Misleading Accounting Exposed

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Accounting Fireworks - December 27, 2000. Richard McCaffery. "According to present accounting rules, that goodwill must be amortized over a maximum of 40 years, which is why fiscal 2000 earnings were reduced by an $897 million goodwill amortization charge. Now, if the FASB proposal goes through, JDS won't have to amortize that goodwill unless it becomes impaired, or loses value. Suddenly, JDS would be reporting an additional $897 million in earnings -- which means rather than reporting a $907 million net loss last year, JDS pretty much broke even." MAE reader submission

SEC: Warnings May Be Related to Crackdown - December 21, 2000. Tim McLaughlin. "The SEC is currently investigating as many as 200 financial fraud cases, agency officials said. Only the most egregious and obvious of accounting errors lead to action by the enforcement division. In the overwhelming majority of cases, companies restate their financial statements quietly after being challenged by the SEC's corporate finance division, Robert Bayless, the division's chief accountant, said in a July speech." MAE reader submission

Purchase and Pooling Headaches - December 14, 2000. Richard McCaffery. "For example, in November 1998 America Online (NYSE: AOL) agreed to acquire Netscape in a pooling of interest transaction valued at $4.2 billion. Netscape at the time had a book value of $394 million. Now, everyone understood Netscape was probably worth a lot more than book value in late 1998. Since the acquisition, however, the Netscape brand name has all but disappeared, and many of the company's talented programmers have left AOL, including creative whiz Mark Andreesen. What else was the goodwill for if not brand name and programming talent? If a goodwill premium had been recorded on the balance sheet at the time, AOL would have been amortizing goodwill against earnings all along. If the new FASB proposal were in effect and a useful impairment test existed, AOL would perhaps have been required to write off a portion of that goodwill premium against earnings, and investors would be able to see the financial effects of a pricey merger that yielded flimsy results, at least relative to the price paid." MAE reader submission

Why the Accounting Wars Matter to You - December 8, 2000. Pat Dorsey. "First, I don't think it ever made a whole lot of sense to treat goodwill as a wasting asset--which is what the current system of amortizing goodwill over time assumes. Unlike a piece of machinery, which wears out over time and thus gradually falls in value, items like brand names and technological expertise can, and often do, increase in value over time." MAE reader submission

Net Income? It's Your Loss - November 14, 2000. Loren Fox. "The cash earnings movement began in earnest, according to Blodget, when Amazon.com reported a pro forma operating loss that excluded goodwill amortization when the online retailer reported its results for the second quarter of 1998. That has snowballed to the point where even non-tech companies such as Blockbuster and H&R Block report cash earnings...The drawback to all of this is that companies are using the cash earnings label while excluding other costs in addition to goodwill."

Mind the Gap: Charting the Disconnect Between Earnings and Cash Flow - November 10, 2000. Ronald Fink. "DuPont, for instance, switched from accelerated to straight-line depreciation in January 1995, which boosted its earnings without any improvement in its operating cash flow, according to Paul Leming, an analyst for ING Barings. What's more, says Leming, DuPont "constantly" uses nonrecurring items such as restructuring charges to make its net income look better than cash flow would suggest. Citing quarterly statements that are typically accompanied by dozens of explanatory footnotes, Leming says DuPont is "one of the worst abusers of recurring nonrecurring items," though he is quick to note that "it's all GAAP."

THE DAY AHEAD: Lehman Bond Analyst Zaps Amazon Again - October 27, 2000. Larry Dignan. "Amazon touted how it had $900 million in cash and equivalents and burned through a mere $4 million in the third quarter. Many equity analysts bought into the $900 million line, but Suria didn't. Citing a footnote at the bottom of Amazon's earnings release, Suria noted in a second research report Thursday that Amazon reclassified its equity investments in Webvan (Nasdaq: WBVN) and Sotheby's as cash and marketable securities, bumping its cash position by $96 million. Excluding the Webvan and Sotheby's holdings and a one-time cash gain of $75 million, Suria reckons that Amazon had actual "operating" cash of $730 million, a sum that "significantly increases worries about the balance sheet."

How Stock Options Hurt Earnings - October 11, 2000. Peter Di Teresa. "Let’s say an employee exercises an option to buy stock for $10 per share. In the open market, it's selling for $50. That means that $40 per share has to come out of someone’s pocket. That someone is the ordinary shareholder."

$1 Billion Doesn't Buy Much These Days - October 9, 2000. Eileen Buckley. "Here's a riddle: How does a company that's made over $1 billion in revenue so far this year have a market cap below that mark? That question, which confronted Priceline after last week's woes, gets at one of the most persistent concerns with the name-your-price company: Does it really bring in all the money its earnings statement cites?"

New Math for Stock Options - October 9, 2000. By Rick Wray. "The U.K. is reviving a push to change the way companies value employee shares. If a company uses cash to pay for something – a chair, business advice, an employee's time – it is recorded as a business expense. If, however, the company pays with options – and yes, some people have used them to buy chairs – it is hit-and-miss whether that makes its way to the financial statements. Companies are omitting those expenses from their statements because there are no clear rules for how to handle them."

CFOs Feel The Heat From The Street - October 2, 2000. Bernice Napach. "First, revenue growth was key, until the middle of last year," Singh says. "Then it was gross margins and revenues per consultant, until the beginning of this year. Then it was cash earnings per share, which added back into earnings the cost of depreciation and amortization of other expenses to come up with cash earnings of a company. Now it's back to a traditional earnings model. Real earnings is the next metric in this sector."

Feathering the Nest Egg - October 2000. Laurie Kaplan Singh. "Sherwin- Williams Co., for example, has pension plan assets almost three times greater than its pension obligations. General Electric Co.'s pension assets of $50 billion are nearly double its liabilities. And the pension plans of Bank of New York, Westvaco, and Cincinnati Financial Corp. are also overfunded by nearly 100 percent, according to Bear, Stearns & Co.'s 1998 estimates. And thanks to the prevailing accounting methodology, a significant portion of those surpluses are boosting corporate bottom lines..." "...says Jack Ciesielski, publisher of The Analyst's Accounting Observer, for many companies, "pension plans--in their ability to contribute to earnings--are becoming almost as significant as operating assets..." [However] "It cannot use this money to finance capital projects, to buy back stock, or to pay dividends," says Ciesielski. "It does nothing to increase or decrease cash flow."

No Ifs, Calls, or Puts? - October 2000. Virginia Munger Kahn. "With stock option grants increasingly seen as a magic elixir for motivating employees, keeping the cost from hurting shareholders has required more and more financial alchemy. The latest trick? As they buy shares in the open market to soak up the dilution from option grants, more and more companies have launched put-warrant and other derivatives-based programs to reduce the cost."

The TSC Streetside Chat, Part 1: Marc Perkins of Gunther International - September 9, 2000. Brett D. Fromson. "Senior management was, to put it mildly, incompetent, and there were no systems. No Wall Street analyst came in here and looked around and asked questions like, "What type of internal controls do you have?" "What type of integrated management package do you have to make sure your place is under control?" The answer to those questions [would have been] "none." There was no management software package. There was no accounting software package. It was all being done, literally, on legal pads. At the end of the quarter, they sat down with a legal pad, took stuff off of the printout they had of the general ledger, and put together financial statements."

Hard Lessons - September 2000. Andrew Osterland. "In its ongoing war on earnings management, the SEC may have outdone itself with new rules on revenue recognition...Financial services firms and real estate outfits will have to change the way they account for contingent rental income. Retailers will change their policies on layaway sales. Biotechnology firms, computer manufacturers, telecommunications providers, and a host of other companies that have long-term service contracts will have to alter the way they record up-front fees."

Five Essentials for Understanding Cash Flow - July 24, 2000. David Kathman. "Sometimes a company gets a big credit that boosts net income but doesn't result in cash inflow. For example, Internet portal CNET posted net income of $417 million in 1999, which looks impressive. But a big chunk of that came when the company traded its stake in Snap.com for a stake in NBC Internet NBCI. No cash changed hands, but CNET received a $324 million credit on its income statement. Overall, CNET's operating cash flow was negative, to the tune of $71 million."

Number Crunchers - July 11, 2000. Carol Pickering. "These companies are not valued on losses, they're valued on revenue streams. It's la-la land. That's the reason regulators, appropriately so, are judging the quality of revenues." As cited in this article, here is the link to the SEC's document on Accounting Issues Related to Internet Operations from October 18, 1999.

What Earnings Reports Don't Tell You - July 3, 2000. David Kathman. "Companies feed information to the analysts to guide their estimates; often, companies will guide the estimates lower to make them easier to beat. That explains why companies such as Cisco Systems CSCO and General Electric GE are able beat analysts' estimates by a penny or two with monotonous regularity."

The Crusade Against Smoothing - June 12, 2000. Dan Seligman. "Clearly, something is missing in the SEC's presentation of the earnings management issue--dare we call it a material omission? What's missing is an acknowledgment of the fact that earnings management is legal and, thus far at least, unchallenged by the commission. Says Walter Schuetze, now a consultant to the SEC (and for many years the chief accountant in its enforcement division), about whether the smoothing-out of earnings is a legitimate business practice: "To my knowledge, there's no SEC statement on that matter."

The Secret Balance Sheet - June 5, 2000. Larry Downes. "Information assets may seem intangible, but you'll find them if you dig under the surface of any company. But what is the value of the DJIA or Coke's logos? According to those companies' financial statements, nothing. Information assets, including brands, intellectual property, customer relationships, expertise and other human capital, appear nowhere on the balance sheet. As Time Warner's 1999 annual report deftly puts it, generally accepted accounting principles (GAAP) "do not recognize the value of such assets." And all public companies must follow GAAP."

What Is Free Cash Flow? - June 5, 2000. Morningstar. "To see what free cash flow tells us that earnings don't, take a look at Rainforest Cafe RAIN, the operator of theme restaurants (its stock has taken a nosedive since the end of 1997). From 1995 through 1997, the company posted $100,000, $5.9 million, and $12.3 million in earnings. Nice growth, right? The company's free cash flow, by contrast, was negative $7.0 million, negative $28.0 million, and negative $57.4 million. Free cash flows also grew--but in the opposite direction as earnings."

Different Types of Profit Margins - June 5, 2000. Morningstar. "Wal-Mart's gross margin in 1997 was lower than Kmart's (20.4% versus 21.8%), because of its policy of keeping prices as low as possible. But Wal-Mart's net margin was more than three times higher (2.9% versus 0.8%), because its operating expenses were significantly lower than Kmart's."

Riding the Bull - June 2000. Towers Perrin and CFO magazine, Text by Ronald Fink. "Granted, many other companies offer options that vest more rapidly if some measure of performance is met. But these typically vest within 10 years anyway, no matter how managers perform, which keeps the cost off the companies' books. Consequently, Redgrave says, such programs create "artificial value." His reasoning: "If I own 100 percent of a company, give away 10 percent, then claim it doesn't matter because it's a noncash charge, that's problematic." When, moreover, the value of such grants escalates along with stock prices, and that is used as a justification to provide still more, as has been the pattern in recent years, the system, says Redgrave, amounts to a "pyramid scheme."

Stock-Option Basics - May 5, 2000. Sue Stevens. "Because stock options are rapidly becoming one of the key components of compensation today, it is important to understand how to integrate them into your overall financial strategy."

The Hidden Value of Intellectual Capital - April 24, 2000. Eileen Buckley. "As an example, he recalls recent events surrounding MicroStrategy (MSTR), in which the company's stock fell 62 percent in one day after it restated its revenue figures. "Almost two-thirds of the whole company was damaged in one day, while nothing happened to the fundamentals of the company. They did not announce that products failed, or that alliances were broken up, or that they lost customers. It was the same company, only [with] a new accounting method."

The Number Runners - April 3, 2000. David Raymond. "Some people call it "massaging the numbers" or "cookie-jar accounting." Whatever the term, Harold grudgingly confirms its place in the financial world: "critical."

Do the Math - April 2000. Richard H. Gamble. "Bullard had not paid a dime to settle the claims, but they stayed on the books as an incurred but not reported liability that fluctuated in value, sometimes reaching as much as $1.8 million. Now the liability is gone. Bullard unloaded the claims from its books by paying an underwriter $250,000 to assume liability for them, explains Andrews. That means almost $750,000 came back to the company as bottom-line income. "Our shareholders were pretty happy," he notes. And the $250,000 Bullard paid the underwriter was tax deductible as an insurance premium."

Are Net Ad Firms Overstating Revenues? - March 27, 2000. Mark A. Mowrey. "Revenues have become the litmus test for valuing Internet stocks. While other stocks are valued based on multiples of earnings, Net stocks are often valued on multiples of revenue. And as demonstrated last week by the MicroStrategy (MSTR) debacle, it's a dark day for investors when a company has to admit that it overstated its revenues."

MicroStrategy: A Wake-Up Call? - March 27, 2000. William Schaff. "The company's recent woes are symptomatic of bigger issues in tech-company valuations and accounting practices...Preliminary restatements of 1999 revenue, which include large deals with NCR, Exchange Applications, and Primark, will likely reduce MicroStrategy's revenue from $205 million to between $150 million and $155 million. This drives down the bottom line from a profit of 17 cents per share to a loss of 43 cents to 51 cents per share."

Why Microsoft's Stock Options Scare Me - February 17, 2000. Rob Landley. "Forget Windows 2000. As far as I can tell, the single most lucrative product Microsoft sells is its own stock. Microsoft receives almost as much cash inflow from the stock market as it does by selling goods and services. Here's how."

AOL+TWX=??? Do the math, and you might wonder if this company's long-term annual return to investors can beat a Treasury bond's - Febuary 7, 2000. By Carol J. Loomis. "Jerry Levin, CEO of Time Warner--and the CEO-to-be of AOL Time Warner--says that the merged company will go along with AOL's practice and will report EBITDA. Hmmm: That means the very real and ever-present cost of depreciation--rising out of Time Warner's big spending, for example, on its cable systems--is to be ignored in getting to "earnings."

New Math for a New Economy - January-February 2000. Alan M. Webber. "This kind of mindless writing-off of all investments in knowledge assets means that there is no accountability -- and no ability to measure the performance of an investment or to learn from it. And the problem is only getting worse: Over the past 20 years, as the actual value of companies' intangible assets has been going up, that value, as it is represented in financial reports, has appeared to be consistently going down."

Ariba's Earnings and the Cost of Compensation - January 12, 2000. Dave Marino-Nachison. "Where that figure comes in vis-a-vis Wall Street's consensus projections really isn't important since it's probably safe to assume First Call's analyst survey was a compilation of figures that were consistent in reporting the pre-adjustment numbers. What does matter is that the two methods of accounting produce a $4.7 million difference in total net losses, more than a 50% increase. That, folks, is huge."

Watch Out: Earnings Season Is Here - January 10, 2000. Pat Dorsey. "Companies may argue that pro forma figures are useful, but the problem is that there are absolutely no set rules for what these numbers are--which means that the "pro forma earnings" reported by two different companies are very often calculated in completely different ways. Reported earnings, on the other hand, are all calculated in the same way, which makes them comparable between companies, which is the whole point of accounting standards in the first place."

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