In This Chapter
Understanding financial reporting: Why it’s important, and who makes the rules Identifying accounting and reporting “stretch”
Looking at what’s being done to improve reporting quality Examining common financial statement tests
F
rom the height of the now-defunct “Y2K” tech boom, take a look at a quarterly earnings release from computer technology supplier Sun Microsystems, Inc.Pro forma net income was $1.367 billion, up 19 percent compared with last year’s pro forma net income of $1.146 billion. Pro forma earnings per share was $0.40, an increase of 18 percent compared to last year’s pro forma earnings per share of $0.34.
Sun reported actual (or GAAP) net income (included realized gains/losses on Sun’s venture equity portfolio, the effects of acquisition related charges, any unusual one-time items, and cumulative tax effects) for the third quarter of 2001 of $136 million or $0.04 per share, compared with $509 million or
$0.15 per share for the same period a year ago.
Did Sun earn 40 cents or 4 cents? Just over $1 billion or just over $100 million?
In many cases it was hard to tell where a company was headed at the start of the new millennium. Back then, it was often difficult to know what the finan- cial statements really revealed, because many companies played hard and fast with the rules to boost their results in investors’ (and analysts’) eyes.
Happily, since those frothy times, with some regulatory stimulus, things have gotten better in the reporting world, although there are still some issues. As a value investor, you need a solid, consistent, and trustworthy set of numbers to evaluate companies.
But accounting rules, while improved, still allow enough flexibility to give companies latitude to manage their business and decide what to recognize, when, and how. Understanding company accounting and reporting policies — and conservative versus aggressive bias — has always been considered a good value investing practice.
The market events of 2000 and 2001, and particularly the subsequent col- lapses of Enron, WorldCom, Adelphia Communications, and others, brought the issue to greater light. Millions of investors who never before picked up nor read a financial statement save for an occasional earnings release won- dered why their stocks and entire portfolios fell apart.
But that was then; this is now. The Enron collapse and others brought the ele- phant in the room to center stage. The public outcry, quite readily noticed by federal and state regulatory bodies and by certain individuals like New York Attorney General Eliot Spitzer, launched an active and decisive effort to dis- cover the games companies play to — at least sometimes — make things seem better than they are. From that outcry came new rules and clarifications and major legislation — the 2002 Sarbanes-Oxley Act — to bring accountability and responsibility for the numbers to those who report them.
This chapter, while not a complete treatise on the subject, illuminates some of the flexibility companies exploit and “games” companies still play, gives some tips on how to recognize misleading information in the statements, and, in certain cases, advises you of what further changes are being considered to improve statement quality and transparency.
The bottom line in this bottom-line reporting issue is quality.Just as with a physical product or service, low quality or poorly represented financial reporting, whether deliberate or not, is less dependable. We don’t bring this issue up to point fingers or accuse companies and their management of mali- cious intent, but rather to caution value-oriented investors that things may not always be what they seem.
Financial Reporting in Perspective
Back in the good old days, around 1970, fewer than 10 percent of the U.S.
population owned common stocks. Stocks were owned, bought, and sold mainly by professionals in large institutions. They were bought and held for the long term. Business cycles were long, companies were stable, predictable, and relatively simple and small, and quarter-to-quarter results variations didn’t much matter. If big fund managers wanted to know more about a com- pany’s numbers or performance, they simply called the company.
Today, more than 50 percent of the public owns shares. There’s a large invest- ment service industry set up to cater to retail customers, as brokers, fund managers, retirement plan managers, financial advisors — you name it. The public — and the industry that serves it — are highly tuned into stock perfor- mance and the factors that drive it. And the industry hires lots of “watchdogs,”
or security analysts, to translate every number, new item, or nuance from a company into a buy, hold, or sell recommendation.
Additionally, business cycles have shortened dramatically. A company with a good idea is expected to profit from it more quickly than ever. The whole world is moving faster because of technology, and because the world moves faster, companies, especially technology companies, must keep up the pace.
And finally, companies are getting bigger and more complex. They buy other companies, operate international subsidiaries, enter new businesses, and employ tens of thousands in dozens of locations worldwide. Even the sim- plest of businesses have become enormously complicated. Even a business like Dell Computer, which started in a dorm room and evolved into a multina- tional giant, ran off the rails when complexity collided with the need to demonstrate superior short-term performance, all with little to no warning to investors.
Managing outcomes
So, what happens? Companies are under tremendous pressure to meet or even beat projections. Anything less — called a missin the industry — can send a stock on a deep dive, from which many have never emerged. Managers, who once worked for shareholders through the company’s board of directors, seem ever more to work for the investment industry and its analysts to meet their projections. The fact that capital is allocated to companies with sus- tained track records of meeting their numbers isn’t lost on management.
Meeting the numbers means raising the share price and getting the capital that a company needs. And for many executives, meeting the numbers means cashing in on the bonuses and stock options they covet in the first place to stimulate aggressive financial reporting.
Add to this fact that fewer and fewer chief financial officers (CFOs) came from the ranks of professional accountants. Increasingly, CFOs rotated into the position from other parts of the business. Often the CFO was charted more with the task of cost cutting and financial efficiency and internal control than with rigorous financial reporting. Fortunately, Sarbanes-Oxley (“SOX”), discussed in Chapter 6, has righted that ship somewhat.
The end result was predictable: Management learned to tell its story in a way that put the company in the best light. Pressure from analysts, capital sources, shareholders, and even employees made other outcomes unlikely.
This phenomenon was especially evident in technology companies, where capital needs are high, business models are complex, business cycles are the shortest, and an honest company picture could be damaging. Startup costs and initial capital outlays were huge, and often technology companies grew or filled product line gaps by acquiring other companies in lieu of incurring massive research and development (R&D) expenses and capital outlays. But it wasn’t just in the tech space as we were soon to learn.
The rest of this chapter describes where we are and where we’re going with accounting principles, how they’re applied in practice, and how their flexibil- ity may still lead to some financial reporting ambiguity.
The Rules — and Where They Come From
Not surprisingly, a well-established body of rules governs financial reporting.
What is surprising: These rules aren’t absolute but rather are designed to provide a framework, or a set of “guardrails” governing financial reporting.
Fall into the GAAP
GAAP, which stands for Generally Accepted Accounting Principles, is a body of accounting rules evolved over many years by regulators, accountants, auditors, and companies in the private sector. GAAP rules provide the guide- line for financial reporting. The SEC works with the FASB (Financial Accounting Standards Board), AICPA (American Institute of Certified Public Accountants), and other watchdog organizations to implement GAAP; they alone have statu- tory authority to enforce it. The SEC’s role tends to be directed more toward investigation and compliance than rule origination.
You may justifiably be surprised at the rather loose sound of GAAP. The accounting profession would seem to be a formulaic, mathematical profes- sion like engineering, not one based on generally accepted principles pro- vided by agencies representing the very entities being regulated.
Instead, accounting operates more like the legal profession, where common law originates from lawyer arguments and is confirmed by a judge and a jury.
GAAP is the accounting “common law,” originating from practitioners and practitioner organizations and confirmed by the SEC. GAAP rules tend to be specific on some points and subject to wide interpretation on others.
Interpreting and applying GAAP to company situations furnish full-time jobs for legions of financial analysts and CPAs.
Further, GAAP is sometimes criticized for allowing companies notto present a sufficiently complete picture of their performance. Performance indicators such as number of employees, number of managers, square-foot occupancy,
sales returns, inventory composition, and so forth are routinely left out. In defense, GAAP is designed to improve financial, not operational, reporting.
Still, GAAP is widely regarded as the fairest and most consistent way for com- panies to report. It provides a common language for reporting, even though the same concept may be communicated in different words. In the eyes of some professionals, GAAP standards don’t always provide the best measure- ment for their business activity, but in general, the standard survives. The details of GAAP are beyond the scope of this book.
Accounting S-t-r-e-t-c-h
The relentless pursuit of the American corporate dream — business growth — has led to increasingly aggressive accounting practices. This section explores some of the “stretch” practices used to make business results look better.
Before you get the idea that value investors should throw in the towel on gleaning dependable information from financial statements, a couple of clari- fying comments are in order. First, although GAAP legally provides stretch lat- itude, that doesn’t mean everyone does it. The largest abuses have occurred in technology and other high-growth industries. These companies felt the most pressure to meet aggressive expectations, support high stock prices, and justify large capital infusions. But this doesn’t mean it doesn’toccur in