Detecting Earnings Management


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Detecting Earnings Management

  2. 2. Chapter 1 What is Earnings Management?
  3. 3. Enron <ul><li>The first financial fiasco of the 21 st century </li></ul><ul><li>Bankruptcy declared December 2, 2001, the largest up to that time (until WorldCom’s bankruptcy) </li></ul><ul><li>Substantial earnings manipulation, using special purpose entities </li></ul><ul><li>Congressional hearings followed </li></ul>
  4. 4. Earnings Management <ul><li>Operating & discretionary accounting methods to adjust earnings to a desired outcome; the incentives of management to modify earnings in their own best interests </li></ul><ul><li>Earnings manipulation includes aggressive earnings management and fraud </li></ul>
  5. 5. Why Earnings Manipulation? <ul><li>“It pays to do it, it’s easy to do,and it’s unlikely that you’ll get caught (Schilit) </li></ul><ul><li>Opportunism: self-interest with guile—violating normal ethical boundaries for personal gain </li></ul><ul><li>Executive incentives include bonuses and stock options </li></ul>
  6. 6. Important Concepts <ul><li>Accounting Choice: Discretionary alternatives for reporting various financial items, such as depreciation or inventory method </li></ul><ul><li>Income Smoothing: Earnings management to smooth out erratic revenue and earnings behavior </li></ul><ul><li>Normalizing Income: Restating earnings results to better reflect economic reality </li></ul><ul><li>Big Bath: Large loss (or other reduction to earnings) for a specific purpose, often when losses are recorded to that period anyway & this can increase the changes of better earnings in future periods </li></ul>
  7. 7. Earnings Management Environment <ul><li>Possible incentives: self-interest & greed </li></ul><ul><li>Institutional environment includes corporate governance, auditing, regulation & standard setting, attorneys, investment bankers, & whistleblowers </li></ul><ul><li>Evaluation includes review of 10-K, 10-Q, proxy statement, and various internet sites </li></ul>
  8. 8. Corporate Governance <ul><li>The board of directors and the structure in place to oversee the management of an organization </li></ul><ul><li>Importance of outside, independent directors </li></ul><ul><li>Key committees include the audit committee & compensation committee </li></ul>
  9. 9. Auditing <ul><li>The external auditors evaluate appropriate financial accounting and reporting according to generally accepted accounting principles (GAAP). Auditors must have the ability to discover significant discrepancies with GAAP (competence) & willingness to report the discrepancies to the audit committee or other relevant bodies (independence) </li></ul><ul><li>The Big 4: KPMG, PricewaterhouseCoopers, Ernst & Young, Deloitte & Touche </li></ul><ul><li>Importance of independence standards </li></ul>
  10. 10. What if the Auditor Finds Fraud? <ul><li>Report the fraud to higher levels of management; if necessary to the audit committee of the board </li></ul><ul><li>If not satisfied, then what? Usually, the auditor cannot report the existence of fraud to the SEC or other regulators (SAS 99—confidentiality) Resign? </li></ul>
  11. 11. Accounting Regulation & Standard Setting <ul><li>The SEC regulates the equity capital market structure, including the stock exchanges & financial reports of some 17,000 public companies </li></ul><ul><li>The FASB promulgates financial accounting standards, includes some 150 SFASs </li></ul>
  12. 12. Earnings Restatements <ul><li>A financial statement restatement is the revision of public financial information that was previously reported. It represents real evidence of past earnings manipulation </li></ul><ul><li>There were 919 restatement from 845 companies on the major exchanges, about 10% of listed companies </li></ul><ul><li>Major categories included revenue recognition and expense recognition </li></ul>
  13. 13. SEC Enforcement Actions <ul><li>The SEC’s Division of Enforcement investigates possible violations of accounting issues and other violations of securities laws. Accounting enforcement actions often indicate earnings manipulation </li></ul><ul><li>About 20% of SEC enforcement actions were accounting related in 2001 </li></ul>
  14. 14. Attorneys <ul><li>Attorneys often write and review contracts, particularly those that are complex and controversial. Other law firms write legal opinion letters. The auditor can normally approve complex contracts based on attorney opinion letters </li></ul><ul><li>Attorney-client privilege—rules vary by state </li></ul>
  15. 15. Investment Bankers <ul><li>Investment banks issue new securities and other financial instruments. Financial analysts provide research on equity investment, including earnings forecasts and buy-hold-sell recommendations. Analysts have incentives to recommend buys on investment banking clients and brokers are encouraged to sell the new issues </li></ul><ul><li>Importance of quarterly earnings forecasts </li></ul><ul><li>Several suits against bankers in 2002-3 </li></ul>
  16. 16. Whistleblowers <ul><li>Employee of a company who comes forward with information (usually to senior executives, board members, the auditor or regulators) that may be incriminating to the company </li></ul><ul><li>Many cases of fraud and other deceptive practices have depended on whistleblowers to come forward </li></ul>
  17. 17. Environment for Earnings Management <ul><li>Strong CEO with substantial perks </li></ul><ul><li>Board made up primarily of insiders </li></ul><ul><li>Poor board committee structure </li></ul><ul><li>Audit problems </li></ul><ul><li>Executive compensation problems </li></ul><ul><li>Investment banking problems </li></ul>
  18. 18. Sarbanes-Oxley Act of 2002 <ul><li>Expanded corporate governance requirements, stressing independent directors & mandatory committees (including audit & compensation) </li></ul><ul><li>Established the PCAOB </li></ul><ul><li>Requires the audit committee to be independent </li></ul><ul><li>Mandated internal control attestation by auditors </li></ul><ul><li>Requires management (CEO & CFO) certification of “fair presentation” </li></ul><ul><li>Add audit independence requirements (e.g., limits non-audit services) </li></ul>
  19. 19. Public Company Accounting Oversight Board (PCAOB) <ul><li>Established by Sarbanes-Oxley </li></ul><ul><li>5-member independent board </li></ul><ul><li>Regulates auditors & establishes auditing standards </li></ul><ul><li>Establishes rules for internal control attestation </li></ul><ul><li>Requires auditor registration for SEC clients </li></ul><ul><li>Auditor inspection (audit the auditors--review auditor working papers, etc.) </li></ul>
  20. 20. Appendix: Defining Earnings Management <ul><li>Mulford & Comisky: “The active manipulation of earnings toward a predetermined target’ </li></ul><ul><li>Shipper: “A purposeful intervention in the external financial reporting process, with the intent of obtaining private gain” </li></ul><ul><li>Fraud (NACFE): “The intentional, deliberate misstatement or omission of material facts. Or accounting data, which is misleading” </li></ul>
  21. 21. Academic Literature <ul><li>Earnings management benchmarks: Around 0 (net income rather than loss) Last period’s earnings Analysts’ EPS forecasts </li></ul><ul><li>Importance of measuring accruals as measurements of potential earnings management </li></ul>
  22. 22. Chapter 2 Companies in Trouble—A Historical Perspective
  23. 23. Why the Scandals <ul><li>Accounting fraud does tend to come in waves, and is discovered most often after a market collapse, since no one is interested in investigating much when stock prices are high and everyone’s making big money. Barbara Toffler </li></ul>
  24. 24. Scandal Perspective <ul><li>Corporate fraud, bankruptcies, and various illegal acts have always been part of the business environment </li></ul><ul><li>Every time fiascos erupt seems a shock, but business history records dozens of major failures, frauds and other measures of massive corruption each decade </li></ul><ul><li>The big ones often hit during recessions or periods of other economic problems </li></ul><ul><li>The high-risk firms are the most vulnerable to economic shocks </li></ul>
  25. 25. Why the Scandals? <ul><li>“ It pays to do it, (2) it’s easy to do, and (3) it’s unlikely that you’ll be caught” [Schilit] </li></ul><ul><li>During the boom times, everyone in the market is brilliant </li></ul><ul><li>But what happens in the bad times? Sales drop, earnings disappear, the stocks become losers, and the cheaters are more likely discovered </li></ul><ul><li>It’s how the system functions during the bad times that determines the long-term success of the companies and institutions involved </li></ul>
  26. 26. Scandal Theories <ul><li>It could be just a few criminals, the rotten apple theory </li></ul><ul><li>It could be the developing culture that allows or encourages increasingly egregious acts </li></ul><ul><li>It could be based on the particular institutional environment that encourages or turns a blind eye to unethical or illegal acts </li></ul><ul><li>It could be the specific incentives structures that exist </li></ul><ul><li>The survival of the fittest theory </li></ul>
  27. 27. Scandal Theory Perspective <ul><li>The 21 st century scandals can be blamed on the high tech, boom period culture that got out of hand in the 1990s; Meeting quarterly earnings gets much of the blame for this greedy culture theory </li></ul><ul><li>Different cultures can explain the problems of different periods: The go-go years of the 1950s-60s. The mass-market speculation of the late 1920s, with stocks bought on margin and open rigging of stock prices; Different cultures, same result: speculative bubbles followed by crashes. </li></ul>
  28. 28. What About the Regulations? <ul><li>Securities and Exchange Commission (SEC), Internal Revenue Service (IRS), the stock exchanges, and the accounting and auditing standard setters </li></ul><ul><li>Incentives, funding levels </li></ul><ul><li>Political environment—corporations, auditors and many others were major contributors to politicians </li></ul><ul><li>Corporate governance practices </li></ul>
  29. 29. The Recent Scandals <ul><li>The obvious corporate greed—is it more widespread than in earlier periods? </li></ul><ul><li>Earnings manipulation is part of (and usually central to) most of the scandals </li></ul><ul><li>Prominent industries included energy companies and telecommunications (+ accommodations by investment banks)—importance of deregulations </li></ul><ul><li>Scale: these were big firms involved </li></ul>
  30. 30. Enron <ul><li>Stogy gas transmission company started with massive debt </li></ul><ul><li>Formed a gas trading company, expanded into electricity, risk mgt. & telecom; expanded internationally </li></ul><ul><li>Based on economic reality, many of these were failures </li></ul><ul><li>Based on earnings magic, all were successful </li></ul>
  31. 31. Enron 2 <ul><li>Gas trading: deregulated & volatile, need for spot market purchases & related derivatives, volatility increased trading profits </li></ul><ul><li>Problem of massive & potential junk bond ratings </li></ul><ul><li>Use of special purpose entities (SPEs) to reduce perception of too much debt </li></ul>
  32. 32. Enron 3 <ul><li>Importance of meeting quarterly earnings, initially through cost savings, then increasingly more gimmicks </li></ul><ul><li>Scheme 1: revalue physical assets using “fair value” models (SFAS 125, designed for financial assets)—front-loading profits </li></ul><ul><li>Scheme 2: using SPEs in virtually any complex context to record earnings </li></ul>
  33. 33. Enron 4 <ul><li>SPEs were mishandled </li></ul><ul><li>CFO Andy Fastow manipulated these for his own enrichment + independence problem </li></ul><ul><li>Particularly shady SPEs approved by auditor Arthur Andersen, attorneys, & board of directors; accommodated by investment banks & no obvious oversight by SEC </li></ul>
  34. 34. Enron 5 <ul><li>Some operations were successful, others were major blunders; the net effect was to dramatically increase financial risk, & Enron’s unwillingness to disclose real losses as they occurred </li></ul><ul><li>Mid-2001: stock price dropped, executives bailed out of stock options, bond ratings back to junk status </li></ul><ul><li>Enron restated earnings in 3 rd quarter 2001 </li></ul><ul><li>With no credibility, Enron declared bankruptcy in December 2001, the biggest bankruptcy until … </li></ul>
  35. 35. WorldCom <ul><li>Bernie Ebbers started long-distance telecom company in 1983 (name changed to WorldCom in 1995) </li></ul><ul><li>Growth through merger strategy (note earnings magic of business combinations) </li></ul><ul><li>WorldCom “looked” solid, with total assets of $104 billion & debt-to-equity of 79.3%, but half the assets were goodwill & other intangibles </li></ul><ul><li>In 2002 internal audit found operating expenses capitalized </li></ul>
  36. 36. WorldCom 2 <ul><li>New auditor KPMG reviewed the books, old auditor Arthur Andersen was fired; Ebbers resigned in April </li></ul><ul><li>In June 2002 WorldCom announced $3.8 billion in accounting errors, mainly by capitalizing “line costs” (fees to other telecom companies for network access rights—these are operating expenses) </li></ul>
  37. 37. WorldCom 3 <ul><li>WorldCom restated earnings, CFO was fired </li></ul><ul><li>Actual capitalization misstatements totaled over $11 billion </li></ul><ul><li>WorldCom filed for bankruptcy in July 2002, replacing Enron as the largest bankruptcy in US history </li></ul>
  38. 38. Tyco <ul><li>Starting as a research lab, Tyco became a conglomerate through acquisitions </li></ul><ul><li>CEO “Deal a Day Dennis” Kozlowski acquired 750 companies, using the earnings magic of combination accounting </li></ul><ul><li>Acquisition of CIT Group a particular fiasco, resulting in big losses (& extra financial reporting that showed many of Tyco’s manipulation shenanigans </li></ul>
  39. 39. Tyco 2 <ul><li>Big loss on sale of CIT & total $9.4 billion loss for 2002 </li></ul><ul><li>Kozlowski indicted for evading taxes & “raiding” Tyco </li></ul><ul><li>Tyco did not go bankrupt </li></ul><ul><li>Despite obvious manipulation & deception on a vast scale, it’s not clear that the company actually engaged in criminal acts (court cases pending) </li></ul>
  40. 40. Adelphia <ul><li>John Regas transformed a cable franchise into a communications empire </li></ul><ul><li>Restated earnings in 2002, including billion in off-balance-sheet “co-borrowing agreements” </li></ul><ul><li>Filed for bankruptcy in June 2002 </li></ul><ul><li>Regas & others charged with financial fraud </li></ul>
  41. 41. What do Enron, WorldCom & Tyco Have in Common <ul><li>Deception on a massive scale—manipulation at the highest levels of the companies </li></ul><ul><li>Growth through acquisitions plus related Business combination accounting abuse </li></ul><ul><li>Importance of meeting quarterly earnings targets at all costs—related enrichment of senior executives </li></ul><ul><li>Accommodating auditors, attorneys & boards of directors </li></ul><ul><li>All three restated earnings </li></ul>
  42. 42. What Happened at Arthur Andersen? <ul><li>One of original Big 8, founded in 1913, stressing integrity & consistency </li></ul><ul><li>Especially since the 1980s, AA had a history of “aggressive auditing,” clients became too valuable to defy (Toffler) </li></ul><ul><li>Associated with many of the big scandals: Sunbeam, Waste Management, Enron, WorldCom & Global Crossing </li></ul><ul><li>Found guilty of obstruction of justice in Enron case </li></ul>
  43. 43. The First 100 Years <ul><li>From agriculture to railroads to manufacturing </li></ul><ul><li>Continued innovation from Eli Whitney to Thomas Edison </li></ul><ul><li>Really big business after the Civil War, including Rockefeller & Carnegie </li></ul><ul><li>The “Trust” & monopoly power </li></ul><ul><li>Consolidation by JP Morgan & other investment bankers </li></ul><ul><li>Drew, Gould, Fisk & other robber barons </li></ul>
  44. 44. The 20 th Century <ul><li>Federal regulations under Roosevelt, Taft & Wilson, including FTC & Federal Reserve </li></ul><ul><li>The Roaring Twenties, including manipulation, fraud & a stock bubble </li></ul><ul><li>The Crash of 1929 & the Great Depression </li></ul><ul><li>The SEC & other reforms of the 1930s </li></ul><ul><li>Massive innovation & economic growth since World War II </li></ul>
  45. 45. Scandals! <ul><li>Standard Oil & other monopolies </li></ul><ul><li>Credit Mobilier </li></ul><ul><li>Sam Insull & utility pyramiding </li></ul><ul><li>McKesson & Robbins </li></ul><ul><li>Equity Funding </li></ul><ul><li>Lincoln Savings (& other S&Ls); Michael Milken & Drexel; Ivan Boesky/insider trading </li></ul>
  46. 46. Scandals in the 1990s <ul><li>Barings Bank </li></ul><ul><li>Waste Management </li></ul><ul><li>Long-term Capital Management </li></ul><ul><li>Sunbeam </li></ul><ul><li>Cendant </li></ul><ul><li>New York Stock Exchange </li></ul><ul><li>Rite Aid </li></ul>
  47. 47. Business/Financial Regulations <ul><li>Interstate Commerce Commission (1887) </li></ul><ul><li>Sherman Antitrust Act (1890) </li></ul><ul><li>Clayton Act, Federal reserve, Federal Trade Commission (1913-4) </li></ul><ul><li>Securities & Exchange Commission (1934) </li></ul><ul><li>Accounting standards in the private sector, beginning with the CAP in 1938 </li></ul>
  48. 48. Business/Financial Regulations 2 <ul><li>Accounting Principles Board (1959-73) </li></ul><ul><li>Financial Accounting Standards Board (from 1973) </li></ul><ul><li>Foreign Corrupt Practices Act (1977) </li></ul><ul><li>Regulation FD </li></ul><ul><li>Sarbanes-Oxley Act (2002) </li></ul><ul><li>Public Company Accounting Oversight Board (2002) </li></ul>
  49. 49. The Lessons of History <ul><li>It’s the incentives, stupid </li></ul><ul><li>Irrational exuberance </li></ul><ul><li>Corporate culture </li></ul><ul><li>Regulation follows the business environment </li></ul><ul><li>Regulations are not fool-proof </li></ul><ul><li>The political environment </li></ul><ul><li>Financial, operating and credit risks </li></ul><ul><li>The economy is global </li></ul>
  50. 50. Chapter 3 What’s in a Financial Report & What to do With It
  51. 51. Financial Reports <ul><li>10-K, Annual Report submitted to the SEC </li></ul><ul><li>Stockholders’ Annual Report (optional, financial information is almost identical to the 10-K </li></ul><ul><li>10-Q, Quarterly Report submitted to the SEC </li></ul><ul><li>Proxy Statement, information for the stockholders’ annual meeting </li></ul><ul><li>Other SEC reports, including the Prospectus (for new securities’ issues) & 8-K (to report specific events) </li></ul>
  52. 52. Contents of the 10-K <ul><li>Management Letter, usually an optimistic assessment of operations & future performance expectations from the CEO or other executive(s) </li></ul><ul><li>Financial Highlights </li></ul><ul><li>Management Discussion & Analysis (MD&A) </li></ul><ul><li>Financial Section </li></ul>
  53. 53. Contents of the Financial Section <ul><li>Auditor’s Report </li></ul><ul><li>Income Statement </li></ul><ul><li>Balance Sheet </li></ul><ul><li>Statement of Cash Flows </li></ul><ul><li>Statement of Stockholders’ Equity </li></ul><ul><li>Notes </li></ul><ul><li>Operating Summary </li></ul>
  54. 54. Management Discussion & Analysis <ul><li>Business Strategy—usually the best source of strategy & operating characteristics of the company </li></ul><ul><li>A brief history & description of the company is often presented </li></ul><ul><li>In-depth analysis of operations & financial position, often by business segments </li></ul><ul><li>Analysis of managing risks, including use derivatives for hedging </li></ul>
  55. 55. Financial Section <ul><li>Auditor’s Opinion, including name of auditor, type (usually unqualified) & date (it should be soon after the fiscal year-end—usually includes internal control report </li></ul><ul><li>Four required financial statements, previously listed </li></ul><ul><li>Extensive notes: note 1 is accounting policies used; remaining note on specific accounting issues, usually required GAAP disclosures </li></ul>
  56. 56. Contents of the 10-Q <ul><li>Income Statement </li></ul><ul><li>Balance Sheet </li></ul><ul><li>Cash Flow Statement </li></ul><ul><li>Notes (limited) </li></ul><ul><li>Other Information </li></ul><ul><li>Note that disclosures are much less extensive than the annual report; quarterly statements are not audited, but reviewed by the auditor </li></ul>
  57. 57. Proxy Statement <ul><li>Statement to shareholders before the annual stockholders’ meeting, with all the issues that will be voted on by the investors </li></ul><ul><li>Extensive information on the board of directors, board committees & important corporate governance issues </li></ul><ul><li>Information on executive & board compensation, including bonuses & stock options </li></ul><ul><li>Information on the audit, including voting on the external auditor, audit & non-audit fees </li></ul>
  58. 58. Additional Information Sources <ul><li>8-K & other reports to the SEC </li></ul><ul><li>Analysts’ Forecasts (available from Zacks & other sources) </li></ul><ul><li>Stock Prices & stock charts (available from most financial sites) </li></ul><ul><li>Business press & other media sources </li></ul><ul><li>Bond ratings (Moody’s & Standard & Poors’ </li></ul>
  59. 59. Reporting Quality Characteristics <ul><li>Well-defined Business Strategy </li></ul><ul><li>Corporate Governance Structure </li></ul><ul><li>Reporting Completeness & Timeliness </li></ul><ul><li>Transparency </li></ul><ul><li>Conservative Accounting </li></ul><ul><li>Evidence of Earnings Manipulation </li></ul>
  60. 60. Earnings Management Detection Strategy <ul><li>Qualitative Analysis—the business strategy & competitive position in the industry must make sense; adequate corporate governance & monitoring structures; SEC findings </li></ul><ul><li>Comprehensive Quantitative Strategy—quantitative financial analysis (ratios, etc.) of the financial statements </li></ul><ul><li>Detailed accounting analysis of financial statement information & various specific issues (usually based on note disclosures) </li></ul>
  61. 61. Chapter 4 The Balance Sheet
  62. 62. Balance Sheet <ul><li>Assets = Liabilities + Owners’ Equity </li></ul><ul><li>Use of historical costs, fair values, reserves, non-recording of assets & liabilities </li></ul><ul><li>Current vs. non-current; monetary vs. non-monetary </li></ul>
  63. 63. Definitions <ul><li>Assets are probable future economic benefits </li></ul><ul><li>Liabilities are probable future economic sacrifices </li></ul><ul><li>Equity (or net assets) is the residual ownership interest in the assets after deducting liabilities </li></ul><ul><li>Problem of matching actual items to these definitions based on GAAP a) Historical cost vs. fair value b) Items not recorded, such as human resources </li></ul>
  64. 64. EMD Strategy <ul><li>Level 1 analysis: balance sheet overview—composition and interrelationships of various categories </li></ul><ul><li>Level 2 analysis: detailed evaluation by category—it is recommended that the analysis starts with cash & work down to equity items </li></ul>
  65. 65. Level 1 Concerns <ul><li>Relative balances: Are there unusual amounts? </li></ul><ul><li>Working capital: Is liquidity adequate? </li></ul><ul><li>Leverage: Is the level reasonable? Is credit risk high? </li></ul><ul><li>Composition issues: How difficult is it to evaluate the balance sheet? </li></ul><ul><li>Importance of industry characteristics </li></ul>
  66. 66. Level 2 Analysis <ul><li>Current assets & liabilities </li></ul><ul><li>Long-term assets </li></ul><ul><li>Long-term liabilities </li></ul><ul><li>Stockholders’ equity </li></ul><ul><li>Consider both concerns and the EM detection strategy for each account </li></ul><ul><li>Specific concerns tend to by industry or company specific </li></ul><ul><li>Importance of notes for detailed analysis </li></ul>
  67. 67. Current Assets & Liabilities <ul><li>Cash: Is the balance appropriate? </li></ul><ul><li>Marketable securities, short-term: Amounts & accounting method(s) used </li></ul><ul><li>Inventory: Amounts & efficiency (especially for manufacturing) </li></ul><ul><li>Accounts receivable: Balances, changes in balances, & credit relationships </li></ul><ul><li>Accounts payable: Amounts & company policy </li></ul><ul><li>Reserve accounts: Amounts, are they disclosed effectively? Potential “cookie-jar” reserves </li></ul>
  68. 68. Cash Equivalents & Marketable Securities <ul><li>Cash equivalents are debt securities maturing within 90 days </li></ul><ul><li>Marketable securities, short-term, are debt securities maturing from 90 days to 1 year </li></ul><ul><li>Trading securities will be sold before maturity (fair value, income statement) </li></ul><ul><li>Available-for-sale securities may be held to maturity or sold before maturity (fair value, other comprehensive income) </li></ul><ul><li>Held-to-maturity securities will be held to maturity (amortized cost) </li></ul>
  69. 69. Inventory <ul><li>Retailers: finished goods held for sale </li></ul><ul><li>Manufacturers: raw materials, work-in-progress & finished goods </li></ul><ul><li>Lower of cost or market; LIFO, FIFO, average method (important differences when prices are changing) </li></ul><ul><li>Inventory efficiency (e.g., as measured by inventory turnover) especially important for manufacturers </li></ul><ul><li>Potential problems with obsolete inventory </li></ul><ul><li>Historically, several inventory fraud cases </li></ul>
  70. 70. Accounts Receivable <ul><li>Related to credit sales; therefore, the amounts, changes in amount, and allowance for bad debts important considerations </li></ul><ul><li>Aggressive revenue recognition would be associated with rising AR balances, often without increasing bad debts allowance </li></ul><ul><li>Evaluate sales, accounts receivable & allowance for bad debts together (i.e., they are interrelated) </li></ul><ul><li>Potential for factoring or “selling” to a special purpose entity (SPE) </li></ul>
  71. 71. Long-term Assets <ul><li>Property, plant & equipment, intangibles, long-term debt investments, long-term equity investments, reserves & others </li></ul><ul><li>Balances & characteristics depend on industry & business strategy </li></ul><ul><li>Important considerations on business combinations & investments described in later chapters—including goodwill & other intangibles </li></ul>
  72. 72. Property, Plant & Equipment (PPE) <ul><li>Magnitude depends on industry & business strategy. </li></ul><ul><li>Age of fixed assets can be important; use average age & other ratios </li></ul><ul><li>Various acquisition, disposal & write-off issues </li></ul><ul><li>Occasionally related to fraud, such as Waste Management </li></ul>
  73. 73. Average Age Calculations <ul><li>Average age = (accumulated depreciation / depreciation expense) </li></ul><ul><li>Average depreciable life = (ending gross investment / depreciation expense) </li></ul><ul><li>Average age % = (accumulated depreciation / ending gross investment) </li></ul><ul><li>Older plants are typically less efficient & subject to breakdowns </li></ul>
  74. 74. Long-term Investments <ul><li>Debt instruments usually for investments (available-for-sale or held-to-maturity) </li></ul><ul><li>Equity securities can be investments or be used for joint ventures, other equity method investments, etc. to provide “effective control” (under 20%, available-for-sale; over 20%, equity method) </li></ul>
  75. 75. Long-term Liabilities <ul><li>Bonded debt, associated with credit risk </li></ul><ul><li>Warranties, which are estimated & subject to abuse </li></ul><ul><li>Commitments & contingencies, usually unreported except in notes; significant in some industries </li></ul><ul><li>Debt retirement issues with gains & losses </li></ul><ul><li>Off-balance-sheet liabilities, especially operating leases & SPEs </li></ul>
  76. 76. Operating Leases <ul><li>Off-balance sheet, recorded in the notes </li></ul><ul><li>Large balances of operating leases </li></ul><ul><li>Check for magnitude: use the 10% of total assets rule for significance </li></ul><ul><li>If greater than 10%, recalculate liabilities & debt to equity ratios; use the capital lease present value to total minimum lease payments for discount % </li></ul>
  77. 77. Operating Lease Example—Office Depot (1) <ul><li>Operating leases at Office Depot (FY 2003, Note I) $2,216 (all numbers in millions); total assets = $6,145 </li></ul><ul><li>The operating lease % is 2216/6145 = 36.1%, greater than 10%; recalculated liabilities & debt to equity ratio </li></ul><ul><li>Capital lease % = PV of $80,586; minimum lease payments of $120,495 </li></ul><ul><li>Discount % = 80,586 / 120,495 = 66.9% </li></ul>
  78. 78. Operating Lease Example—Office Depot (2) 1.7 1.2 Debt to Equity 2,794 2,794 Total Equity $4,834 $1,483 [2,216 x .669] $3,351 Total Liabilities Adjusted Operating Leases Balance Sheet
  79. 79. Stockholders’ Equity <ul><li>Preferred stock, paid-in capital, retained earnings, treasury stock & other comprehensive income are important categories </li></ul><ul><li>Share outstanding important especially for dilution potential </li></ul><ul><li>Treasury stock usually related to stock options [a possible concern if treasury stock is greater than 10% of stockholders’ equity] </li></ul><ul><li>Other comprehensive income: accumulated “dirty surplus” items </li></ul>
  80. 80. Chapter 5 The Income Statement 1
  81. 81. Operating Elements <ul><li>Revenues </li></ul><ul><li>Expenses </li></ul><ul><li>Gains </li></ul><ul><li>Losses </li></ul><ul><li>Comprehensive Income </li></ul><ul><li>No mention is made of Net Income in the FASB’s Conceptual Framework </li></ul>
  82. 82. Operating Perspectives <ul><li>Current Operating Performance: Most common perspective is income from continuing operations (that is, focus on on-going operations) </li></ul><ul><li>All Inclusive: Include all gains & losses; the most common perspective is Comprehensive Income (note that Net Income is close to all inclusive) </li></ul>
  83. 83. Above the Line <ul><li>Revenues </li></ul><ul><li>Cost of Revenues </li></ul><ul><li>Operating Expenses </li></ul><ul><li>Interest, taxes, & other income & expenses </li></ul><ul><li>Income from Continuing Operations </li></ul><ul><li>These items represent current operations & earnings considered “above the line” </li></ul><ul><li>Above the line has a current operating performance perspective </li></ul>
  84. 84. Below the Line <ul><li>Includes Non-recurring items (extraordinary items, discontinued operations, accounting changes, other; recorded net of tax) </li></ul><ul><li>Net Income is the most common “below the line” perspective </li></ul><ul><li>Items “below” Income from Continuing Operations are considered unusual and earnings measures considered “below the line” </li></ul><ul><li>Comprehensive Income is the “all inclusive” “below the line” perspective </li></ul>
  85. 85. EMD Income Statement Strategy <ul><li>Importance of management incentives to manage earnings: Earnings below zero Earnings below last period Earnings below analysts’ forecasts </li></ul><ul><li>Incentives for “big bath” write-offs Operating losses Required restructuring Changes in top management </li></ul>
  86. 86. Level 1 Analysis <ul><li>Sales & revenue recognition concerns </li></ul><ul><li>Comparison of cost of sales to revenues </li></ul><ul><li>Operating expense concerns </li></ul><ul><li>Income tax, especially effective tax rate </li></ul><ul><li>Non-recurring items: existence & amounts </li></ul><ul><li>Relative composition of amounts compared to what’s expected </li></ul><ul><li>Erratic numbers compared to earlier periods </li></ul><ul><li>Net losses, red flags </li></ul>
  87. 87. Level 1—Quantitative Analysis <ul><li>Overview of income statement format and composition </li></ul><ul><li>Common-size analysis </li></ul><ul><li>Industry comparisons </li></ul><ul><li>Comparisons to earlier periods </li></ul><ul><li>Net income & earnings per share, compare to analysts’ forecasts </li></ul>
  88. 88. Income Statement for Apple (Appendix 1) <ul><li>Relationship of sales & cost of sales </li></ul><ul><li>Operating income close to zero ($17 million or 0.3% of net sales) </li></ul><ul><li>Thanks to other income (net) net income at $65 million above operating income—up from previous year, but down substantially from 2000 </li></ul><ul><li>Sales by geographic segment & product in Appendix 2 </li></ul><ul><li>Substantial operating expenses, including SG&A & R&D; note special charges all three year </li></ul>
  89. 89. When Should Revenue Be Recognized--Manufacturing? <ul><li>When product is completed (finished goods) </li></ul><ul><li>When sale is recorded </li></ul><ul><li>When product is shipped </li></ul><ul><li>When title passes to customer </li></ul><ul><li>When product is received by customer & is accepted </li></ul><ul><li>When payment is made </li></ul>
  90. 90. Revenue Recognition <ul><li>Revenue recognized when (1) realized or realizable and (2) earned </li></ul><ul><li>Considerable difference by industry has led to considerable complexity and alternative recognition issues, primarily by industry </li></ul><ul><li>Importance of SAB 101 (1999) on revenue recognition: usually recognize when delivery is made & collectibility is assured </li></ul>
  91. 91. Revenue Recognition Concerns <ul><li>Conservative vs. aggressive recognition policies </li></ul><ul><li>Importance of sales trends: are they changing or erratic (if so, why)? </li></ul><ul><li>Issues: bill-and-hold, channel stuffing, round-trip transactions, affiliated & related party transactions, other front-end revenue recognition, back-pocket sales, overly conservative sales, shipping costs, out-of-period sales </li></ul>
  92. 92. Aggressive Revenue Recognition <ul><li>Xerox: immediate recognition from leased contracts </li></ul><ul><li>Critical Path: back-pocket sales </li></ul><ul><li>Global Crossing: revenue recognition on exchanges of fiber optics capacity </li></ul><ul><li>Microsoft: reserve accounts used to reduce revenue recognized (overly conservative) </li></ul>
  93. 93. Earnings Restatements <ul><li>Restating previous periods; should be a rare event, but has been increasingly common in the last 5 years. </li></ul><ul><li>GAO discovered over 900 restatements from 1997-mid-2002 </li></ul><ul><li>38% involved revenue recognition issues </li></ul><ul><li>Market reaction: on average, stock price dropped 10% </li></ul>
  94. 94. Chapter 6 The Income Statement, Part II—Expenses & Non-operating Items
  95. 95. Operating Expenses <ul><li>Matching principle (conceptually; note—this concept is becoming less important) </li></ul><ul><li>Product vs. period costs </li></ul><ul><li>Concerns include relative efficiency of cost of sales, capitalizing operating costs, the use of reserves, SG&A, R&D, provision for tax, interest expenses & other expenses </li></ul>
  96. 96. Expense Recognition at Apple <ul><li>Cost of sales, 72.1% of sales, down from 77.0% in 2001 </li></ul><ul><li>SG&A 19.3% of sales, down from 21.2% in 2001, considerably higher than Dell </li></ul><ul><li>R&D at 7.8% of sales & capitalizes software development costs (higher than Dell) </li></ul><ul><li>Special charges, each of the last 3 years </li></ul><ul><li>Low net income after loss in previous year </li></ul>
  97. 97. Effective Tax Rates <ul><li>Effective Tax Rate = Provision for Tax / Pretax Income; federal statutory rate is 35% & effective rate should be about that (note: other taxing authorities, but companies use tax-reducing practices) </li></ul><ul><li>Taxes Payable Rate = taxes Payable / Pretax Income; this rate is the liability to the IRS & usually lower than the effective tax rate </li></ul><ul><li>Apple: (1) effective tax rate 22 / 87 = 25.3%; taxes payable negative due to tax loss carryforwards </li></ul>
  98. 98. Aggressive Expense Recognition <ul><li>Sunbeam: operating expenses not accrued (sales returns, advertising, reserves for product liability & warranties) </li></ul><ul><li>Rite Aid: adjustments to COGS & Inventory; maintenance costs to PPE capitalized; misstated compensation expense </li></ul><ul><li>Aurora Food: misstated marketing expense </li></ul><ul><li>Waste Management: vast scheme of fraud, including depreciation expense on PPE (misstating useful lives & salvage values), capitalizing interest, & write-downs of reserves </li></ul>
  99. 99. S&P 500 Restatements <ul><li>11 S&P 500 companies restated earnings based on expense or cost issues </li></ul><ul><li>AOL on Netscape operations </li></ul><ul><li>Health Management: understated allowances & overstated inventories </li></ul><ul><li>Xerox: charge-offs of uncollectible receivables & miscalculated interest expense </li></ul>
  100. 100. Non-recurring Items & Other Unusual Items <ul><li>Extraordinary items (unusual & infrequent) </li></ul><ul><li>Discontinued operations </li></ul><ul><li>Accounting changes (accounting principle, estimate or reporting entity) </li></ul><ul><li>Unusual items: restructuring charges, special charges, other write-offs—these can be “above or below the line” </li></ul>
  101. 101. Du Pont’s Non-recurring Items <ul><li>Disposed of Conoco in 1999 (recorded as a discontinued item) and Du Pont Pharmaceuticals in 2001 (part of continuing operations) </li></ul><ul><li>In both cases, the gains of disposal had a big impact on net income; in 1999 Du Pont had income from continuing operations of $219 million, but gain on disposal of $7.5 billion, increased net income to $7.7 billion; the gain on sale of Du Pont Pharmaceutical was $6.1 billion (before tax) and net income was $4.3 billion </li></ul>
  102. 102. Net Income & Earnings per Share <ul><li>What is the “bottom line”? </li></ul><ul><li>Net income the most common measure of earnings </li></ul><ul><li>EPS the most common earnings measure for market analysis (e.g., comparisons to analysts’ forecasts), stated on both a basic and diluted basis & before and after non-recurring items </li></ul>
  103. 103. Market Value Considerations <ul><li>Stock prices, current, historic—use of stock charts </li></ul><ul><li>Useful calculations: PE, PEG, market value, market-to-book </li></ul><ul><li>Importance of earnings forecast information: EPS forecasts available for future quarters, current & future years, & 5-year ahead forecasts </li></ul>
  104. 104. Credit Risk Issues <ul><li>Probability a company will default on debt or go bankrupt </li></ul><ul><li>Importance of financial analysis, including liquidity & leverage ratios </li></ul><ul><li>Credit risk indicators: recurring losses, troubled debt restructuring, bond downgrading, going-concern audit qualifications </li></ul>
  105. 105. Altman’s Z-score <ul><li>A quantitative measure of relative financial health </li></ul><ul><li>Equation includes: working capital/total assets; retained earnings/total assets; EBIT/total assets; & equity/debt </li></ul><ul><li>A z-score below 1.1 classifies as failing, below 2.6 gray area </li></ul>
  106. 106. Chapter 7 Cash Flows & Alternative Definitions of the Bottom Line
  107. 107. Statement of Cash Flows <ul><li>Required by SFAS No. 95 </li></ul><ul><li>Evaluates cash inflows & outflows </li></ul><ul><li>Format under indirect method: Cash from Operations Cash from Investing Activities Cash from Financing Activities Reconcile beginning & ending cash </li></ul>
  108. 108. Cash From Operations (CFO) <ul><li>Can be considered an alternative definition of performance (e.g., compare to net income) </li></ul><ul><li>Starts with net income, then adds back depreciation & amortization & other non-cash operating items (an approach to reconcile accruals) </li></ul><ul><li>Adds back changes in non-cash current items (accounts receivable, inventory, etc.) </li></ul>
  109. 109. CFO Measures <ul><li>CFO is usually positive, since net income is positive (most of the time) & depreciation & amortization increases CFO </li></ul><ul><li>Ratios such as CFO / current liabilities are potential measures of liquidity & performance </li></ul><ul><li>Free cash flow (FCF) is CFO – CFI & represents cash available for discretionary uses after making required cash outlays; FCF also can be measured as CFO – capital expenditures </li></ul><ul><li>CFO per share: compare to EPS & other per share measures </li></ul>
  110. 110. Cash From Investing (CFI) & Financing Activities (CFF) <ul><li>CFI includes the acquisition of property, plant & equipment as well as other long-term assets (e.g., investments); consequently, it is typically negative </li></ul><ul><li>CFF includes cash transactions related to capital structure, both long-term debt & equity & is usually positive </li></ul>
  111. 111. Cash Flow Statement for Apple (Appendix 1) <ul><li>Large cash balance over $2.3 billion </li></ul><ul><li>CFO for 2002 of $89 million, $24 million (36.9%) above net income; depreciation & amortization of $118 million, largely offset by increases in other current assets </li></ul><ul><li>CFI , negative $252 million, $174 million for PPE & increase in investments </li></ul><ul><li>CFF, increase of $105 million from issuing common stock </li></ul><ul><li>Small net decrease in cash of $58 million, resulting in ending cash balance of $2.25 billion </li></ul>
  112. 112. Cash Flow Statement of Pulte Homes (Appendix 2) <ul><li>Substantial income of $301 million for 2001, but CFO a negative $419 million—a likely red flag </li></ul><ul><li>Major factors were large increase of inventories (housing stock) of $648 million & mortgage loans of $157 million </li></ul><ul><li>Possible implication is that housing is not selling well, at least compared to level of building </li></ul>
  113. 113. Earnings Management Concerns <ul><li>CFO should be positive & larger than net income; if not, the reasons need to be investigated </li></ul><ul><li>CFO composition & trends over time may signal possible earnings management </li></ul><ul><li>Taxes paid & stock options require additional analysis </li></ul><ul><li>Non-recurring items & special charges are subject to different cash flow reporting & require additional evaluation </li></ul>
  114. 114. Additional Earnings Management Concerns <ul><li>Composition of CFI, normally negative, associated with acquisition of PPE; consider composition issues & possible impact on income smoothing & other earnings management issues [e.g., selling PPE, investments] </li></ul><ul><li>Composition of CFF, especially for long-term implications of debt & equity </li></ul><ul><li>Evaluate cash balances & possible liquidity problems (e.g., negative working capital) </li></ul>
  115. 115. Alternative Bottom Line Numbers <ul><li>“ Above the line”: gross profit & operating profit, EBIT & EBITDA, income from continuing operations; concept of current operating performance & sustainable earnings </li></ul><ul><li>“ Below the line”: after income from continuing operations, importance of non-recurring items: net income & comprehensive income; all-inclusive perspective of earnings </li></ul>
  116. 116. EBIT & EBITDA <ul><li>Earnings before interest & taxes: start with earnings before tax & add back interest expense; EBIT is often considered the best measure of operating earnings </li></ul><ul><li>Earnings before interest, taxes, depreciation & amortization; starting with EBIT, add back depreciation & amortization; EBITDA is often considered an alternative operating cash flow measure </li></ul>
  117. 117. Net Income & Comprehensive Income <ul><li>Net income (& EPS) are the traditional bottom line measures & are close to the all-inclusive concept </li></ul><ul><li>Comprehensive income include “dirty surplus” items: find these as “other comprehensive income” in the Statement of Stockholders’ Equity & add them to net income; occasionally, these can be large losses & a potential concern </li></ul>
  118. 118. Pro Forma Earnings <ul><li>Companies may report pro forma earnings & claim these are more valid than net income </li></ul><ul><li>These are non-GAAP numbers & usually presented by companies that are performing poorly to improve “reported earnings” </li></ul><ul><li>These normally should be treated skeptically (or ignored) </li></ul>
  119. 119. S&P’s Core Earnings <ul><li>S&Ps own measure of standardized earnings, introduced in 2002 </li></ul><ul><li>This measure will usually be lower than net income (& often much lower) & includes items such as stock options expense that are not currently required to be reported as part of net income </li></ul><ul><li>GE’s core earnings on a per share basis was $1.11 for 2001, 31 ¢ or 22% below EPS </li></ul>
  120. 120. Chapter 8 Evaluating Trends, Norms & Quarterly Data
  121. 121. Analyzing Multi-period Data <ul><li>Called trend analysis or time series analysis </li></ul><ul><li>Can be used for annual or quarterly data </li></ul><ul><li>Usually requires at least 5 period for useful analysis </li></ul><ul><li>Can include comparisons to competitors, industry, market averages, & expected results (norms) </li></ul><ul><li>A thorough analysis is suggested for areas of particular concern </li></ul>
  122. 122. Trend Analysis <ul><li>Used as a generic terms to consider an array of quantitative financial techniques to analyze multi-period data </li></ul><ul><li>Common-size analysis, converts $ to percentages for comparative purposes </li></ul><ul><li>Growth analysis which considers growth rates in terms of annual percentages </li></ul><ul><li>Base year analysis which uses 1 period as the base = 100% & compares this to all other years </li></ul>
  123. 123. Common-size Strategies <ul><li>This is the same technique as described earlier; for the income statement, all items are stated as a % of revenues </li></ul><ul><li>Relationships should be relatively constant over time (for example, a gross margin of a relatively constant 20%) </li></ul><ul><li>If relationships are erratic, it suggests possible concerns & further analysis to explain unexpected behavior </li></ul><ul><li>Note that some relationships are “good news,” such as rising gross margins </li></ul>
  124. 124. Growth Analysis <ul><li>Multiple period comparisons of specific financial statement items to calculate periodic growth rates </li></ul><ul><li>Calculate as more (recent period – previous period) / previous period </li></ul><ul><li>The calculation provides the percentage growth rate from one period to the next </li></ul><ul><li>This is particularly useful for major income statement categories, such as revenues, gross profit & net income </li></ul>
  125. 125. Growth Analysis Strategies <ul><li>Usually more useful for income statement line items rather than balance items </li></ul><ul><li>A useful first step is to compute the growth ratios for major categories only for the past 5-6 years. </li></ul><ul><li>If concerns become obvious (e.g., recurring negative growth rates in some periods), then expand the analysis to more categories & additional years </li></ul>
  126. 126. Growth Analysis Strategies 2 <ul><li>Look for specific expected patterns (e.g., the relative change in revenues should be matched by gross profit, net income, and so on) </li></ul><ul><li>Unexpected relationships (e.g., increasing SG&A when revenues are declining) require reasonable explanations </li></ul>
  127. 127. Base Year Analysis <ul><li>Multiple period analysis by setting a base year equal to 100 and comparing financial statement items relative to the base year </li></ul><ul><li>The earliest year analyzed is usually the base year; however, the base year must be relatively “typical” for this analysis to be effective </li></ul><ul><li>Compare all other years by dividing the remaining remaining years by the base year; for example if 1998 revenues are $587 and 1999 revenues are $607, then 1998 revenues = 100.0% & 1999 revenues = 103.4 (607 / 587) </li></ul>
  128. 128. Base Year Analysis Strategies <ul><li>The focus of base year analysis is long-term—what are the fundamental patterns over the period of analysis? </li></ul><ul><li>Year-to-year charges are “under-emphasized” with this approach </li></ul><ul><li>Concerns generally focus on long-term drops, especially in revenues & net income (& other “bottom line” measures) </li></ul><ul><li>Some declining patterns, such as SG&A drops may be “good news” </li></ul>
  129. 129. Problems with Trend Analysis <ul><li>Several factors distort the ability to compare numbers over time </li></ul><ul><li>Economic, competitive, & regulatory factors are dynamic & change over time </li></ul><ul><li>Accounting standards change, which may make long-term comparisons problematic </li></ul><ul><li>Business acquisitions & divestitures distort multi-period comparisons </li></ul>
  130. 130. Quarterly Analysis <ul><li>Quarterly data is less complete than annual data (& unaudited), but (except for the 4 th quarter) is the most up-to-date information available </li></ul><ul><li>Particularly important are (1) the current quarter to the previous quarter & (2) the current quarter to the same quarter 1 year ago </li></ul><ul><li>Quarterly analysis should include at least the last 5 quarters </li></ul><ul><li>If concern exist, a more detailed analysis for the last 3-5 years is recommended </li></ul>
  131. 131. Quarterly Analysis 2 <ul><li>The same trend approach is suggested for quarterly as for annual data: common-size Growth analysis Base quarter analysis </li></ul><ul><li>Quarterly data is particularly important because potential problems can be detected sooner with quarterly analysis—big changes can show up from one quarter to the next </li></ul>
  132. 132. Problems With Quarterly Analysis <ul><li>Incomplete disclosure—much information is not required in quarterly reports (& unaudited) </li></ul><ul><li>Accounting policies may differ from annual report data; estimates can be a real problem (e.g., reserve accounts) </li></ul><ul><li>Certain accounting issues may only be dealt with annually, such as impairment charges </li></ul><ul><li>A complicating factor is seasonal data—there can be recurring quarterly patterns, such as the “Christmas season” for retailers </li></ul>
  133. 133. Detecting Earnings Management using Multi-period Analysis <ul><li>A longer- term perspective, looking for recurring patterns or negative trends </li></ul><ul><li>Quarterly patterns than may signal intra-year earnings management </li></ul><ul><li>Balance sheet issues </li></ul><ul><li>Income statement issues </li></ul>
  134. 134. Balance Sheet Issues <ul><li>Low liquidity, especially negative working capital </li></ul><ul><li>Relationship of inventories & receivables to sales (esp. relative growth & changes) </li></ul><ul><li>Excessive use of operating leases & other off-balance-sheet items </li></ul><ul><li>Warranties, commitments, contingencies & other obligations that may understate true liabilities </li></ul><ul><li>Long-term debt levels (especially is growing) </li></ul><ul><li>Excessive & growing treasury stock levels </li></ul>
  135. 135. Income Statement Issues <ul><li>Trends in revenues, gross margin, operating margin, etc. </li></ul><ul><li>Operating expense issues, including SG&A, R&D spending, special charges, etc. </li></ul><ul><li>Effective tax rates & other tax issues </li></ul><ul><li>Non-recurring charges—these should be rare </li></ul><ul><li>Net income & other “bottom line” measures </li></ul>
  136. 136. Cash Flow Issues <ul><li>CFO trends, especially related to net income </li></ul><ul><li>Free cash flows & relative capital expenditures </li></ul><ul><li>Relationships of CFO, CFI & CFF & comparisons to cash balances </li></ul>
  137. 137. Stock Price & Other Market Analysis <ul><li>Long-term stock charts (5 years is common) indicate the longer-term trends in investor reactions </li></ul><ul><li>Reasons for large rises & dips should be explainable; if not, they may signal potential concerns </li></ul><ul><li>Relationship of stock prices to EPS & 5-year forecast earnings growth rates </li></ul><ul><li>Earnings “surprises,” actual to analyst forecast estimates </li></ul>
  138. 138. Chapter 9 Business Combinations & Related Items
  139. 139. Business Combinations <ul><li>Long history of acquisitions: Rockefeller, Morgan, Ford, LTV, GE </li></ul><ul><li>Horizontal mergers, direct competitors </li></ul><ul><li>Vertical mergers, expanding into related areas </li></ul><ul><li>Conglomerate mergers, diversify into unrelated industries </li></ul><ul><li>Recent mega-mergers, e.g., AOL Time Warner, Exxon Mobil, Warner Lambert by Pfizer, GTE by Bell Atlantic, Citicorp by Travelers Group </li></ul>
  140. 140. Accounting Issues <ul><li>Pooling of interests vs. purchase method </li></ul><ul><li>Octopus acquires Guppy: book value $10 million, fair value $18.1 million </li></ul><ul><li>Actual acquisition cost is $30 million (assume stock for pooling & cash for purchase) </li></ul><ul><li>What are the journal entries? </li></ul>
  141. 141. Pooling Journal Entry <ul><li>Accounts Receivable, net 1.1 </li></ul><ul><li>Inventory 2.9 </li></ul><ul><li>Fixed Assets, net 8.0 </li></ul><ul><li>Liabilities 2.0 </li></ul><ul><li>Equity 10.0 </li></ul>
  142. 142. Purchase Journal Entry <ul><li>Accounts Receivable, net 1.0 </li></ul><ul><li>Inventory 3.5 </li></ul><ul><li>Fixed Assets, net 10.6 </li></ul><ul><li>Patents 5.0 </li></ul><ul><li>Goodwill 11.9 </li></ul><ul><li>Liabilities 2 </li></ul><ul><li>Cash 30 </li></ul>
  143. 143. Recent Pronouncements <ul><li>SFAS No. 141 requires purchase method for all acquisitions, started July 1, 2001 (& accounting somewhat different from APB Opinion 16) </li></ul><ul><li>SFAS No. 142 requires that goodwill is no longer amortized; instead, goodwill is tested for impairment at least annually (Note AOL Time Warner write-off of $54 billion in goodwill in 2001) </li></ul>
  144. 144. Earnings Management Issues <ul><li>Analysis somewhat easier since only a single method is used </li></ul><ul><li>Data problems exist, since only limited reported is required at the merger date & little available data after the acquisition consummated. </li></ul><ul><li>Difficult to evaluate the effectiveness of mergers 1 or more years after the fact </li></ul><ul><li>Possible goodwill impairment problematic & difficult to anticipate </li></ul>
  145. 145. Acquisition Strategies <ul><li>Consider acquisition price & stock market reaction (often a negative reaction due to premium paid for target) </li></ul><ul><li>Valuation strategies: (1) allocate to depreciable/ amortizable assets (future tax “benefits”), (2) allocate as much as possible to in-process R&D (written off after acquisition), & (3) maximize goodwill, which is no longer expensed (reduces future expenses, but risk of impairment write-offs). Note that strategy 3 used by Apple in 2002 </li></ul>
  146. 146. Stock Price Reaction to AOL’s Time Warner Acquisition
  147. 147. AOL Stock Price After the Merger
  148. 148. Acquisition Concerns—At Acquisition Date <ul><li>Does acquisition fit the business strategy of the corporation?—evaluate MD&A </li></ul><ul><li>Was the price paid excessive?—evaluate stock market reaction to the announcement </li></ul><ul><li>What are the acquisition/divestiture trends?--review acquisitions for the last 2-5 years </li></ul><ul><li>What is the overall quantity & magnitude of recent acquisitions?—review for evidence of problems & earnings management potential </li></ul>
  149. 149. Acquisition Concerns—After Acquisition Date <ul><li>How were asset valuations allocated?—calculated acquisition percentages to: (1) depreciable/amortizable assets, </li></ul><ul><li>especially impact on expenses & taxes </li></ul><ul><li>(2) in-process R&D & write-offs (3) goodwill, both in terms of magnitude & also potential for future write-offs for impairments </li></ul>
  150. 150. Apple Allocation of Acquisition Costs--2002 $107.0 $66.1 $14.9 $26.0 Total 68.0 39.7 9.7 18.6 Goodwill 12.8 12.8 Deferred stock compensation 11.3 10.8 0.5 In-process R&D 8.5 2.6 5.9 Other intangible assets 0.8 0.8 Trade name 3.8 3.8 Acquired technology $1.8 $0.2 $-0.7 $2.3 Net tangible assets Total Power School Space Technologies Emagic
  151. 151. Acquisition Disasters <ul><li>The estimate is that two out of three acquisitions are mistakes: poor fits to business strategy, over-paying for acquisition, difficulty fitting new operations to operating culture of the acquiring firms, stated synergies did not materialize </li></ul><ul><li>AOL Time Warner & the $54 billion write-off </li></ul><ul><li>CUC: acquisition of CUC by HFS, when fraud was discovered at CUC </li></ul>
  152. 152. Equity Method <ul><li>When parent has less than complete voting control (50% + 1 share), parent is considered to have “influence but not control;” therefore, the subsidiary is NOT consolidated </li></ul><ul><li>Normally, when ownership is between 20%-50%, the equity method is used </li></ul><ul><li>The acquisition is recorded at cost as an investment, then the subs. share of net income is recorded as income & increases investment (cash dividends from the sub. decrease investment) </li></ul>
  153. 153. Equity Method Concerns <ul><li>Does the use of the equity method make sense based on business strategy (or just an earnings management tool)? </li></ul><ul><li>How were these subs. established (e.g., purchase of shares, spin-off of existing sub.)? </li></ul><ul><li>Evaluate former subs. that were spun off—consider reasons such as relative profitability & transferred debt, gains or losses from spin-off </li></ul>
  154. 154. Coca-Cola: the 49% Solution <ul><li>Coca-cola does no bottling; this is left to bottling partners; these are usually subsidiaries where Coke has between 20%-50% ownership & uses the equity method (for about one-third, Coke has less than 20% ownership & these are recorded as marketable securities) </li></ul><ul><li>Investments using the equity method total $5.1 billion & represent about 23% of total assets; marketable securities total another $2.8 billion </li></ul>
  155. 155. Coca-Cola Spin-offs—Earnings Management? <ul><li>Generally, the major bottlers were initially owned by Coke & then spun off </li></ul><ul><li>The largest bottler is Coca-Cola Enterprises (CCE), a 1986 spin-off, with Coke maintaining 38% </li></ul><ul><li>With the spin-off went considerable debt (CCE now has a debt-to-equity ratio of 7.4, while Coke’s is 97.2%); margins with the bottlers also are lower than for Coke </li></ul>
  156. 156. Joint Ventures (JVs) <ul><li>JVs are contracts with other entities (usually corporations) to establish a JV as a separate legal entity </li></ul><ul><li>In most cases, each Partner has 50% ownership in the JV; since these is no outright control, the equity method is used </li></ul><ul><li>The advantages of JVs are the unique contractual relationships that can be structured </li></ul><ul><li>JVs are common in integrated oil & gas companies, as well as banks & other financial institutions </li></ul>
  157. 157. Joint Venture Concerns <ul><li>Does the JV make sense based on business strategy? </li></ul><ul><li>Does the JV make economic sense (e.g., why was it established)? </li></ul><ul><li>What are the financing arrangements (e.g., borrowed money vs. equity) </li></ul><ul><li>Are there special risk management concerns (e.g., foreign subs.)? </li></ul>
  158. 158. Divestitures <ul><li>Divestitures include selling a sub. to another corporation or a spin-off </li></ul><ul><li>These can be big, such as the breakup of ATT in 1984 </li></ul><ul><li>Concerns include why the divestiture was made, how it was recorded, & impact on debt levels </li></ul>
  159. 159. Segment Reporting <ul><li>Corporations must disclose note information on major operating & geographical segments (SFAS Nos. 14 & 131), based primarily on “10% rules” </li></ul><ul><li>Information is required on net sales, segment assets, & (for operating segments) operating income </li></ul><ul><li>Limited performance analysis possible includes operating return on sales (operating income / net sales) & asset efficiency (net sales / identifiable assets) </li></ul>
  160. 160. Segment Reporting Concerns <ul><li>Full disclosure (transparency): since performance analysis must include analysis by segments, complete disclosure is essential </li></ul><ul><li>Relative performance by segments, especially by operating return on sales </li></ul><ul><li>Segments may relate to specific acquisitions & may be useful to evaluate the effectiveness of the acquisition </li></ul><ul><li>Additional analysis of financial & operating risks if data are available </li></ul>
  161. 161. Problem 9.2 (b), p. 237 115.2% 24.7% Timeshare 60.6% 21.7% Managing & Franchising 43.0% 18.1% Hotel Ownership Revenues / Assets Operating Income/Revenue
  162. 162. Problem 9.3 (a), p. 238 327.1 -69.4 RF Synthetic Fuel 54.2 15.2 Time Share 219.0 -0.5 RF Extended-service Lodging 125.4 13.4 Select-service Lodging 159.9% 7.3% Full-service Lodging Revenues / Assets Operating Income/Revenues
  163. 163. Chapter 10 Corporate Governance, Compensation & Other Employee Issues
  164. 164. The Corporate Governance Environment <ul><li>Corporate governance practices signal the potential for earnings management—permissive structures indicate that manipulation is more likely </li></ul><ul><li>The board of directors sets overall policy & provided oversight for operating activities </li></ul><ul><li>Historically, boards were composed mainly of owners, managers & other insiders </li></ul><ul><li>It is now clear that a majority of independent board member is essential for effective oversight </li></ul>
  165. 165. Analyzing Corporate Governance <ul><li>Analysis of corporate governance is a qualitative analysis, based on structures & policies of the board </li></ul><ul><li>The primary source of information is the Proxy statement, usually issued after the annual report (& associated with the upcoming annual stockholders’ meeting) </li></ul>
  166. 166. Areas of Corporate Governance Analysis <ul><li>The CEO & board of directors—composition, independence & policies </li></ul><ul><li>Executive compensation—what forms, how much, relation to performance </li></ul><ul><li>Auditing—the role of the audit committee, the external auditor, non-audit fees </li></ul><ul><li>Related-party transaction—potential conflicts of interest </li></ul><ul><li>Insider trading—patterns that suggest abuse </li></ul><ul><li>Investment banking relationships </li></ul><ul><li>Evidence of past abuse such as earnings restatements </li></ul>
  167. 167. Concerns with the Board of Directors <ul><li>Is the CEO also the chairman of the board? </li></ul><ul><li>Evidence of CEO oversight abuse </li></ul><ul><li>Are a majority of board members independent? </li></ul><ul><li>What are the board committees & is there evidence that they’re active & effective </li></ul><ul><li>Evaluate board compensation—is it based on performance & active participation </li></ul>
  168. 168. Concerns with Executive Compensation <ul><li>Evaluate the compensation committee for independence & competence </li></ul><ul><li>Analyze the executive compensation (especially the CEO) by component: base pay, bonuses, stock options (& other forms of ownership-related compensation) & perks </li></ul><ul><li>Is compensation based on performance? Evaluate based on earnings & stock price performance </li></ul><ul><li>Particular concerns are for over-compensation of CEO for poor performance & impact of previous accounting-related abuses </li></ul>
  169. 169. Concerns with Auditing <ul><li>Evaluate the audit committee for independence, competence with financial information, how many times the committee meets & other evidence of diligence </li></ul><ul><li>Review audit procurement practices, including the external auditor (usually a Big 4 firm), non-audit fees, the audit opinion & timeliness of reports </li></ul>
  170. 170. Other Concerns <ul><li>Are there related-party transactions? If so, do they signal potential manipulation or a permissive environment? </li></ul><ul><li>Evaluate insider trading (buying & selling of corporate stock by senior executives)—are there patterns that suggest abuse? </li></ul><ul><li>Do investment banking relations exist that suggest potential abuse? </li></ul><ul><li>Is there evidence of past accounting abuse (e.g., earnings restatements) or on-going problems (such as SEC investigations) </li></ul>
  171. 171. Stock Options <ul><li>Options grant the holder the right to purchase stock at a set price (exercise price) over some fixed time period, usually the closing price at the issue date </li></ul><ul><li>Options are a one-directional participation in the success of the company—the employee benefits (will exercise the options) only if the stock price goes up. If the price goes down, there is no loss the the employee </li></ul><ul><li>Presumably, options give employees the incentives to behave as owners of the company </li></ul>
  172. 172. Stock Options Accounting <ul><li>Under SFAS No. 123, companies can either expense the estimated cost of options or provide note disclosure—most companies provide note disclosure including net income— pro forma </li></ul><ul><li>If not expensed, when options are exercised the company debits cash & credits paid-in capital </li></ul><ul><li>When options are exercised, the difference between the market price & exercise price is a tax benefit to the company (& a tax liability to the employee) </li></ul>
  173. 173. Stock Option Dilution <ul><li>The stock option note gives the analyst the information to determine the magnitude of options outstanding & estimate the impact of options on the net income of the firm </li></ul><ul><li>The dilution effect of options is: stock options outstanding / shares outstanding; 10% or more can be considered significant </li></ul><ul><li>Substantial potential dilution is a concern to analysts; e.g., EPS could fall even when net income is rising </li></ul>
  174. 174. Restating for Stock Option Expense <ul><li>The stock option note gives: (1) net income-as reported & (2) net income- pro forma </li></ul><ul><li>The difference between the two is the estimated options expense (net of tax) </li></ul><ul><li>Calculate the % difference between (1) & (2) above; over 10% is considered significant & return ratios (e.g., return on sales or equity) should be recalculated using the net income- pro forma number </li></ul>
  175. 175. Alternative to Stock Options <ul><li>The use of stock options has been criticized since the recent scandals </li></ul><ul><li>Some companies are now expensing options (& usually issuing fewer options) </li></ul><ul><li>Many companies are moving to alternative methods of employee participation in ownership, including restricted stock, phantom stock & stock appreciation rights </li></ul>
  176. 176. Stock Options, Treasury Stock & Dividends <ul><li>Companies with substantial options typically buy back shares (treasury stock), usually as a use of cash rather than paying dividends; the rationale is to avoid dilution of shares </li></ul><ul><li>Treasury stock decreases equity; there is also the potential concern of “propping up” stock price with these purchases </li></ul>
  177. 177. Types of Pensions <ul><li>Defined contribution plans (including 401-K): employers &/or employees make tax deductible cash (or stock) contributions to the employee’s retirement plan—the company has no further obligations </li></ul><ul><li>Defined benefit plans: employer agrees to fund the employees’ retirement, usually based on final salary & length of service; the company has complete responsibility for the obligation & substantial accounting is required </li></ul>
  178. 178. Defined Benefit Plan—Balance Sheet <ul><li>The pension plans includes a set of obligations based on various actuarial & other assumptions (& smoothing procedures required by SFAS No. 87) </li></ul><ul><li>Company invests in plan assets (which are invested) to fund the obligations; these are stated at fair value </li></ul><ul><li>Assets & obligations are reported net on the balance sheet (usually as part of other assets or liabilities); e.g., a prepaid pension cost (a net assets for over-funded plans) & a prepaid pension obligation (a net liability for an under-funded plan </li></ul>
  179. 179. Defined Benefit Plan—Income Statement <ul><li>A net pension expense (net pension income is possible) includes: </li></ul><ul><li>Expected return on plan assets (“income”) Service costs for benefits earned Interest costs on benefit obligations Other “smoothing adjustments”) </li></ul><ul><li>This amount is reported on the income statement, usually as an other income or expense </li></ul><ul><li>Because of complex “smoothing calculations” & adjustments these numbers do not record “economic reality” </li></ul>
  180. 180. Numbers Presented on the Financial Statements <ul><li>First, determine the amounts recorded on the balance & income statement </li></ul><ul><li>The net amount recorded on the balance sheet is found in the pension note as the “prepaid pension asset” (over-funded) or “prepaid pension cost” (under-funded), note that terminology varies; an under-funded plan is a concern </li></ul><ul><li>The net amount recorded on the income statement is found in the pension note as “pension income” (income increasing, essentially a “negative expense”) or “pension expense”; again actual terms used vary </li></ul>
  181. 181. Adjustments to Economic Reality—Balance Sheet <ul><li>The major balance sheet categories are fair value of pension (plan) assets & projected benefit obligations </li></ul><ul><li>Economic reality is best represented by funded status </li></ul><ul><li>The difference between funded status & “net pension asset or obligation” (the amount actually recorded on the balance sheet) represents the accumulated “smoothing calculations” </li></ul>
  182. 182. Adjustments to Economic Reality—Income Statement <ul><li>The amount recorded on the income statement starts with “expected return on plan assets” (a smoothed expected return) </li></ul><ul><li>The actual return on plan assets is presented under the “fair value of assets” </li></ul><ul><li>S&P’s core earnings subtracts the “expected return on plan assets” from pension expense </li></ul><ul><li>The alternative calculation is to replace “expected return” with “actual return” for the year </li></ul>
  183. 183. Actuarial Assumptions <ul><li>Actuarial assumptions that are presented include discount rate, compensation increases, & expected return on plan assets </li></ul><ul><li>These are used as part of the smoothing process & the major concern is when these are “overstated”; e.g., high returns on plan assets would reduce the obligation & also reduce the pension expense </li></ul><ul><li>Compare to competitors & over time </li></ul>
  184. 184. Other Post-employment Benefits (OPEB) <ul><li>OPEB represent obligations for benefits to retired or terminated employees, the largest category is healthcare funding </li></ul><ul><li>The OPEB obligation is recorded as a liability & an annual OPEB expense is calculated </li></ul><ul><li>The accounting is similar to defined benefits pension plans </li></ul><ul><li>Actual operating practices are partially explained by tax rules (for example, there is no tax benefits for plan assets) </li></ul>
  185. 185. OPEB Accounting <ul><li>Based on the OPEB note (sometimes combined with the pension note), the net liability recognized is the obligation shown on the balance sheet (because of tax rules, little or no pension assets are presented) </li></ul><ul><li>The net OPEB expense also is presented </li></ul><ul><li>These are similar calculations to pensions & it may be possible to analyze them together </li></ul>
  186. 186. Chapter 11 Risk Management, Derivatives & Special Purpose Entities
  187. 187. Risk Management <ul><li>Techniques used by corporations to reduce or control for potential adverse consequences (uncertainty), primarily related to prices, interest rates, and foreign currency </li></ul><ul><li>Risks described in MD&A & methods used to control risks </li></ul><ul><li>Corporations can use hedges to manage specific risks </li></ul>
  188. 188. Risk Categories <ul><li>Commodity risk—changing prices </li></ul><ul><li>Interest rate risk—rate fluctuations </li></ul><ul><li>Market value risk—price changes </li></ul><ul><li>Foreign exchange risk—currency rates fluctuations </li></ul><ul><li>Event risk—uncertainties about events </li></ul><ul><li>Credit risk—default, bankruptcy risk </li></ul><ul><li>Counterparty risk—default risk on private contracts </li></ul>
  189. 189. Derivatives <ul><li>Financial contract derived from another financial instrument, including options, futures, and swaps </li></ul><ul><li>The basic derivative strategy is hedging to reduce specific risks </li></ul><ul><li>Analysts evaluate hedging effectives & potential for speculating </li></ul>
  190. 190. Common Derivatives <ul><li>Collars—Derivatives that limit the effects of fluctuations beyond a set range </li></ul><ul><li>Currency Swaps--Agreement to make payments in one currency in exchange for the obligations in another currency </li></ul><ul><li>Forward Contract -- Agreement between buyer and seller to deliver an asset in exchange for cash (or financial instrument) at a fixed price on a specific future date. Examples include commodities, currencies, or stocks </li></ul>
  191. 191. Common Derivatives <ul><li>Interest Rate Swaps -- Contract to exchange fixed for floating interest payments on bonds and other credit agreements </li></ul><ul><li>Options--Agreement that gives a party the right to buy (call) or sell (put) a specific quantity at a specific price (exercise price) until a specified maturity date </li></ul><ul><li>Swaps--Contract to exchange one series of payments for another </li></ul>
  192. 192. Accounting Categories of Hedges <ul><li>Fair value—hedge exposure to changes in market values: record gains & losses as part of income from continuing operations </li></ul><ul><li>Cash flow—futures transaction on interest rate exposure for floating rate debt: record as other comprehensive income </li></ul><ul><li>Foreign exchange exposure—hedge on currency rate changes: other comprehensive income </li></ul>
  193. 193. Risk Management Concerns <ul><li>Overall risk management strategy to control basic risks—evaluate MD&A & compare to other companies </li></ul><ul><li>Magnitude & changes—large hedging positions & big fluctuations (especially increases) may indicate increasing risk rather than hedging </li></ul><ul><li>Consider hedge effectiveness; fair value vs. cash flow & foreign exchange hedges; counterparty risk; & using puts on corporate stock </li></ul>
  194. 194. Special Purpose Entities <ul><li>Special Purpose Entity (SPE)--A unique legal entity to be used for a specific purpose, such as leasing arrangements or project development activities; the purpose is to treat this as an off-balance-sheet item </li></ul><ul><li>Structured financing—A financial contract to achieve specific financial purpose, including SPEs, joint ventures, & so on </li></ul>
  195. 195. Examples of SPEs <ul><li>General Motors created SPEs to redevelop closed factories with environmental problems </li></ul><ul><li>Airlines created SPEs to hold airplane leases </li></ul><ul><li>Mortgage companies used them to consolidate and sell mortgages to investors </li></ul><ul><li>AOL Time Warner and Microsoft used SPEs to create synthetic leases </li></ul><ul><li>GE used SPEs to resell credit card & trade receivables </li></ul>
  196. 196. Advantages of SPEs <ul><li>SPEs are created for specific tasks involving financial risks; for example, an SPE can have a higher credit rating (& lower interest rates) than the parent </li></ul><ul><li>SPEs can be used for tax avoidance, such as synthetic leases </li></ul><ul><li>Banks use SPEs to securitize pools of mortgages, credit card balances, accounts & other receivables—it generates cash & eliminates the receivables from the parent’s books </li></ul>
  197. 197. Common Uses of SPEs <ul><li>Synthetic leases—sale & leaseback to the originator, with tax benefits </li></ul><ul><li>Securitize mortgages (& other credit receivables) & package them as bonds or notes </li></ul><ul><li>Take-or-pay contracts—buyer guarantees to buy some about of product, which can be used to collateralize loans; throughput arrangement are similar, usually using pipelines </li></ul><ul><li>R&D funding, transferring risks & avoiding expenses & liabilities of R&D </li></ul>
  198. 198. Enron <ul><li>Extreme (fraudulent?) use of SPEs for blatant earnings manipulation </li></ul><ul><li>Initially, SPEs were used to grow the company while keeping additional debt off the books </li></ul><ul><li>More complex SPEs allowed Enron to record future services as current revenues using “mark-to-market” </li></ul><ul><li>Extensive conflicts of interest & related-party transactions, especially involving Andy Fastow </li></ul>
  199. 199. SPE Structure <ul><li>SPE must have at least one equity investor; the investor must contribute assets (usually cash) of at least 10% of the fair value of the assets. </li></ul><ul><li>Trustee—an independent 3 rd party to advocate the interests of the SPE. </li></ul><ul><li>Servicer—provides the basic accounting & administrative requirements (which may be the originator, such as a bank servicing the loans or mortgages that have been securitized). </li></ul>
  200. 200. New Accounting Rules <ul><li>SPEs created to isolate & contain financial risks. </li></ul><ul><li>Variable interest entities (VIEs, legal entities often holding financial assets with specific characteristics defined by FASB Interpretation 46R); may require consolidation if originator exposed to a majority of the risks & rewards. </li></ul><ul><li>Qualified SPEs (QSPEs, SFAS No. 140), generally the transfer of securitized portfolios; major question is when transfers are considered a sales (recording gains & losses). </li></ul><ul><li>Other SPEs are accounted for under SFAS 94. </li></ul>
  201. 201. SPE Concerns <ul><li>Fit to business strategy—evaluate MD&A </li></ul><ul><li>Lack of transparency—are disclosures adequate (notes & MD&A)? </li></ul><ul><li>Impact on financial ratios, especially leverage, but also performance & financing costs </li></ul><ul><li>Added risk by firms with high credit risk & poor operating performance </li></ul><ul><li>Accounts & other receivables—are these understated? </li></ul>