In other words, goodwill may simply be the price paid for poor judg- ment. This was the implication of a comment about the demise of Global Crossing: “The ending was gruesome. When Global Crossing filed for bankruptcy in January, it listed assets of $22.4 billion and liabilities of $12.4 billion. At first blush that might look like $10 billion in value, but most of the assets were worthless goodwill from overpaying for all those acquisitions.”18 A write-off for goodwill also can offer an easy way out for colossal errors of judgment in the past. Referring to a change in the accounting method for goodwill applicable to 2001 financial results (FASB 142), Shawn Young reported in the Wall Street Journal:
Qwest’s charge stems from a change in rules set by the federal agency that has put pressure on companies to write off in a lump sum goodwill assets that have fallen in value. In this case, the write-down reflects the fallen value of Qwest, which merged with the former US West in 2000. The new rules also will allow the company to stop making deductions from earn- ings of about $900 million a year for amortizing its goodwill costs. . . . Many companies are facing huge goodwill write-downs after paying large premiums for acquisitions, many of which turned out to be speculative, during the technology frenzy of the late 1990s. Indeed, WorldCom expects to take a charge of $15 billion to $20 billion and last week AOL Time Warner said it would take a $54 billion goodwill write-down.19
Acquisitions.Companies that have acquired others may be tempted to report improved overall earnings that actually only reflect the good health of the acquisitions.
Netting.One-time gains are improperly netted against operating expenses, making operating earnings appear better than they really are.20
These are not new practices, nor is the SEC new to the game of scrutiniz- ing them. It is fair to say, however, that the scopeand scaleof abuses in these and similar realms in recent years have been unprecedented. Most likely, the regulators have been spurred to a new standard of scrutiny. And this is all to the good.
LESSONS FOR INVESTORS
You are not being paranoid; they are ganging up on you.Cor- porate executives have lots of incentives—and lots of leeway—to
“cook the books” and make their earnings look better than they actually are. Their aggressive accountants have as much leeway or more and may feel compelled to conspire with the executives to protect the account.
Not all reporting styles are meaningful.Beware the pro forma and similar kinds of accounting. These are often management’s way of putting its best foot forward. In other words, they may be nonsense.
Look for off-the-balance-sheet items.What are they, and why are they off the balance sheet?
If there is no established market, be doubly cautious about the numbers.I mentioned a version of this in Chapter 7, but it is worth reiterating: If your company is creating a market and then assigning a long-term value to that market, clamp your hand on your wallet.
Look for the hiding places.There are lots of entries in standard financial reports—starting with goodwill—where strange stuff hap- pens and odd numbers squirt out. Train yourself to look for these words and phrases, and read carefully when you find them.
Massaging Financial Reports
In a nascent industry with few financial
conventions, both Wall Street and companies such as Global Crossing focused on revenue growth as the arbiter of the firms’ financial health.
—DENNIS K. BERMANin The Wall Street Journal1
Imagine that you are an investor in a fast-moving technology-intensive com- pany. (If you have gotten this far in this book, you probably are, or have been, and/or hope to be in the future.) Assume, too, that you are an involved investor. You read your annual report and quarterlies carefully, you keep an eye on the company through its Web site, and you follow the company and its industry through the financial press and trade publications.
Do you think that you would develop a true picture of the economic value of the company in which you are investing?
Don’t be too quick to answer “yes.” First of all, developing an accurate picture of anycomplex organization is extremely difficult, even if its lead- ers are trying their hardest to help you get it right.
And what if they are nottrying to be helpful?
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C H A P T E R
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In financial circles, there is a pretty solid consensus that if management wants to hide from the shareholder what’s really going on, it can. In fact, this is one of the principal lessons of the Enron mess. A lot of very savvy people were taken in.
However, there is something of a silver lining here. In the wake of Enron and similar fiascoes, self-policing has kicked in. Companies are trying harder to get it right and to convey it in accessible terms. And equally impor- tant, the Securities and Exchange Commission (SEC) has lurched into action and has started to crack down on delinquent companies.
This is belated, but it is all to the good. This chapter looks at financial reports—what’s in them and how they are massaged. My hope is that this chapter will be less important as self-policing and the SEC have their com- bined effect, but only time will tell. Meanwhile, the self-interested investor should be aware of where we have come from and—to some extent—where we still are today.