Misleading Accounting ExposedHome - What's new - Background - Articles - Message board What the Securities & Exchange Commission says...Quality Information: The Lifeblood of Our Markets - October 18, 1999. SEC Chairman Arthur Levitt. "A little over a year ago, I voiced concerns over a gradual, but perceptible, erosion in the quality of financial reporting. The motivation to satisfy Wall Street earnings expectations was beginning to override long established precepts of financial reporting and ethical restraint. A culture of gamesmanship over the numbers was not only emerging, but weaving itself into the fabric of accepted conduct...A gamesmanship that says it's okay to bend the rules, tweak the numbers, and let small, but obvious and important discrepancies slide; a gamesmanship that tells managers it's fine to cut corners and look the other way to boost the stock price; where companies bend to the desires and pressures of Wall Street analysts rather than to the reality of numbers; where auditors are pressured not to rock the boat; and a gamesmanship that focuses exclusively on short-term numbers rather than long-term performance...I can only point to what I see as a web of dysfunctional relationships; where analysts develop models to gauge a company's earnings but rely heavily on a company's guidance; where companies' reported results are tailored more for the benefit of consensus estimates than to the reality of the ups and downs of business; where companies work to lower expectations when they fully expect they'll beat the estimates; and where the analyst attempts to walk the tightrope of fairly assessing a company's performance without upsetting his firm's investment banking relationships." Current Regulatory and Enforcement Developments Affecting the Accounting Profession - January 20, 1999. SEC Commissioner Norman Johnson. The importance of auditor independence. SEC Chief Accountant's October 1998 Letter to AICPA on Auditing and Financial Reporting Concerns - October 9, 1998. Chief Accountant, U.S. Securities and Exchange Commission. "The high earnings multiples on which stocks are assessed and traded in today's markets have heightened the importance of reported earnings. Familiar measures of materiality, for example, 5% of pre-tax income, may not be adequate in a marketplace with P/E multiples of 40, where missing the market's expectation of earnings per share by a penny can have significant consequences. In such an environment, management, auditors, and boards of directors should be concerned when known violations of GAAP are present in the financial statements." The Numbers Game - September 28, 1998. SEC Chairman Arthur Levitt. Speech includes earnings management, gray areas in accounting that are being perverted, big bath restructuring charges, cookie jar reserves, merger magic, and abuse of materiality. A must read recommended by Warren Buffett.
What Warren Buffett says...The Economics of Property/Casualty Insurance - 1999 Berkshire Hathaway Annual Report Chairman's letter. Warren Buffett. "Because loss costs must be estimated, insurers have enormous latitude in figuring their underwriting results, and that makes it very difficult for investors to calculate a company's true cost of float. Errors of estimation, usually innocent but sometimes not, can be huge. The consequences of these miscalculations flow directly into earnings. An experienced observer can usually detect large-scale errors in reserving, but the general public can typically do no more than accept what's presented, and at times I have been amazed by the numbers that big-name auditors have implicitly blessed. In 1999 a number of insurers announced reserve adjustments that made a mockery of the "earnings" that investors had relied on earlier when making their buy and sell decisions." To jump to the proper area of the document, click on the link, wait for the document to load completely, hit CTRL-F and enter float. Acquisition Accounting - 1999 Berkshire Hathaway Annual Report Chairman's letter. Warren Buffett. "To escape from the fiction of goodwill charges, managers embrace the fiction of pooling. This accounting convention is grounded in the poetic notion that when two rivers merge their streams become indistinguishable. Under this concept,a company that has been merged into a larger enterprise has not been "purchased" (even though it will often have received a large "sell-out" premium). Consequently, no goodwill is created, and those pesky subsequent charges to earnings are eliminated. Instead, the accounting for the ongoing entity is handled as if the businesses had forever been one unit." To jump to the proper area of the document, click on the link, wait for the document to load completely, hit CTRL-F and enter once again. Accounting Part 1 and Part 2 - 1998 Berkshire Hathaway Annual Report Chairman's letter. Warren Buffett. "If options aren't a form of compensation, what are they? If compensation is not an expense, what is it? And if expenses shouldn't go into the calculation of earnings, where in the world should they go?" To jump to the proper area of the document, click on the link, wait for the document to load completely, hit CTRL-F and enter part 1. Purchase Accounting Adjustments - 1998 Berkshire Hathaway Owner's Manual. Warren Buffett. "In our annual reports, therefore, we will sometimes talk of earnings that we will describe as "before purchase-accounting adjustments." The discussion that follows will tell you why we think earnings of that description have far more economic meaning than the earnings produced by GAAP." To jump to the proper area of the document, click on the link, wait for the document to load completely, hit CTRL-F and enter spinach. To the Shareholders of Berkshire Hathaway Inc. - 1996 Berkshire Hathaway Annual Report Chairman's letter. Warren Buffett. "The restatement was required because GEICO became a wholly-owned subsidiary of Berkshire on January 2, 1996, whereas it was previously classified as an investment. From an economic viewpoint - taking into account major tax efficiencies and other benefits we gained - the value of the 51% of GEICO we owned at year-end 1995 increased significantly when we acquired the remaining 49% of the company two days later. Accounting rules applicable to this type of "step acquisition," however, required us to write down the value of our 51% at the time we moved to 100%. That writedown - which also, of course, reduced book value - amounted to $478.4 million. As a result, we now carry our original 51% of GEICO at a value that is both lower than its market value at the time we purchased the remaining 49% of the company and lower than the value at which we carry that 49% itself." Just this paragraph above. To the Shareholders of Berkshire Hathaway Inc. - 1993 Berkshire Hathaway Annual Report Chairman's letter. Warren Buffett. "Oddly, GAAP required both this charge and the one described above to be deducted from the earnings we report, even though the unrealized appreciation that gave rise to the charges was never included in earnings, but rather was credited directly to net worth." First four numbered items. Two New Accounting Rules and a Plea for One More - 1992 Berkshire Hathaway Annual Report Chairman's letter. Warren Buffett. "Managers thinking about accounting issues should never forget one of Abraham Lincoln's favorite riddles: "How many legs does a dog have if you call his tail a leg?" The answer: "Four, because calling a tail a leg does not make it a leg." It behooves managers to remember that Abe's right even if an auditor is willing to certify that the tail is a leg." Includes discussion of post-retirement health-care benefits and misuse of stock options. To jump to the proper area of the document, click on the link, wait for the document to load completely, hit CTRL-F and enter two new. "Look-Through" Earnings - 1990 Berkshire Hathaway Annual Report Chairman's letter. Warren Buffett. "In reality, however, earnings can be as pliable as putty when a charlatan heads the company reporting them. Eventually truth will surface, but in the meantime a lot of money can change hands. Indeed, some important American fortunes have been created by the monetization of accounting mirages." To jump to the proper area of the document, click on the link, wait for the document to load completely, hit CTRL-F and enter look-through. Taxes - 1989 Berkshire Hathaway Annual Report Chairman's letter. Warren Buffett. "As you can see from our balance sheet on page 27, we would owe taxes of more than $1.1 billion were we to sell all of our securities at year-end market values. Is this $1.1 billion liability equal, or even similar, to a $1.1 billion liability payable to a trade creditor 15 days after the end of the year? Obviously not - despite the fact that both items have exactly the same effect on audited net worth, reducing it by $1.1 billion." To jump to the proper area of the document, click on the link, wait for the document to load completely, hit CTRL-F and enter taxes. Accounting Changes - 1988 Berkshire Hathaway Annual Report Chairman's letter. Warren Buffett. "CEOs are free to treat GAAP statements as a beginning rather than an end to their obligation to inform owners and creditors - and indeed they should. After all, any manager of a subsidiary company would find himself in hot water if he reported barebones GAAP numbers that omitted key information needed by his boss, the parent corporation's CEO. Why, then, should the CEO himself withhold information vitally useful to his bosses - the shareholder-owners of the corporation?" To jump to the proper area of the document, click on the link, wait for the document to load completely, hit CTRL-F and enter accounting. Insurance Operations - 1987 Berkshire Hathaway Annual Report Chairman's letter. Warren Buffett. "Nevertheless, auditors annually certify the numbers given them by management and in their opinions unqualifiedly state that these figures "present fairly" the financial position of their clients. The auditors use this reassuring language even though they know from long and painful experience that the numbers so certified are likely to differ dramatically from the true earnings of the period. Despite this history of error, investors understandably rely upon auditors' opinions. After all, a declaration saying that "the statements present fairly" hardly sounds equivocal to the non-accountant." To jump to the proper area of the document, click on the link, wait for the document to load completely, hit CTRL-F and enter earnings figures. Marketable Securities - Permanent Holdings - 1987 Berkshire Hathaway Annual Report Chairman's letter. Warren Buffett. "...GAAP accounting lets us reflect in our net worth the up-to-date underlying values of the businesses we partially own, but does not let us reflect their underlying earnings in our income account. In the case of our controlled companies, just the opposite is true. Here, we show full earnings in our income account but never change asset values on our balance sheet, no matter how much the value of a business might have increased since we purchased it." To jump to the proper area of the document, click on the link, wait for the document to load completely, hit CTRL-F and enter accounting irony. Purchase-Price Accounting Adjustments and the "Cash Flow" Fallacy - 1986 Berkshire Hathaway Annual Report Chairman's letter appendix. Warren Buffett. "What does all this mean for owners? Did the shareholders of Berkshire buy a business that earned $40.2 million in 1986 or did they buy one earning $28.6 million? And, if a business is worth some given multiple of earnings, was Scott Fetzer worth considerably more the day before we bought it than it was worth the following day?" To jump to the proper area of the document, click on the link, wait for the document to load completely, hit CTRL-F and enter fallacy. Three Very Good Businesses (and a Few Thoughts About Incentive Compensation) - 1985 Berkshire Hathaway Annual Report Chairman's letter. Warren Buffett. "Many stock options in the corporate world have worked in exactly that fashion: they have gained in value simply because management retained earnings, not because it did well with the capital in its hands." Excellent discussion of compound interest and of misuse of stock options. To jump to the proper area of the document, click on the link, wait for the document to load completely, hit CTRL-F and enter incentive. Sources of Reported Earnings - 1984 Berkshire Hathaway Annual Report Chairman's letter. Warren Buffett. "Sharp-eyed shareholders will notice that the amount of the special GEICO distribution and its location in the table have been changed from the presentation of last year. Though they reclassify and reduce "accounting" earnings, the changes are entirely of form, not of substance." To jump to the proper area of the document, click on the link, wait for the document to load completely, hit CTRL-F and enter sharp. Errors in Loss Reserving - 1984 Berkshire Hathaway Annual Report Chairman's letter. Warren Buffett. "Companies that would be out of business if they realistically appraised their loss costs have, in some cases, simply preferred to take an extraordinarily optimistic view about these yet-to-be-paid sums. Others have engaged in various transactions to hide true current loss costs. Both of these approaches can work for a considerable time: external auditors cannot effectively police the financial statements of property/casualty insurers. If liabilities of an insurer, correctly stated, would exceed assets, it falls to the insurer to volunteer this morbid information. In other words, the corpse is supposed to file the death certificate. Under this "honor system" of mortality, the corpse sometimes gives itself the benefit of the doubt." To jump to the proper area of the document, click on the link, wait for the document to load completely, hit CTRL-F and enter loss reserving. Goodwill and its Amortization: The Rules and The Realities - 1983 Berkshire Hathaway Annual Report Chairman's letter appendix. Warren Buffett. "Assume an investor buys the stock at $100 per share, paying in effect $80 per share for Goodwill (just as would a corporate purchaser buying the whole company). Should the investor impute a $2 per share amortization charge annually ($80 divided by 40 years) to calculate "true" earnings per share? And, if so, should the new "true" earnings of $3 per share cause him to rethink his purchase price?" To jump to the proper area of the document, click on the link, wait for the document to load completely, hit CTRL-F and enter march. Non-Reported Ownership Earnings - 1982 Berkshire Hathaway Annual Report Chairman's letter. Warren Buffett. "If GEICO had earned less money in 1982 but had paid an additional $1 million in dividends, our reported earnings would have been larger despite the poorer business results. Conversely, if GEICO had earned an additional $100 million - and retained it all - our reported earnings would have been unchanged. Clearly "accounting" earnings can seriously misrepresent economic reality." To jump to the proper area of the document, click on the link, wait for the document to load completely, hit CTRL-F and enter ownership. Non-Controlled Ownership Earnings - 1980 Berkshire Hathaway Annual Report Chairman's letter. Warren Buffett. "Thus, conventional accounting only allows less than half of our earnings "iceberg" to appear above the surface, in plain view." To jump to the proper area of the document, click on the link, wait for the document to load completely, hit CTRL-F and enter ownership. Insurance Industry Conditions - 1980 Berkshire Hathaway Annual Report Chairman's letter. Warren Buffett. "It might strike some as strange that an insurance company's survival is threatened when its stock portfolio falls sufficiently in price to reduce net worth significantly, but that an even greater decline in bond prices produces no reaction at all." To jump to the proper area of the document, click on the link, wait for the document to load completely, hit CTRL-F and enter problem arises. Again, we must lead off with a few words about accounting - 1979 Berkshire Hathaway Annual Report Chairman's letter. Warren Buffett. "Should the same equities be purchased at an identical price by an insurance subsidiary of Berkshire Hathaway and by Blue Chip Stamps, present accounting principles often would require that they end up carried on our consolidated balance sheet at two different values. (That should keep you on your toes)" First two paragraphs. First, a few words about accounting - 1978 Berkshire Hathaway Annual Report Chairman's letter. Warren Buffett. "Such a grouping of Balance Sheet and Earnings items - some wholly owned, some partly owned - tends to obscure economic reality more than illuminate it. In fact, it represents a form of presentation that we never prepare for internal use during the year and which is of no value to us in any management activities." First four paragraphs.
What Accounting Experts say...Center for Financial Research & Analysis - Web site. Example reports here The Analyst's Accounting Observer - Web site. Jack Ciesielski. The Observer is a research service published by R.G. Associates, Inc. that, simply put, provides "remedial accounting" for institutional investors and security analysts who should know better. Managing by the Numbers - Book. May 15, 2000. Chuck Kremer. This book discusses the Mobley Matrix -- a table which shows, at a glance, the relationship between the beginning balance sheet (first column), income statement (second column), cash flow statement (third column) and ending balance sheet (fourth column). MAE reader submission Wiley GAAP 2001: Interpretation and Application of Generally Accepted Accounting Principles 2000 (Annual) - Book. November 2000. Patrick R. Delaney. "The book is filled with examples of GAAP application and will be definitely useful for both practitioners and advanced students of accounting." Cases in Financial Reporting : An Integrated Approach With an Emphasis on Earnings Quality and Persistance (Charles T. Horngren Series in Accounting) - Book. January 1998. Eric Hirst, Mary Lea McAnally, D. Eric Hirst. "A collection of financial accounting cases designed to help readers become financial statement users. Each case utilizes financial statement information (balance sheet, income statement, statement of cash flow and/or footnotes) and a number of topical questions. Financial statement information is used to infer and interpret the economic events underlying the numbers." The Art of Short Selling - Book. October 1997. Kathryn F. Staley. Case studies of short sellers and short selling via financial statement analysis. Some of the things she has actually found may surprise you. One set of statements did not add up -- literally! MAE reader submission Accounting for Growth - Book. July 1996. Terry Smith. UK book written by a former bank analyst. Each chapter reviews a different aspect of creative accounting. MAE reader submission Financial Warnings - Book. April 1996. Charles Mulford and Eugene Comiskey. "The authors identify the financial traits of firms which precede unanticipated and typically disastrous reductions in corporate earnings and forecasted cash flow to help users of financial information recognize these potentially catastrophic financial characteristics." Financial Shenanigans: How to Detect Accounting Gimmicks and Fraud in Financial Reports - Book. March 1993. Howard Mark Schilit, Ph.D. "Would a company with serious financial problems want to broadcast that fact in its corporate report? Of course not! Prospective investors and lenders should understand that some companies in hot water try to hide the fact with "creative accounting" techniques that provide a distorted picture of their financial health." Quality of Earnings; The Investor's Guide to How Much Money a Company is Really Making - December 1987. Thornton L. O'glove, Robert Sobel (Contributor). "An indispensable guide to determining how much money a company is really making."
What Scholars say...Advanced Accounting Theory: On Earnings Management - Web site. It is an often debated contention that managers have the ability, within GAAP, to manipulate earnings. The objective of earnings management is to report a smooth, regular, (and hopefully increasing) pattern of earnings. An interactive course with the answers to the case study. Forensic Investing: Red Flags - Web site. Nicholas G. Apostolou, DBA, CPA and D. Larry Crumbley, Ph.D., CPA. "Businesses are often clever in hiding these accounting tricks and gimmicks, so investors must be ever alert to the signs of outright financial shenanigans. Investors must attack financial statements and company information the way the fictional Sherlock Holmes approached murder cases."
What Haywood Kelly says...Tearing Through Padded Profits - April 23, 1999. Haywood Kelly. Explains how overfunded pension plans inflate earnings and offers a checklist on how to read 10-k's in order to find a company's true pension position...since it is NOT shown on the balance sheet. The Earnings Your Mother Didn't Tell You About - March 10, 1999. Haywood Kelly. Explains "options adjusted earnings" which are found in a company's footnotes, NOT on the income statement. Excellent footnote examples. "It just goes to show that the old saw about reading an annual report - that it's best to read it backwards, starting with the footnotes - is as true as ever." Do Corporate Executives Believe in Ghosts? - March 1, 1999. Haywood Kelly. "Why should the full value of the purchase appear on the books? Because the acquiring company should be held accountable for earning a return on its investment in the acquired company." Most of them didn't realize it, but thousands of people got robbed last week. - September 28, 1998. Haywood Kelly. "At the time of last week's announcement, Cendant had no less than 185 million options outstanding, compared with 850 million shares. Talk about potential dilution. Asking the board for an annual salary of $70 million in cash is a little much, even in the U.S. But options--what a concept! Who'll notice? The cost of options isn't even taken into account in the company's earnings. And during a bull market, shareholders won't mind." Are Companies Telling us the Truth? - July 20, 1998. Haywood Kelly. "How artificial this thing called earnings is." How balance sheet "write downs" can increase earnings. It's easy to grow in a bull market. Just issue more shares - May 18, 1998. Haywood Kelly. "Some firms create wealth not by growing, but by taking investors' capital and earning a good return on it." It's that time of year again - February 2, 1998. Haywood Kelly. "Time for companies to announce their restructuring charges." A recent post on our Socialize boards pointed out some fund managers' emphasis on free cash flow - January 26, 1998. Haywood Kelly. "Free cash flow strips away all the accounting assumptions built into earnings. That's one reason it's such an important number. A company's earnings may be high and growing, but until you look at free cash flow, you don't know if the company's really generated money in a given year or not." Microsoft: A money-loser? - November 17, 1997. Haywood Kelly. "Stock options have become a significant hidden cost for shareholders. it's a cost you ideally want to take into account when measuring how much a company can earn for you, the shareholder." Are share buybacks always in the best interests of shareholders? - July 21, 1997. Haywood Kelly. "All companies will say that they're trying to increase shareholder value, but those words have been so overused and abused they don't mean a whole lot anymore." |