Financial statement analysis is an essential skill in a variety of occupations including investment management, corporate finance, commercial lending, and the extension of credit. For individuals engaged in such activities, or who analyze financial data in connection with their personal investment decisions, there are two distinct approaches to the task.
The first is to follow a prescribed routine, filling in boxes with standard financial ratios, calculated according to precise and inflexible definitions. It may take little more effort or mental exertion than this to satisfy the formal requirements of many positions in the field of financial analysis. Operating in a purely mechanical manner, though, will not provide much of a professional challenge. Neither will a rote completion of all of the “proper” standard analytical steps ensure a useful, or even a non harmful, result. Some individuals, however, will view such problems as only minor drawbacks.
The analyst who will adopt the second and more rewarding alternative, the relentless pursuit of accurate financial profiles of the entities being analyzed. Tenacity is essential because financial statements often conceal more than they reveal. To the analyst who pursues this proactive approach, producing a standard spreadsheet on a company is a means rather than an end. Investors derive but little satisfaction from the knowledge that an untimely stock purchase recommendation was supported by the longest row of figures available in the software package. Genuinely valuable analysis begins after all the usual questions have been answered. Indeed, a superior analyst adds value by raising questions that are not even on the checklist.
Some readers may not immediately concede the necessity of going beyond an analytical structure that puts all companies on a uniform, objective scale. They may recoil at the notion of discarding the structure altogether when a sound assessment depends on factors other than comparisons of standard financial ratios. Comparability, after all, is a cornerstone of generally accepted accounting principles (GAAP). It might therefore seem to follow that financial statements prepared in accordance with GAAP necessarily produce fair and useful indications of relative value.
The corporations that issue financial statements, moreover, would appear to have a natural interest in facilitating convenient, cookie-cutter analysis. These companies spend heavily to disseminate information about their financial performance. They employ investor-relations managers, they communicate with existing and potential shareholders via interim financial reports and press releases, and they dispatch senior management to periodic meetings with securities analysts. Given that companies are so eager to make their financial results known to investors, they should also want it to be easy for analysts to monitor their progress. It follows that they can be expected to report their results in a transparent and straightforward fashion or so it would seem.
THE PURPOSE OF FINANCIAL REPORTING
Analysts who believe in the inherent reliability of GAAP numbers and the good faith of corporate managers misunderstand the essential nature of financial reporting. Their conceptual error connotes no lack of intelligence, however. Rather, it mirrors the standard accounting textbook’s idealistic but irrelevant notion of the purpose of financial reporting. Even Howard Schilit, an acerbic critic of financial reporting as it is actually practiced, presents a high minded view of the matter:
The primary goal in financial reporting is the dissemination of financial statements that accurately measure the profitability and financial condition of a company. Missing from this formulation is an indication of whose primary goal is accurate measurement. Schilit’s words are music to the ears of the financial statements users listed in this chapter’s first paragraph, but they are not the ones doing the financial reporting. Rather, the issuers are for-profit companies, generally organized as corporations.
A corporation exists for the benefit of its shareholders. Its objective is not to educate the public about its financial condition, but to maximize its shareholders’ wealth. If it so happens that management can advance that objective through “dissemination of financial statements that accurately measure the profitability and financial condition of the company,” then in principle, management should do so. At most, however, reporting financial results in a transparent and straightforward fashion is a means unto an end.
Management may determine that a more direct method of maximizing shareholder wealth is to reduce the corporation’s cost of capital. Simply stated, the lower the interest rate at which a corporation can borrow or the higher the price at which it can sell stock to new investors, the greater is the wealth of its shareholders. From this standpoint, the best kind of financial statement is not one that represents the corporation’s condition most fully and most fairly, but rather one that produces the highest possible credit rating and price-earnings multiple. If the highest ratings and multiples result from statements that measure profitability and financial condition inaccurately, the logic of fiduciary duty to shareholders obliges management to publish that sort, rather than the type held up as a model in accounting textbooks.
The best possible outcome is a cost of capital lower than the corporation deserves on its merits. This admittedly perverse argument can be summarized in the following maxim, presented from the perspective of issuers of financial statements:
The purpose of financial reporting is to obtain cheap capital.
Attentive readers will raise two immediate objections. First, they will say, it is fraudulent to obtain capital at less than a fair rate by presenting an unrealistically bright financial picture. Second, some readers will argue that misleading the users of financial statements is not a sustainable strategy over the long run. Stock market investors who rely on overstated historical profits to project a corporation’s future earnings will find that results fail to meet their expectations. Thereafter, they will adjust for the upward bias in the financial statements by projecting lower earnings than the historical results would otherwise justify. The outcome will be a stock valuation no higher than accurate reporting would have produced. Recognizing that the practice would be self-defeating, corporations will logically refrain from overstating their financial performance. By this reasoning, the users of financial statements can take the numbers at face value, because corporations that act in their self-interest will report their results honestly.
The inconvenient fact that confounds these arguments is that financial statements do not invariably reflect their issuers’ performance faithfully. In lieu of easily understandable and accurate data, users of financial statements often find numbers that conform to GAAP yet convey a misleading impression of profits. Worse yet, outright violations of the accounting rules come to light with distressing frequency. Not even the analyst’s second line of defense, an affirmation by independent auditors that the statements have been prepared in accordance with GAAP, assures that the numbers are reliable.
A few examples from recent years indicate how severely an overly trusting user of financial statements can be misled.
Mercury Plunges
In January 1997, Mercury Finance’s controller was reported to have disappeared after the company reduced its 1996 earnings to $56.7 million from an originally reported $120.7 million. The used-car loan company’s cofounder and chief executive officer, John Brincat, contended that the irregularities necessitating the restatements were apparently “the result of unauthorized entries being made to the accounting records of the company by the principal accounting officer,” the missing James A. Doyle. On January 28, the day before the earnings revision, Mercury’s stock closed at $14.875 a share. When trading in the shares reopened on January 31, the price plunged to $2.125. As the story developed, controller Doyle’s attorney denied that his client had disappeared. Rather, “He decided with the advice of counsel to no longer participate in the charade taking place at Mercury Finance.”
Speaking through his lawyer, Doyle added that he was cooperating with a federal investigation of the company. Thickening the plot was the provision in CEO Brincat’s management contract whereby he was not entitled to any bonus in any year in which earnings per share rose by less than 20%. Doyle had no such bonus arrangement, leading some observers to wonder what motive he would have had to falsify the financials. Additional earnings revisions announced along with the 1996 restatement indicated that Mercury did not, after all, achieve the 20% target in 1994 or 1995, even though Brincat received bonuses of $1.4 million and $1.6 million, respectively, for those years.6 In any case, Brincat resigned as chief executive officer on February 3. A year later he stepped down from the company’s board and agreed to repay part of his 1994–1996 bonuses.
Also in February 1998, Mercury announced that it would file for bankruptcy. By then, the company had revised its originally reported 1996 profit of $120.7 million to a net loss. In hindsight, the financial statements had incorporated unrealistic assumptions about the percentage of Mercury’s low income borrowers who would fail to keep up their loan payments. The auditors had certified the results, despite the telltale warning sign that the statements showed Mercury earning more than double the historical average return on equity (see Chapter 13) of other companies in its business.
Securities analyst Charles Mills of Anderson & Strudwick likened such improbably superior performance to a human running a two-minute mile.
MicroStrategy Changes Its Mind
On March 20, 2000, MicroStrategy announced that it would restate its 1999 revenue, originally reported as $205.3 million, to around $150 million.
The company’s shares promptly plummeted by $140 to $86.75 a share, slashing chief executive officer Michael Saylor’s paper wealth by over $6 billion. The company explained that the revision had to do with recognizing revenue on the software company’s large, complex projects.8 Micro- Strategy and its auditors initially suggested that the company had been obliged to restate its results in response to a recent (December 1999) Securities and Exchange Commission (SEC) advisory on rules for booking software revenues. After the SEC objected to that explanation, the company conceded that its original accounting was inconsistent with accounting principles published way back in 1997 by the American Institute of Certified Public Accountants.
Until MicroStrategy dropped its bombshell, the company’s auditors had put their seal of approval on the company’s revenue recognition policies.
That was despite questions raised about MicroStrategy’s financials by accounting expert Howard Schilit six months earlier and by reporter David Raymond in an issue of Forbes ASAP distributed on February 21.9 It was reportedly only after reading Raymond’s article that an accountant in the auditor’s national office contacted the local office that had handled the audit, ultimately causing the firm to retract its previous certification of the 1998 and 1999 financials.
No Straight Talk from Lernout & Hauspie
On November 16, 2000, the auditor for Lernout & Hauspie Speech Products (L&H) withdrew its clean opinion of the company’s 1998 and 1999 financials.
The action followed a November 9 announcement by the Belgian producer of speech-recognition and translation software that an internal investigation had uncovered accounting errors and irregularities that would require restatement of results for those two years and the first half of 2000. Two weeks later, the company filed for bankruptcy.
Prior to November 16, 2000, while investors were relying on the auditor’s opinion that Lernout & Hauspie’s financial statements were consistent with generally accepted accounting principles, several events cast doubt on that opinion. In July 1999, short-seller David Rocker criticized transactions such as L&H’s arrangement with Brussels Translation Group (BTG). Over a two-year period, BTG paid L&H $35 million to develop translation software. L&H then bought BTG and the translation product along with it. The net effect was that instead of booking a $35 million research and development expense, L&H recognized $35 million of revenue. 11 In August 2000, certain Korean companies that L&H claimed as customers said that they in fact did no business with the corporation. In September, the Securities and Exchange Commission and Europe’s Easdaq stock market began to investigate L&H’s accounting practices.12 Along the way, Lernout & Hauspie’s stock fell from a high of $72.50 in March 2000 to $7 before being suspended from trading in November. In retrospect, uncritical reliance on the company’s financials, based on the auditor’s opinion and a presumption that management wanted to help analysts get the true picture, was a bad policy.
THE FLAWS IN THE REASONING
As the preceding deviations from GAAP demonstrate, neither fear of antifraud statutes nor enlightened self-interest invariably deters corporations from cooking the books. The reasoning by which these two forces ensure honest accounting rests on hidden assumptions. None of the assumptions can stand up to an examination of the organizational context in which financial reporting occurs.
To begin with, corporations can push the numbers fairly far out of joint before they run afoul of GAAP, much less open themselves to prosecution for fraud. When major financial reporting violations come to light, as in most other kinds of white-collar crime, the real scandal involves what is not forbidden. In practice, generally accepted accounting principles countenance a lot of measurement that is decidedly inaccurate, at least over the short run.
For example, corporations routinely and unabashedly smooth their earnings. That is, they create the illusion that their profits rise at a consistent rate from year to year. Corporations engage in this behavior, with the blessing of their auditors, because the appearance of smooth growth receives a higher price-earnings multiple from stock market investors than the jagged reality underlying the numbers.
Suppose that, in the last few weeks of a quarter, earnings threaten to fall short of the programmed year-over-year increase. The corporation simply “borrows” sales (and associated profits) from the next quarter by offering customers special discounts to place orders earlier than they had planned. Higher-than-trendline growth, too, is a problem for the earnings smoother.
A sudden jump in profits, followed by a return to a more ordinary rate of growth, produces volatility, which is regarded as an evil to be avoided at all costs. Management’s solution is to run up expenses in the current period by scheduling training programs and plant maintenance that, while necessary, would ordinarily be undertaken in a later quarter.
These are not tactics employed exclusively by fly-by-night companies.
Blue chip corporations openly acknowledge that they have little choice but to smooth their earnings, given Wall Street’s allergy to surprises. Officials of General Electric have indicated that when a division is in danger of failing to meet its annual earnings goal, it is accepted procedure to make an acquisition in the waning days of the reporting period. According to an executive in the company’s financial services business, he and his colleagues hunt for acquisitions at such times, saying, “Gee, does somebody else have some income?
Is there some other deal we can make?”13 The freshly acquired unit’s profits for the full quarter can be incorporated into GE’s, helping to ensure the steady growth so prized by investors.
Why do auditors not forbid such gimmicks? They hardly seem consistent with the ostensible purpose of financial reporting, namely, the accurate portrayal of a corporation’s earnings. The explanation is that sound principles of accounting theory represent only one ingredient in the stew from which financial reporting standards emerge.
Along with accounting professionals, the issuers and users of financial statements also have representation on the Financial Accounting Standards Board (FASB), the rule-making body that operates under authority delegated by the Securities and Exchange Commission. When FASB identifies an area in need of a new standard, its professional staff typically defines the theoretical issues in a matter of a few months. Issuance of the new standard may take several years, however, as the corporate issuers of financial statements pursue their objectives on a decidedly less abstract plane.
From time to time, highly charged issues such as executive stock options and mergers lead to fairly testy confrontations between FASB and the corporate world. The compromises that emerge from these dustups fail to satisfy theoretical purists. On the other hand, rule-making by negotiation heads off all-out assaults by the corporations’ allies in Congress. If the lawmakers were ever to get sufficiently riled up, they might drastically curtail FASB’s authority. Under extreme circumstances, they might even replace FASB with a new rule-making body that the corporations could more easily bend to their will.
There is another reason that enlightened self-interest does not invariably drive corporations toward candid financial reporting. The corporate executives who lead the battles against FASB have their own agenda. Just like the investors who buy their corporations’ stock, managers seek to maximize their wealth. If producing bona fide economic profits advances that objective, it is rational for a chief executive officer (CEO) to try to do so. In some cases, though, the CEO can achieve greater personal gain by taking advantage of the compensation system through financial reporting gimmicks.
Suppose, for example, the CEO’s year-end bonus is based on growth in earnings per share. Assume also that for financial reporting purposes, the corporation’s depreciation schedules assume an average life of eight years
for fixed assets. By arbitrarily amending that assumption to nine years (and obtaining the auditors’ consent to the change), the corporation can lower its annual depreciation expense. This is strictly an accounting change; the actual cost of replacing equipment worn down through use does not decline.
Neither does the corporation’s tax deduction for depreciation expense rise nor, as a consequence, does cash flow. Investors recognize that bona fide profits (see Chapter 5) have not increased, so the corporation’s stock price does not change in response to the new accounting policy.
What does increase is the CEO’s bonus, as a function of the artificially contrived boost in earnings per share.
This example explains why a corporation may alter its accounting practices, making it harder for investors to track its performance, even though the shareholders’ enlightened self-interest favors straightforward, transparent financial reporting. The underlying problem is that corporate executives sometimes put their own interests ahead of their shareholders’ welfare.
They beef up their bonuses by overstating profits, while shareholders bear the cost of reductions in price–earnings ratios to reflect deterioration in the quality of reported earnings.
The logical solution for corporations, it would seem, is to align the interests of management and shareholders. Instead of calculating executive bonuses on the basis of earnings per share, the board should reward senior management for increasing shareholders’ wealth by causing the stock price to rise. Such an arrangement gives the CEO no incentive to inflate reported earnings through gimmicks that transparently produce no increase in bona fide profits and therefore no rise in the share price.
Following the logic through, financial reporting ought to have moved closer to the ideal of accurate representation of corporate performance as companies have increasingly linked executive compensation to stock price appreciation. In reality, though, no such trend is discernible. If anything, the preceding examples of Mercury Finance, Micro Strategy, and Lernout & Hauspie suggest that corporations are becoming more creative and more aggressive in their financial reporting.
Aligning management and shareholder interests, it turns out, has a dark side. Corporate executives can no longer increase their bonuses through financial reporting tricks that are readily detectable by investors. Instead, they must devise better-hidden gambits that fool the market and artificially elevate the stock price. Financial statement analysts must work harder than ever to spot corporations’ subterfuges.
SMALL PROFITS AND BIG BATHS
Certainly, financial statement analysts do not have to fight the battle singlehandedly.
The Securities and Exchange Commission and the Financial Accounting Standards Board prohibit corporations from going too far in prettifying their profits to pump up their share prices. These regulators refrain from indicating exactly how far is too far, however. Inevitably, corporations hold diverse opinions on matters such as the extent to which they must divulge bad news that might harm their stock market valuations. For some, the standard of disclosure appears to be that if nobody happens to ask about a specific event, then declining to volunteer the information does not constitute a lie.
The picture is not quite that bleak in every case, but the bleakness extends pretty far. A research team led by Harvard economist Richard Zeckhauser has compiled evidence that lack of perfect candor is widespread. Zeckhauser et al. focus on instances in which a corporation reports quarterly earnings that are only slightly higher or slightly lower than its earnings in the corresponding quarter of the preceding year.
Suppose that corporate financial reporting followed the accountants’ idealized objective of depicting performance accurately. By the laws of probability, corporations’ quarterly reports would include about as many cases of earnings that barely exceed year-earlier results as cases of earnings that fall just shy of year-earlier profits. Instead, Zeckhauser et al. find that corporations post small increases far more frequently than they post small declines.
The strong implication is that when companies are in danger of showing slightly negative earnings comparisons, they locate enough discretionary items to squeeze out marginally improved results.
On the other hand, suppose a corporation suffers a quarterly profit decline too large to erase through discretionary items. Such circumstances create an incentive to “take a big bath” by maximizing the reported setback.
The reasoning is that investors will not be much more disturbed by a 30% drop in earnings than by a 20% drop. Therefore, management may find it expedient to accelerate certain future expenses into the current quarter, thereby ensuring positive reported earnings in the following period. It may also be a convenient time to recognize long-run losses in the value of assets such as outmoded production facilities and goodwill created in unsuccessful acquisitions of the past. In fact, the corporation may take a larger write-off on those assets than the principle of accurate representation would dictate.Reversals of the excess write-offs offer an artificial means of stabilizing reported earnings in subsequent periods.
Zeckhauser and his associates corroborate the big bath hypothesis by showing that large earnings declines are more common than large increases. By implication, managers do not passively record the combined results of their own skill and business factors beyond their control, but intervene in the calculation of earnings by exploiting the latitude in accounting rules.
The researchers’ overall impression is that corporations regard financial reporting as a technique for propping up stock prices, rather than a means of disseminating objective information.
If corporations’ gambits escape detection by investors and lenders, the rewards can be vast. For example, an interest-cost savings of one-half of a percentage point on $1 billion of borrowings equates to $5 million (pretax) per year. If the corporation is in a 34% tax bracket and its stock trades at 15 times earnings, the payoff for risk-concealing financial statements is $49.5 million in the cumulative value of its shares.
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