3. Xerox Corporation
On April 11, 2002, the U.S. Securities and Exchange Commission filed a
complaint against Xerox.
The complaint alleged Xerox deceived the public between 1997 and 2000
by employing several "accounting maneuvers," the most significant of
which was a change in which Xerox recorded revenue from copy
machine leases – recognizing a "sale" when a lease contract was
signed, instead of recognizing revenue over the entire length of the
contract.
In response to the SEC's complaint, Xerox Corporation neither admitted nor
denied wrongdoing. It agreed to pay a $10 million penalty and to restate
its financial results for the years 1997 through 2000.
On January 29, 2003, the SEC filed a complaint against Xerox's auditors,
KPMG, alleging four partners permitted Xerox to "cook the books" to fill
a $3 billion "gap" in revenue and $1.4 billion "gap" in pre-tax earnings.
In April 2005 KPMG settled with the SEC by paying a US$22.48 million
fine. As part of the settlement KPMG neither admits nor denies
wrongdoings.
4. WorldCom
Beginning modestly during mid-year 1999 and continuing at an accelerated
pace through May 2002, the company used fraudulent accounting
methods to disguise its decreasing earnings to maintain the price of
WorldCom’s stock.
The fraud was accomplished primarily in two ways:
• Booking ‘line costs’ (interconnection expenses with other
telecommunication companies) as capital expenditures on the balance
sheet instead of expenses.
• Inflating revenues with bogus accounting entries
CEO Bernard became very wealthy from the increasing price of his
holdings in WorldCom common stock.
5. - Non-provision of diminution in the value of long-term
investments due to discretion available to management
11. • In 1994-95, WIPRO Ltd. transferred land of Rs.197 million from
fixed assets to current assets, pending its sale.
Asset was transferred at the fair market value of Rs.4500 million and
the surplus of Rs.4303 million was transferred to capital reserve
improving the net worth per share and current ratio.
In subsequent years (1996-97 to 1999-2000), reduction in the value of
land was charged to the profit & loss account and an equivalent
amount was withdrawn from the capital reserve to offset the impact on
profit & loss account.
The actual sale of land took place after 5 years from the date of
conversion.
12. • In 1999-2000 and 2001-02, L & T assigned some of its outstanding
debt to one of its subsidiaries at a lower value and reported the
difference between the outstanding loan amount and the transfer value
as income in P & L A/c with a note to accounts.
13. • Hindustan Zinc Ltd.’s marketable investments represented
investments of Rs.6193 million in mutual funds as at 31-03-2004 and
Rs.688 million as at 31-03-2005.
The company changed the classification of these investments to
Intangible Assets.
The motive behind such reclassification might be to avoid the
requirements for providing for losses in value of investment as
provided in AS 13.
The auditors qualified the accounts in respect of the investments
disclosed by the company as Intangible Assets.
14. • Anantraj Industries, a north Indian commercial developer, transferred
part of one of its projects (0.52 mn sf out of 0.75 mn sf in a mall in
Delhi) to its wholly-owned subsidiary and consequently showed
equivalent revenues in its standalone results (93% of Q1 FY09
revenues).
15. • Jet Airways changed its depreciation policy from WDV to SLM, and
thereby wrote back Rs 920 crore into its P&L, which helped the
company to report profits during the quarter.
16. • Prajay Engineers, Hyderabad-based developer, reported a loss in its
fourth quarter results against expectations of a profit.
The company “lost” records for a project worth 40% of its annual
revenues at the site office. The company, in its press release, said -
“After the year end, basic records relating to sale agreements/revenue
and construction expenses of one of the projects of property
development were lost at the site office, Vishakapatnam. The auditors
in their report have stated that they were not able to verify the books
and records relating to income of Rs 143.77 crore and relevant
construction cost of Rs 75.26 crore. Management is making all efforts
to locate/ retrieve the lost records.”
17. Earnings Quality
Key objective of financial statement analysis is to estimate
future earnings from current earnings
Profit reported in the annual report is a noisy measure of a
company’s operating performance
Earnings are said to be of high quality if
- can be distributed in cash
- derived primarily from continuing operations
- methods used in measuring profit are conservative.
Earnings are said to be of low quality if
- have only a small percentage of distributable cash
- derived from non-operating sources
- computed using liberal accounting methods
18. Earnings Quality
Quality of earnings is lowered by management’s discretionary
actions.
Managers have great temptations to choose accounting
policies that will maximize their own utility and/or market
value of the company.
Managing earnings through accounting manipulations is
known as earnings management.
Creative accounting means accounting practices that may
follow the letter of the rules of standard accounting
practices, but certainly deviate from the spirit of those rules.
19. Motivation for earnings management
Imagine you're a kid with a lemonade stand and you want to build a roof
over it so that you and your customers aren't in the hot sun. You don't
have the money because business hasn't been that good. Your brother
has the money, but he won't lend it to you unless he knows that he'll
make something in the deal. You're sure that having a covered
lemonade stand will make all the difference for your business because
your customers will enjoy sipping their drinks in the cool shade.
So you decide to creatively boost your current sales figures and offer
your brother a chance to invest in your business. He gives you the
money to build your roof in exchange for 25 percent of your profits.
For reasons unknown to you, the covered stand doesn't really sell any
more lemonade than the uncovered stand did.
Now your brother is mad, because the profit he thought he was going to
make was based on phony sales figures. At this rate, it'll take four
summers to break even and much more to actually make a profit.
20. Motivation for earnings management
Employee compensation may be linked to current year’s earnings
Reduce tax liability
Maintain financial parameters like debt-equity ratio, net worth, etc.
Show rosy picture to prospective investors before IPO
Retiring CEO would like to enhance his retiring benefits that are linked
to earnings
Borrowing from financial institutions
Camouflage poor management decisions
Shoot up market price of shares and build good future expectations
Gain institutional support
Improve credit rating
Increase revenue from takeovers
Gain shareholder approval
21. Limitations of Financial Statements
Quality of earnings suffers from certain limitations of financial
statements, which stem basically from two sources:
1. Leverage provided by GAAPs in the choice of accounting
policies and changes therein
2. Window dressing in accounts and financial statements
22. Leverage provided by GAAPs
Ind AS 8 allows changes in accounting policies when is
considered to result in more appropriate preparation or
presentation of financial statements
While provision is well intended, it leaves management with a
handle to justify the appropriateness of its decision to effect
a change suiting its own requirements
Even within the framework of GAAPs, it is possible for
management to fabricate the financial statements, thus
affecting the quality of earnings
23. Leverage provided by GAAPs
AS permit management choice between alternative accounting
policies in certain areas
Property, plant & equipment (cost of acquisition and
revaluation)
Depreciation (Method, estimation and revision of useful life
and residual value)
Assets under lease
Inventories (valuation method and estimating net realizable
value)
Recognition of profit on long-term contracts
Treatment of contingent liabilities
24. Window dressing
Financial statements are said to be window dressed when
management tries to portray a rosier performance and
financial position of the company than is true
- Capitalization of revenue expenses
inflate bottom-line
WorldCom
- Revaluation of fixed assets
to show better financial position
Wipro
- Advancing billing on the customers towards the year-end
inflate top-line as well as bottom-line
Xerox
25. Window dressing
- Extension of accounting year
Liberty Shoes Ltd. / Annual Report 1999-2000
Extracts from the directors’ report:
The financial results as on 30th June, 2000 are for the period of 15
months as compared to the previous 12 months period ended on 31st
March, 1999 and are therefore not comparable.
The intention of extending the financial year by 3 months was to
implement the then ongoing restructuring programme.
However considering its complexity and financial burden, the
programme has been postponed for the time being.
Financial year may be extended to cover up a major loss or to
include a major likely gain of immediately following 2-3
months
26. Window dressing
- Inadequate or no provision for doubtful debts to inflate the
financial position and bottom-line; Hindustan Motors
- No separate disclosure of prior-period adjustments or
extraordinary income
- Increasing the estimates of useful life of fixed assets
to charge a lower depreciation; Cadila Healthcare
- Round-tripping: Getting into fictitious transactions to inflate
revenue; Satyam Computers
A company sells unused assets to a party with the promise
of buying back at a later date at the same or different price.
27. Window dressing
- Companies put aside money for possible loan defaults.
Some companies, during periods of high revenue growth,
increase the amount of reserves and release the same during
periods of poor revenue, offsetting the impact of low sales
growth.
cookie jar reserves
e.g. Dell
28. Window dressing
- Non-operational/non-recurring income being the major
source of income
OMCs encountered sharp reductions in their profits during the
last FY. In fact, during the first nine months of the last FY
all OMCs registered operating losses. Indian Oil
Corporation, India’s largest company, only prevented itself
from sliding into losses by selling-off their shares in India’s
upstream major, ONGC.
Clearly, this one-off non-operational profit cannot be repeated.
29. Big bath/kitchen sinking
- Practice of making big asset write-downs, huge provisions for
restructuring or liabilities
- Enables a firm to come clean
- Productive assets/saleable inventories may be written off, large
impairment charges, excessively large provisions for credit losses,
losses on disposal of assets
- Even if business does not do well, reported profit will go up in next
period because of lower depreciation and COGS
- Big bath is usually done when a new CEO takes over or M&A
30. Other things which companies do to manipulate earnings- modify
operating decisions
- Reducing discretionary expenditures- R&D, advertising, training,
plant maintenance
- Offering price discounts to boost sales
- Selling surplus assets at a gain
- Generous credit terms
- Overproduction- reduce cost per unit and hence COGS
- Delaying plant commissioning- defers recognition of depreciation,
extends interest capitalization
- Deferring capital expenditure- reduces current depreciation (but would
hurt future production capacity)
- Deferring planned maintenance- reduce current maintenance (but
damages the equipment)
Perfectly within GAAP, may be harmful to firm value
More difficult to detect
31. Beating window dressing
We have to live with street smart managements and their
window dressed financial statements
We can just make some efforts and resort to some measures to
beat window dressing to the extent possible in analyzing
financial statements
- Careful study of ‘notes to accounts and accounting policies’
and assessment of variations in policies, accounting
estimates, extraordinary items and contingent liabilities
- Assessment of the financial impact of qualifications in
auditors’ report on the corporate profitability and financial
position
- Comparison of basic and diluted EPS to predict EPS
sustainability in future
32. Beating window dressing
- Study of chairman’s statement, directors’ report, corporate
governance report, management discussion and analysis and
integrate them with the study of financial statements
- Analysis of related party transactions to find out whether
any undue benefit is being provided to them at the cost of
the company
- Analysis of segment results to analyze whether any line of
business is making a dent on the overall bottom-line
33. Ten Commandments
Prof. W H Beaver put together a list of warnings for those intending to
use financial statements
1. Do not use financial statements in isolation, but only in the context of
other available information.
2. Do not use financial statements as the only source of firm-specific
information.
3. Do not avoid reading the footnotes, which are an integral part of
financial statements.
4. Do not focus on a single number.
5. Do not overlook the implications of what is read.
6. Do not ignore events subsequent to the financial statements.
7. Do not overlook the limitations of financial statements.
8. Do not use financial statements without adequate knowledge.
9. Do not shun professional help.
10. Do not take unnecessary risks.
34. Potential red flags
An analyst should develop the skill of identifying red flags
- Unexplained change in accounting policy
- Unusual increase in accruals including receivables,
inventory, creditors and depreciation
- Increasing gap between reported earnings and cash flow
from operations
- Increasing gap between reported income and taxable income
- Increase in unusual short-term financing
- Large adjustments in fourth quarter
- Qualified audit opinion
- Change in external or internal auditor
- Increase in related party transactions