When Enron collapsed late last year amidst allegations of misleading financial statements, investors could be forgiven for a sense of deja vu. After all, like Enron, a long list of New and Old Economy companies had also been given clean bills of health by auditors and analysts, only to later reveal that devastating losses had never been booked (e.g. Enron), and income was not being properly recognized (e.g. Cendant, Sunbeam).
Increasingly, regulatory agencies are asking why outside auditors, who are supposed to protect the investing public from fraud, and stock analysts, who are supposed to know the companies they cover, were caught off guard until the very end. The answer, in many cases, is that these companies covered up or otherwise withheld meaningful information.
But according to analyst Howard Schilit, the businesses were, in fact, broadcasting their misdeeds long before corporate watchdogs caught on. The problem is that nobody was looking in the right places. “Companies do not disclose financial improprieties in footnotes or in the Management’s Discussion & Analysis section of a financial statement,” he says. “Instead, the warning flags are buried in 10Ks and other financial reports.”
Schilit, who recently spoke at Wharton, is the founder of the Center for Financial Research & Analysis in Rockville, Md. In March he was called to testify before Congress in hearings that focused on the collapse of Enron. Schilit also authored three books on games that accountants play, including, most recently, Financial Shenanigans: How to Detect Accounting Gimmicks and Fraud in Financial Reports.
According to Schilit, seven strategies account for much of the misleading reporting. Five of them, which generally inflate earnings, consist of: Recording revenue too soon (shipping goods before a sale is finalized), recording bogus revenue (recognizing income on an exchange of similar assets), boosting income with one-time gains (increasing profits by retiring debt), shifting current expenses to a later or earlier period (improperly capitalizing costs), and failing to disclose major liabilities (engaging in transactions to keep debt off the books).
Two other schemes let companies manage earnings by deferring current profits and using them to offset future losses: Shifting current income to a later period (creating reserves and releasing them into income in a later period), or shifting future expenses into a current period (accelerating discretionary expenses).
While Schilit and other industry observers decry such “shenanigans” as smoothing out a company’s period-to-period earnings through the use of reserves and other accounting strategies, Wharton professor Franklin Allen says there may, in fact, be some merit to managing earnings.
“I certainly think they (the accountants and their companies) shouldn’t commit fraud,” he says. “They certainly shouldn’t lie either. But there are many other examples where there really is latitude as to what they can do. “
Noting that many companies manage earnings so that there are no surprises in the short run, Allen says that “as long as people know they are doing this, which I think they do if they have studied the company, it’s not unethical. Although this has changed since Enron it seemed that before that they were rewarded for this.”
He goes on to address the issue of why this kind of earnings management might in fact be good for investors. “If they simply reported everything then the stock price would quite variable,” says Allen. “Somebody who had to sell just after some bad news was released would suffer a windfall loss while somebody selling after some good news was released would have a gain. Both may prefer to share this risk by having the company manage earnings.”
Schilit, however, is not so charitable.
As an example, he highlights a practice used in the early 1990s by America Online before it acquired communications giant Time Warner and became AOL Time Warner. “AOL’s revenue was growing very rapidly, but the company was incurring substantial costs to sign up new customers,” notes Schilit, referring to the marketing expenses associated with sending out millions of computer disks to potential customers. “AOL inflated its revenues by capitalizing those costs as ‘deferred subscriber acquisition costs,’ and writing them off over a 12 month period instead of expensing them.”
The SEC later filed a complaint in U.S. District Court in WashingtonD.C. against the company, suggesting that these capitalized costs should have been treated as an expense. On May 15, 2000, the company agreed to pay a $3.5 million fine without admitting or denying any wrongdoing.
Schilit says one way to spot potential window dressing is to study the Statement of Cash Flows, which reconciles income or loss from continuing operations to the net increase or decrease in cash and cash equivalents. If a company’s change in cash flow historically moves in tandem with the change in net income, then any sudden deviation (such as an increase in net income and a decrease in cash) may be cause for concern.
Oxford Health Plans was one such case. In October 1997, Schilit observed that the company was posting steady increases in income while its cash flow kept declining. “I was suspicious,” he recalls. “Were they selling off receivables?” He alerted clients to the problem in a report, and one week later Oxford warned of huge losses and saw its stock fall from $69 to $26 in a single day.
Schilit says that Cisco Systems, which in April 2001 announced charges against earnings of almost $4 billion, provides an example of shifting current income to a later period. The lion’s share of the charge, $2.5 billion, was made up of an inventory writedown. “They (Cisco) essentially wrote off an amount equal to the cost of the entire inventory that was sold in the previous quarter,” says Schilit. “If you write off more than a billion dollars from inventory now, that’s more than a billion dollars of less cost in a future period. At some point down the road Cisco will announce that business is starting to get better and the company will report results that confirm it, even if sales stay flat. Remember that selling a product that was written off to zero (in a prior period) is the best way to get 100% margins (in the current period).”
When it’s put that way, Cisco’s writeoff appears to be suspect. But in an interview with TheStreet.com soon after Cisco took its historic writeoff, Lehman Brothers analyst Robert Willens observed that, “As long as Cisco can argue that currently it believes the value of written-down materials is nil, it can take the charge. It would be difficult to prove that this was all part of a single plan to manipulate the padding of future profits.”
Yet even if a company doesn’t plan to distort its financial results, reserving for estimated costs could still lead to distortions. Schilit uses the hypothetical example of a company that plans layoffs and wants to legitimately capture charges that will be associated with the terminations.
“Establishing a reserve for layoffs involves an estimate, and accounting guidelines encourage a conservative outlook,” he says. What happens, however, if “the company takes a $1 billion writeoff, but in fact lays off 30% fewer employees than anticipated? Do people who read the financial statements keep tabs on how many people were actually laid off?”
In this case, the company would have a $300 million “cookie jar” reserve that could be tapped at some point in the future to mitigate a less-than-favorable income statement. “So if a company announces it’s taking a charge for restructuring, ask for details of what makes it up,” says Schilit. “Then follow up to see what actually took place.”
Perhaps the very nature of accounting contributes to the problem. When a CPA is hired to prepare a company’s tax return, for example, he or she is expected to act as an advocate for the client, searching for the best way to legally minimize tax liabilities. In a case like this, IRS regulations may be legitimately viewed as hurdles to be overcome.
In contrast, such accounting codes as Generally Accepted Accounting Principles are not meant to be hurdles. Instead, like a financial version of Emily Post, they are guides that are intended to lead to a meaningful flow of information. All too often, however, accountants view them as a challenge.
Schilit offers Priceline.com as an example. He says the online sales company inflates its revenue by booking the full price of airline tickets, rental cars and hotel rooms, even though it keeps only a small percentage of the cost after paying the supplier. “If Priceline.com secures a hotel room for $100, and a customer bids $150 for the room, Priceline books the full $150 as revenue,” says Schilit. “But it should be booking only $50. Because if the room remained vacant, would Priceline write out a check to the hotel for $150? No, so the company’s risk is limited to $100. If, on the other hand, Priceline was bearing a risk of $150, then it would be fine to book the full dollar amount as revenue.”
Priceline, it should be pointed out, has defended its reporting, noting that it doesn’t take title to a product until after the customer makes a nonrefundable purchase by credit card. The company also assumes the risk if the customer’s credit is bad, the charge is disputed, or the supplier goes out of business.
While the quantity of revenue booked by a company can be an issue, the quality may also be questioned. Schilit observes that, depending on circumstances, a customer may have the right to reject a good or service within a specified period of time after a sale is made. In this case, a reserve for returns should be established. “Investors or analysts need to ask the right questions to determine if there’s a return period, and what that period is,” he says. “Then see if a reserve has been established for returns, what the basis is for that estimate, and how that compares with the company’s historical experience.”
Asked to look to the future and assess the potential for truly transparent financial reporting, Schilit expresses a sense of mixed optimism. “I don’t believe that the post-Enron efforts of the SEC and Congress will make much difference,” he says. “There will be more disclosure, but it won’t change the way that management makes its disclosures. Instead, financials will get even thicker and it will be easier to hide meaningful information.”
Instead, he says, change must come from investor pressure. “If investors say they’re mad as hell and won’t take it anymore, and they start to punish companies that use aggressive accounting techniques, then you’ll see changes. The true power to force change is not in the hands of regulators. It’s in the hands of investors.”