 1990s by aggressively acquiring food
service companies around the world. Parmalat relied heavily on the debt markets to fund its
shopping spree, borrowing at least $7 billion in various offerings between 1998 and 2003. As its
business ran into serious problems, Parmalat began having trouble generating sufficient cash to
pay down this debt.