How to Spot Financial Trouble at Companies

Funny Money

By Mark Tatge DePauw University

How companies play games with numbers

Author, TV guest, professor

Misbehaving CEOs

Ex-Tyco CEO Dennis Kozlowski

Guilty: Misappropriation of funds. Cost: $81 million

Ex-Worldcom CEO Bernie Ebbers

Guilty: Fraud and conspiracy. Cost: $100 Billion

Enron

• Faked blackouts and shortages so company could raise electricity prices and book huge profits.

• Duped investors with shell games, phony financials.

• Enron failed 2001.• Died 2006, heart attack.

Kenneth Lay

Guilty: Securities Fraud. Cost: $11 billion

Bernie Madoff

Guilty: Fraud. Cost: $60 billion.

Why fraud occurs

• Aggressive accounting is rewarded.• Higher numbers = higher stock price.• Bigger piece of CEOs compensation tied to

stock.• Accountants hired and paid by the company.• Firm provides the numbers.

• Most companies are honest.• But fraud has been on the rise.

WHERE TO LOOK

The Coverup

• If a company is going to deliberately falsify a financial statement – it will be very difficult to find.•Deal with what is publicly disclosed – not what we can’t access.

Concept: Basic rules

• Are the statements you are viewing audited?

• Are the statements prepared in accordance with Generally Accepted Accounting Principles (GAAP).

• Are they based on cash or accrual?• Are you viewing more than one period’s

data?

Concept: Cash v. Accrual

Concept: Matching Principle

• Companies are supposed to match each revenue item with its corresponding expense.

Watch for revenue games

• Recording fake or bogus revenue • Boosting income on one-time

gains (asset sales).• Recording revenue too soon, or

revenue of questionable quality. • Release of excess reserves – to

cover losses.

Revenue matters

• Companies also play games with expenses – but if there is going to be a problem it will most likely be on the revenue side of the equation.

Tip 1: Deferring expenses

• Companies are supposed to match income with the corresponding expense.

• The period where the revenue is recorded, the expense used to create that revenue should be expensed.

• But some companies will defer expenses until a later period of time.

Lesson: marketing costs

• AOL in 1994 decided to exclude current marketing costs in its profit.

• Instead of immediately expensing these costs – AOL shifted them to the balance sheet as an asset and charged them off in future periods.

• This decision had the impact of inflating AOL’s profits since it did not expense market costs.

• These costs were amortized over time.

Tip 2: Pro-forma earnings

• Companies that plan to merge or divest often will come up with “pro-forma” earnings.

• Pro-forma is supposed to be an estimate of what the firm will be after the merger.

• Often based on inaccurate assumptions.

• Management will include or remove net income that it feels is not “material” to the remaining operations of the company.

Tip 3: Firing auditors

• Has the company recently changed accountants?• The change may

have occurred due to a disagreement over accounting standards.

Tip 4: Burying Exhibits

• Companies often bury important documents and then reference them in reports.

• Finding the detail means looking through several levels of reports dating back quarters, or in some cases, years.

• 8Ks are a catchall – may be changes in CEO compensation agreement, changes in accounting policies, even changes in auditors.

Tip 5 – Fudging Inventory

• How a company accounts for the value of its inventory can have a big impact on profits

Concept: Inventory

• Inventory are goods that are finished and available for sale. May also be “raw materials” used in finished goods.• The company must actually sell these goods to produce cash.

Concept: Inventory

• The value of a company’s inventory is found on the balance sheet, categorized as an asset.

Lesson: Pharmor (1992)

• Executives faked inventory to borrow millions.• Told the lenders the money was for

expansion.• Pharmor needed the cash to pay

suppliers.• Pharmor was forced to file bankruptcy.• Founder and CFO sent to prison.

Concept: Inventory

• Companies are expected to use a single standard in measuring the value of inventories.• FIFO – First in- First Out• LIFO – Last in – First Out. LIFO - charges the latest (or last inventory)

costs first FIFO – charges the earliest (or oldest) costs Companies are required to pick one method

and are not allowed to keep switching back and forth

Concept: Inventory

• In times of rising costs, the differences can be substantial. If a company switched to FIFO – this would produce much higher profits.

Tip 6: Stock buybacks

• Beware of stock buybacks.• Flashes sign company is confident in

its future prospects.• Should the company be doing

something different with its cash?• Buyback artificially improves earnings

per share.

Concept: Boosting EPS

• EPS = Net earnings / Outstanding shares.

• $10 million / 5 million shares = $2.00 EPS

• After 3 million share buyback• $10 million / 2 million shares = $5.00

EPS

Tip 7: Shell games

• Companies are forced to set aside funds to cover defaults, decreases in asset values, inventory obsolescence.• The asset reserve or pot of money set aside is expensed and reduces net income.

Shell games to watch

• As assets are written down, the amount of the written down is charged against the reserves.

• If a company has set aside too much – it can recapture reserves.

• Failing to reserve enough to cover potential losses boosts profits – firm’s expenses are less.

• Recapturing extra funds set aside in reserves – can also artificially boost profits for a given quarter.

Tip 8: Pay attention to cash

• Cash flow – is often more important to earnings.

• How much cash flow is the company generating?

• How much cash is the company burning?• Does the company have enough cash to cover

its current liabilities.

What are the sources and uses of cash?

Lesson: Cash flow

Lesson: Cash Flow

• Subtract current liabilities from current assets. The calculation tells us how much in liquid assets the company has on had to pay its debts during the next year.

Lesson: Cash flow

• As you can see using the figures from Dell's abbreviated balance sheet, we have approximately $1.48 of current assets to cover every dollar of liabilities. This is OK, but nothing superior. A better margin of comfort would be a 2-to-1 ratio.

Tip 9: Understating Liabilities

• Companies understate liabilities. This inflates current earnings• Best example of this is pension and retiree

health care obligations.• Has the company signed contracts or agreed to

contingencies that could cost it dearly?• Merger breakup fees• Legal obligations / pending lawsuits• Contractual arrangements with vendors.

Lesson: GM Pension Mess

• GM and many cities and states have grossly underfunded their their pensions

Tip 10: Blowing deadlines

• Watch filing deadlines.• If a company misses or delays filing a 10Q or

10K – it usually means something is wrong. Company may be faced with:• Bankruptcy or liquidation.• Face a large charge against earnings.• Re-valuation of assets or the business.• Restatement of past financial results.

A few parting thoughts…

• No one item on this list is a silver bullet.• Uncovering problems often involves being a

careful reader of financial statements and drawing comparisons.

• If you don’t understand then ask. (e.g. Enron)

• If the company can’t explain it – you probably have a story.

• It if looks too good to be true – it probably is.