Introduction To "Watch Out" Accounting Practices.

Introduction To "Watch Out" Accounting Practices

Read Financial Report First

• Generally, this letter contains a "clean" opinion.

• Watch for qualified Opinions.• Investors should be cautious about investing in

any company that receives a qualified opinion-even more so if it is a "going concern" qualification.

Next: Read Footnotes to Financial Statement

• Provides wealth of information for assessing financial condition and quality of its reported earnings. accounting policies selected– pending or imminent litigation– long-term purchase commitments– changes in accounting principles or estimates– industry specific notes (e.g., unbilled receivables

for a government contractor)– segment information showing healthy and

unhealthy operations

Back of Footnotes

• The back of the report, the footnotes is where they hide the bad stuff they didn't want to disclose but had to• They bury the bodies where the

fewest folks find them in the fine print.

Favor Companies With Conservative Accounting Policies

• Footnotes can indicate signs of "creative" accounting or gimmicks.• Companies that fail to use

conservative accounting methods might demonstrate a lack of integrity in their financial reporting process.

Favor Companies With Conservative Accounting Policies

• If a company does not cut corners in its accounting, there's a good chance it doesn't cut corners in its operations. You know you've got your money with a high quality management

Next Read The Letter from the President

• After reading the footnotes, you should turn to the front of the annual report, where you are greeted with a picture of and some words from the president. • Tone of this letter is almost invariably

upbeat

Read The Letter from the President

•Watch the word "challenging"• "Your company has lost

money, is losing money, and will continue to lose money."

Read The Letter from the President

• Wall Street Advice: "If the C word appears in any form three or more times in the front pages of any annual report-sell immediately!"• Read the Letter from the President

with a Grain of Salt.

In Some Annual Reports

•Your company is now poised for significant earnings growth."

TRANSLATION

•"We lost so much last year and wrote off everything possible, so earnings couldn't get much worse”

In One Annual Report Years Back

• These results were somewhat below the projections management had announced publicly during the quarter"

TRANSLATION

•We lied

ANNUAL REPORT

• "The quarter's earnings contained a substantial contribution from a settlement arising from the involuntary termination of operating equipment."

TRANSLATION

• "If the plane hadn't crashed, we would have been in the red. Fortunately, only one was killed, and the insurance company paid off a helluva lot."

Signs of Misleading Financial Statements

• MANAGEMENT DECISION

• Choosing accounting policy

• Changing accounting policies

• Deferring expenses• Income smoothing• Recognizing revenue

too soon

• INVESTOR'S CONCERN• Too Liberal

• Unjustified

• Profits are overstated• Profits understated

• Profits are overstated



• Expense under accrued

• Expense over accrued

• Changing discretionary cost

• Low quality controls

• INVESTOR'S CONCER

• Profits overstated and Liabilities understated

• Profits understated and Liabilities overstated

• Manipulation profits

• Risk of financial statement manipulations



• Change in auditors on a frequent basis

• INVESTOR'S CONCER

• Risk of financial statement manipulations

Where to look Concern Warning Signs: Assets

• Cash– A portion is restricted– Currency uncertainty divisional levels

• Receivables– Large overdue receivables– Large increase with sales flat– Overly dependent on one or two customers– Related-party Receivables– Slow Receivables turnover– Right of return exists

Early Warning Signs on the Balance Sheet

• Uncollectibility of Receivables Warning Signs• Large amount of overdue Receivables• Large increase in Receivables with flat sales• Exaggerated dependence on one or two

customers

Receivable Check List

• Watch and work the Average Collection Period (see chapter on ratios)

• Business dispute with customer• Watch "channel stuffing"– making last minute sales to distributor just before

quarters end.• Change one bad asset for another

Inadequate Salability of Inventory Warning Signs

• Large increase when sales are flat• Slow inventory turnover• Faddish inventory• Collateralized inventory• Insufficient insurance• Change of corporate inventory valuation

methods

Inventory Note

• Large inventory of high tech products can be disastrous because improved products hit

• the market every 6 to 24 months• Who wants a 2,600 baud modem?• Watch Inventory turnover

Fixed Assets Warning Signs

• Old equipment and technology• Cash flow signals• High maintenance and repair expense • Declining output level• Inadequate depreciation charge • Change in depreciation method

Fixed Assets Warning Signs

• Lengthening depreciation period •Decline in depreciation

expense• Large write-off of assets

Investments Watch Realization

• Switching between current and noncurrent categories• Investments recorded in excess of

costs• Risky investments that must be

written off

Overstatement of Intangibles Warning Signs

• Slow amortization period• Lengthening amortization period• High ratio of intangibles to total

assets and capital• Large balance in goodwill even

though profits are weak

Warning Signs: Liabilities

• Watch for understated liabilities• Amortize warranties quickly• Arbitrary adjustments• Smoothing

Warning Signs: Equity

• Treasury Stock - large and frequent transactions• Large and unreasonable dividends• Unexpected and/or substantial reserves• Worrisome negative cumulative

translation adjustments

Liabilities Examples

• Example of one firm’s pension shenanigans–Play around with calculation of the PV of

future benefits and its estimate of how fast the pension assets are growing.

• Hide or "keep off the books" actual or probable liabilities. –This gimmick is often referred to as "off

balance sheet financing"

Watch This:The Profit and Loss Account

• Revenue measured at fair value of consideration received or receivable.

• Recognize revenue when:– significant risks and rewards are transferred to the buyer– managerial involvement and control have passed– revenue can be measured reliably– probable that benefits flow to firm– costs of transaction can be measured reliably.

: Reporting Financial Information By Segment

• Breakdown of Segmental information meaning, analysis of trends, • cost of investments • obtaining information on

international competitive markets and producers

: Reporting Financial Information By Segment

• How this information plays an important role later in the workshop when we analyze McKinsey’s restructuring pentagon.• The size and relative importance of

diversified companies presented many problems for the users of accounts.

Reporting Financial Information By Segment

• Different industries and different countries have various profit potentials, degrees and types of risk and growth opportunities.

• Different rates of return on investment and different capital needs are also likely to occur across the various segments of a business.

Reporting Financial Information By Segment

• Segmental information allows shareholders to combine company-specific information with external information with a more accurate assessment of both risk and potential for future growth.

• Compare segments to other industries• Default rate of industry

Fraud at Waste Management

• Refused to record expenses necessary to write off the costs of unsuccessful and abandoned landfill development projects

• Established inflated environmental reserves (liabilities) in connection with acquisitions so that the excess reserves could be used to avoid recording unrelated operating expenses


• Improperly capitalized a variety of expenses • Failed to establish sufficient

reserves (liabilities) to pay for income taxes and other expenses


• The Company's revenues and profits were not growing fast enough to meet targets, so management inflated earnings by improperly eliminating and deferring current period expenses.

• Employing a multitude of improper accounting practices to achieve this objective, management:


–Avoided depreciation expenses on their garbage trucks by both assigning unsupported and inflated salvage values and extending their useful lives–Assigned arbitrary salvage values to other

assets that previously had no salvage value – Failed to record expenses for decreases in

the value of landfills as they were filled with waste


• Waste Management used netting to eliminate approximately $490 million in current period operating expenses and accumulated prior period accounting misstatements by offsetting them against unrelated one-time gains on the sale or exchange of assets.


• They used geography entries to move tens of millions of dollars between various line items on the Company's income statement to, in Koenig's words, "make the financials look the way we want to show them."


•Some believe that Andersen would have survived Enron if not for the blatant acts at Waste Management

The Enron Scandal

• November 1997– Enron buys out a partner's stake in a company called JEDI

and sells the stake to a firm it creates, called Chewco, to be run by an Enron officer. Thus begins a complex series of transactions that enable Enron to hide debts.

• February 20, 2001– A FORTUNE story calls Enron a "largely impenetrable"

company that is piling on debt while keeping Wall Street in the dark.

• Stock Close: $75.09

The Enron Scandal

• August 14– CEO Jeffrey Skilling resigns, becoming the sixth senior

executive to leave in a year. Lay says in a conference call with stock analysts, "I never felt better about the company." He deflects analysts' pleas for more disclosure. They lower their ratings on Enron stock, which drops in after-hours trading to a 52-week low.

– Stock Close: $39.55• October 12– Arthur Andersen legal counsel instructs workers who audit

Enron's books to destroy all but the most basic documents.– Andersen acknowledges destroying Enron file

The Enron Scandal

• October 16– Enron reports a third-quarter loss of $618 million. Moody's investors Service

indicates that it is considering lowering its credit rating on Enron debt securities.

– Stock Close: $33.84– October 22– Enron discloses that the Securities Exchange Commission has opened an

inquiry.• October 24

– Chief financial officer Andrew Fastow, who ran some of Enron's stealth partnerships, is replaced.

• October 26– The Wall Street Journal reports the existence of the Chewco partnerships run

by an Enron manager. Ken Lay calls Fed Chairman Alan Greenspan to alert him of the company's problems.

– Stock Close: $15.40

The Enron Scandal

• October 16– Enron reports a third-quarter loss of $618 million. Moody's

investors Service indicates that it is considering lowering its credit rating on Enron debt securities.

– Stock Close: $33.84• October 22– Enron discloses that the Securities Exchange Commission

has opened an inquiry.• October 24– Chief financial officer Andrew Fastow, who ran some of

Enron's stealth partnerships, is replaced.

The Enron Scandal

• October 26– The Wall Street Journal reports the existence of the Chewco

partnerships run by an Enron manager. Ken Lay calls Fed Chairman Alan Greenspan to alert him of the company's problems.

– Stock Close: $15.40• October 28

– Lay calls Treasury Secretary Paul O'Neill. In October and November, Enron's president phones an O'Neill deputy at least six times, seeking help.

• October 29– Lay calls Commerce Secretary Donald Evans, suggesting he help Enron.

The Enron Scandal

• November 8– Enron admits accounting errors, inflating income by $586

million since 1997.• November 9– Lay again talks to Treasury's O'Neill.

• November 29– The SEC expands its investigation to include auditor Arthur

Andersen.• December 2– Enron files for bankruptcy.– Stock Close: 26 cents

The Enron Scandal

• December 12– Andersen CEO Joseph Berardino testifies his firm

discovered "possible illegal acts" committed by Enron.• January 9, 2002– The Justice Department launches a criminal investigation.

• January 10– Attorney General John Ashcroft rescues himself from the

investigation because of contributions he received

The Tyco Accounting Scandal

• Tyco International engaged for years in financial gimmickry to inflate its earnings, the company acknowledged yesterday, saying that it would erase $382 million in profits it had previously claimed.


• Tyco said that a five-month internal investigation had uncovered a corporate culture that openly encouraged managers to push the rules of accounting to mislead investors about the company's results. – A memorandum to employees at one division directed

them to find cost savings by ''financial engineering.'' At another unit, employees were told to ''create stories'' to justify an accounting change that would improve Tyco's earnings.


• The integrity of the company's earnings suffered from ''a pattern of using aggressive accounting that, even when not erroneous, was undertaken with the purpose and effect of increasing reported results above what they would have been.'‘

• For the 2002 fiscal year, which ended Sept. 30, the company previously reported a net loss of $9.1 billion after a series of earlier write-offs. T– Tyco's accounting, tax and executive pay practices continue to be

investigated by the Securities and Exchange Commission, the Manhattan district attorney's office, federal lawyers in New Hampshire and the Internal Revenue Service.

What These Examples Teaches Us

• There Is No Substitute For Accounting and Credit Due Diligence

• There Is No Substitute For A Full and Complete Cash Flow Analysis.

• Lenders Should Not Accept Cash Flow In Annual Reports Without Good Old Fashioned Digging

Introduction To "Watch Out" Accounting Practices.

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Transcript of Introduction To "Watch Out" Accounting Practices.