Reading Financial Reports for Dummies (51 page)

Regarding Reinvestment Plans

Another way a company can build better relations with its investors is to offer them stock directly so they can avoid broker costs on every share they buy. Some companies offer their investors dividend-reinvestment plans and direct-stock-purchase plans. Both plans provide companies effective ways to maintain direct contact with their shareholders instead of going through a broker.

Dividend-reinvestment plans

Dividend-reinvestment plans
give current investors a way to automatically reinvest any dividends toward the purchase of new shares of stock. In order to take advantage of this plan, a shareholder must register her stock directly with the company rather than open an account with a broker.

Shareholders can reinvest all or just part of their dividends through the reinvestment plans. Many times, these plans offer investors the opportunity to buy additional shares by using cash, check, or a debit that’s automatically taken from the investor’s bank account. This option gives small investors a way to steadily increase their ownership in the company. Many firms also allow investors to access their dividend-reinvestment plan on the company Web site, making maintaining accounts and managing transactions even easier.

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Direct-stock-purchase plans

Through
direct-stock-purchase plans,
companies can offer stock directly to the public so that investors don’t have to contact a broker to purchase even the first share of stock. Prior to these programs, investors had to buy stock through a broker before they could participate in a dividend-reinvestment plan.

Today, shareholders can buy all their stock directly from a company, if it offers the service, and avoid paying any broker fees. Direct-stock-purchase plans also provide the same features as dividend-reinvestment plans, such as the ability to reinvest dividends.

Depending on how a company sets up its program, the shareholder or the company may pay the direct-stock-purchase plan’s fees. Some companies offer this service for free; others charge a fee for every transaction, which can amount to more than what a broker would charge. Be sure you understand the fees involved if you buy directly from a company, and compare those fees with the cost of buying through your broker to make sure that you’re getting a good deal.

Chapter 23

Keeping Score When Companies

Play Games with Numbers

In This Chapter

▶ Discovering the methods of creative accounting

▶ Finding massaged company earnings

▶ Recognizing beefed-up revenues

▶ Spotting expense-cutting strategies

▶ Detecting cash-flow games

Companies cooking the books — and I don’t mean throwing them in a raging fire in disgust — fuel an ongoing game of hide-and-seek among company outsiders that results in millions, and sometimes billions, of dollars of losses for investors every year. In some cases, company insiders use numerous tactics to deceive their shareholders and pad their own pockets.

The mortgage mess in 2007, where mortgage-related securities were held off the books, destroyed the stock value of many major financial institutions, such as Citigroup and Merrill Lynch.

Throughout most of this book, I concentrate on reading financial reports that accurately portray the financial status of a company, but unfortunately, that isn’t always the case. The pressure companies face to meet the quarterly expectations of Wall Street drive many firms to play with their numbers.

When expectations aren’t met, the company’s stock price is beaten down, which lowers the company’s market value. Sometimes, this game to meet expectations goes beyond legal methods to fraud and deception.

In this chapter, I review the primary tools that companies use to hide their financial problems and to deceive the public and the government.

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Getting to the Bottom of

Creative Accounting

Enron, once the world’s largest energy trader, now lives in infamy as the host of one of the world’s largest accounting scandals. After the company declared bankruptcy in 2001, Congress enacted legislation to correct the flaws in the U.S. financial reporting system and protect investors and consumers from misleading accounting practices. But corporate lobbyists are powerful, and Congress continues to get pressure to weaken the legislation passed after the Enron scandal because the companies think the new laws are too burdensome.

In the meantime, the public’s faith in corporate financial accounting has taken a nose dive, in large part because of the glut of creative accounting that came to light during the late 1990s and continued to rear its ugly head in 2007 during the latest scandals related to the mortgage mess. Companies that practice creative accounting deviate from generally accepted accounting principles (GAAP). The financial reports they issue use loopholes in financial laws in ways that are, at the very least, misleading, and in some cases illegal, to gain an advantage for the company over the users of those financial reports.

Defining the scope of the problem

In the hundreds of cases where companies
restated
their earnings
(that is, when companies changed the numbers they originally reported to the general public to correct “accounting errors”), company insiders used creative accounting techniques to cook the books. And when trying to unearth the accounting problem, you have to be creative yourself.

In these scandals, some company insiders used corporate accounts for personal purposes, such as buying expensive cars or numerous houses and taking luxury trips — all at the expense of shareholders. Rather than using profits to grow the company and increase the stock’s value for the stockholders, these insiders lined their own pockets. How’d they get away with that?

Well, most board members were closely tied to the corporate chiefs, which means that no one was really watching the cookie jar — or the hands going into it. In some cases, these close ties were members of the same family who wouldn’t question their father or brother. In other cases, the board members were close friends and didn’t want to question a buddy. You can find more details about these scandals in Chapter 24.

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Company insiders use different techniques to cook the books. In some cases, earnings are
managed,
meaning that companies use legitimate accounting methods in aggressive ways to get the bottom-line results they need. Other companies present revenues that are pure fiction. Still others toy with how they handle their capital financing, or overvalue their assets, or undervalue their liabilities. Those who want to deceive company outsiders can use a variety of these tactics.

Recipes for cooked books

Former Securities and Exchange Commission (SEC) chairman Arthur Levitt groups these creative techniques — which he calls “accounting hocus-pocus” — into the following five categories.

I discuss how company insiders use these various techniques, but too often, you don’t find out about the deception until someone inside the company decides to blow the whistle or the company seeks bankruptcy protection.

Big-bath charges

Company insiders use this technique to clean up their balance sheet by giving it a “big bath,” meaning they wash away past financial problems.

When earnings take a big hit, some executives hope that Wall Street will look beyond a one-time loss and focus on future earnings.

A good time to use this practice is when the company decides to restructure some parts of its business — for example, when two divisions of a company merge or a single division is split into two. During the restructuring process, executives can clean up any problems in previous reporting. This cleaning process may include hiding past financial reporting problems. The accounting problems washed off the books can be deliberate or nondeliberate accounting errors made during previous reporting periods.

Creative acquisition accounting

Levitt also calls this category “merger magic” because it includes the technique in which companies use acquisitions to hide their problems. It’s particularly useful when the acquisition is merely a stock exchange rather than a cash exchange. By setting a stock price for an acquisition that enables a company to hide previous problems, a lot of past accounting problems can disappear like magic because the higher stock price can cover up the problems, such as previous losses that were not accurately reported. Most times, company insiders can erase the problems in a popular write-off called
in-process
research and development,
which is a one-time charge mentioned in the notes to the financial statements detailing an acquisition. Getting rid of problems with this charge removes any future earnings drag, and future earnings statements look better.

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Miscellaneous cookie-jar reserves

Companies that use liabilities rather than revenue to hide problems do so by using what Levitt calls “cookie jars.” When using this technique, company insiders make unrealistic assumptions about company liabilities. In a good year, a firm assumes that its sales returns will be much higher than they have been historically. These higher assumptions are “banked” as a liability, which means they’re added to an accrual account that can be adjusted in a later year. When a business has a bad year and needs to manage its earnings, it can massage those earnings by reducing the actual sales returns, using some of the banked sales returns from the cookie jar.

Materiality

In accounting, the generally accepted principle is to report only financial matters that can have a material effect on a company’s earnings. Whether an item has a material effect on the company’s bottom line is purely a judgment call made by company executives and the auditors. For example, a $1 million loss in inventory may have a material effect on a company’s bottom line if the company’s total profits are $10 million. But that same million-dollar loss for a company that reports multibillion-dollar earnings may not be considered material because that loss has less impact on the company’s bottom line.

Firms that play the materiality game set a percentage ceiling under which errors don’t matter because they’re not material. For example, the multibillion-dollar company may decide that as long as errors reflect less than 5 percent of any department’s revenues, the error isn’t material to the company’s results. But those little errors can add up when spread carefully across a firm’s financial reports. Sometimes small errors can help a business make up for the one or two cent loss per share that may miss Wall Street expectations and cause the stock price to drop. Any time a company misses Wall Street expectations — even by pennies — the stock price takes a drop, and the company’s overall value on the market may also fall by millions of dollars.

Revenue recognition

Companies using this technique boost their earnings by manipulating the way they count sales. For example, these companies recognize a sale before it’s complete or count something as sold even though the customer still has options to terminate, void, or delay the sale.

Unearthing the Games

Played with Earnings

All companies manage earnings to a certain extent because they want their bottom lines to look as good as possible, and they use whatever accounting method gets them there. For example, a company can improve its earnings by
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using different methods for valuing assets and costs. As I discuss in Chapter 9, the accounting policies and methods that a company uses can have a great impact on its bottom line.

In accrual accounting, revenue is recognized when it’s earned (when the sale of the product or service is complete and payment for the product or service is due), and expenses are recognized when they’re incurred (when the purchase is complete, even if cash has not yet been paid). See Chapter 4 for more details. Cash doesn’t have to change hands for revenue to be earned or expenses incurred. The key is whether the revenue is actually earned and the expenses are actually incurred or if a company is reporting them prematurely or fictitiously.

The generally accepted accounting principles (GAAP; see Chapter 18) that govern reporting practices are pretty flexible. Managing earnings becomes abusive when it involves using tricks that actually distort a company’s true financial picture to present the desired view to outsiders. And the games that companies play along those lines are numerous. The only limit to these games is the creativity of those who manage the company’s finances.

Companies usually play with numbers that impact revenue recognition or expense recognition. That’s really the bottom line for any company: the amount of revenue that a company takes in or the amount of expenses that it pays out in order to generate that revenue. All the other numbers that a company reports are based on either its revenue or its expenses.

Reading between the revenue lines

In this section, I cover the gamut of revenue recognition games, from slight misrepresentations to gross exaggerations. Unfortunately, many of these problems are difficult for readers who are company outsiders to find. Still, if you’re an investor, you need to be familiar with the terms I discuss in this section so you can understand news reports about problems that may exist inside a company.

Goods ordered but not shipped

In some cases, a company considers goods that have been ordered but not yet shipped to be part of its revenue earned. In the long term, this system can create not only an accounting nightmare but also a nightmare for managers throughout the company. Orders can get severely backlogged, and ultimately, the company may have a lot of problems satisfying its customers.

Additionally, this practice can have a big impact on a company’s bottom line. Accrual accounting is specifically designed to match revenue with expenses each accounting period. As more and more goods build up that are ordered but not shipped, financial reports overstate the firm’s revenue 300
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