Reading Financial Reports for Dummies (56 page)

Without admitting or denying the allegations, Bristol-Meyers Squibb settled the civil fraud action with the SEC in August 2004 by agreeing to pay a civil penalty of $100 million plus $50 million for a shareholder fund. On Aug. 20, 2008, a judge ruled in favor of shareholders and decided that the company had made false or misleading statements about pending litigation regarding Canadian generic drug maker Apotex. The judge refused to dismiss the class action suit, which is still pending.

In addition to the fines Bristol-Meyers Squibb paid to the SEC, the company consented to a permanent injunction against future violations of certain antifraud and booking rules and agreed to appoint an independent adviser to review its accounting practices and internal control systems.

Halliburton

Between 1998 and 2000, Halliburton (an oil-field services company) changed its accounting policies for booking revenues from its contracts, boosting its paper profits by about $300 million and giving investors a misleading view of the company’s true earnings.

This change in accounting policies, which the company didn’t report to its investors, related to when and how Halliburton would include on its income statement revenue it expected to earn from
cost overruns
(costs that exceed the contract price) on contracts. The company usually gets part of those overruns reimbursed and can include that part as additional revenue on its income statement after it receives the reimbursement. The contracts in question were
cost-plus contracts,
which means the company could negotiate for additional revenue based on cost overruns. Before 1998, Halliburton didn’t book any of these cost overruns as revenue until it settled with the purchaser of its services and knew exactly how much the purchaser would pay toward the overruns.

326
Part VI: The Part of Tens

After the change in accounting policy, Halliburton booked revenue from the cost overruns immediately upon completing the job to improve its earnings reports to investors. But Halliburton had no guarantee that the purchaser would pay the full amount in overruns that it was asking for. In fact, the purchaser often reduced these amounts in negotiations, and Halliburton would have to adjust its revenues downward after it had reported the higher earnings to investors. Halliburton’s auditor during this period was Arthur Andersen. (I know. It’s shocking, isn’t it?)

Counting revenue before final settlement is an aggressive accounting method, and the company should have reported the change to its investors immediately. The SEC filed a civil action against Halliburton charging that because the company didn’t disclose the accounting changes, it deprived investors of the information they needed to assess the firm’s earnings and compare them with earnings of prior years, before the accounting change was made. The change allowed the company to report higher earnings and hide losses. In September 2004, Halliburton agreed to a $7.5 million settlement with the SEC.

Halliburton’s accounting system faces regular federal scrutiny from the Pentagon. The Pentagon has charged Halliburton with overbilling millions of dollars for services in Iraq that it never provided. These disputes will probably continue throughout the course of the Iraq war.

Arthur Andersen

One name that has shown up all over this list is Arthur Andersen. Once one of the top five accounting firms, this company is now defunct because of its role in assisting Enron with its deceptive practices. In March 2002, a grand jury indicted Arthur Andersen on charges of obstruction of justice, including charges of withholding documents from official proceedings and destroying, mutilating, and concealing documents.

Arthur Andersen was convicted on these charges in June 2002 and could no longer audit financial statements or provide CPA guidance, which essentially ended the firm’s ability to earn money from its accounting activities. The Supreme Court overturned its conviction on May 31, 2005, because of problems with the instructions to the jury. Yet this was a hollow victory, because the company was no longer a viable business.

Chapter 24: Ten Financial Scandals That Rocked the World
327

The staff of Arthur Andersen fell from a high of 28,000 people before the conviction to just 200 in 2008. The remaining staff is responsible for dealing with the legal issues still pending in 2008 and working on an orderly dissolution of the company.

Over 100 civil lawsuits are still making their way through the courts against Arthur Andersen and its accounting practices related to Enron and other companies. In June 2008 Arthur Andersen was socked with $23 million in damages in one of those pending lawsuits in Oregon.

328
Part VI: The Part of Tens

Chapter 25

Ten Signs That a Company’s

in Trouble

In This Chapter

▶ Keeping an eye on a company’s financial numbers

▶ Examining a company’s methods and procedures

If you don’t recognize traffic signs, driving is going to be pretty hairy. By the same token, if you don’t recognize a company’s danger signs by reading the financial reports, your investment decisions may not be the best ones.

Many companies put out glossy financial reports more than 100 pages long with the most graphically pleasing sections providing only the news about the company that its managers want you to read. Don’t be fooled. Take the time to read the pages in smaller print and the ones without the fancy graphics, because these pages are where you find the most important financial news about the company. The following are key signs of trouble that you may find within these pages.

Lower Liquidity

Liquidity
is the ability of a company to quickly convert assets to cash so that it can pay its bills and meet other debt obligations, such as a mortgage payment or a payment due to bond investors. The most liquid asset a company holds is cash in a checking or savings account. Other good liquid sources are holdings that a company can quickly convert to cash, such as marketable securities and certificates of deposits.

Other assets take longer to turn into cash, but they can be more liquid than long-term assets, such as a building or equipment. Take, for instance, accounts receivable. Accounts receivable can often be liquid holdings, 330
Part VI: The Part of Tens

provided that the company’s customers are paying their bills on time. If customers are paying their bills late, the company’s accounts receivable are less liquid, meaning that it takes longer for the company to collect that cash. I show you how to test a company’s accounts receivable management in Chapter 16.

Another sign of trouble may be inventory. If a company’s inventory continues to build, it may have less and less cash on hand as it ties up more money in the products it’s trying to sell. I show you how to test a company’s inventory management in Chapter 15, and I show you how to measure a company’s overall liquidity in Chapter 12.

Low Cash Flow

If you don’t have cash, you can’t pay your bills. The same is true for companies. You need to know how well a company manages its cash, and you can’t do that just by looking at the balance sheet and income statement, because neither of these statements reports what’s actually happening with cash.

The only way you can check out a company’s cash situation is by using the cash-flow statement. I show you numerous ways to test a company’s cash flow in Chapter 13. After doing the calculations in Chapter 13, if you find that a company can’t meet its cash obligations or is close to reaching that point, this situation is a clear sign of trouble.

Disappearing Profit Margins

Everyone wants to know how much money a company makes — in other words, its profits. A company’s profit dropping year to year is another clear sign of trouble.

Companies must report their profit results for the current year and the two previous years on their income statements, one of the three key financial statements that are part of the financial reports. (See Chapter 7 for more information about income statements.) When investigating a company’s viability, looking at the past five years or more — if you can get the data —

is a good idea.

Chapter 25: Ten Signs That a Company’s in Trouble
331

Luckily, finding a company’s historical profit data isn’t hard. In the investor relations section on their Web site, most companies post financial reports for the current year and two or more previous years. The Securities and Exchange Commission (SEC) also keeps previous years’ reports online at Edgar (www.

sec.gov/edgar.shtml).

Any time you notice that a company’s profit margins have fallen from year to year, take it as a clear sign that the company is in trouble. Research further to find out why, but definitely don’t invest in a company with falling profit margins unless you get good, solid information about an expected turnaround and how the company plans to pull that off. To find out more about how to test whether a company is making a profit, turn to Chapter 11.

Revenue Game-Playing

A day rarely goes by when you don’t see a story about company bigwigs who’ve played with their firm’s revenue results. Although the number of companies being exposed for revenue problems has certainly fallen since the height of scandals set off by the fall of Enron in 2001, a steady stream of reporting about the games that companies play with their revenue continues.

Problems can include managing earnings so results look better than they really are and actually creating a fictional story about earnings. I talk more about how companies play games with their revenue numbers in Chapter 23.

Unfortunately, the only way that a member of the general public can find out about these shenanigans is from the financial press. If the SEC or one of the country’s state attorneys general begins an investigation, you likely won’t know about it until the financial press decides to report on it. The SEC does post details about its investigations at http://www.sec.gov/

litigation.shtml. Usually, by the time that info is posted, the financial press has already done a story.

The initial stages of an investigation usually involve private inquiries between the SEC and the company regarding financial information filed on one of the SEC’s required forms. (For more information about those forms, see Chapter 19.) These initial inquiries aren’t discussed publicly. Only after the SEC

decides a company isn’t cooperating does it decide to start a formal investigation. When the SEC does start a formal investigation, the company must put out a press release to inform the general public (as well as its investors, creditors, and others interested in the company) that the SEC has some questions about the company’s financial reports.

332
Part VI: The Part of Tens

Too Much Debt

Borrowing too much money to continue operations or to finance new activities can be a major red flag that indicates future problems for a company, especially if interest rates start rising. Debt can overburden a company and make it hard for the business to meet its obligations, eventually landing it in bankruptcy.

You can test a company’s debt situation by using the ratios I show you in Chapter 12. These ratios are calculated using numbers from the balance sheet and income statement. Compare a company’s debt ratios with those of others in the same industry to judge whether the company is in worse shape than its competitors.

Unrealistic Values for

Assets and Liabilities

Some firms can make themselves look financially healthier by either overvaluing their assets or undervaluing their liabilities.
Overvalued assets
can make a company appear as if its holdings are worth more than they are. For instance, if customers aren’t paying their bills but the accounts-receivable line item isn’t properly adjusted to show the likely bad debt, accounts receivable will be higher than they should be.
Undervalued liabilities
can make a company look as though it owes less than it actually does. An example of this is when debts are moved off the balance sheet to another subsidiary to hide the debt. That’s just one of the things Enron and other scandal-ridden companies did to hide their problems. If a firm hides its problems well to offset the overvaluing of assets or the undervaluing of liabilities, equity is probably overstated as well.

If you suspect a company of either possibility, it’s a clear sign of trouble ahead. You should certainly begin to suspect a problem if you see stories in the newspapers about the SEC or state authorities raising questions regarding the company’s financial statements. You may be able to spot problems sooner by using the techniques I discuss in Chapter 23.

A Change in Accounting Methods

Accounting rules are clearly set in the generally accepted accounting principles (GAAP) developed by the Financial Accounting Standards Board (FASB).

You can find details about the GAAP at the FASB’s Web site (www.fasb.org).

Sometimes a company can file a report that’s perfectly acceptable by GAAP

Chapter 25: Ten Signs That a Company’s in Trouble
333

standards, but it may hide a potential problem by changing its accounting methods. For example, all firms must account for their inventory by using one of five methods. Changing from one method to another can have a great impact on the bottom line. To find out whether this kind of change has occurred, read the fine print in the financial notes. I talk more about accounting methods in Chapter 4 and delve deeper into inventory-control methods in Chapter 15.

Questionable Mergers and Acquisitions

Mergers and acquisitions can be both good news and bad news. Most times, you won’t know whether a merger or acquisition will actually be good for a company’s bottom line until years later, so be careful buying into the fray when you see stories about the possibility of a merger or acquisition.

If you don’t already own the stock, stay away until the dust settles and you get a clear view of how the merger or acquisition will impact the companies involved. If you do own shares of stock, you’ll be able to vote for or against the merger or acquisition if it involves the exchange of stock. You can get to know the issues by reading what the company sends out when it seeks your vote. Follow the stories in the financial press, and read reports from analysts about the merger or acquisition.