How Companies Cook the Books

How Companies Cook the Books Guidance on Part I of Project Cash Flow Projections & Earnings Quality – Provide an descriptive analysis of your company, its strategy for generating profit/cashflow growth, potential competition, technological risks, etc. • Ie: How cashflows will be generated – Then, based on this strategic analysis, use techniques we discussed in class and for the Dell case to provide estimates of FCFE for: • • • • Current Year Next 5 Years Years 5-10 (or 20) …. If necessary Cash flows in perpetuity (growing perpetuity) Guidance on Part I of Project Cash Flow Projections & Earnings Quality – Provide robustness analysis CF projections: • Differing growth rate estimates • Different assumptions on Working Capital Accruals, CapEx, Depreciation, Financing changes – Analyze Earnings Quality using discussed in this and next class. • • • • techniques Excessive accruals Wedge between CFO and Operating Income Growth in receivables that exceeds growth in sales Aggressive accounting techniques compared to competitors • SEE PROJECTS FROM PRIOR YEARS ON WEB Cooking the books and earnings management/manipulation • Central theme: Firms & managers often have incentives to misstate earnings/balance sheet items: – Contracting incentives: • • • • Avoid violating accounting covenants in loan agreements Avoid taxation (Progressive tax scheme) Maximize bonus (managers) Avoid regulatory/government/union intervention (understate profits) • Avoid detection of managerial shirking or outright “stealing” – Stock market incentives: Meet analysts’ targets • Stock options; issuing equity in near future Outcome of Accounting Manipulation at Oracle in early 1990’s • What happened after the revelation of overlyaggressive accounting: – – – – Stock market impact What happened to executives Litigation SEC fines …. In the end, there usually is a “settling up.” • Do companies learn from mistakes of others? – Fast-forward to now: • 2001: Lucent Technologies • 2002: Worldcom Types of Possible Manipulation • Unacceptable methods: Too “liberal”: – Not writing off the cost of unsaleable inventory. – Depreciation of long-lived assets over longer period than they will be useful to the business. – Recording sales before they final (or failure to recognize the likelihood of returns or bad debts) • Unacceptable methods: Too “conservative”: – Expensing cost of inventory that will not be sold until future. – Over depreciating assets with long lives. – Delaying recording sales that have already occurred. Red Flags • Warnings signs to watch out for: – – – – – – – – Reported NI grows faster than CFO. AR growth faster than sales growth. Sales slow while inventories pile up. Bad debt reserves debt cut. Methods for calculating revenue & costs change. Sales are booked before payments received. Dramatic change in gross margin. Turnover of auditor, key execs or lawyers. Industry-Specific Manipulation: Warnings for your company analysis! • Computer/Telecom Hardware: – Technological change: impact on receivables & inventory, appropriate depreciation allowances? • Retailing: – Are accounts receivables questionable? – Do sales factor on rebate programs? – Warranties liabilities • Subscription Services: – How are promotion costs treated (capitalizes? i.e AOL) – Subscriptions paid in advance: quality of deferred revenues • Real Estate: – Carrying values for real property Problems with “New Economy” Firms • Recognizing sales before they exist (iVillage) • Net vs Gross (Priceline) • Barter transactions (Starmedia) • Coupons/discounts/loss leaders (AOL) • Fulfillment costs (Amazon.com) • Swap Transactions: – See Handout “Tricks of the Trade” • Big Bath: • Take big write-off today to set up the books for the future • PROBLEM: Investors may forget write-off, Expenses are understated in the future and earnings are overstated. • Example of Kodak with “Special items” • Vendor Financing: • Make loans to customers with questionable ability to repay loans • Understate bad debt reserves (ie Lucent) • Profits too high today …. Big potential losses in future. • Booking Revenues Too Early: • Check again SEC SAB 101 Statement! • Classic cases of Cendant and Microstrategy “Tricks of the Trade” • Defined Benefit Pension Plan Games: • What is a defined benefit plan? • Fund assets are separate from the company. Funds are used to pay present and future pension obligations to retirees. It must be properly funded! (ERISA ACT 1974). • Is there enough money? Need to know: – – – – Who are beneficiaries and amount required Rate of return of investments Attrition rate Growth rate in future retiree benefits • Company must make periodic payments if plan is “underfunded” • BIG QUESTION: Is it underfunded or overfunded • This vagueness creates the “cookie-jar” for managers Expectations Management of Analysts’ Earnings Forecasts Forecast Error= (Actual EPS – Forecast EPS)