Earnings Magic & the Unbalance Sheet The Search for Financial Reality

What the Book is About The focus of this book is on earnings management and other factors related to transparency (complete disclosure based on financial reality) The Big 8 are the major items that can distort financial reality, from revenue recognition to stock options and off-balance sheet items The Dirty 30 are the Big 8 plus a host of other issues that can distort financial reality

Sections of the Book Section 1 provides background on what earnings magic is all about, a bit of financial scandal history, and new regulatory requirements since Sarbanes-Oxley Section 2 reviews the Big 8 and Dirty Thirty is some detail, focusing on the Dow 30 The final section puts is all together to reevaluate financial reality and rate companies on earnings magic and transparency; the focus is again on the Dow 30

Background on Earnings Magic Section 1 Background on Earnings Magic

Content of Section 1 1. What is Earnings magic? Definition & overview, particularly incentives 2. Caught in the Act! History of current scandals 3. The New Accounting. Thanks to the scandals, new regulations are in place & more are on the way 4. Wading Through the Earnings Numbers. Strategies for reviewing financial disclosures

Chapter 1 What is Earnings Magic?

What is Earnings Magic? Earnings magic: all the factors that limit understanding financial reality Earnings management: Operating & discretionary accounting methods to adjust earnings to a desired outcome; the incentives of management to modify earnings in their own best interests Earnings manipulation includes aggressive earnings management and fraud Earnings manipulation is at the heart of earnings magic—how companies can recast financial information to avoid financial reality

Conservative vs. Aggressive Accounting & Fraud Conservative accounting generally is close to financial reality; firms can move toward aggressive accounting (with fraud being the extreme case) to make earnings look better Conservative revenue recognition: revenue recognized after sale, delivery, & acceptance; that is, the earnings process is complete Aggressive revenue recognition example: bill & hold (that is, revenue is recognize although goods have not been shipped) Fraud example: nonexistent or other fraudulent sales

Incentives for Earnings Magic “It pays to do it, it’s easy to do, and it’s unlikely that you’ll get caught” (Schilit) Opportunism: self-interest with guile—violating normal ethical boundaries for personal gain Executive incentives include bonuses and stock options: executives can increase compensation by making the performance look great through earnings magic Many contracts (e.g., lending & employee contracts) are based on accounting numbers, which can be fudged to “make the numbers” See Exhibit 1.4

Institutional Framework (1) The purpose of the various market & financial institutions is to facilitate economic transactions and protect the key constituents, especially stakeholders Generally, the institutional players are expected to ensure market efficiency and financial transparency (including fiduciary responsibility) The institutions can be classified as (1) regulatory (e.g., SEC, FASB) & (2) private (e.g., board of directors, auditors, investment banks, attorneys)

Institutional Framework (2) Corporate governance: The board of directors and the structure in place to oversee the management of an organization Auditors: evaluate appropriate financial accounting and reporting according to generally accepted accounting principles (GAAP). Auditors must have the ability to discover significant discrepancies with GAAP (competence) & willingness to report the discrepancies to the audit committee or other relevant bodies (independence)

Institutional Framework (3) Securities & Exchange Commission (SEC): primary financial regulator of financial disclosure (with oversight over securities markets) Financial Accounting Standards Board (FASB): sets accounting standards (generally accepted accounting principles or GAAP) for U.S. firms

Institutional Framework (4) Investment banks: Investment banks issue new securities and other financial instruments. Financial analysts provide research on equity investment, including earnings forecasts and buy-hold-sell recommendations. Analysts have incentives to recommend buys on investment banking clients and brokers are encouraged to sell the new issues Attorneys: Attorneys often write and review contracts, particularly those that are complex and controversial. Other law firms write legal opinion letters. The auditor can normally approve complex contracts based on attorney opinion letters

Institutional Signals of Earnings Magic Environment Strong CEO (who is also chairman of the board) with substantial perks Board made up primarily of insiders Poor board committee structure, especially audit committee Audit problems, including non-audit fees Executive compensation problems, including huge (& poorly structured) incentives packages Investment banking problems, including non-independent analysts

What is Financial Reality? Transparency—complete disclosure attempting to approximate financial reality Financial statements are a potential summary of financial reality Complex disclosures in the notes, MD&A, etc. can be used to better measure reality What bottom line measure is the best measure: net income, income from operations, comprehensive income? Income from continuing operations is a possible starting point

Detecting Earnings Magic Standard Financial Analysis (including ratios & other quantitative analysis Industry analysis (e.g., occupancy rates are important to hotels) Detailed accounting analysis (found in notes, proxy statements, etc) Importance of multi-period analysis

Detecting Earnings Magic using Multi-period Analysis A longer- term perspective, looking for recurring patterns or negative trends Quarterly patterns than may signal intra-year earnings management Balance sheet issues Income statement issues Focus is on signals of earnings magic, not absolute proof

Chapter 2 Caught in the Act!

Capitalism in Action Crises—unsustainable booms followed by calamitous busts—have always been with us, and with us they will always remain. … The very things that give capitalism its vitality—its powers of innovation and its tolerance for risk—can also set the stage for asset and credit bubbles and eventually catastrophic meltdowns whose ill effects reverberate long afterward. Nouriel Roubini and Stephen Mihm

What is a Scandal? Like the terms speculation or corruption, the idea of a business scandal is loosely defined According to Wikipedia: “A scandal is a widely publicized incident that involves allegations of wrongdoing, disgrace, or moral outrage” How corruption and scandals are defined has changed over time, but bribery, speculation, greed, and power seem to be common in all periods A corporate scandal often involves accounting fraud

19th & 20th Century Scandals Panics of 1792, 1819, 1837, 1857, 1873, 1893, 1907. Credit Mobilier (transcontinental railroad) Raiding the Erie Boss Tweed & Tammany Hall Teapot Dome Charles Ponzi Great Depression: markets rigged, lack of disclosure (Krueger & Toll), stock pyramiding, excessive leverage McKesson & Robbins (auditing deficiencies) Conglomerates (merger magic) & hostile takeovers Michael Milken: junk bonds, insider trading, savings & loan crisis Derivatives (1987 Crash, Mexico to Long-term Capital Management)

Key Scandals Through 2005 Waste Management (1997) Sunbeam (1998) Enron (2001) Global Crossing (2002) WorldCom (2002) Tyco (2002) Adelphia (2002) Imclone (2002) Merrill Lynch & other investment banks (2002) HealthSouth (2003) Fannie Mae (2004) AIG (2005)

The Wisdom of Crowds (Surowiecki) Trust is central to economic systems because of cooperative behavior Corruption is very damaging to the system Current scandals: short-term gains from corruption were immense Institutions designed to limit corruption were ineffectual (or perhaps facilitated corruption)

Scandal “Theory” Rotten apple theory—sleazy leaders establishing illegal conspiracies Specific cultural issues; e.g., speculation in the 1920s, conglomerate mergers in the 1950s, hostile takeovers in the 1980, stock options and earnings forecasts in the 1990s Institutional theory—the business & regulatory structure in place Corporate governance practices Survival of the fittest Importance of excessive leverage Incentives of key players, especially compensation

Reasons for the 1990s/2000s Scandals Euphoria: Booming stock market, with a focus on internet, telecom, & other high-tech industries Large number of initial public offerings (many with no evidence of ability to make money) Underfunded SEC & FASB & political pressure NOT to regulate effectively Emphasis on meeting quarterly earnings estimates (largely because of executive compensation incentives) Poor corporate governance practices were common Accommodating investment bankers, attorneys, and auditors

Historical Perspective on Scandals Corporate fraud, bankruptcies, and various illegal acts have always been part of the business environment Every time fiascos erupt seems a shock, but business history records dozens of failures, frauds and other measures of massive corruption each decade The big ones often hit during recessions or periods of other economic problems The high-risk firms are the most vulnerable to economic shocks

Why the Scandals? The obvious corporate greed—is it more widespread than in earlier periods? Incredible incentives to cheat, especially stock options Earnings manipulation is part of (and usually central to) most of the scandals Prominent industries included energy companies and telecommunications (+ accommodating investment banks)—importance of deregulations Scale: these were big firms involved

Enron (1) Stogy gas transmission company started with massive debt Formed a gas trading company, expanded into electricity, risk mgt. & telecom; expanded internationally Based on economic reality, many of these were failures Based on earnings magic, all were successful

Enron (2) Gas trading: deregulated & volatile, need for spot market purchases & related derivatives, volatility increased trading profits Problem of massive debt & potential junk bond ratings Use of special purpose entities (SPEs) to reduce perception of too much debt Substantial reliance on stock options and bonuses

Enron (3) Importance of meeting quarterly earnings, initially through cost savings, then increasingly more gimmicks Scheme 1: revalue physical assets using “fair value” models (SFAS 125, designed for financial assets)—front-loading profits Scheme 2: using SPEs in virtually any complex context to record earnings

Enron (4) SPEs were mishandled CFO Andy Fastow manipulated these for his own enrichment + independence problem Particularly shady SPEs approved by auditor Arthur Andersen, attorneys, & board of directors; accommodated by investment banks & no obvious oversight by SEC—failure of the gatekeepers

Enron (5) Some operations were successful, others were major blunders; the net effect was to dramatically increase financial risk, & Enron’s unwillingness to disclose real losses as they occurred Mid-2001: stock price dropped, executives bailed out of stock options, bond ratings back to junk status Enron restated earnings in 3rd quarter 2001 With no credibility, Enron declared bankruptcy in December 2001, the biggest bankruptcy until …

WorldCom (1) Bernie Ebbers started long-distance telecom company in 1983 (name changed to WorldCom in 1995) Growth through merger strategy (note earnings magic of business combinations) WorldCom “looked” solid, with total assets of $104 billion & debt-to-equity of 79.3%, but half the assets were goodwill & other intangibles In 2002 internal audit found operating expenses capitalized

WorldCom (2) New auditor KPMG reviewed the books, old auditor Arthur Andersen was fired; Ebbers resigned in April In June 2002 WorldCom announced $3.8 billion in accounting errors, mainly by capitalizing “line costs” (fees to other telecom companies for network access rights—these are operating expenses)

WorldCom (3) WorldCom restated earnings, CFO was fired Actual capitalization misstatements totaled over $11 billion WorldCom filed for bankruptcy in July 2002, replacing Enron as the largest bankruptcy in US history

Tyco (1) Started as a research lab, Tyco became a conglomerate through acquisitions CEO “Deal a Day Dennis” Kozlowski acquired 750 companies, using the earnings magic of combination accounting Acquisition of CIT Group particular fiasco, resulting in big losses (& extra financial reporting that showed many of Tyco’s manipulation shenanigans

Tyco (2) Big loss on sale of CIT & total $9.4 billion loss for 2002 Kozlowski indicted for evading taxes & “raiding” Tyco Tyco did not go bankrupt Despite obvious manipulation & deception on a vast scale, it’s not clear that the company actually engaged in criminal acts

Adelphia John Regas transformed a cable franchise into a communications empire Restated earnings in 2002, including billion in off-balance-sheet “co-borrowing agreements” Filed for bankruptcy in June 2002 Regas & others charged with financial fraud—pilfering the company

What do Enron, WorldCom & Tyco Have in Common Deception on a massive scale—manipulation at the highest levels of the companies Growth through acquisitions plus related Business combination accounting abuse Importance of meeting quarterly earnings targets at all costs—related enrichment of senior executives Accommodating auditors, attorneys & boards of directors All three restated earnings

What Happened at Arthur Andersen? One of original Big 8, founded in 1913, stressing integrity & consistency Especially since the 1980s, AA had a history of “aggressive auditing,” clients became too valuable to defy (Toffler) Associated with many of the big scandals: Sunbeam, Waste Management, Enron, WorldCom & Global Crossing Found guilty of obstruction of justice in Enron case (later overturned by Supreme Court)

Other Scandals Stock option backdating—back up the issue date to the lowest security price data; this increases the value of the options; this apparently has been going on a long time, but only surfaced when academics discovered & named the process. About 140 companies are now under investigation Related issues: spring-loading: give options just before good news; Speed-vesting: make sure the options vest before expensing in 2006; Exercise backdating: backdate when options are exercised—to a lower stock price

Scandals (2) Corporate governance at Hewlett-Packard—”pretexting” used to determine source of board of director leaks Hundreds of companies have restated earnings, a likely sign of substantial earnings magic Fraudulent accounting practices at Fannie Mae totaled some $16 billion; Fannie has restated several years of financial statements & paid substantial fines

Scandals (3) Insider trading at UBS & Bear Stearns (note major scandals in 1980s) Related insider trading based on prearranged stock trading plans (10b5-1 plans) by executives: gaming the system by stopping, restarting & amending the plans Front running: trading ahead of big buy and sell orders based on insider information.

Scandals (4) Robert Nardelli canned at Home Depot & received a $210 million exit package; Home Depot executives fired for taking kick backs from Asian vendors; Nardelli resurfaced to become CEO of Chrysler Bernie Madoff, a $50 billion ponzi scheme Allen Stanford ponzi scheme, somewhat smaller See the Earnings Magic web page

Sub-Prime Loan Crisis Mortgage loans are among the safest lending categories because the property is used for collateral and can’t get away. As long as a reasonable down payment is made and credit is good, default chances are low. Sub-prime loans are made to people with relatively poor credit, often requiring little down payment, and made at higher interest rates “Just about anyone in America can afford no money down” (Michael Lewis)

Sub-Prime Loans (2) How do you make a huge market in sub-prime loans? Banks packaged hundred or thousands of them using structured finance into bonds. The key was an investment grade rating (because of1970s regulations plus later foreign regulations). Moody’s & Standard & Poor’s used models that indicated that diversified portfolios of these had low default rates & rated the highest tranches AAA & even low tranches got investment grade ratings. [Bond rating models at the time did not have any equation that included the possibility that housing values could go down!]

Sub-Prime Loans (3) How does a bank make money on these bonds? With a AAA rating, these bonds sold for large premiums over the face value of the underlying mortgages. As long as housing values kept climbing, default rates stayed low. In addition, various forms of “insurance” were available: credit default swaps (think AIG) & liquidity puts (Citi)

Sub-Prime Loans (4) Sub-prime loans packaged into tranches by risk---AAA to BAA & sold as bonds. The low-tranche bonds are accumulated as collateralized debt obligations (CDOs), again by risk tranche; amazingly a large percentage of these are given AAA ratings. Synthetic CDOs are another financial innovation.

Sub-Prime Loans (5) What happened? Cheap credit fueled this environment, but prices were rocketing up after about 2004 (about the time American had a negative savings rate). Housing prices stopped going up. This started about 2006 and became an obvious problem in 2007. The number one problem: LEVERAGE.

Sub-Prime Loans (6) Credit default swaps (CDSs): A premium is paid by the buyer & will pay off if he underlying financial instrument defaults. It’s a derivative & not technically insurance (insurance is regulated, CDSs were exempted from regulation by the Commodity Futures Modernization Act of 2000); CDSs were used as hedges by buyers of CDOs. Smart hedge funds & others started buying CDSs to speculate (rather than sell short mortgage companies, investment banks & home builders). These are the people making a fortune in the current crisis. Investment banks packaged CDSs (they are an asset to them) & sold them as synthetic CDOs Why are there $50 trillion in CDSs when the total US mortgage market is $10-$12 trillion? Part of the explanation: synthetic CDOs

Sub-Prime Villains Alan Greenspan-Fed Structured financing Moody’s; Standard & Poor’s Country-wide (the biggest) & other mortgage companies Lehman Bros & other investment banks AIG Fannie Mae & Freddie Mac SEC Congressional legislation Bond insurance & other derivatives Home buyers

Sub-Prime Chronology Federal National Mortgage Association (FNMA-Fannie Mae) established in 1938 to purchase residential mortgages. Incorporated in 1968 (getting it off the federal balance sheet); Federal Home Loan Mortgage Corporation (FHLMC-Freddie Mac) created the same year to “compete with Fannie Mae.” 1970: collapse of Penn Central (commercial paper); SEC required banks & brokers to hold investment grade securities (or face penalties) 1970: Department of Housing & Urban Development (HUD) created asset securitization using mortgage-backed securities. Government National Mortgage Association (GNMA-Ginnie Mae) sold securities backed by portfolio of mortgage loans. 1977: Community Reinvestment Act required banks to lend to minority communities

Sub-Prime Chronology (2) 1977: First private mortgage-backed securities developed by Salomon Brothers & Bank of America; securitization expanded to auto loans (1985), credit cards (1986), and insurance (1990s). 1978: Solomon Brothers incorporates; other investment banks follow 1994: Home Ownership & Equity Protection Act prohibits certain abusive practices & addresses unfair home lending practices; Federal Reserve given regulatory jurisdiction; Fed provided little oversight until 2008

Sub-Prime Chronology (3) 1997: First public securitization of Community Reinvestment Act for loans targeting low & moderate income borrowers. 1997: Credit default swaps (CDSs) invented at J.P. Morgan to shift risks. 2000: Commodity Futures Modernization Act of 2000 specifically exempted OTC derivatives including CDSs from regulation

Sub-Prime Chronology (4) 2003: Bear Stearns hedge funds for CDOs, collapsed in November 2007 Alan Greenspan’s Fed keeps interest rates low, stimulating credit and housing speculation Housing prices stop going up about 2005 Greenspan retires in 2006, considered the best Fed chairman ever, replaced by Ben Bernanke

Federal Funds Rate, 30 Day, 20 Year Treasury Rates, 2001-2008

Case-Shiller Index Home prices relatively stable (adjusted for inflation) until 21st century. Prices peaked in 2005

The Big Five Investment Banks Went Pub- lic Lever- age, 2006 ROE, 2006 Discussion Bear Stearns 1985 28.9 16.9% Bear was the first of the major wholesale banks to go public. Gold- man Sachs 1999 23.4 26.7% Goldman maintained considerable partner capital (plus a large equity stake by Sumitomo Bank) and was the last of the major investment banks to go public (the smaller and specialized firm Lazard Freres did not go public until 2005). Lehman Brothers 1994 26.2 20.9% Lehman was acquired by Shearson/ American Express in 1984 and spun off in an IPO in 1994. Merrill Lynch 1971 21.6 19.2% As a retail banker with a huge broker and customer base, Merrill went public early. Morgan Stanley 1986 31.7 21.1% Morgan went public relatively early for a wholesale bank.

Sub-Prime Chronology (5) Mid 2007: S&P & Moody’s started cutting bond ratings October 2007: Mortgage write-down start at major banks; e.g., Merrill Lynch--& write-downs continue & get bigger: UBS, Citigroup, AIG, Morgan Stanley, etc. Dow peaked October 9, 2007 at 14165 December 2007: U.S. in a recession according to National Bureau of Economic Research (announced a year later) January 2008: Countrywide acquired by Bank of America March 2008 J.P. Morgan acquires Bear Stearns (initially for $2 a share with federal guarantees on potential losses, raised to $10)

Sub-Prime Chronology (6) September 2008: Fannie Mae & Freddie Mac placed in conservatorship September 2008:Bank of America acquires Merrill Lynch (effective 1/1/09) September 2008: Lehman Brothers declares bankruptcy September 2008:Washington Mutual place in FDIC receivership, bank sold to J.P. Morgan September 2008: Goldman Sachs and Morgan Stanley convert to bank holding companies September 2008: Federal Reserve bailout of AIG for $85 billion.

Sub-Prime Chronology (7) September 2008: Credit markets freeze up; commercial paper & repo markets almost stop Reserve Primary Fund (a money market fund) “broke the buck,” creating a run on money market funds Ben Bernanke: “We came very close in October to Depression 2.0” Fed creates Temporary Liquidity Guarantee Program to guaranty new bank debt; Commercial Paper Funding Facility; and Term Asset-Backed Securities Facility

Sub-Prime Chronology (8) October 2008, first $350 billion released from Troubled Asset Relief Program (TARP), designed to purchase troubled assets. Treasury Secretary Henry Paulson used funds to bailout major banks; by early 2009, 300 banks received $314 billion. [Historical comparison to Reconstruction Finance Corp. (RFC), 1984 fed stake in Continental Illinois Bank, & 1989 Resolution Trust Corp.] December 2008, FOMC drops the fed funds rate to 0%-0.25%. January 2009: Porn industry seeks $5 billion bailout. Dow tanked, reaching its low of 6547 on March 6, 2009

Sub-Prime Chronology (9) May 2009: Fraud Enforcement & Recovery Act to improve enforcing violations of financial fraud. The act created the Financial Crisis Inquiry Commission to examine the causes of the crisis. June 2009: Ten banks repay the Treasury $68 billion in TARP money June 2009: President Obama announced a financial regulatory overhaul plan with additional executive powers and a new agency. The proposal would create a Financial Services Oversight Council under the direction of the Treasury Secretary. Dow hit 10000 October 14, 2009 July, 2010: Dodd-Franks Wall Street Reform Bill

Chapter 3 The New Accounting

Sarbanes-Oxley Act of 2002 Expanded corporate governance requirements, stressing independent directors & mandatory committees (including audit & compensation) Established the PCAOB Requires the audit committee to be independent Mandated internal control attestation by auditors Requires management (CEO & CFO) certification of “fair presentation” Add audit independence requirements (e.g., limits non-audit services)

New Corporate Governance Requirements Corporate governance is the oversight structure to provide long-term policy and oversee management Governance was one of the weak links leading to corporate scandal SOX requires SEC oversight & new rules from the stock exchanges New rules require independent board and competent audit committees

Audit Requirements SOX moves audit oversight from the AICPA to a new independent body, the PCAOB New rules established for audit committees Both senior executives (Section 302) and auditors (Section 404) must issue internal control reports Auditors are banned from most non-audit services

Public Company Accounting Oversight Board (PCAOB) Established by Sarbanes-Oxley 5-member independent board Regulates auditors & establishes auditing standards Establishes rules for internal control attestation Requires auditor registration for SEC clients Auditor inspection (audit the auditors--review auditor working papers, etc.) See PCAOG webpage: www.pcaobus.org

Increased Disclosures Companies must disclose off-balance-sheet items in MD&A (with particular emphasis on special purpose entities) Companies must issue 10-Ks (within 60 days beginning in 2006) and 10-Qs (within 30 days) more quickly Better FASB funding; encouragement of FASB to issue principles-based standards & integrate with international standards

Management Discussion & Analysis Business Strategy—usually the best source of strategy & operating characteristics of the company A brief history & description of the company is often presented In-depth analysis of operations & financial position, often by business segments Analysis of managing risks, including use derivatives for hedging Discussion of off-balance-sheet transactions, including SPEs

Financial Section Auditor’s Opinion, including name of auditor, type (usually unqualified) & date (it should be soon after the fiscal year-end—usually includes internal control report Four required financial statements, previously listed Extensive notes: note 1 is accounting policies used; remaining note on specific accounting issues, usually required GAAP disclosure

Proxy Statement Statement to shareholders before the annual stockholders’ meeting, with all the issues that will be voted on by the investors Extensive information on the board of directors, board committees & important corporate governance issues Information on executive & board compensation, including bonuses & stock options Information on the audit, including voting on the external auditor, audit & non-audit fees

Additional Information Sources 8-K & other reports to the SEC Analysts’ Forecasts (available from Yahoo, Zacks & other sources) Stock Prices & stock charts (available from most financial sites) Business press & other media sources Bond ratings (Moody’s & Standard & Poors’

Dodd-Frank Bill Derivatives regulation by CFTC & SEC, including OTC derivatives Consumer Financial Protection Agency created Rating agencies subject to SEC regulation Volcker rule: reduces proprietary trading by banks Compensation: investors vote on executive pay packages (but vote not binding) Federal Reserve subject to some GAO audits

Reporting Quality Questions Is There a well-defined Business Strategy? Is Corporate Governance Structure adequate? Are the reports complete & issued on a timely basis? Are they transparent? Is the accounting conservative? Is there any evidence of earnings magic?

Earnings Magic Detection Strategy Qualitative Analysis—the business strategy & competitive position in the industry must make sense; adequate corporate governance & monitoring structures; SEC findings Comprehensive Quantitative Strategy—quantitative financial analysis (ratios, etc.) of the financial statements Detailed accounting analysis of financial statement information & various specific issues (usually based on note disclosures)

Wading Through the Earnings Numbers Chapter 4 Wading Through the Earnings Numbers

Content of the 10-K Management letter, financial highlights, mission (objectives) statement, management reports Management discussion & analysis (MD&A) Financial Statements including auditors reports and notes Operating summary

Earnings Quality Well-defined business strategy Independent & competent corporate governance structure Financial reports complete & timely Transparency No signals of earnings magic

Can Earnings Magic be Detected? Quantitative financial analysis—look for signals of magic (e.g., how revenues line up with receivables and inventory); most ratio categories provide clues Documentation in MD&A, proxy statement, & notes incomplete, not understandable, or missing key disclosures Poor reconciliation of financial statements to notes

Section 2 The Big 8 and Dirty 30: Key Accounting Issues That Signal Earnings Magic

Key Accounting Issues: An Overview Chapter 5 Key Accounting Issues: An Overview

When Are Earnings Magic Incentives Strong? When earnings performance (especially quarterly) is threatened. 1. When below consensus analysis forecasts 2. When below zero (i.e., a net loss) 3. When below the previous period 4. When close to violating debt covenants When directly related to executive bonuses “Big bath” write-offs likely

The Big Eight Stock options Pension & other post-employment benefits Revenue recognition Earnings, expenses & expectations Special items & other stuff that should not be on the income statement Treasury stock (& its relationship to dividends) Off-balance-sheet items (operating leases & special purpose entities) Acquisition accounting, including goodwill

The Rest of the Dirty 30 Detailed ratio analysis, including working capital, receivables & inventory, reserves, cash from operations, credit risk, SG&A, R&D, & comprehensive income Complex accounting issues, including derivatives, contingencies, equity method, divestitures, taxes, pro forma earnings, and segment reporting Auditing & corporate government issues Other issues including restated earnings & stock market reactions

Dow Jones Industrial Average (Dow 30) One definition of the market Multiple industries involved Banks: Citigroup & J.P. Morgan Pharmaceuticals: Merck, Johnson & Johnson, Pfizer High tech: Hewlett-Packard, IBM, Intel, Microsoft Telecom: SBC (now AT&T), Verizon Other financials: American Express, AIG Conglomerates: GE, Honeywell, United Technologies Retail: Home Depot, Wal-Mart Charles Dow started indexing in 1889, Dow 30 started in 1928

Chapter 6 Stock Options

What is a Stock Option? Options grant the holder the right to purchase stock at a set price (exercise price) over some fixed time period, usually the closing price at the issue date Options are a one-directional participation in the success of the company—the employee benefits (will exercise the options) only if the stock price goes up. If the price goes down, there is no loss to the employee Presumably, options give employees the incentives to behave as owners of the company

Why Would Companies Issue Stock Options? Tax deductible (& increases CFO) Theory that options match incentives of executives with those of stockholders Has been a big incentive to attract talent at high tech startups Prior to 2006, zero compensation expense had to be recorded

What’s Wrong With Stock Options? Options increase the number of shares outstanding—a dilution effect Treasury stock used to “fund” options, potentially a poor use of cash Companies can cheat on grant date (see backdating slide) Options represent a real compensation expense, whether recognized or not

What’s Wrong With Stock Options? (2) Incentives to meet analysts forecasts at all costs—the big driver of Earnings Magic Can increase risky decisions—executives holding options don’t “lose” with bad decisions; worthless options are just not exercised Mediocrity can be lucrative if options are issued when stock prices are down “Underwater options” often are revalued, rewarding poor executive performance

Stock Options Accounting—Before 2006 Under SFAS No. 123, companies could either expense the estimated cost of options or provide note disclosure—most companies provided note disclosure including net income—pro forma If not expensed, when options were exercised the company debits cash & credits paid-in capital When options were exercised, the difference between the market price & exercise price was a tax benefit to the company (& a tax liability to the employee) Phased out under SFAS No. 123R

New Stock Options Scandals The newest scandals (although most of these started in the bad old days of the 1990s) include stock option backdating and spring-loading. Backdating sets the grant date to an earlier day with a lower stock price (is it deliberate earnings magic or sloppy accounting?) Spring-loading: companies issue options before “good news,” which boosts stock price. See WSJ Options Scoreboard (120 companies investigated, including Apple, HealthSouth & Home Depot) Note also “speed-vesting,” accelerating the vesting dates for options before the 2006 expensing requirement

Stock Option Dilution The stock option note gives the analyst the information to determine the magnitude of options outstanding & estimate the impact of options on the net income of the firm The dilution effect of options is: stock options outstanding / shares outstanding; 10% or more can be considered significant Substantial potential dilution is a concern to analysts; e.g., EPS could fall even when net income is rising

SFAS No. 123R Stock options are now being expensed: (1) requiring an entity to recognize the cost of employee services received in share-based payment transactions, thereby reflecting the economic consequences of those transactions in the financial statements; (2) improving comparability by eliminating alternative accounting methods; (3) simplifying US GAAP; (4) converging with international standards. Options pricing is based on Black-Scholes or other options pricing model.

SFAS No. 123R (2) The expense of the option is based on the grant-date fair value; the fair value is re-measured each reporting date until the settlement date (changes in fair value also are recognized as compensation expense) Fair value is estimated based on the option-pricing models The effective date is the beginning of the first interim or annual report period that begins after June 15, 2005 New Earnings Magic Trick: The value of the options is based on estimates of price volatility and how long options will be held; options values can be lowered by decreasing volatility estimates and reducing the expected holding period of options

Finding the Stock Compensation Expense This only applies to financial reports after 2006 The stock option/compensation note gives: stock compensation expense & tax effect (also reported in cash flow statement—before tax) Calculate the % difference between after-tax compensation expense & net income; over 10% is considered a potential concern

Alternative to Stock Options The use of stock options has been criticized since the recent scandals Companies are now expensing options (& usually issuing fewer options) Many companies are moving to alternative methods of employee participation in ownership, including restricted stock, phantom stock & stock appreciation rights Restricted stock is common shares that vest at a later date (perhaps with strings)

Pensions & Other Postemployment Benefits Chapter 7 Pensions & Other Postemployment Benefits

Types of Pensions Defined contribution plans (including 401-K): employers &/or employees make tax deductible cash (or stock) contributions to the employee’s retirement plan—the company has no further obligations Defined benefit plans: employer agrees to fund the employees’ retirement, usually based on final salary & length of service; the company has complete responsibility for the obligation & substantial accounting is required

Defined Benefit Plan—Balance Sheet The pension plans includes a set of obligations based on various actuarial & other assumptions Company invests in plan assets (which are invested) to fund the obligations; these are stated at fair value Assets & obligations are reported net on the balance sheet (usually as part of other assets or liabilities); e.g., a prepaid pension cost (a net assets for over-funded plans) & a prepaid pension obligation (a net liability for an under-funded plan) Beginning in 2006, the balance sheet amount is reported net of tax (adjusted for other comprehensive income) Detailed information is presented in a pension footnote

Defined Benefit Plan—Income Statement A net pension expense (net pension income is possible) includes: Expected return on plan assets (“income”) Service costs for benefits earned Interest costs on benefit obligations Other adjustments The amount is reported on the income statement, usually as an other expense (or income) Detailed information is presented in a pension footnote

Numbers Presented on the Financial Statements First, determine the amounts recorded on the balance & income statement The net amount recorded on the balance sheet is (usually) funded status net of tax (adjusted by other comprehensive income) The net pension expense recorded on the income statement is found in the pension note as “net periodic benefit cost” [or “gain” (income increasing, essentially a “negative expense”)]; again actual terms used vary

Financial Reality The major balance sheet categories are fair value of pension (plan) assets (PA) & projected benefit obligations (PBO). PA is the market value of retirement investments; PBO represents an estimate of the total pension obligations Funded status is FV of plan assets minus PBO; if PA>PBO, the plan is overfunded Economic reality is best represented by funded status

Financial Statement Update: SFAS No. 158 SFAS 158 effective beginning with fiscal year 2006 [companies with fiscal years ending after December 15, 2006]: Most companies will now recognize funded status on the balance sheet Gains and losses and prior service costs are recognized as other comprehensive income (or loss) Expected return on plan assets used rather than actual return The Pension Protection Act of 2006—where plans with a funding status of less than 80% of current liability are considered “at risk”—effective for 2008

Adjustments to Economic Reality—Income Statement The amount recorded on the income statement starts with “expected return on plan assets” (a smoothed expected return) The actual return on plan assets is presented under the “fair value of assets” S&P’s core earnings subtracts the “expected return on plan assets” from pension expense The alternative calculation is to replace “expected return” with “actual return” for the year

Actuarial Assumptions Actuarial assumptions that are presented include discount rate, compensation increases, & expected return on plan assets These are used as part of the smoothing process & the major concern is when these are “overstated”; e.g., high returns on plan assets would reduce the obligation & also reduce the pension expense Compare to competitors & over time

Other Post-employment Benefits (OPEB) OPEB represent obligations for benefits to retired or terminated employees, the largest category is healthcare funding The OPEB obligation is recorded as a liability & an annual OPEB expense is calculated The accounting is similar to defined benefits pension plans Actual operating practices are partially explained by tax rules (for example, there is no tax benefits for plan assets)

OPEB Accounting Based on the OPEB note (sometimes combined with the pension note), the net liability recognized is the obligation shown on the balance sheet (because of tax rules, little or no pension assets are presented) The net OPEB expense also is presented These are similar calculations to pensions & it may be possible to analyze them together

Pension & OPEB for the Dow 30 The Dow 30 are overfunded on their pension based on GAAP (total $4.6 billion), but underfunded by $1.8 billion using funded status The Dow 30 are underfunded on both a GAAP ($3.4 billion) & funded status ($6.1 billion) basis for OPEB The numbers for GM are extraordinary, underfunded on a combined funded status basis by $35.6 billion; pension & OPEB expense for 2004 totaled $7.0 billion, some 250% of net income

Chapter 8 Revenues

Revenue Recognition Revenue recognized when (1) realized or realizable and (2) earned Considerable difference by industry has led to considerable complexity and alternative recognition issues, primarily by industry Importance of SAB 101 (1999) on revenue recognition: usually recognize when delivery is made & collectability is assured

When Could Revenue Be Recognized--Manufacturing? When product is completed (finished goods) When sale is recorded When product is shipped When title passes to customer When product is received by customer & is accepted When payment is made

Revenue Recognition Concerns Lack of information available in the annual report; what can be analyzed? Conservative vs.. aggressive recognition policies—conservative recognition signals financial reality; aggressive, earnings magic Importance of sales trends: are they changing or erratic (if so, why)? Complex transactions: combined product sales & long-term service contracts; leases recorded as sales; installment sales problems Shipping & handling issues: should these costs be part of revenues?

Revenue Recognition Concerns (2) Relationship of revenues with inventory & receivables (including bad debts reserve) [from Chapter 14] A signal of earnings magic: sales rise, receivables go up much faster, while bad debts expense drops Companies can increase sales temporarily by reducing credit standards, but long-term bad debts will increase Companies can increase earnings by reducing bad debts reserve Obsolete inventory problems, especially in some industries (e.g., high tech & fashion)

Revenue Recognition Concerns (3) Reporting out-of-period sales, a timing difference Bill-&-hold: sales where delivery will occur in a later period Channel stuffing: deep discounts used to increase end-of-period sales Round-trip transactions: transactions with related parties Back-pocket sales: fictitious (or real) sales used only if needed to make earnings targets

Aggressive Revenue Recognition Xerox: immediate recognition from leased contracts Critical Path: back-pocket sales Global Crossing: revenue recognition on exchanges of fiber optics capacity (a form of round-trip transactions) Microsoft: reserve accounts used to reduce revenue recognized (overly conservative) These were the ones caught & had to restate earnings

Earnings Restatements (GAO Report)--Revenues Earnings restatements (restating financial statements from earlier periods) have gone up since Sarbanes-Oxley—67% since 2002 From 1997 to mid-2002, 845 companies restated; from mid-2002 to 2005 1,121 companies restated From 1997-2002, revenue issues involved 37.9% of the restatements; from 2002-2005, this dropped to 20.1% (cost or expense issues was number 1) Reasons for restatements included questionable revenues & improper revenue recognition; several round-trip transaction were cited

Earnings, Expenses & Expectations Chapter 9 Earnings, Expenses & Expectations

Net Income & Earnings per Share What is the “bottom line”? Net income the most common measure of earnings EPS the most common earnings measure for market analysis (e.g., comparisons to analysts’ forecasts), stated on both a basic and diluted basis & before and after non-recurring items

EPS: The Number Earnings per share used by analysts Analysts’ consensus forecast of EPS is “The Number,” the benchmark to measure earnings surprise--& the number to meet or beat by management; the consensus provides the major incentive to Earnings Magic The focus is extremely short-term & not likely consistent with long-term trends

Alternative Bottom Line Numbers “Above the line”: gross profit & operating profit, EBIT & EBITDA, income from continuing operations; concept of current operating performance & sustainable earnings “Below the line”: after income from continuing operations, importance of non-recurring items: net income & comprehensive income; all-inclusive perspective of earnings

EBIT & EBITDA Earnings before interest & taxes: start with earnings before tax & add back interest expense; EBIT is often considered the best measure of operating earnings Earnings before interest, taxes, depreciation & amortization; starting with EBIT, add back depreciation & amortization; EBITDA is often considered an alternative operating cash flow measure

Net Income & Comprehensive Income Net income (& EPS) are the traditional bottom line measures & are close to the all-inclusive concept Comprehensive income include “dirty surplus” items: find these as “other comprehensive income” in the Statement of Stockholders’ Equity & add them to net income; occasionally, these can be large losses & a potential concern

Bottom Line Analysis ($ millions)--Hotels HLT MAR HET MGM HOT Reven $4437 11550 $7111 $6482 $5977 OpsInc 1667 1308 3417 2935 2682 EBIT 897 823 984 1335 900 ICO 460 668 264 443 423 NI 669 236 422 CI 452 649 230 442 355

Bottom Line Analysis (%)--Hotels HLT MAR HET MGM HOT Reven 100% OpsInc 37.6 11.3 48.1 45.3 44.9 EBIT 20.2 7.1 13.8 20.6 15.1 ICO 10.4 5.8 3.7 6.8 NI 3.3 CI 10.2 5.6 3.2 5.9

Bottom Line Analysis ($ millions)--Conglomerates MMM ITT UTX TXT HON Reven 22,923 7,807 47,829 11,490 31,367 OpsInc 5,696 801 6,098 1,413 3,061 EBIT 5,747 813.5 3,172 ICO 3,851 499.7 3,732 706 2,078 NI 581.1 601 2,083 CI 2,389

Bottom Line Analysis (%)--Conglomerates MMM ITT UTX TXT HON Reven 100% OpsInc 24.8 10.3 12.7 12.3 9.8 EBIT 25.1 10.4 10.1 ICO 16.8 6.4 7.8 6.1 6.6 NI 7.4 5.2 CI

Operating Expenses Matching principle (conceptually; note—this concept is becoming less important because of mark-to-market) Product vs.. period costs Concerns include relative efficiency of cost of sales, capitalizing operating costs, the use of reserves, SG&A, R&D, provision for tax, interest expenses & other expenses

Expense Categories Cost of Sales Measure of operating efficiency; calculate operating margin over time & compare to competitors Reserves Reserves can be used to smooth income; focus on bad debts & other reserve accounts presented Selling Genl & Admin. “Overhead” measure; compare (e.g., SG&A/Revenue) over time & to competitors

Expense Categories (2) Interest Expense High leverage associated with high interest; calculate interest coverage & Interest Expense/Revenue Research & Development Important for some industries; how much is the right amount? Concern with erratic amounts Other Expenses Various expenses “dumped” here; calculate Other Expenses/Revenues

Aggressive Expense Recognition Sunbeam: operating expenses not accrued (sales returns, advertising, reserves for product liability & warranties) Rite Aid: adjustments to COGS & Inventory; maintenance costs to PPE capitalized; misstated compensation expense Aurora Food: misstated marketing expense Waste Management: vast scheme of fraud, including depreciation expense on PPE (misstating useful lives & salvage values), capitalizing interest, & write-downs of reserves WorldCom: capitalized operating expenses

Earnings Restatements--Expenses From 2002-2005, cost- and expense-related items were the major reasons for restatements (it was revenue for the 1997-2002 period), 35.2% of all restatements (compared to 15.7 earlier) Typical restatements were for under- or overstating expenses or improperly categorizing them Companies involved included Bristol-Myers Squibb, Kerr-McGee, Dynegy, US Steel, Verizon, eBay, Sears, Starbucks, Toys R Us, Lowe’s, Halliburton, Blockbuster, Eastman Kodak, Rite Aid, ConAgra

Chapter 10 Strange Special Items and Other Things That Should Not be on the Income Statement

Non-recurring Items & Other Unusual Items Extraordinary items (unusual & infrequent) Discontinued operations Accounting changes (accounting principle, estimate or reporting entity) Unusual items: restructuring charges, special charges, other write-offs—these can be “above or below the line”

Du Pont’s Non-recurring Items Disposed of Conoco in 1999 (recorded as a discontinued item) and Du Pont Pharmaceuticals in 2001 (part of continuing operations) In both cases, the gains of disposal had a big impact on net income; in 1999 Du Pont had income from continuing operations of $219 million, but gain on disposal of $7.5 billion, increased net income to $7.7 billion; the gain on sale of Du Pont Pharmaceutical was $6.1 billion (before tax) and net income was $4.3 billion

Du Pont (in millions) 2001 1999 Revenues $25,370 $27,892 Sale of Du Pont Pharm. (CO) 6,136 Income from Continuing Ops 6,844 219 Sale of Conoco (Discon. Ops) 7,471 Accounting Change 11 Net Income $4,339 $7,690

Biggest Ever Losses AOL Time Warner wrote of $54 billion in goodwill as a nonrecurring item in 2002 WorldCom emerged from bankruptcy in 2004 as MCI; the $87 billion decline in assets (much of that was goodwill & other intangibles) was not mentioned, only a discontinued gain of $26 million

Dow 30, 2004 (pp. 146-7) 19 of the Dow 30 reported nonrecurring items in 2004; 21 reported strange or special items SBC reported discontinued operations (2002-4), accounting change & extraordinary item AIG restated earnings 2002-4, one of the big scandals in 2005 Note special items: impairment charges, restructuring, repositioning, litigation reserve Coca-Cola reported goodwill impairment, franchise impairment & streamlining costs

Treasury Stock and Dividends Chapter 11 Treasury Stock and Dividends

Dividends Historically, dividends were at least as important as earnings; the way to show that earnings were “real” was to pay dividends (note that the matching principal assumed that the earnings process related to cash flows); at least half the gain from holding stocks was from dividends As stock prices took off in the 1990s & stock options gained importance, dividend payouts declined

Treasury Stock Companies buy back shares of their own stock in the open market This is a use of cash & usually considered an alternative to payment of dividends; note that cash is NOT being used for operating purposes or paying down debt Treasury stock decreases equity by the amount of the cash payment Treasury stock purchases are anti-dilutive; that is, it decreases shares outstanding

Treasury Stock & the Relationship to Stock Options Companies with substantial options typically buy back shares to “fund” the issuance of options The usual rationales are: (1) to avoid dilution of shares as employees exercise shares, (2) this is the best use of cash when shares are “cheap” Since there are fewer shares outstanding, EPS will rise even if net income does not There is the potential concern of “propping up” stock price with these purchases; open question: do stock purchases coincide with executive compensation payments or when executives exercise options?

Treasury Stock, Options & Dividends Since dividend payments have declined as options have increased & companies typically view repurchasing shares as an alternative to dividends, these should be analyzed together Wal-Mart bought back 266 million shares from 2000-05 for $14.5 billion (32% of net income); 41 million options were exercised for $1.6 billion—treasury stock increased $12.9 billion; in 2004 Wal-Mart paid out 22.5% of net income in dividends, a yield of 1.2%

How Is Treasury Stock Reported in the Financial Statements? The total value of treasury stock is usually listed as a separate line item as a contra-equity item (it decreases stockholders’ equity) on the balance sheet Annual acquisitions and use of treasury stock are reported in both the cash flow statement (financial activities) and statement of stockholders’ equity It is a concern if companies report annual treasury stock acquisition in the cash flow statement but not list it on the balance sheet. [It appears that the company does not buyback its own shares, and the actual balance cannot be easily determined.]

How Much Treasury Stock is Too Much? The 23 companies reporting treasury stock have an average of $11.8 billion or 41% of equity (it’s over 100% at Coca Cola, Intel, and Merck); perhaps anything over 10% could be considered a concern The Dow 30 still pay out a substantial 57.8% of net income as dividends for a yield of 2.8%; options to shares outstanding are 9%

Not Reporting Treasury Stock Seven of the Dow 30 do not report treasury stock on the balance sheet (including Wal-Mart), although all of them buy back their own shares What to do? Check the statement of stockholders’ equity to determine purchase of treasury stock. Calculate TS as a % of net income. For the 7 firms this averaged 63.1% of NI! Calculate for earlier years

Off-balance-sheet Items: Operating Leases & Special Purpose Entities Chapter 12 Off-balance-sheet Items: Operating Leases & Special Purpose Entities

Operating Leases Leases are financial arrangements for the acquisition of fixed assets Long-term arrangements should be capital leases, which are recorded on the balance sheet as assets and liabilities Operating leases should be short-term arrangements and only the rental expense is recorded

Operating Lease Concerns Off-balance-sheet liabilities—a concern when the lease intent is really long-term (i.e., capital leases) & amount is substantial Operating leases are significant in specific industries, especially retail (leasing stores) and airlines (leasing airplanes); the problem is these are really long-term assets

Operating Lease Calculations Off-balance sheet, recorded in the notes Large balances of operating leases Check for magnitude: use the 10% of total assets rule for significance If greater than 10%, recalculate liabilities & debt to equity ratios; use the capital lease present value to total minimum lease payments for discount % (or an arbitrary percentage if capital leases are not used)

Operating Lease Example—Office Depot (1) Operating leases at Office Depot (FY 2003, Note I) $2,216 (all numbers in millions); total assets = $6,145 The operating lease % is 2216/6145 = 36.1%, greater than 10%; recalculated liabilities & debt to equity ratio Capital lease % = PV of $80,586; minimum lease payments of $120,495 Discount % = 80,586 / 120,495 = 66.9%

Operating Lease Example—Office Depot (2) Balance Sheet Operating Leases Adjusted Total Liabilities $3,351 $1,483 [2,216 x .669] $4,834 Total Equity 2,794 Debt to Equity 1.2 1.7

Operating Leases for the Dow 19 reported operating leases, averaging $4.8 billion Only McDonald’s and Home Depot had operating leases greater than 10% of total assets; these are retail chains Wal-Mart had operating leases of $10.3 billion, but this was only 9% of total assets

Special Purpose Entities Special Purpose Entity (SPE)--A unique legal entity to be used for a specific purpose, such as leasing arrangements or project development activities; the purpose is to treat this as an off-balance-sheet item Structured financing—A financial contract to achieve specific financial purpose, including SPEs, joint ventures, & so on

Examples of SPEs General Motors created SPEs to redevelop closed factories with environmental problems Airlines created SPEs to hold airplane leases Mortgage companies used them to consolidate and sell mortgages to investors AOL Time Warner and Microsoft used SPEs to create synthetic leases GE used SPEs to resell credit card & trade receivables

Advantages of SPEs SPEs are created for specific tasks involving financial risks; for example, an SPE can have a higher credit rating (& lower interest rates) than the parent SPEs can be used for tax avoidance, such as synthetic leases Banks use SPEs to securitize pools of mortgages, credit card balances, accounts & other receivables—it generates cash & eliminates the receivables from the parent’s books

Common Uses of SPEs Synthetic leases—sale & leaseback to the originator, with tax benefits Securitize mortgages (& other credit receivables) & package them as bonds or notes Take-or-pay contracts—buyer guarantees to buy some about of product, which can be used to collateralize loans; throughput arrangement are similar, usually using pipelines R&D funding, transferring risks & avoiding expenses & liabilities of R&D

Enron Extreme (fraudulent?) use of SPEs for blatant earnings manipulation Initially, SPEs were used to grow the company while keeping additional debt off the books More complex SPEs allowed Enron to record future services as current revenues using “mark-to-market” Extensive conflicts of interest & related-party transactions, especially involving Andy Fastow

SPE Structure SPE must have at least one equity investor; the investor must contribute assets (usually cash) of at least 10% of the fair value of the assets. Trustee—an independent 3rd party to advocate the interests of the SPE. Servicer—provides the basic accounting & administrative requirements (which may be the originator, such as a bank servicing the loans or mortgages that have been securitized).

New Accounting Rules SPEs created to isolate & contain financial risks. Variable interest entities (VIEs, legal entities often holding financial assets with specific characteristics defined by FASB Interpretation 46R); may require consolidation if originator exposed to a majority of the risks & rewards. Qualified SPEs (QSPEs, SFAS No. 140), generally the transfer of securitized portfolios; major question is when transfers are considered a sales (recording gains & losses). Other SPEs are accounted for under SFAS 94.

SPE Concerns Fit to business strategy—evaluate MD&A Lack of transparency—are disclosures adequate (notes & MD&A)? Impact on financial ratios, especially leverage, but also performance & financing costs Added risk by firms with high credit risk & poor operating performance Accounts & other receivables—are these understated?

SPEs Used by the Dow 30 Citigroup: QSPEs for securitized credit card receivables, mortgages, auto loans, student loans, & corporate debt. VIEs for commercial paper conduits, structured finance, collateralized debt obligations, & investment vehicles. J.P. Morgan: QSPEs for residential & commercial mortgages, credit card receivables, & auto loans. VIEs used for synthetic leases & asset-backed securities. GE: SPEs for securitizing commercial & residential real estate, credit card receivables, & GE trade receivables. GM: Synthetic leases, consumer finance receivables, wholesale lines of credit, mortgage funding, & construction & real estate lending. See Appendix 12.2 for detailed analysis

Acquisitions and All That Goodwill Chapter 13 Acquisitions and All That Goodwill

Business Combinations Long history of acquisitions: Rockefeller, Morgan, Ford, LTV, GE Horizontal mergers, direct competitors Vertical mergers, expanding into related areas Conglomerate mergers, diversify into unrelated industries Recent mega-mergers, e.g., AOL Time Warner, Exxon Mobil, Warner Lambert by Pfizer, GTE by Bell Atlantic, Citicorp by Travelers Group, Gillette by Procter & Gamble, AT&T by SBC

Can Acquisitions Be Useful? Economies of scale (& potential cost savings)—plus expected synergies Reduce competition Expanding into new geographic or technical areas where acquired company has expertise Acquisitions that are “cheap,” perhaps a low price (e.g., at or near bankruptcy) or a company that can be restructured effectively

Stupid Reasons for an Acquisition Merger pushed by investment bankers (they charge huge fees) Thoughts of “BIG”—[firm can be number 1 & executives can get huge compensation] Focus on marketing “story,” rather than details and due diligence There is excess cash lying around It turns out, the majority of acquisitions are failures

What Can Go Wrong? Premium price paid too big—likely impairment write-offs in the future Delayed integration because of different cultures & other problems Expected cost savings don’t materialize Damaging cost cutting & restructuring, causing negative impact on operations and customer service

Acquisition GAAP SFAS No. 141 requires purchase method for all acquisitions SFAS No. 142 requires that goodwill is no longer amortized; instead, goodwill is tested for impairment at least annually (Note AOL Time Warner write-off of $54 billion in goodwill in 2001)

Importance of Goodwill Goodwill is the difference between the acquisition price and the fair value of the net assets acquired Goodwill can be considered a “premium price” paid for the acquired company It represents the accumulated “premium prices” paid for all previous acquisitions It is on the books until underlying assets are sold or goodwill is written off as impaired It can be considered a “plug figure,” that is essentially meaningless (especially for a bankrupt company)

Financial Statement Effects Acquisitions can have a big impact on financial statements and ratios: big increases in assets & liabilities—composition of assets & liabilities can change substantially Use of cash if exchange is based on cash (borrowing may be required to raise the necessary cash) Difference impact if acquisition is based on exchange of stock After the acquisition year the financial identity of the acquisition is lost (unless it is recorded as a separate operating segment)

Earnings Magic Issues Analysis somewhat easier since only a single method is used (no pooling of interests) Data problems exist, since only limited reported is required at the merger date & little available data after the acquisition consummated. Difficult to evaluate the effectiveness of mergers 1 or more years after the fact Possible goodwill impairment problematic & difficult to anticipate Big Earnings Magic such as spring loading (forcing acquired company to take big losses just before the acquisition, a Tyco specialty)

Acquisition Analysis: Consider Stock Price Reaction Consider acquisition price & stock market reaction (often a negative reaction due to premium paid for target) AOL announces the acquisition of Time Warner (TWX) on Jan. 10, 2000; this was reflected in a bump up in stock price of TWX & fall in price of AOL

Stock Price Reaction to AOL’s Time Warner Acquisition

Long-term Impact Was the acquisition of TWX a brilliant business strategy as a vertical merger into “old line” media? AOL called it “the first fully integrated median and communications company in the internet age” The immediate reaction for a few months after the acquisition was up, but the market plunged in 2001—AOL would drop some 80% in market cap; a goodwill write-off would follow

AOL Stock Price After the Merger

Acquisition Concerns—At Acquisition Date Does acquisition fit the business strategy of the corporation?—evaluate MD&A Was the price paid excessive?—evaluate stock market reaction to the announcement What are the acquisition/divestiture trends?--review acquisitions for the last 2-5 years What is the overall quantity & magnitude of recent acquisitions?—review for evidence of problems & earnings management potential

Acquisition Concerns—After Acquisition Date How were asset valuations allocated?—calculated acquisition percentages to: (1) depreciable/amortizable assets, especially impact on expenses & taxes (2) in-process R&D & write-offs (3) goodwill, both in terms of magnitude & also potential for future write-offs for impairments

Valuation Strategies (1) allocate to depreciable/ amortizable assets (future tax “benefits”) (2) allocate as much as possible to in-process R&D (written off after acquisition) (3) maximize goodwill, which is no longer expensed (reduces future expenses, but risk of impairment write-offs).

Acquisition Disasters The estimate is that two out of three acquisitions are mistakes: poor fits to business strategy, over-paying for acquisition, difficulty fitting new operations to operating culture of the acquiring firms, stated synergies did not materialize AOL Time Warner & the $54 billion write-off CUC: acquisition of CUC by HFS, when fraud was discovered at CUC

Acquisitions by the Dow 30 Citigroup was formed in 1998 by the acquisition of Citicorp by Travelers Exxon acquired Mobil in 1999 Hewlett-Packard acquired Compaq in 2002 Procter & Gamble acquired Gillette in 2005 SBC acquired AT&T in 2006 (now called AT&T) J.P. Morgan acquired Bear Stearns in 2008

Goodwill at the Dow 30 All 30 firms have goodwill on their books, an average $11.5 billion or 10.1% of total assets Ten of the firms have goodwill greater than 10% of total assets, 34.4% for Procter & Gamble GE has $71 billion in goodwill, while JP Morgan has $43 billion

Dishonorable Mention: The Rest of the Dirty 30 Chapter 14 Dishonorable Mention: The Rest of the Dirty 30

Dishonorable Mention Categories Detailed Ratio Analysis Complex Accounting Issues Auditing Corporate Governance Other Issues: investigations & restated earnings, stock price reaction

Detailed Ratio Analysis Balance sheet Issues, including working capital & liquidity, receivables & inventory, & reserve accounts Income statement issues, including comprehensive income, SG&A, & R&D Cash flow issues, including cash from operations & free cash flow Credit risk & leverage

Balance Sheet Issues Low liquidity, especially negative working capital Relationship of inventories & receivables to sales (esp. relative growth & changes) Warranties, commitments, contingencies & other obligations that may understate true liabilities Long-term debt levels (especially is growing)

Working Capital & Liquidity Are the levels of cash and liquidity adequate? The average current ratio of the Dow 30 was 1.4; cash ratio averaged 59% Negative working capital can be considered a red flag; however, some companies have a policy of deferring the payment of liabilities as long as possible (six Dow 30 companies had negative working capital)

Inventory Retailers: finished goods held for sale; balances can be large (77% of current asset & 25% of total assets for Wal-Mart) Manufacturers: raw materials, work-in-progress & finished goods Inventory efficiency (e.g., as measured by inventory turnover) especially important for manufacturers Potential problems with obsolete inventory; note potential write-downs based on inventory impairment Historically, several inventory fraud cases Inventory usually not an issue with service companies

Accounts Receivable Related to credit sales; therefore, the amounts, changes in amount, and allowance for bad debts important considerations Aggressive revenue recognition would be associated with rising AR balances, often without increasing bad debts allowance Evaluate sales, accounts receivable & allowance for bad debts together (i.e., they are interrelated) Large and growing receivables suggest declining credit terms Potential for factoring or “selling” to a special purpose entity (SPE)

Bad Debts & Other Reserves Companies may have dozens or hundred of reserve accounts; an income smoothing (“cookie jar reserve”) issue Allowance for doubtful accounts is the only reserve account likely to be disclosed (plus loan loss reserves for financial institutions) The allowance should be a reasonable percent of sales & expected to stay relatively constant Doubtful accounts for the Dow 30 (24 disclosers) averaged 2% of receivables Large drops in this percentage are a potential signal of Earnings Magic (e.g., GM & Ford in 2005)

Income Statement Issues Trends in revenues, gross margin, operating margin, etc. Operating expense issues, including SG&A, R&D spending, special charges, etc. SG&A are “overhead” items including marketing R&D are expensed & can be reduced only by decreasing current R&D (note use of SPEs) Both SG&A & R&D vary by industry (big for pharmaceuticals) & business strategy (e.g., Apple vs. Dell Non-recurring charges—these should be rare Net income & other “bottom line” measures

Comprehensive Income Comprehensive income is all-inclusive, including all gains & losses for the current period Other comprehensive income gains & losses are usually reported on the statement of stockholders’ equity, not the income statement (marketable securities, foreign currency, & pension are major items) Loss: comprehensive losses are a potential concern; GE has an other comprehensive loss of $7.2 billion (primarily foreign currency), 43% of net income

Cash Flow Issues CFO trends, especially related to net income; CFO is expected to be larger than net income (e.g., depreciation increases CFO) & should parallel net income over time The Dow 30 had an average CFO of $9.9 billion, 47% above net income Free cash flows (a measure of cash available for discretionary uses): FCF1 = CFO – Capital Expenditures; FCF2 = CFO – CFI Cash flows can highlight certain problems such as lagging cash collections

Credit Risk & Leverage Credit risk is the probability of default or declaring bankruptcy Leverage is the relative mix of debt & equity; credit risk increases as leverage increases Importance of financial analysis, including liquidity & leverage ratios Credit risk indicators: recurring losses, troubled debt restructuring, bond downgrading, going-concern audit qualifications Altman Z-score a quantitative measure of relative financial health A junk bond rating can be considered a credit risk red flag

Complex Accounting Issues These usually require qualitative analysis (with quantitative help when available) Risk management & derivatives Contingencies Equity method & joint ventures Divestitures Taxes Pro forma earnings Segment reporting

Risk Management & Derivatives Techniques used by corporations to reduce or control for potential adverse consequences (uncertainty), primarily related to prices, interest rates, and foreign currency Risks described in MD&A & methods used to control risks Corporations can use hedges to manage specific risks

Risk Categories Commodity risk—changing prices Interest rate risk—rate fluctuations Market value risk—price changes Foreign exchange risk—currency rates fluctuations Event risk—uncertainties about events Credit risk—default, bankruptcy risk Counterparty risk—default risk on private contracts

Derivatives Financial contract derived from another financial instrument, including options, futures, and swaps Key point: Derivatives transfer risk The basic derivative strategy is hedging to reduce specific risks Analysts evaluate hedging effectives & potential for speculating; basic question: is the hedging strategy effective? Derivatives are “weapons of mass destruction” according to Warren Buffett

Common Derivatives Forward Contract--Agreement between buyer and seller to deliver an asset in exchange for cash (or financial instrument) at a fixed price on a specific future date. Examples include commodities, currencies, or stocks (futures are standardized contracts that trade on an organized exchange); futures are standard forward contracts that trade on an exchange Options--Agreement that gives a party the right to buy (call) or sell (put) a specific quantity at a specific price (exercise price) until a specified maturity date Swaps--Contract to exchange one series of payments for another

Common Derivatives Collars—Derivatives that limit the effects of fluctuations beyond a set range Currency Swaps--Agreement to make payments in one currency in exchange for the obligations in another currency Interest Rate Swaps--Contract to exchange fixed for floating interest payments on bonds and other credit agreements Credit Default Swap—Contract where buyers seeks protection against a bond default & pays a premium to seller; seller holds collateral and will pay off as default occurs

Accounting Categories of Hedges Fair value—hedge exposure to changes in market values: record gains & losses as part of income from continuing operations Cash flow—futures transaction on interest rate exposure for floating rate debt: record as other comprehensive income Foreign exchange exposure—hedge on currency rate changes: other comprehensive income

Risk Management Concerns Overall risk management strategy to control basic risks—evaluate MD&A & compare to other companies Magnitude & changes—large hedging positions & big fluctuations (especially increases) may indicate increasing risk rather than hedging Consider hedge effectiveness; fair value vs.. cash flow & foreign exchange hedges; & using puts on corporate stock In 2008 and 2009, counterparty risk was one of the most significant risks (think Lehman Brothers)

Hedging History Hedging & derivatives invented by Dutch in early 17th century. Early uses of arbitrage. First hedge fund: Alfred Jones in 1949 (fewer than 100 investors, invested long & short on stocks). 1973: Fischer Black & Myron Scholes invent model to price options. 1987: October 19 stock crash caused by portfolio insurance used as a hedge.

Hedging History (2) 1992: Orange county bankruptcy, derivative trading (also: big losses by Procter & Gamble, San Jose, West Virginia, CALPERS). 1992: George Soros made $1 billion by shorting the British £. 1994: Credit default swaps invented at J.P. Morgan.

Hedging History (3) 1995: Trader Nick Leeson lost $1.3 billion betting on the Nikkei 225 index, causing the failure of Barings Bank. 1998: Latin American crisis, Asian currency crisis, Russia default, failure of Long-term Capital Management. 2006: Derivatives become $600 trillion market.

Hedging History (4) 2007: Failure of 2 Bear Stearns hedge funds investing in mortgage-back securities & collateralized debt obligations. 2008: Collapse of Bear Stearns, Fannie Mae & Freddie Mac, Lehman Brothers, AIG, Merrill Lynch over mortgage securitization market. Massive federal bailout. Importance of credit default swaps and counter-party risk 2008: John Paulson hedge fund makes $20 billion using credit default swaps and other plays betting against the mortgage market.

Dow 30 Derivative Use The Dow 30 are big users of derivatives Banks & financial firms make markets in derivative instruments (e.g., Citigroup & JP Morgan) Most industries use interest rate & foreign currency hedges Firms using commodities typically manufacturing, mining, agriculture (e.g., Alcoa, ADM & Du Pont) See Exhibit 14.5 for examples

Contingencies Potential liabilities not reported on the balance sheet include commitments & contingencies Prominent contingencies are legal issues including law suits & outstanding regulatory issues Contingencies are reported in detailed notes; analysis is qualitative Certain industries have large contingencies, including chemical, tobacco, and pharmaceutical companies Examples include Merck’s Vioxx lawsuits All Dow 30 companies have substantial contingencies; see Exhibit 14.6 for examples

Equity Method When parent has less than complete voting control (50% + 1 share), parent is considered to have “influence but not control;” therefore, the subsidiary is NOT consolidated Normally, when ownership is between 20%-50%, the equity method is used The acquisition is recorded at cost as an investment, then the subs. share of net income is recorded as income & increases investment (cash dividends from the sub. decrease investment)

Equity Method Concerns Does the use of the equity method make sense based on business strategy (or just an earnings management tool)? How were these subs. established (e.g., purchase of shares, spin-off of existing sub.)? Evaluate former subs. that were spun off—consider reasons such as relative profitability & transferred debt, gains or losses from spin-off Distortions: profit is reported net & return ratios overstated (e.g., ROA), liabilities are hidden, information is lost

Coca-Cola: the 49% Solution Coca-cola does no bottling; this is left to bottling partners; these are usually subsidiaries where Coke has between 20%-50% ownership & uses the equity method (for some bottlers, Coke has less than 20% ownership & these are recorded as marketable securities) Investments using the equity method total $5.1 billion & represent about 23% of total assets; marketable securities total another $2.8 billion (2004)

Coca-Cola Spin-offs—Earnings Magic? Generally, the major bottlers were initially owned by Coke & then spun off The largest bottler is Coca-Cola Enterprises (CCE), a 1986 spin-off, with Coke maintaining 38% With the spin-off went considerable debt (CCE now has a debt-to-equity ratio of 7.4, while Coke’s is 97.2%); margins with the bottlers also are lower than for Coke (2004)

Joint Ventures (JVs) JVs are contracts with other entities (usually corporations) to establish a JV as a separate legal entity In most cases, each Partner has 50% ownership in the JV; since these is no outright control, the equity method is used The advantages of JVs are the unique contractual relationships that can be structured, including risk-sharing JVs are common in integrated oil & gas companies, as well as banks & other financial institutions

Equity Method at the Dow 30 Twenty-three use the equity method Twenty-one use joint ventures Coca-Cola and AT&T are the only ones where the equity method represents more than 10% of total assets

Divestitures Divestitures include selling a sub. to another corporation or a spin-off These can be big, such as the breakup of ATT in 1984 Concerns include why the divestiture was made, how it was recorded, & impact on debt levels Fourteen of the Dow 30 reported divestitures in 2004 (e.g., IBM sold its personal computer business)

Taxes Executives want to minimize current taxes Financial reporting is more complex, involving financial reality versus earnings magic incentives Temporary differences between tax & GAAP are recorded as assets & liabilities Analysis includes calculating effective tax rates & look for unusual items (e.g., Marriott’s—and more recently Hilton—use of synthetic fuel to lower taxes

Effective Tax Rates Effective Tax Rate = Provision for Tax / Pretax Income; federal statutory rate is 35% & effective rate should be about that (note: other taxing authorities, but companies use tax-reducing practices) The effective tax rate averaged 26% for the Dow 30 Taxes Payable Rate = Taxes Payable / Pretax Income; this rate is the liability to the IRS & usually lower than the effective tax rate

Pro Forma Earnings Companies may report pro forma earnings & claim these are more valid than net income These are non-GAAP numbers & usually presented by companies that are performing poorly to improve “reported earnings” Amazon.com was a master using pro forma earnings, until the company started making money based on GAAP These normally should be treated skeptically (or ignored)

Segment Reporting Corporations must disclose note information on major operating & geographical segments (SFAS Nos. 14 & 131), based primarily on “10% rules” Information is required on net sales, segment assets, & (for operating segments) operating income Limited performance analysis possible includes operating return on sales (operating income / net sales) & asset efficiency (net sales / identifiable assets)

Segment Reporting Concerns Full disclosure (transparency): since performance analysis must include analysis by segments, complete disclosure is essential Relative performance by segments, especially by operating return on sales Segments may relate to specific acquisitions & may be useful to evaluate the effectiveness of the acquisition Additional analysis of financial & operating risks if data are available A major analysis problem is the differences in disclosure levels and lack of standardization across companies

The Corporate Governance & Auditing Environment Corporate governance practices signal the potential for earnings management—permissive structures indicate that manipulation is more likely The board of directors sets overall policy & provided oversight for operating activities Historically, boards were composed mainly of owners, managers & other insiders It is now clear that a majority of independent board member is essential for effective oversight The external auditor is the primary monitor of financial accounting and disclosure

Analyzing Corporate Governance Analysis of corporate governance is a qualitative analysis, based on structures & policies of the board The primary source of information is the Proxy statement, usually issued after the annual report (& associated with the upcoming annual stockholders’ meeting)

Areas of Corporate Governance Analysis The CEO & board of directors—composition, independence & policies Executive compensation—what forms, how much, relation to performance Auditing—the role of the audit committee, the external auditor, non-audit fees Related-party transaction—potential conflicts of interest Insider trading—patterns that suggest abuse Investment banking relationships Evidence of past abuse such as earnings restatements

Concerns with the Board of Directors Is the CEO also the chairman of the board? Evidence of CEO oversight abuse Are a majority of board members independent? What are the board committees & is there evidence that they’re active & effective Evaluate board compensation—is it based on performance & active participation

Concerns with Executive Compensation Evaluate the compensation committee for independence & competence Analyze the executive compensation (especially the CEO) by component: base pay, bonuses, stock options (& other forms of ownership-related compensation) & perks Is compensation based on performance? Evaluate based on earnings & stock price performance Particular concerns are for over-compensation of CEO for poor performance & impact of previous accounting-related abuses

Auditing Auditor’s Opinion—it should be unqualified (clean); check audit date, a date long after the end of the fiscal year suggests possible audit problems; likely audited by Big 4 firm Internal Control Report—there should be no material weaknesses Audit Committee composition—should be made up of independent board members, chairman should have financial expertise Audit fees—substantial non-audit fees implies possible independence problems

Concerns with Auditing Evaluate the audit committee for independence, competence with financial information, how many times the committee meets & other evidence of diligence Review audit procurement practices, including the external auditor (usually a Big 4 firm), non-audit fees, the audit opinion & timeliness of reports

Other Concerns Are there related-party transactions? If so, do they signal potential manipulation or a permissive environment? Evaluate insider trading (buying & selling of corporate stock by senior executives)—are there patterns that suggest abuse? Do investment banking relations exist that suggest potential abuse? Is there evidence of past accounting abuse (e.g., earnings restatements) or on-going problems (such as SEC investigations

Earnings Restatements Restating previous periods; should be a rare event, but has been increasingly common in the last 5 years. GAO discovered over 900 restatements from 1997-mid-2002 38% involved revenue recognition issues Market reaction: on average, stock price dropped 10%

Market Value Considerations Stock prices, current, historic—use of stock charts Useful calculations: PE, PEG, market value, market-to-book Importance of earnings forecast information: EPS forecasts available for future quarters, current & future years, & 5-year ahead forecasts

Stock Price & Other Market Analysis Long-term stock charts (5 years is common) indicate the longer-term trends in investor reactions Reasons for large rises & dips should be explainable; if not, they may signal potential concerns Relationship of stock prices to EPS & 5-year forecast earnings growth rates Earnings “surprises,” actual to analyst forecast estimates

Putting it all Together Section 3 Putting it all Together

Finding Signals of Financial Excellence and Earnings Magic Chapter 15 Finding Signals of Financial Excellence and Earnings Magic

A Checklist for Evaluating Financial Excellence Chapter 16 A Checklist for Evaluating Financial Excellence

Grading Earning Magic A Transparent company—thorough disclosure, near financial reality, no evidence of earnings magic, & no history of past abuse. B Good disclosure & high financial reality, with limited evidence of potential problems & little or no history of past abuse (or evidence that the company has changed its ways). C Average company—adequate disclosures & level of financial reality, potential manipulation but consistent with industry practices.

Grading Earnings Magic Indicators of inadequate disclosure, not close to financial reality, signals of poor transparency, potential manipulation problems, or evidence of past abuse. F Substantial evidence of serious issues, history of past abuse. Company with serious problems, probably made worse by financial mismanagement and misleading disclosures.

Grading the Dow 30 Altria: D AIG: F GM: Pension & OPEB underfunding, treasury stock (80.9% of equity), goodwill (27.6% of TA), BBB bond rating, negative working capital, substantial contingencies. AIG: F Pension & OPEB underfunding, poor disclosure on SPEs, substantial contingencies, earnings restatement, accounting investigations by regulators, 147 days to issue audit report, substantial internal control weaknesses. GM: Stock options (18.9% of shares), Pension underfunding (pension expense 87.6% of NI), OPEB underfunding (12.8% of TA, FS--$61.5 billion), OPEB expense (162.8% of NI), [negative equity if funded status is used], dividend payout 229.9% of NI, treasury stock not listed, substantial exposure to SPEs & derivatives, rising receivables despite declining revenues, substantial contingencies, failing Altman’s, non-investment grade bond rating (BB), 73 days to audit report.

Grading the Dow 30 IBM: C SBC (now ATT): Disney: Stock options (15.3% of shares, 11.3% decrease in NI), pension underfunding, pension expense (12.7% of NI), OPEB underfunding, treasury stock (104.5% of equity), acquisition in 2004 ($24 billion, $14.5 billion charged to goodwill, 67.8%), discontinued operations (2002-4), non-audit fees (72.2% of total fees). SBC (now ATT): OPEB underfunding (15.1% of TA, FS), OPEB expense (21.7% of NI), negative working capital, discontinued operations (2002-4, accounting change, extraordinary item, restructuring, use of equity method for Cingular (60% ownership), CEO compensation ($10.7 million), AT&T Wireless acquisition, ATT acquisition pending. Disney: Stock options (11.1% of TA, 10.9% decrease in NI), underfunded OPEB, BBB+ bond rating, negative working capital, SG&A (86.8% of revenue), 70 days to audit report.

An Investment Strategy Chapter 17 An Investment Strategy

Searching for Help: Useful Internet Sites Chapter 18 Searching for Help: Useful Internet Sites