Bloomberg Personal Finance"
Sun, 28 Jul 2002, 11:54pm EDT
Liar Liar
When financial statements are increasingly an artful blend of truth, half-truth, and fiction,
investor's need to become better lie detectors. Here's how.
By Chuck Carlson Bloomberg Personal Finance
One of the greatest threats to the U.S. economy--much more serious than any cyclical downturn-is the wholesale undermining of investor confidence in the stock market as a result of corporate
deceptions like those of Enron. Yet the volume of obfuscation, misdirection, and, in a few cases,
outright lying in corporate quarterly and annual reports (10-Qs and 10-Ks) grows every year. The
incentives for the top brass to push the truth envelope are large. After all, their pay is frequently
tied to stock performance, which pressures management to pump up the good and gloss over the
bad. Demanding investors deserve a share of the blame, too, because they are quick to dump
shares of companies that disappoint on earnings. Ever more complex business models lead to
more complicated financial reports and additional opportunities to hide inconvenient facts. The
rules of the game defined by GAAP--Generally Accepted Accounting Principles--are so loose as
to provide plenty of interpretation on how companies report the numbers.
Finally, auditors too often sign off on financial statements that don't reflect an accurate picture of
the company. An April 2002 study by Bloomberg News found that in 54 percent of the 673 largest
public bankruptcies since 1996, auditors provided no cautions in financial statements in the
months before the filings. In the 10 largest of those bankruptcies, none of which received
warnings, investors lost nearly $120 billion.
What's the solution? One approach is to make such duping of the public ineffective and
unprofitable. That means it's more essential than ever for investors to understand how companies
manipulate financial reports. Although there are countless ways to mislead, these 10 lies that
companies tell, often through misrepresentation and selective disclosure of information, are
among the most pernicious.
The lie: "Our revenues are rising." The truth: "Yes, income is rising because we make barter
deals, stuff distribution channels, and extend lots of credit to deadbeats." Lie detectors: A rising
amount of receivables is a sure danger sign. This can be tracked by the receivables turnover ratio
in the financial statements. Main offenders include pharmaceutical, consumer products, Internet,
and computer hardware and software companies.
**Embellishing the revenue line has become a science at all too many companies. A favorite
means is by extending generous credit to financially strapped customers. This practice was fairly
common at telecommunications-equipment companies, including Cisco Systems (CSCO) and
Lucent Technologies (LU), as they pulled out all the stops in order to maintain sales growth. The
companies crammed their distribution channels by unloading product onto distributors. This can
easily be accomplished with a combination of price cuts, special deals, and bullying. Some
companies book as revenue receivables (money they are owed by other companies) that are in
dispute and that may never be collected. Shares in Gemstar- TV Guide (GMST), for example,
plunged 37 percent after the firm disclosed it recorded $108 million in revenue that it might never
receive because of a patent dispute with Scientific-Atlanta.
Howard Schilit, in his influential book, Financial Shenanigans (McGraw-Hill Professional), notes
some warning signs, such as calling refunds from suppliers "revenue" and recording revenue
under suspect conditions--before goods are shipped, when it's uncertain that payment will be
made, or on the exchange of similar assets.
It's not surprising, then, that investors are migrating to companies with simpler business models
and relatively clean financial statements. For example, Wm. Wrigley Jr. (WWY), the gum
company, trades at a rich price-to-earnings ratio of 34. The stock commands a premium valuation
because its business model is simple and the company has been able to boost revenue 4 to 8
percent over each of the past six years without resorting to creative accounting.
Another danger signal is receivables that are growing much faster than sales. Consider the case
of LifePoint Hospitals (LPNT), a for- profit operator of health-care centers, where revenue rose 18
percent for the first quarter of 2002. But receivables increased 37 percent over the same period.
The lie: "Our profits are growing!" The truth: "The quality of our earnings is questionable. That
profit is built on asset sales, pro forma accounting tricks, reduced research and development
spending, or unrealistic pension assumptions." Lie detectors: Cash flow numbers. Footnotes to
the financial statements relating to pension accounting. Profit puffing is not exclusive to any
particular industry, but many New Economy businesses prefer pro forma (not in conformance with
GAAP) numbers simply because they have no GAAP profits.
**If there are 10 ways to manipulate revenue, there are 100 ways to gin up earnings. For
example, IBM (IBM) sold an asset in the fourth quarter of 2001 and booked a gain of $300 million
on the sale. The firm used that cash (an extraordinary one-time gain by more conservative
accounting standards) to offset certain costs, thus boosting reported profits. Firms spin profits by
using pro forma numbers, a loosey-goosey accounting trick which includes (or excludes) virtually
anything a company wants. Amazon.com (AMZN), which has played this game since going public
in 1997, reported in the first quarter of 2002 that it had a net loss of 1 cent a share on a pro forma
basis. The firm actually lost 6 cents a share based on GAAP accounting.
Companies also must make certain pension assumptions that have a direct effect on the balance
sheet. They tend to be optimistic, predicting, for example, that their pension plan assets will grow
9 percent or more a year. The higher the assumptions, the smaller the hit to profits from pension
costs. Health-care benefits work the same way. Companies typically assume these costs are
going to rise a lot less than they actually do.
Before accepting these numbers, check the assumptions of competitors with similar retirement
benefit programs. If one company is being much more optimistic than another, you'll want to know
how much the bottom line is benefiting. For example, General Motors (GM) assumes that its
pension fund will return 10 percent annually. One analyst estimates that if it used a return of 8
percent (still a bit optimistic, but closer to reality), annual earnings per share would be cut by an
estimated $1.70.
Another popular way to inflate profits is to write down costs on supposedly "obsolete" products or
excess inventory, only to sell the goods later. When that occurs, profits go up, since the costs of
production have already been deducted. Cisco Systems, for example, wrote off more than $2
billion worth of inventory last year. This tactic probably played a key role in its better-thanexpected earnings and profit margin results in the first quarter of 2002.
As a check on earnings quality, examine the cost side of the income statement. Did the firm
reduce R&D spending, marketing, or capital expenditures? Study the statement of cash flows.
How much cash is being created by the gains in net income? Be suspicious if a company's net
income is rising, but free cash flow generated from the business is falling. Free cash flow is
what's left over after paying the bills and dividends, and buying the equipment and services
needed to run the business.
The lie: "Our cash flow is rising." The truth: "We have more cash because we no longer pay our
bills on time." Lie detectors: Growth in accounts payable (what the company owes to others).
The level of tax benefits as a result of employee stock option exercise.
**No number is an island, not even the Holy Grail of financial statements--cash flow. True, cash
flow has fewer ways of being manipulated than, say, net income. Nevertheless, simply looking at
a company's cash flow from operations (found in the statement of cash flows) without examining
factors that affect this number may lead to erroneous conclusions.
Cash flow may tell an incomplete story if items are included from operations that reveal nothing
about the true money-making capacity of the underlying enterprise. For example, companies are
required to record the tax benefits from the exercise of employee stock options as part of
operating cash flow. When such tax breaks boost reported cash flow, they mask the performance
of a company in terms of generating cash.
A favorite tactic for bolstering cash flow is simply not to pay bills. Broadcom (BRCM), the battered
maker of chips for telecom equipment, comes to mind. Its cash flow from operating activities in
2001 was $49 million, but its accounts payable (the money the company owes) rose that year by
nearly $25 million. In other words, Broadcom's declining cash flow--off from $200 million in 2000-would have been even worse if the firm hadn't delayed payments to its creditors.
The lie: "Our stock is incredibly cheap. Just look at how our stock price compares with book
value per share." The truth: "Our book value is a mirage. It's about to be decimated when we
write down our goodwill." Lie detectors: Size of goodwill (or "intangible assets") on the balance
sheet. Previous write-down history. Companies that have been active in the acquisition arena are
especially vulnerable to write-downs of book value.
**Value investors love to compare a stock's price with its book value per share. Book value is
what's left over after subtracting liabilities from assets. Since most assets are recorded at cost on
the balance sheet, book value may understate the liquidation value of a firm. That's why bargainhunting investors often get excited about firms whose stock price is trading at a substantial
discount to book value. But a major part of book value is goodwill--the financial accounting entry
for the amount paid in an acquisition over the value of the assets being acquired. The purchase of
a powerful brand name, for example, usually results in the creation of goodwill, since brands have
no dollar value. Accounting rules require companies to write down the value of goodwill when it
becomes "impaired," a common occurrence in the past year or two. When goodwill is charged off,
it comes out of a company's book value.
AOL Time Warner (AOL) is a classic case. In February of this year, the stock, then at $25 a
share, traded at about 70 percent of its book value at the end of 2001. However, the shares were
anything but cheap. AOL Time Warner slashed its goodwill in the first quarter by some $54 billion,
the biggest such write-off ever. If you intend to buy a stock because it looks cheap based on book
value, evaluate the amount and quality of goodwill on the books.
The lie: "We have been very successful at making acquisitions work for us." The truth: "We've
been very good at getting companies to take huge write-offs just before they come under our
wing. The acquisitions give us an excuse to work the financial statements-- bury poor results, set
up reserves to draw from later, and generally confuse the heck out of investors." Lie detectors:
Goodwill write-downs. Substantial charges following an acquisition, such as the write-down of
inventory or in-process R&D. Pay close attention to acquisitions in the technology, banking, and
insurance sectors.
**I've never been a big fan of acquisitions, because buyers tend to overpay, and a company's
subsequent financial statements become immensely more complicated. Goodwill is created,
acquired assets get written down, special charges are often taken, all providing cover for
accounting manipulation. For example, when insurance companies merge, it's not unusual for the
buyer to increase its loss reserves. Such a move allows the buyer to squirrel away profits in those
increased reserves that can be released at a later date. For years, Tyco International (TYC) was
regarded as a merger magician, seemingly spinning gold from all of its deals.
However, some analysts believe that what Tyco was really good at was getting the acquired
companies to "clear the decks" prior to the close of the transaction--for example, prepaying
liabilities, even if they weren't due--thus making Tyco's financial statements look better after the
deal closed. Other firms that have been accused of such practices are Cisco Systems and
General Electric. Cisco, for example, has made about 70 acquisitions since 1993.
Serial acquisitions could be a clue that the firm can't grow organically and must buy growth. For
signs of trouble, examine the changes in goodwill on the balance sheet and the sources of that
goodwill. Look closely at restructuring charges.
The lie: "We believe the use of corporate resources to buy back our stock makes sense because
the shares offer good value." The truth: "We're buying back our overpriced stock to offset dilution
resulting from our overly generous stock option plan. And, quite frankly, this is the best way we
can think of to boost per-share results." Lie detectors: A shrinking number of outstanding shares
coupled with rising long-term debt levels. Compare net income versus per-share profits.
Industries to watch include slow-growth consumer markets like food and packaged goods and
technology companies that have long since ceased to post impressive revenue gains.
**Microsoft (MSFT) purchased some $6 billion worth of its common shares in fiscal 2001. A show
of confidence by the company? Maybe. But more likely, Microsoft was trying to stem the dilution
resulting from the billions of dollars of stock issued under its employee option plan. Despite the
company's hefty stock purchases during the year, the number of outstanding shares actually
increased from fiscal 2000 to fiscal 2001. Were the purchases a good use of corporate capital?
Not if you compare the purchase price of the stock then, which averaged in the $60s, with its
current price of $52.
This practice also helps explain the "IBM Miracle" of the last eight years, when the company's
shares shot from $13 to more than $120. Earnings jumped from $1.25 per share in 1994 to $4.35
in 2001, but revenues rose only 34 percent over the period, a rather anemic showing for a
technology company. And, long-term debt rose 27 percent over the period, from $13 billion to $16
billion. During those years, IBM was busy buying back its shares--its outstanding common stock
declined from 2.35 billion to 1.72 billion, a decrease of 27 percent. That drop, coupled with
stringent cost controls, generated the big per-share earnings gains. But a company can't play the
buyback/cost-cutting card forever. At some point, there must be genuine revenue growth.
The lie: "Our same-store sales are increasing nicely, which proves that our brand is strong." The
truth: "Same-store sales are increasing because we have either unloaded our lousy stores onto
franchisees/licensees or closed them. If you look at our store counts, we are not growing the
brand." Lie detectors: Compare the growth in company-owned stores with franchise-owned
stores. Compare the total number of outlets from year to year.
**A retailer can pump up same-store sales by shutting laggard outlets that may be pulling down
systemwide results. A company may franchise outlets, thus removing them from same-store
sales calculations (which usually reflect only "company-owned" stores). Of course, offloading
underperforming stores may make perfect sense. However, a firm whose outlet numbers are
static or falling will likely have a difficult time generating robust revenue and earnings growth.
Yum! Brands (YUM), formerly known as Tricon Global Restaurants, has been reporting stellar
same-store results, which is a bit of a surprise, since not too long ago its KFC, Pizza Hut, and
Taco Bell brands were struggling. The shares are up, but real growth is missing. In 1997, the firm
had 29,712 outlets; at the end of 2001, it had 30,489. What has changed dramatically is the
composition of those units. In 1997, company-owned restaurants made up 34 percent of the total.
By 2001, that number had fallen to just 21 percent. This is significant, because Yum!'s U.S.
same-store sales include only company-owned stores open a year or more. Systemwide sales
grew only 9 percent from 1997 to 2001, and revenue dropped from $9.7 billion to $6.9 billion over
the same period, a 28 percent decline.
The lie: "Our balance sheet is clean, with manageable debt." The truth: "We've got debt buried
everywhere--in our financing unit, special related entities, contingent liabilities, and elsewhere."
Lie detectors: Footnotes to the financial statements related to subsidiary debt. Companies with
their own financing and financial services units (autos, heavy equipment, finance, insurance)
deserve special scrutiny.
** If you look up General Electric (GE) in Value Line Investment Survey, you will find that the
company's long-term debt was a miniscule $787 million at the end of 2001, or just 1 percent of
total capital for the firm. What you won't see, however, is the debt assigned to GE Capital, GE's
finance unit. Footnote 18 of GE's 2001 10-K reports that GE Capital has short-term borrowings of
some $153 billion and long-term borrowings of another $80 billion.
GE is a good example of why investors cannot accept a firm's reported debt load at face value.
Finance units need to be scrutinized, as well as "special purpose entities" that are created
principally to assist a company in financing activities. The debt for these businesses is usually an
obligation of the parent.
The lie: "We have a diversified stream of revenue that should help us weather downturns in any
one area." The truth: "Although we have many subsidiaries and operating units, we are
dependent on just a couple of them for the bulk of our earnings. However, our diverse operating
base allows plenty of cover for financial maneuvering." Lie detectors: Footnotes to the financial
statements, especially those related to reporting for business units.
**Diversification is a wise concept, but it entails more businesses that a company must manage
effectively, more record keeping, more complexity. Indeed, one of the biggest clues that
something was amiss at Enron was the complexity of its statements, caused by an absurd
number of operating subsidiaries and partnerships. Enron's 2000 10-K filing listed 83 pages of
subsidiaries and limited partnership interests.
But even a smaller number of divisions can distract corporate management. Dover (DOV), a
diversified industrial company, has four operating segments encompassing 53 stand-alone
operating units. Earnings tailed off sharply in 2001, and 2002 is expected to be well below
historical levels. One could argue that the increasing complexity of its business structure--the firm
made 34 acquisitions in 2000 and 2001--is taxing its management expertise. Certainly, the
diversification of the firm's operating structure makes it more difficult for investors to comprehend
Dover's financial statements. The stock trades at 29 times 2002 earnings estimates, a rich
multiple that may shrink if improvement does not occur.
The lie: "Our stock option plan has been an excellent way to motivate employees and unite their
interests with shareholders." The truth: "Our option plan has been a great way for us to remove
compensation expenses from the cost side of the income statement, increasing per-share
profits." Lie detectors: The footnote section of the financial statements contains information on a
firm's stock option plan, its potential dilution to outstanding shares, and the compensation costs
that are not reaching the bottom line. Although technology companies are still the hotbed of
option use, much of corporate America relies on options as a key part of employee
compensation.
**Companies are increasingly handing out stock options to workers for the simple reason that
they aren't recorded as costs. Options are a "free ride" for companies, a way to pay employees
without incurring expenses that lower profits. Best of all, companies actually get a tax deduction
for gains on options, even though the options aren't considered an expense.
A 2001 Bear Stearns report says that had options been included as an expense on the income
statement, the earnings for the S&P 500 companies in 2000 would have been lower on average
by 9 percent. In the technology sector, the impact would have been much greater. According to
an April 2002 Merrill Lynch report, expensing options would have cut overall 2001 earnings for
semiconductor companies as much as 69 percent.
Companies argue that options should not be considered an expense. After all, they reason, the
company isn't writing a check to the employee. However, when a firm awards stock to its workers,
it dilutes shareholders' stakes. Dell Computer (DELL) earned 65 cents a share in the fiscal year
ending February 1, 2002. If options were included in expenses, the gain would have been cut to
38 cents a share. Hewlett-Packard's profits of 32 cents per share would have evaporated entirely
had options been expensed.
Chuck Carlson, CFA, is chief executive officer of Horizon Investment Services and the author of
The Smart Investor's Survival Guide (Doubleday). David Wright, CFA, provided research
assistance for this article.
#<579646.18602># -0- (BN ) Jul/24/2002 15:35 GMT