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Mind The GAAP

On Aug. 14, as part of the government's new get-tough policy on deceptive corporate accounting, the CEOs and CFOs of 974 of the country's largest public companies had to personally swear that their financial documents were accurate. But if you think this will prevent publicly traded firms from playing financial games to inflate income or enhance the appearance of balance sheets, think again. I don't

On Aug. 14, as part of the government's new get-tough policy on deceptive corporate accounting, the CEOs and CFOs of 974 of the country's largest public companies had to personally swear that their financial documents were accurate. But if you think this will prevent publicly traded firms from playing financial games to inflate income or enhance the appearance of balance sheets, think again. “I don't see how this law makes any difference,” says one short seller who requested anonymity. “I mean, it's always been illegal to submit false documents to the SEC.”

What hasn't changed — yet — are the rules, known as Generally Accepted Accounting Principles (GAAP). Indeed, many of the headline-grabbing revelations of accounting chicanery have not violated GAAP, which gives management broad discretion on how to record sales and value inventory. And this discretion is never going to go away. That leaves companies free to pursue “aggressive accounting,” which is not necessarily illegal. It only becomes illegal if the action is in direct violation of GAAP, or management knowingly interprets GAAP to mislead investors. As many investors learned, you can't count on accountants, your firm's research department, journalists or anyone else to uncover questionable accounting. There are so many ways to fold, spindle and mutilate the truth that you couldn't possibly foresee them all.

If you are a broker who sells individual stocks, the onus is on you — not just your research department — to make sure the stocks you recommend are not bombs waiting to explode. That means digging for discrepancies in corporate filings and reading the footnotes. At bottom, a company has to expand and grow to increase its stock earnings and hence its stock price. If the company is not generating enough cash flow to cover its costs and reinvest in that expansion, it's not worth much and that will eventually come out, usually in the form of lagging or shrinking free cash flow. Enron was a classic example.

“Even if you didn't know anything,” says Whitney Tilson, a partner at money management firm Tilson Capital Partners in New York, “This was a company that was reporting massive revenues and earnings growth, and yet actual free cash flow was feeble and erratic.” WorldCom was another case, where free cash flow was almost nonexistent.

“It wasn't clear that its free cash flow was even as valuable as its debt,” says Tilson. “If that's the case, its equity has no value.” Here is a refresher course on some of the more popular gimmicks that companies have used to manufacture earnings.

Overstating Revenue

Companies can artificially enhance earnings by overstating revenues, or what the SEC calls “improper revenue recognition.” On the most basic level, this involves booking the sale of goods on the income statement when those goods haven't yet been sold. The classic form is to ship goods to distributors or wholesalers who may not yet have final customers to take the product. Or the seller can offer favorable terms to induce the acceptance of products not yet sold. Or, it can take the particularly aggressive form it reached in the Internet and energy trading business, wherein two companies would merely “swap” products with each other, with no exchange of cash, but then book sales as if cash had been taken.

Another sales technique that can distort reported earnings is vendor financing. That's when a company sells products but lends the buyer money for the purchase. Vendor financing can be as simple as providing $1-off coupons for Kellogg's cereals or a $200 rebate on a Dell computer. But when companies report the sales without accounting for these discounts upfront, it looks like they're taking in more than they are. The seller books the sales and profits and everything is great, until the buyer goes bankrupt, returns the product or presents his rebates. Vendor financing is a big part of most big-ticket purchases. It was rampant among telecommunications equipment providers, such as Lucent and Nortel, who fronted the money to dozens of telecom startups whose names are already fading into history.

Banks that helped finance these deals, such as J.P. Morgan Chase and Citigroup, are now vulnerable. But providers of anything from homes and autos to household appliances also offer consumers various financing arrangements, leaving those providing the loans vulnerable when times get tough. Financing firms such as the CIT Group (recently acquired and divested by Tyco) and GE Capital are supposed to put reserves aside in case of nonpayment, but as the economy weakens, and people can't make their payments, those reserves look skimpier.

The same applies to banks and mortgage and credit card companies that have lent to riskier and riskier clients in order to keep expanding during the good times. They make loans and sell that consumer debt into the secondary bond market and lend the proceeds out to riskier clients. The mortgage financiers and their insurers, therefore, may be the next dominoes to collapse.

“There's talk that housing is the next bubble,” says Jeff Middleswart, an analyst with David W. Tice & Associates in Dallas. “Then mortgage insurance companies, such as Radian and PMI Group, could be next to go. And the risk profile has also dramatically increased for municipal-bond insurers like AMBAC now that cities and states are reporting huge deficits.”

Stuffing the quarter — accelerating sales to inflate current results by “stealing” sales from the future — can be difficult to spot. But there are a couple of tests you can use to detect the practice. Follow the trends in cash flows, for example. “Cash flow from operations should be relatively similar to the trend in earnings. If earnings are going up and cash flow is going down, ask questions,” says Ted Wright of LJH, a fund of hedge funds in Naples, Fla. That's because cash flow from operations should equal what the company is taking in from its ongoing business minus the costs of running the business — a purer barometer of growth than revenues, which can skew earnings.

Profit margins are another clue. Compare the increase in revenue to the profit margin on the income statement. “If revenue is rising, and there's no significant change in profit margins,” says Joe Blake, a CFA at a Pennsylvania regional broker/dealer, “either the company is selling more for less or doing something funny.”

Capitalizing Expenses

Companies can, in fact, choose how to account for certain costs. They can expense them, charge them against the current period's profits, or they can capitalize them, listing them as assets. Day-to-day costs such as office supplies are generally expensed, that is, subtracted from the current year's income on the income statement. But the cost of items with more enduring value such as property, plants and equipment can be charged against profits over a longer period. This is legitimate since office supplies only last for the period they are used, while machinery can last for several years. But, when done aggressively or fraudulently, it inflates current earnings.

AOL was fined $3.5 million by the SEC and restated earnings during the mid-1990s for capitalizing instead of expensing the costs of recruiting new customers. Now, WorldCom is being accused of a similar tactic on a much larger scale. By capitalizing the cost of connecting customers to its long distance network (the routine “access charges” that the carrier pays to local phone companies for every call), WorldCom managed to report profits of $3.8 billion when it should have recorded losses of $1.2 billion for 2001 and the first quarter of 2002.

Global Crossing both overstated revenue and capitalized expenses by agreeing to swap capacity on its fiber optic network for capacity on other companies' fiber optic networks. The capacity “sold” was counted as revenue, while the capacity it “bought” counted as a capital expense.

Spring-loading Acquisitions

Companies that go on acquisition jags may be using those purchases to boost earnings in a tactic some analysts call spring-loading. Tyco is accused of depressing the value of its many acquisition targets just before buying these companies. Then Tyco asked its targets to lower earnings by paying bills early, overstating reserves that are set aside against future losses and delaying recognition of payments received until after the merger. After that time, Tyco would reverse this process and take credit for the pop-up in earnings.

“Tyco would announce that it was acquiring a company, try to have the company take huge losses and charge that to the cost of buying them,” says Aaron Edelheit, president of Sabre Value Management, a hedge fund in Boca Raton, Fla. After the merger, Tyco would “look like these great turnaround experts, and it makes their earnings look stronger than they are.” You have to question companies that are growing through continual acquisitions, he says. “They made like 700 acquisitions in the past few years. How do you actually run a business and make all those acquisitions?”

The Big Bath

Companies can hide a certain amount of accounting alchemy in “one-time” charges or gains. For example, a company can decide its software, which is worth $30 per package, is outdated, and write off its inventory of 3 million units for a $30 million loss in 2000. In 2001, the company sells the same software for $15 a piece and books what is in fact a loss as pure profit. But big gains and losses are not sustainable, says Middleswart. “What people miss is that the charge-off can help future earnings because it includes future costs. It's called big bath restructuring because the company writes off everything they can think of.”

Cisco played this game in 2001 when it wrote off more than $2 billion in inventory. Management admitted that some of this inventory was not worthless, and would be sold in future periods. Although Cisco has since broken out how much this written-off inventory contributed to sales and earnings, investors are forced to take management's word for it. Many companies are not this transparent. The more transparent approach is to simply not write down inventory that can still be sold.

Companies can use one-time gains this way too. For example, IBM used the $300 million income from the sale of IBM's optical transceiver business to JDS Uniphase at the end of last year to cover the cost of ongoing operations instead of reporting it clearly as a one-time gain. IBM smoothed out its earnings and made the business look like it was growing when it was stagnating. “IBM treated the sale as a reduction to SG&A (selling, general and administrative expenses) so suddenly SG&A as a percent of sales went up and IBM's profit looked better,” says Middleswart. That's a little like using the proceeds from a yard sale to pay down your mortgage.

Pension fund accounting games are also a popular way to inflate operating results. If a company's pension fund earns more than anticipated, part of the extra gain can be taken from the pension fund and applied to corporate purposes, because the larger-than-expected gain reduces the amount of future contributions to the fund. So a company can reduce its SG&A expense without telling investors on the income statement that these gains are coming from a pension fund. This game was huge in the late 1990s, when the stock market pumped up pension plans. Now, with the market floundering, many companies are in the opposite dilemma — being forced to contribute more to the pension fund, increasing SG&A and possibly creating an unpleasant surprise for investors.

Don't have the time or the inclination to monitor quarterly earnings reports to ascertain the quality of earnings? That's understandable. But clients may not understand why somebody wasn't watching on their behalf.

“In the final analysis, if someone wants to defraud you they will,” says Wright. “Cash flow is the most foolproof way of doing equity research, but it takes a lot more time to do than looking at p/e multiples.” If you don't have that time or the necessary training, you might want to stick with proven money managers or mutual funds instead.

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