Simple, easy-to-understand steps outlining how to make sense of a company's financial statements.

1. Funny Money
How companies play games with numbers
By Mark Tatge
DePauw University

3. Author, TV guest, professor

5. Ex-Tyco CEO Dennis Kozlowski
Guilty: Misappropriation of funds. Cost: $81 million
Misbehaving CEOs

6. Guilty: Fraud and conspiracy. Cost: $100 Billion
Ex-Worldcom CEO Bernie Ebbers

7. Guilty: Securities Fraud. Cost: $11 billion
Kenneth Lay
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.

8. Guilty: Fraud. Cost: $60 billion.
Bernie Madoff

9. 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.
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Why fraud occurs

10. WHERE TO LOOK

11. • 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.
The Coverup

12. • 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: Basic rules

13. Concept: Cash v. Accrual

14. • Companies are supposed to match
each revenue item with its
corresponding expense.
Concept: Matching Principle

15. • 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.
Watch for revenue games

16. • 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.
Revenue matters

18. • 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.
Tip 1: Deferring expenses

19. • 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.
Lesson: marketing costs

20. • 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 2: Pro-forma earnings

21. • Has the company
recently changed
accountants?
• The change may
have occurred due
to a disagreement
over accounting
standards.
Tip 3: Firing auditors

22. • 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 4: Burying Exhibits

23. • How a company
accounts for the value
of its inventory can
have a big impact on
profits
Tip 5 – Fudging Inventory

24. • 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

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

27. • 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.
Lesson: Pharmor (1992)

28. • Companies are expected to use a single standard in
measuring the value of inventories.
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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

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

30. • 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.
Tip 6: Stock buybacks

31. •
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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
Concept: Boosting EPS

32. • 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.
Tip 7: Shell games

33. • 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.
Shell games to watch

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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.
Tip 8: Pay attention to cash

35. What are the
sources and
uses of cash?

36. Lesson: Cash flow

37. • 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

38. • 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.
Lesson: Cash flow

39. • 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.
Tip 9: Understating Liabilities

40. • GM and many
cities and states
have grossly
underfunded their
their pensions
Lesson: GM Pension Mess

41. • 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:
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Bankruptcy or liquidation.
Face a large charge against earnings.
Re-valuation of assets or the business.
Restatement of past financial results.
Tip 10: Blowing deadlines

42. • 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.
A few parting thoughts…