Oct 11, 2010 2
Adversarial Accounting: Juking the Stats
One of my favorite accounting books is . This is not a substitute for an introductory text to financial accounting, but it is useful for improving your knowledge of financial accounting as an analyst. I typically try to come back to it every few months to keep me on my toes.
I am hoping to make this a once a week series of posts. The purpose of this series is to basically go through texts such as Fridson’s, where I try to offer a summary of the ideas expressed chapter by chapter, but also try to present relevant and current examples to support his ideas.
Fridson begins his book with a discussion on the adversarial nature of financial accounting. It’s sometimes hard for people to understand why a field like accounting would involve so much deception. Surely, with laws and regulations in place, there would be no room for deception. But that’s not really the case at all. Companies can use financial statements to help distort their financial reality. He gives us a few examples:
1. Mercury Finance: a company that made used-car loans, in 1997 Mercury’s controller temporarily disappeared and later resurfaced, claiming the company’s earnings were a charade. At the time, the CEO had a bonus system where he only received bonuses if EPS grew by more than 20%. Such perverse incentives led executives to take extremely optimistic views on loan repayments and keep abnormally low loss reserves in place for their low-income borrowers. In 1998, Mercury filed for bankruptcy.
2. MicroStrategy: this company played games with how they recognized revenue from large customers. Eventually they had to restate revenues from $205M down to $150M.
3. Lernout & Hauspie: L&H crafted a series of transactions with Brussels Translation Group (BTG). Over two years, BTG paid L&H $35M to develop translation software. L&H then acquired BTG along with the product that they developed, allowing them to recognize $35M in revenues, instead of R&D expenses.
In , there is a recurring term called juking the stats:
ASSISTANT PRINCIPAL: So for the time being, all teachers will devote class time to teaching language arts sample questions. Now if you turn to page eleven, please, I have some things I want to go over with you.
ROLAND “PREZ” PRYZBYLEWSKI: I don’t get it, all this so we score higher on the state tests? If we’re teaching the kids the test questions, what is it assessing in them?
TEACHER: Nothing, it assesses us. The test scores go up, they can say the schools are improving. The scores stay down, they can’t.
PREZ: Juking the stats.
TEACHER: Excuse me?
PREZ: Making robberies into larcenies, making rapes disappear. You juke the stats, and major become colonels. I’ve been here before.
TEACHER: Wherever you go, there you are.
Juking the stats is what occurs when there is an overwhelming focus on one or two data points and participants are incentivized to do whatever they can to make those numbers look as good as possible. In the show, police officers regularly modify their crime statistics before presenting them in order to make things appear better than they really are. In a later season, we see that the school system similarly jukes the stats with state tests and student attendance records.
Similarly, a number of companies have juked the stats when it comes to figures like earnings per share. Take the focus on earnings per share, Fridson uses General Electric (NYSE:) as an example:
These are not tactics employed exclusively by fly-by-night companies. Blue chip corporations openly acknowledge that they have little choice but to smooth their earnings, given Wall Street’s allergy to surprises. Officials of General Electric have indicated that when a division is in danger of failing to meet its annual earnings goal, it is accepted procedure to make an acquisition in the waning days of the reporting period. According to an executive in the company’s financial services business, he and his colleagues hunt for acquisitions at such times, saying, “Gee, does somebody else have some in- come? Is there some other deal we can make?”13 The freshly acquired unit’s profits for the full quarter can be incorporated into GE’s, helping to ensure the steady growth so prized by investors.
Why do auditors not forbid such gimmicks? They hardly seem consistent with the ostensible purpose of financial reporting, namely, the accurate portrayal of a corporation’s earnings. The explanation is that sound principles of accounting theory represent only one ingredient in the stew from which financial reporting standards emerge.
Today, many executives have a direct incentive to keep numbers like EPS or the company’s stock price as high as possible. Compensation factors like bonuses are usually tied to growth in these metrics. Sometimes just an overly optimistic perspective about a company’s issues can be a problem. Fridson describes three ways this can happen when it comes to a company with slowing growth:
1. YoY Comparisons are distorted: this is probably the most common excuse. You will see companies complain about the weather or the general macro-economic environment in order to argue that their annual dip in sales was an aberration.
2. Sales are down, but new products will get us back on track: when you hear a company use this argument, it means that they will be trying to use capital to either fund R&D research for new products or that they will try to do some acquisitions to help their pipeline.
3. Diversification: sometimes a market might mature. Competitors come in and drive down the returns on invested capital, making the economics more commodity-like. A recent example of this would be in the computer manufacturing business where HP and Dell have been forced to look for acquisitions in the cloud space as they search for growth.
In theory this sounds great, but typically corporate acquirers overpay for their targets. In some cases, investors are open to what’s called “event risk”. Imagine owning shares of a company that then decides to acquire a rival by issuing stock. If the purchase price is too high, not only do you get dilution but you also get value destruction. That’s precisely what happened to shareholders of Time Warner with their merger with AOL.
Besides growth, Fridson says that managers can downplay contingencies. He gives the example of Manville Corporation, a building products firm. This was in the early 1980s when analysts grew increasingly concerned with the potential for asbestos liabilities. But in 1982, the company disclosed in quarterly filings that it estimated its asbestos-related claims were only $350M versus a shareholder’s equity of $830M. Most analysts who analyzed the company believed that their liabilities were more than sufficiently covered. But in August of that year, Manville filed for bankruptcy and revised its estimates for asbestos-related claims to almost $2 billion dollars.
The Manville case exemplifies why analysts need to be skeptical of whatever a management team reports, especially when it comes to the nature of long-tail claims which are by nature hard to estimate. Even if Manville’s management knew the claims would come in higher than they estimated, it would be in their interest to downplay such claims because tanking the stock price would impair their bonuses and stock options.
How can you prevent a Manville-style situation from happening to you? I always recommend that you talk to the CEOs and CFOs of companies that you invest in. What I try to do is come in with a very skeptical approach to what the CEOs are going to tell me. Sometimes, I will pick two CEOs that are competitors and ask them the same questions. I try to hone in on differences in what they say and compare that to what I know is going on in their industry. You want to figure out who is the one that’s overly optimistic and who is the one that is more of a realist.
Fridson goes on to compare the adversarial nature of financial statement analysis to playing basketball with your friends or two attorneys facing off in the court room. It should not be a matter of moral outrage when you see companies employ aggressive techniques. It’s a natural part of the game. Instead, you should seek to learn from them and maybe even admire them. He says that an ideal analyst will begin to anticipating instances where companies employ aggressive accounting techniques.
Finally, he ends the chapter with a discussion on how even when armed with good techniques as a financial analyst, you may see your analysis stifled by institutional factors. Fridson gives an example of a credit analyst for a vendor. With rigorous financial analysis, an analyst could employ rigorous standards which makes it so they never provide credit to borrowers who might be unable to pay. But in order to increase the company’s margins, they must focus on a more sub-optimal standard because they might earn enough on the incremental customers to offset their credit losses. Similarly, banks might have to approve loans to well known borrowers, even if their financial situation is strained. Or, maybe the analyst approves a loan to a young startup company, even if financial ratios argue otherwise — because the capital might allow them to survive long enough to become economically viable. In these cases, analysts might rely on qualitative arguments which might be unsound.
I think that the financial crisis really served as a reason to become more cognizant of the kinds of things that management teams can do to make their financial statements appear better than they really are. If you look back, the investors who got burned the most were the ones who believed the CEOs were being straight talkers or simply did not delve deep enough at the issues like mark to market accounting or off balance sheet liabilities. Maybe they saw these issues, but they deferred their judgement to the management team. So there were investors who saw banks trading at 1/2 book value that bought, only to see that book value get written down to nothing in the following quarters.
More recently, a number of investors have been burned by Chinese micro-cap frauds. Again, it’s an instance where investors have blindly trusted the reported financials of a company. So far there’s been a few recognizable patterns. In one case, a company retained an auditor only for annual financial filings. So what they did was initially report their past annuals and began to release unaudited quarterly reports. With each quarter, the company reported increases in free cash flow, driving up the cash on their balance sheet. Some investors chose to take these filings at face value and believed the company was not only safe, but also extremely cheap. Only later did they find out they were investing in a complete fraud.
Even when you see the name of a well known audit firm, you need to be cautious. With Duoyuan Printing (NYSE:), many investors assumed that by taking on Deloitte as their auditor, the company was not a fraud. In reality, Deloitte never actually got to audit their financials. They had upgraded to Deloitte from Chinese micro-cap specialized Frazer Frost. But when it came time to perform the audit in FY2010, Deloitte refused to sign off on the financials and stepped down as their auditor. Moreover, DYP never even had their internal controls audited before, at the time they were excluded from the SOX 404 requirement for an external audit of controls.
This is what it means when Seth Klarman or Bruce Berkowitz says you need to read the footnotes. In the footnotes, you can find extra disclosure that is often ignored. You can see what kinds of charges are being left out when calculating “adjusted EBITDA” or find buried disclosure on contingent liabilities. Reading the footnotes can help an analyst counter-balance and check the aggressive accounting techniques that they sometimes employ. Next week we’ll look at the balance sheet.
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