Bloomberg Personal Finance"
Sun, 28 Jul 2002, 11:54pm EDT
Liar Liar
When financial statements are increasingly an artful blend of truth, half-truth, and fiction, investor's need to become better lie detectors. Here's how.

By Chuck Carlson Bloomberg Personal Finance
One of the greatest threats to the U.S. economy--much more serious than any cyclical downturn--is the wholesale undermining of investor confidence in the stock market as a result of corporate deceptions like those of Enron. Yet the volume of obfuscation, misdirection, and, in a few cases, outright lying in corporate quarterly and annual reports (10-Qs and 10-Ks) grows every year. The incentives for the top brass to push the truth envelope are large. After all, their pay is frequently tied to stock performance, which pressures management to pump up the good and gloss over the bad. Demanding investors deserve a share of the blame, too, because they are quick to dump shares of companies that disappoint on earnings. Ever more complex business models lead to more complicated financial reports and additional opportunities to hide inconvenient facts. The rules of the game defined by GAAP--Generally Accepted Accounting Principles--are so loose as to provide plenty of interpretation on how companies report the numbers.

Finally, auditors too often sign off on financial statements that don't reflect an accurate picture of the company. An April 2002 study by Bloomberg News found that in 54 percent of the 673 largest public bankruptcies since 1996, auditors provided no cautions in financial statements in the months before the filings. In the 10 largest of those bankruptcies, none of which received warnings, investors lost nearly $120 billion.

What's the solution? One approach is to make such duping of the public ineffective and unprofitable. That means it's more essential than ever for investors to understand how companies manipulate financial reports. Although there are countless ways to mislead, these 10 lies that companies tell, often through misrepresentation and selective disclosure of information, are among the most pernicious.

The lie: "Our revenues are rising."The truth: "Yes, income is rising because we make barter deals, stuff distribution channels, and extend lots of credit to deadbeats."Lie detectors: A rising amount of receivables is a sure danger sign. This can be tracked by the receivables turnover ratio in the financial statements. Main offenders include pharmaceutical, consumer products, Internet, and computer hardware and software companies.

**Embellishing the revenue line has become a science at all too many companies. A favorite means is by extending generous credit to financially strapped customers. This practice was fairly common at telecommunications-equipment companies, including Cisco Systems (CSCO) and Lucent Technologies (LU), as they pulled out all the stops in order to maintain sales growth. The companies crammed their distribution channels by unloading product onto distributors. This can easily be accomplished with a combination of price cuts, special deals, and bullying. Some companies book as revenue receivables (money they are owed by other companies) that are in dispute and that may never be collected. Shares in Gemstar- TV Guide (GMST), for example, plunged 37 percent after the firm disclosed it recorded $108 million in revenue that it might never receive because of a patent dispute with Scientific-Atlanta.

Howard Schilit, in his influential book, Financial Shenanigans (McGraw-Hill Professional), notes some warning signs, such as calling refunds from suppliers "revenue" and recording revenue under suspect conditions--before goods are shipped, when it's uncertain that payment will be made, or on the exchange of similar assets.

It's not surprising, then, that investors are migrating to companies with simpler business models and relatively clean financial statements. For example, Wm. Wrigley Jr. (WWY), the gum company, trades at a rich price-to-earnings ratio of 34. The stock commands a premium valuation because its business model is simple and the company has been able to boost revenue 4 to 8 percent over each of the past six years without resorting to creative accounting.

Another danger signal is receivables that are growing much faster than sales. Consider the case of LifePoint Hospitals (LPNT), a for- profit operator of health-care centers, where revenue rose 18 percent for the first quarter of 2002. But receivables increased 37 percent over the same period.

The lie: "Our profits are growing!"The truth: "The quality of our earnings is questionable. That profit is built on asset sales, pro forma accounting tricks, reduced research and development spending, or unrealistic pension assumptions."Lie detectors: Cash flow numbers. Footnotes to the financial statements relating to pension accounting. Profit puffing is not exclusive to any particular industry, but many New Economy businesses prefer pro forma (not in conformance with GAAP) numbers simply because they have no GAAP profits.

**If there are 10 ways to manipulate revenue, there are 100 ways to gin up earnings. For example, IBM (IBM) sold an asset in the fourth quarter of 2001 and booked a gain of $300 million on the sale. The firm used that cash (an extraordinary one-time gain by more conservative accounting standards) to offset certain costs, thus boosting reported profits. Firms spin profits by using pro forma numbers, a loosey-goosey accounting trick which includes (or excludes) virtually anything a company wants. Amazon.com (AMZN), which has played this game since going public in 1997, reported in the first quarter of 2002 that it had a net loss of 1 cent a share on a pro forma basis. The firm actually lost 6 cents a share based on GAAP accounting.

Companies also must make certain pension assumptions that have a direct effect on the balance sheet. They tend to be optimistic, predicting, for example, that their pension plan assets will grow 9 percent or more a year. The higher the assumptions, the smaller the hit to profits from pension costs. Health-care benefits work the same way. Companies typically assume these costs are going to rise a lot less than they actually do.

Before accepting these numbers, check the assumptions of competitors with similar retirement benefit programs. If one company is being much more optimistic than another, you'll want to know how much the bottom line is benefiting. For example, General Motors (GM) assumes that its pension fund will return 10 percent annually. One analyst estimates that if it used a return of 8 percent (still a bit optimistic, but closer to reality), annual earnings per share would be cut by an estimated $1.70.

Another popular way to inflate profits is to write down costs on supposedly "obsolete" products or excess inventory, only to sell the goods later. When that occurs, profits go up, since the costs of production have already been deducted. Cisco Systems, for example, wrote off more than $2 billion worth of inventory last year. This tactic probably played a key role in its better-than- expected earnings and profit margin results in the first quarter of 2002.

As a check on earnings quality, examine the cost side of the income statement. Did the firm reduce R&D spending, marketing, or capital expenditures? Study the statement of cash flows. How much cash is being created by the gains in net income? Be suspicious if a company's net income is rising, but free cash flow generated from the business is falling. Free cash flow is what's left over after paying the bills and dividends, and buying the equipment and services needed to run the business.

The lie: "Our cash flow is rising."The truth: "We have more cash because we no longer pay our bills on time."Lie detectors: Growth in accounts payable (what the company owes to others). The level of tax benefits as a result of employee stock option exercise.

**No number is an island, not even the Holy Grail of financial statements--cash flow. True, cash flow has fewer ways of being manipulated than, say, net income. Nevertheless, simply looking at a company's cash flow from operations (found in the statement of cash flows) without examining factors that affect this number may lead to erroneous conclusions.

Cash flow may tell an incomplete story if items are included from operations that reveal nothing about the true money-making capacity of the underlying enterprise. For example, companies are required to record the tax benefits from the exercise of employee stock options as part of operating cash flow. When such tax breaks boost reported cash flow, they mask the performance of a company in terms of generating cash.

A favorite tactic for bolstering cash flow is simply not to pay bills. Broadcom (BRCM), the battered maker of chips for telecom equipment, comes to mind. Its cash flow from operating activities in 2001 was $49 million, but its accounts payable (the money the company owes) rose that year by nearly $25 million. In other words, Broadcom's declining cash flow--off from $200 million in 2000--would have been even worse if the firm hadn't delayed payments to its creditors.

The lie: "Our stock is incredibly cheap. Just look at how our stock price compares with book value per share."The truth: "Our book value is a mirage. It's about to be decimated when we write down our goodwill."Lie detectors: Size of goodwill (or "intangible assets") on the balance sheet. Previous write-down history. Companies that have been active in the acquisition arena are especially vulnerable to write-downs of book value.

**Value investors love to compare a stock's price with its book value per share. Book value is what's left over after subtracting liabilities from assets. Since most assets are recorded at cost on the balance sheet, book value may understate the liquidation value of a firm. That's why bargain-hunting investors often get excited about firms whose stock price is trading at a substantial discount to book value. But a major part of book value is goodwill--the financial accounting entry for the amount paid in an acquisition over the value of the assets being acquired. The purchase of a powerful brand name, for example, usually results in the creation of goodwill, since brands have no dollar value. Accounting rules require companies to write down the value of goodwill when it becomes "impaired," a common occurrence in the past year or two. When goodwill is charged off, it comes out of a company's book value.

AOL Time Warner (AOL) is a classic case. In February of this year, the stock, then at $25 a share, traded at about 70 percent of its book value at the end of 2001. However, the shares were anything but cheap. AOL Time Warner slashed its goodwill in the first quarter by some $54 billion, the biggest such write-off ever. If you intend to buy a stock because it looks cheap based on book value, evaluate the amount and quality of goodwill on the books.

The lie: "We have been very successful at making acquisitions work for us."The truth: "We've been very good at getting companies to take huge write-offs just before they come under our wing. The acquisitions give us an excuse to work the financial statements-- bury poor results, set up reserves to draw from later, and generally confuse the heck out of investors."Lie detectors: Goodwill write-downs. Substantial charges following an acquisition, such as the write-down of inventory or in-process R&D. Pay close attention to acquisitions in the technology, banking, and insurance sectors.

**I've never been a big fan of acquisitions, because buyers tend to overpay, and a company's subsequent financial statements become immensely more complicated. Goodwill is created, acquired assets get written down, special charges are often taken, all providing cover for accounting manipulation. For example, when insurance companies merge, it's not unusual for the buyer to increase its loss reserves. Such a move allows the buyer to squirrel away profits in those increased reserves that can be released at a later date. For years, Tyco International (TYC) was regarded as a merger magician, seemingly spinning gold from all of its deals.

However, some analysts believe that what Tyco was really good at was getting the acquired companies to "clear the decks" prior to the close of the transaction--for example, prepaying liabilities, even if they weren't due--thus making Tyco's financial statements look better after the deal closed. Other firms that have been accused of such practices are Cisco Systems and General Electric. Cisco, for example, has made about 70 acquisitions since 1993.

Serial acquisitions could be a clue that the firm can't grow organically and must buy growth. For signs of trouble, examine the changes in goodwill on the balance sheet and the sources of that goodwill. Look closely at restructuring charges.

The lie: "We believe the use of corporate resources to buy back our stock makes sense because the shares offer good value."The truth: "We're buying back our overpriced stock to offset dilution resulting from our overly generous stock option plan. And, quite frankly, this is the best way we can think of to boost per-share results."Lie detectors: A shrinking number of outstanding shares coupled with rising long-term debt levels. Compare net income versus per-share profits. Industries to watch include slow-growth consumer markets like food and packaged goods and technology companies that have long since ceased to post impressive revenue gains.

**Microsoft (MSFT) purchased some $6 billion worth of its common shares in fiscal 2001. A show of confidence by the company? Maybe. But more likely, Microsoft was trying to stem the dilution resulting from the billions of dollars of stock issued under its employee option plan. Despite the company's hefty stock purchases during the year, the number of outstanding shares actually increased from fiscal 2000 to fiscal 2001. Were the purchases a good use of corporate capital? Not if you compare the purchase price of the stock then, which averaged in the $60s, with its current price of $52.

This practice also helps explain the "IBM Miracle" of the last eight years, when the company's shares shot from $13 to more than $120. Earnings jumped from $1.25 per share in 1994 to $4.35 in 2001, but revenues rose only 34 percent over the period, a rather anemic showing for a technology company. And, long-term debt rose 27 percent over the period, from $13 billion to $16 billion. During those years, IBM was busy buying back its shares--its outstanding common stock declined from 2.35 billion to 1.72 billion, a decrease of 27 percent. That drop, coupled with stringent cost controls, generated the big per-share earnings gains. But a company can't play the buyback/cost-cutting card forever. At some point, there must be genuine revenue growth.

The lie: "Our same-store sales are increasing nicely, which proves that our brand is strong."The truth: "Same-store sales are increasing because we have either unloaded our lousy stores onto franchisees/licensees or closed them. If you look at our store counts, we are not growing the brand."Lie detectors: Compare the growth in company-owned stores with franchise-owned stores. Compare the total number of outlets from year to year.

**A retailer can pump up same-store sales by shutting laggard outlets that may be pulling down systemwide results. A company may franchise outlets, thus removing them from same-store sales calculations (which usually reflect only "company-owned" stores). Of course, offloading underperforming stores may make perfect sense. However, a firm whose outlet numbers are static or falling will likely have a difficult time generating robust revenue and earnings growth. Yum! Brands (YUM), formerly known as Tricon Global Restaurants, has been reporting stellar same-store results, which is a bit of a surprise, since not too long ago its KFC, Pizza Hut, and Taco Bell brands were struggling. The shares are up, but real growth is missing. In 1997, the firm had 29,712 outlets; at the end of 2001, it had 30,489. What has changed dramatically is the composition of those units. In 1997, company-owned restaurants made up 34 percent of the total. By 2001, that number had fallen to just 21 percent. This is significant, because Yum!'s U.S. same-store sales include only company-owned stores open a year or more. Systemwide sales grew only 9 percent from 1997 to 2001, and revenue dropped from $9.7 billion to $6.9 billion over the same period, a 28 percent decline.

The lie: "Our balance sheet is clean, with manageable debt."The truth: "We've got debt buried everywhere--in our financing unit, special related entities, contingent liabilities, and elsewhere."Lie detectors: Footnotes to the financial statements related to subsidiary debt. Companies with their own financing and financial services units (autos, heavy equipment, finance, insurance) deserve special scrutiny.

** If you look up General Electric (GE) in Value Line Investment Survey, you will find that the company's long-term debt was a miniscule $787 million at the end of 2001, or just 1 percent of total capital for the firm. What you won't see, however, is the debt assigned to GE Capital, GE's finance unit. Footnote 18 of GE's 2001 10-K reports that GE Capital has short-term borrowings of some $153 billion and long-term borrowings of another $80 billion.