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Howard M. Schilit Jeremy Perler

SH€NANIGAN$ FINANC1AL

THIRD EDITION

Copyright © 2010 by Howard Schilit. All rights reserved. Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written permission of the publisher.

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To Diane and Andrea

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Contents

Preface vii Acknowledgments xi

PART ONE: Establishing the Foundation 1

Chapter 1: As Bad as It Gets 3 Chapter 2: Just Touch Up the X Rays 23

PART TWO: Earnings Manipulation Shenanigans 43

Chapter 3: Earnings Manipulation Shenanigan No. 1: Recording Revenue Too Soon 47

Chapter 4: Earnings Manipulation Shenanigan No. 2: Recording Bogus Revenue 75

Chapter 5: Earnings Manipulation Shenanigan No. 3: Boosting Income Using One-Time or Unsustainable Activities 93

Chapter 6: Earnings Manipulation Shenanigan No. 4: Shifting Current Expenses to a Later Period 111

Chapter 7: Earnings Manipulation Shenanigan No. 5: Employing Other Techniques to Hide Expenses or Losses 137

Chapter 8: Earnings Manipulation Shenanigan No. 6: Shifting Current Income to a Later Period 159

Chapter 9: Earnings Manipulation Shenanigan No. 7: Shifting Future Expenses to an Earlier Period 175

PART THREE: Cash Flow Shenanigans 189

Chapter 10: Cash Flow Shenanigan No. 1: Shifting Financing Cash Inflows to the Operating Section 197

Chapter 11: Cash Flow Shenanigan No. 2: Shifting Normal Operating Cash Outflows to the Investing Section 213

Chapter 12: Cash Flow Shenanigan No. 3: Inflating Operating Cash Flow Using Acquisitions or Disposals 227

Chapter 13: Cash Flow Shenanigan No. 4: Boosting Operating Cash Flow Using Unsustainable Activities 241

PART FOUR: Key Metrics Shenanigans 253

Chapter 14: Key Metrics Shenanigan No. 1: Showcasing Misleading Metrics That Overstate Performance 261

Chapter 15: Key Metrics Shenanigan No. 2: Distorting Balance Sheet Metrics to Avoid Showing Deterioration 281

PART FivE: Putting it All Together 297

Chapter 16: Shenanigans Recap and Recommendations 299

Index 311

vi� Contents

vii

Preface

What has been will be again, what has been done will be done again; There is nothing new under the sun. —ecclesiastes 1:9

Senior management at publicly traded companies, no doubt, yearn to report positive news and impressive financial results that will please investors and drive the share price higher. While most com- panies act ethically and follow prescribed accounting rules when reporting their financial performance, some take advantage of gray areas in the rules (or worse, ignore the rules altogether) in order to portray their financial results in a misleadingly positive way.

Management’s desire to put a positive spin on financial results has been around as long as corporations and investors themselves. Dishonest companies have long used these tricks to prey on unsus- pecting investors, and it is unlikely that they will ever cease to do so. As King Solomon observed in the book of Ecclesiastes, “What has been will be again, what has been done will be done again.” With the never-ending need to please investors, the temptation for management to exaggerate the positive through the use of financial shenanigans will always exist. The lure of accounting gimmickry is particularly strong at companies that are struggling to keep up with their investors’ expectations or their competitors’ perfor- mance. And while investors have become more savvy to these gim- micks over the years, dishonest companies continue to find new tricks (and recycle old favorites) to fool investors.

The original 1993 edition of Financial Shenanigans introduced readers to the world of corporate chicanery in the form of the seven

Earnings Manipulation Shenanigans. The 2002 edition built on the original framework by identifying new techniques and present- ing the worst offenders of the 1990s. With the wave of accounting frauds, restatements, and other financial reporting improprieties over the last decade, this third edition identifies many new tech- niques companies use to mislead investors. This book expands the discussion of Earnings Manipulation Shenanigans, introduces en- tirely new categories of shenanigans (Cash Flow Shenanigans and Key Metrics Shenanigans), and investigates new industries (banks and insurance companies) and new regions of the world (Europe and Asia) that have been hit with financial frauds.

Structure of the New Edition This edition goes far deeper into the corporate bag of tricks than the earlier ones did, to give readers a comprehensive look at the various kinds of scams that are prevalent today. We have grouped these financial reporting shenanigans into three categories:

Earnings Manipulation Shenanigans reveals how companies ma- nipulate the Statement of Income to report higher revenue, in- flated profits, or improperly smoothed income. Cash Flow Shenanigans discusses tricks used by companies to re- port misleadingly high cash flow measures, including cash flow from operations and free cash flow. Key Metrics Shenanigans exposes how companies fool investors by showcasing misleading metrics that are being billed as key mea- sures of business performance or economic health.

Postmortem: Lessons Learned from Financial Reporting Failures We believe that the best training for professionals who are involved in preparing, auditing, or evaluating financial reports is an im- mersion in case studies to learn lessons from real-world financial reporting failures. Robert J. Sack, former chief accountant of the Di- vision of Enforcement at the U.S. Securities and Exchange Commis- sion (SEC), underscored this point by suggesting that accountants be trained more like medical students, who study cadavers to learn from history, stating:

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viii� Preface

The objective of a medical autopsy is simply to learn what went wrong, and to make a judgment as to what might have been done differently. The medical profession tries to learn from those failures to expand the list of answers. Unfortunately, the financial reporting process sometimes fails too . . . we must find a way for accountants to use those financial reporting failures in the expansion of our knowledge base.

This book uses such an approach, shining a light on the most shocking frauds in recent times and on other companies that tricked investors by reporting false or misleading financial results. Using illustrations culled from SEC enforcement actions, securities class- action litigation, and forensic accounting research by the Center for Financial Research and Analysis (now a part of RiskMetrics Group), we present the most relevant and instructive anecdotes of companies that have employed financial shenanigans to hide busi- ness deterioration. These vignettes offer valuable lessons that teach investors how to identify when a company’s reported results fail to represent economic reality.

Who Will Benefit from Reading This Book While we regularly refer to investors in addressing readers through- out this book, we believe that many other parties will also benefit from a rigorous lesson in how to study financial reports to find mis- leading reporting practices. For example, any party with an eco- nomic interest (e.g., commercial bankers, bondholders, insurance underwriters, and other credit providers) needs accurate financial reports that portray the underlying economic reality in order to make informed decisions about an organization. In addition, inde- pendent auditors must understand the accounting tricks used by management in order to provide a reasonable opinion on the fair- ness of financial reports. Boards of directors cannot serve as effec- tive fiduciaries for investors without carefully searching for signs of financial shenanigans. Government regulators must understand accounting gimmickry in order to properly enforce their rules. In- fluential credit rating organizations will fail to protect bondholders and others if their evaluation of an issuer’s financial reports lacks rigor. And corporate executives themselves, who need to monitor both their own performance and that of the competition, would benefit from the lessons in this book.

Preface� ix

Universal Message about Financial Shenanigans While most companies report their results honestly to investors, a significant number use accounting or financial reporting tricks to hide the truth. Since they are likely to be unaware of management’s integrity level, smart investors would do well to maintain a healthy skepticism and perform rigorous due diligence with regard to finan- cial reports. Additionally, financial shenanigans occur in every in- dustry and know no geographic borders. Thus, investors following companies headquartered in China, for example, will benefit as much as those interested in companies based in the United States, Brazil, or any other country. Our universal message is that investors should assume that the urge to exaggerate the positive and hide the negative will never disappear. And where temptation exists, she- nanigans often follow.

x� Preface

xi

Acknowledgments

From Howard Many wonderful and generous people have been invaluable in nur- turing and shaping my career dedicated to studying and teaching others about ethics in financial reporting.

First thank you to my parents, Irving and Ethel Schilit, for giv- ing me the confidence to believe anything was possible with hard work.

To my siblings, Audrey, Keith, and Rob, for your lifelong friend- ship and support in all my endeavors.

To my wife, Diane, for accompanying me on a very interest- ing journey, from life as a professor and author to one as a globe- trotting businessman.

To my children, Jonathan, Suzanne, and Amy, for laughing at my corny jokes and not always laughing at my nerdy accountinglike appearance.

To my inspirational teachers at Queens College, Binghamton University, and the University of Maryland for providing me both the direction and tools to pursue my dreams.

To my students and colleagues at American University, who challenged me intellectually as I first researched and taught about financial shenanigans.

To my former colleagues and friends at the Center for Financial Research and Analysis (CFRA) (particularly, Jeremy Perler, Marc Siegel, Jay Huck, Debbie Meritz, and Yoni Engelhart) for helping me build a very special place.

To my clients, who became my most challenging “students.” And finally, to the dedicated team at McGraw-Hill (notably Leah

Spiro, Joe Berkowitz, Janice Race, and Jennifer Ashkenazy) for their tireless effort to shape and polish the book.

From Jeremy There are many people to whom I owe gratitude and appreciation:

To Howard Schilit, who inspired me to pursue my passion for fi- nancial sleuthing, taught me the art of forensic accounting research, and graciously welcomed me into his house, both figuratively and literally.

To the incredibly talented team of accounting detectives at Risk- Metrics Group (and CFRA before it), whose unique blend of curi- osity, acumen, ingenuity, and passion helps me grow every day. Financial Shenanigans benefited immensely from their bodies of knowledge and work; indeed, it is they who unearthed many of the vignettes featured in this book, in particular, Dan Mahoney (my co- director of research), Enitan Adebonojo, David Bassett, Alisa Guyer Galperin, Jill Lehman, and Matt Schechter. Many other colleagues (past and present) were instrumental to this book as well, sharing enlightening stories and shouldering an extra workload.

To the leadership team at RiskMetrics, especially Ethan Berman and Garvis Toler, whose professional support and personal devo- tion are both endearing and enduring.

To Marc Siegel, a mentor, colleague, and friend, who led me to the crossroads of accounting and the financial markets and showed me how to direct traffic.

To the accounting faculty at the University of Michigan’s Ross School of Business, who cultivated my curiosity for navigating a financial maize and blue the wind that lifted my accounting sails.

To my parents, Vicki and Arthur, who stocked my tool bench and taught me how to build; and to my brothers, Ari, Elie, and Jacob, who filled my foundation.

And most of all, to my wife, Andrea, who strengthens and in- spires me every day with her brilliance, benevolence, and endless love. And to our two beautiful girls, Shira and Orli, whose loving eyes and contagious smiles provide me with eternal harmony.

xii� Acknowledgments

�

part one Establishing the

Foundation

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�

1 As Bad as It Gets

Like millions of other movie lovers, our families look forward to the late-winter evening each year when Hollywood stages its most prestigious night: the Academy Awards ceremony. The Oscars rank the year’s best films, certifying their place in cinematic history. Like the title of a particularly Academy-honored film from 1997, the competitors for the Best Picture Oscar are As Good as It Gets.

If we were going to hand out awards for financial shenanigans, however, the competitors would be vying for the title of As Bad as It Gets.

Awards for Most Outrageous Financial Shenanigans In reviewing the most colossal financial reporting scandals of the last decade, we added our own Creative Accounting Award cat- egory, As Bad as It Gets, to highlight those in management who pos- sessed the talent, vision, and chutzpah to mislead investors with financial shenanigans.

And the winners are . . .

“As Bad as It Gets” Awards in Financial Shenanigans

Category Company

Most Imaginative Fabrication of Revenue Enron Most Brazen Creation of Fictitious Profit and

Cash Flow WorldCom

Most Shameless Heist by Senior Management Tyco Most Ardent and Prolific Use of Numerous

Shenanigans Symbol Technologies

� Chapter One

Enron: Most Imaginative Fabrication of Revenue Houston-based Enron Corp. quickly became synonymous with the term massive accounting fraud in the fall of 2001 with its sudden collapse and bankruptcy. Many people have described the utility company’s ruse as a cleverly designed fraud involving the use of thousands of off-balance-sheet partnerships to hide massive losses and unimaginable debts from investors. While that story line is es- sentially correct, detection of red flags required no special account- ing skills or even advanced training in reading financial statements. It simply required the curiosity to notice and question a stupendous five-year jump in Enron’s sales revenue from 1995 to 2000.

Warning for Enron Investors—Revenue Growth Defied Reality Enron ranked number seven in Fortune magazine’s list of the 500 largest companies in 2000 (ranked by total revenue), surpassing such giants as AT&T and IBM. In just five short years, Enron’s revenue had miraculously increased by an astounding factor of 10 (rising from $9.2 billion in 1995 to $100.8 billion in 2000). Curious investors might have questioned how frequently companies tend to grow their revenue from under $10 billion to over $100 billion in five years. The answer: never. Enron’s staggering increase in rev- enue was unprecedented, and the company achieved this growth without any large acquisitions along the way. Impossible!

As Table 1-1 shows, in 2000, only seven companies produced revenue of $100 billion or more. Except for Citigroup (with its 1998

Table 1-1. Fortune 500 Largest Companies Ranked by Sales (as of 2000)

($ millions) 2000 1999 1998 1997 1996 1995

ExxonMobil 210,392 163,881 100,697 122,379 119,434 110,009 Wal-Mart 193,295 166,809 139,208 119,299 106,147 93,627 General

Motors 184,632 189,058 161,315 178,174 168,369 168,829

Ford 180,598 162,558 144,416 153,627 146,991 137,137 General

Electric 129,853 111,630 100,469 90,840 79,179 70,028

Citigroup 111,826 82,005 76,431 Predecessor Predecessor Predecessor Enron 100,789 40,112 31,260 20,273 13,289 9,189

As Bad as It Gets �

merger of Citicorp and Travelers), these large companies’ growth essentially came organically, not through acquisitions.

Notice in Table 1-2 that in 2000, Enron’s sales grew a staggering 151 percent, from $40.1 billion to $100.8 billion.

Curiously, even though Enron made the list with the big boys, its reported profits, totaling less than $1 billion (or 1 percent of sales), paled in comparison to the others. Moreover, profits never grew proportionally with sales, a pretty unusual occurrence and a defi- nite warning sign of accounting tricks. If sales grow by 10 percent, for example, investors generally would expect expenses and profits to rise by a similar amount at a business with steady margins. At Enron, no logical pattern existed except that sales shot to the moon and profits barely moved at all. In 2000, sales grew by more than 150 percent, yet profits increased by less than 10 percent, as shown in Table 1-3. How was that possible?

Table 1-2. 2000 Sales Growth at Largest Fortune 500 Companies

($ millions) 2000 1999 % Change

ExxonMobil 210,392 163,881 28% Wal-Mart 193,295 166,809 16% General Motors 184,632 189,058 (2%) Ford 180,598 162,558 11% General Electric 129,853 111,630 16% Citigroup 111,826 82,005 36% Enron 100,789 40,112 151%

Table 1-3. Net Income of Largest Fortune 500 Companies, Ranked by 2000 Sales Level

($ millions) 2000 Net Income

ExxonMobil 17,720 Wal-Mart 6,295 General Motors 4,452 Ford 3,467 General Electric 12,735 Citigroup 13,519 Enron 979

� Chapter One

Let’s go back a few years further and track Enron’s meteoric rev- enue rise and its race up the Fortune 500 list of largest companies from a middling rank of 141 in 1995 to its lofty top 10 position in the 2000 results (see Table 1-4).

Few companies ever reach $100 billion in revenue, as Enron did in 2000, and the climb from $10 to $100 billion generally takes de- cades. As Table 1-5 shows, ExxonMobil first reached $10 billion in revenue in 1963, and not until 1980 did it join the $100 billion club. General Motors first reached $10 billion in 1955, yet it took the com- pany 31 more years to join the more exclusive club. Yet, nimble Enron, which hit $10 billion in 1996, raced to the $100 billion mark in only 4 years. Such a rapid ascent had never taken place before. In fact, the previous record was set by Wal-Mart, which did it in 10 years. It might have seemed implausible, to an observer, that Enron could have found a legitimate formula to achieve business success immortality. Sure enough, as we will explore throughout this book, this immortality came through perpetrating a gigantic fraud.

Table 1-4. Enron’s Sales, Profit, and Fortune 500 Ranking (Based on Annual Sales)

($ millions) 2000 1999 1998 1997 1996 1995

Sales 100,789 40,112 31,260 20,273 13,289 9,189 Profit 979 893 703 105 584 520 Fortune 500 ranking 7 18 27 57 94 141

Table 1-5. The $100 Billion Club

First $100 B Year

Revenue ($ millions)

First $10 B Year

Revenue ($ millions)

Years from $10 B to $100 B

ExxonMobil 1980 103,143 1963 10,264 17 Wal-Mart 1996 106,147 1986 11,909 10 General

Motors 1986 102,813 1955 12,443 31

Ford 1992 100,786 1965 11,537 27 General

Electric 1998 100,469 1972 10,240 26

Enron 2000 100,789 1996 13,289 4

Source: Fortune magazine.

As Bad as It Gets �

The Enron Fraud Revealed The first signs of a massive fraud were revealed when an Enron com- mittee and the firm’s auditor, Arthur Andersen, reviewed the account- ing for several unconsolidated (“off-balance-sheet”) partnerships in October 2001 and concluded that Enron should have consolidated some of these partnerships and included them as a part of the com- pany’s financial results. Things went from bad to worse the following month when Enron disclosed a $586 million reduction in previously reported net income and took a $1.2 billion reduction in its stockhold- ers’ equity. Investors began to flee, and Enron’s stock price sank like a boulder. Before Enron’s final descent, credit rating agencies cut its rat- ing and virtually all borrowing froze. In early December 2001, Enron filed for bankruptcy with assets of about $65 billion. It was the larg- est corporate bankruptcy in U.S. history—until WorldCom declared bankruptcy seven months later (WorldCom was subsequently sur- passed by Lehman Brothers in 2008).

In the end, most shareholders suffered staggering losses as En- ron’s stock price in 2000 plunged from over $80 per share (with a market capitalization exceeding $60 billion) to $0.25 nine short but painful months later. Some insiders, however, sold large parts of their holdings before the collapse. Enron’s chairman and former CEO, Ken Lay, and other top officials sold hundreds of millions of dollars worth of stock in the months leading up to the crisis.

Legal Justice for Enron Executives—a Minor Consolation for Shareholders On May 25, 2006, a jury returned guilty verdicts against Enron’s chairman, Ken Lay, and CEO, Jeffrey Skilling. Skilling was con- victed on 19 of 28 counts of securities and wire fraud and sentenced to over 24 years in prison. Lay was tried and convicted on 6 counts of securities and wire fraud, but he died two months later while awaiting sentencing that could have locked him up for 45 years.

Investors should also have questioned how, despite sales growing tenfold over this period, profits failed to even double. The sales fig- ures and their unprecedented annual rise year after year should have raised alarms for investors. Chapters 3 and 4 of this book will share some of Enron’s darkest secrets in how it inflated revenue without de- tection for all those years by using a little-understood method known as mark-to-market accounting and by improperly “grossing up” sales to give the illusion of being a much larger company.

� Chapter One

Key Lesson: When reported sales growth far exceeds any nor- mal patterns, revenue recognition shenanigans may likely have fueled the increase.

ENRON: FiNaNciaL ShENaNigaNS idENtiFiEd

Earnings Manipulation Shenanigans

Recording Revenue Too Soon Recording Bogus Revenue Boosting Income Using One-Time or Unsustainable Activities Employing Other Techniques to Hide Expenses or Losses

Cash Flow Shenanigans

Shifting Financing Cash Inflows to the Operating Section Shifting Normal Operating Cash Outflows to the Investing Section Inflating Operating Cash Flow Using Acquisitions or Disposals Boosting Operating Cash Flow Using Unsustainable Activities

Key Metrics Shenanigans

Showcasing Misleading Metrics That Overstate Performance Distorting Balance Sheet Metrics to Avoid Showing Deterioration

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WorldCom: Most Brazen Creation of Fictitious Profit and Cash Flow WorldCom Inc. began life in 1983 as the American telecommunica- tions company Long Distance Discount Services (LDDS). In 1989, LDDS merged into a shell company called Advantage Companies

As Bad as It Gets �

in order to become publicly traded, and in 1995, LDDS changed its name to LDDSWorldCom.

Throughout WorldCom’s history, its growth came largely from making acquisitions. (As we will explain later, acquisition-driven companies offer investors some of the greatest challenges and risks.) The largest of these occurred in 1998 with the $40 billion acquisition of MCI Communications. Accordingly, the name was again changed, this time to MCI WorldCom. A few years later, the name was finally shortened to WorldCom.

The Accounting Games at WorldCom Almost from the beginning, WorldCom used aggressive account- ing practices to inflate its earnings and operating cash flows. One of its principal shenanigans involved making acquisitions, writing off much of the costs immediately, creating reserves, and then releas- ing those reserves into income as needed. With more than 70 deals over the company’s short life, WorldCom continued to “reload” its reserves so that they were available for future release into earnings.

This shenanigan would probably have been able to continue had WorldCom been allowed to acquire the much larger Sprint in a $129 billion deal announced in October 1999. Antitrust law- yers and regulators at the U.S. Department of Justice and their counterparts at the European Union disapproved of the merger, citing monopoly concerns. Without the acquisition, WorldCom “lost” the expected infusion of new reserves that it needed, as its prior ones had rapidly been depleted by being released into income.

Key Warning: acquisitive companies—Financial shenanigans often lurk at companies that grow predominantly by making acquisitions. Moreover, acquisition-driven companies often lack internal engines of growth, such as product development, sales, and marketing.

By early 2000, with its stock price declining and intense pressure from Wall Street to “make its numbers,” WorldCom embarked on a new and far more aggressive shenanigan—moving ordinary

�0 Chapter One

business expenses from its Statement of Income to its Balance Sheet. One of WorldCom’s major operating expenses was its so-called line costs. These costs represented fees that WorldCom paid to third- party telecommunication network providers for the right to lease their networks. Accounting rules clearly require that such fees be expensed and not be capitalized. Nevertheless, WorldCom removed hundreds of millions of dollars of its line costs from its Statement of Income in order to please Wall Street. In so doing, WorldCom dra- matically understated its expenses and inflated its earnings, while duping investors. This trick continued quarter after quarter from mid-2000 through early 2002 until it was uncovered by internal au- ditors at WorldCom.

CEO Bernie Ebbers Spends Like a Drunken Sailor With WorldCom regularly meeting Wall Street’s earning targets, its stock price rose dramatically. CEO Bernie Ebbers sold large blocks of his stock to support other business ventures (timber) and his lavish lifestyle (yachting). As the stock declined in 2001 dur- ing the technology meltdown, Ebbers found some extra cash that he needed by borrowing against (i.e., margining) his stock hold- ings. As margin calls from brokers increased, Ebbers convinced the board of directors to give him corporate loans and guaran- tees in excess of $400 million. Ebbers had probably hoped that these loans would prevent the need for him to sell a substantial portion of his WorldCom stock, which would have further hurt the company’s share price. However, this strategy to prevent the stock price from collapsing ultimately failed, and Ebbers was ousted as CEO in April 2002, just months before the fraud was revealed.

The Collapse of WorldCom Meanwhile, in early 2002, a small team of internal auditors at WorldCom, working on a hunch, were secretly investigating what they thought could be fraud. After finding $3.8 billion in inappro- priate accounting entries, they immediately notified the company’s board of directors, and events progressed swiftly. The CFO was fired, the controller resigned, Arthur Andersen withdrew its au- dit opinion for 2001, and the Securities and Exchange Commission (SEC) launched an investigation.

As Bad as It Gets ��

WorldCom’s days were numbered. On July 21, 2002, the com- pany filed for Chapter 11 bankruptcy protection, the largest such filing in U.S. history at the time (a record that has since been over- taken by the collapse of Lehman Brothers in September 2008). Un- der the bankruptcy reorganization agreement, the company paid a $750 million fine to the SEC and restated its earnings in an amount that defies belief. In total, the company reported an accounting re- statement that exceeded $70 billion, including adjusting the 2000 and 2001 numbers from the originally reported gain of nearly $10 billion to an astounding loss of over $64 billion. The directors also felt the pain, having to pay almost $25 million to settle class-action litigation.

Postbankruptcy and the Fate of Bernie Ebbers The company emerged from bankruptcy in 2004. Previous bond- holders were paid 36 cents on the dollar, in bonds and stock in the new company, while the previous stockholders were wiped out completely. In early 2005, Verizon Communications agreed to acquire MCI for about $7 billion. Two months later, Ebbers was found guilty of all charges and convicted of fraud, conspiracy, and filing false documents. He was later sentenced to 25 years in prison.

Warning for WorldCom Investors—Evaluate Free Cash Flow Investors would have found some clear warning signs in evalu- ating WorldCom’s Statement of Cash Flows (SCF), specifically, its rapidly deteriorating free cash flow. WorldCom manipulated both its net earnings and its operating cash flow. By treating line costs as an asset instead of an expense, WorldCom improperly inflated its profits. In addition, since it improperly placed those expendi- tures in the Investing rather than the Operating section of the SCF, WorldCom similarly inflated operating cash flow. While reported operating cash flow appeared consistent with reported earnings, the company’s free cash flow told the story.

Reported Cash Flow from Operations Looked Solid As shown in Table 1-6, WorldCom cleverly hid its problems from investors, as the cash flow from operations (CFFO) regularly exceeded net income. (Part 3 of this book shows how investors

�2 Chapter One

could have known that WorldCom’s CFFO was artificially inflated.)

Free Cash Flow Told the Real Story A key to uncovering WorldCom’s shenanigans required taking the analysis of cash flow a step further—computing its “free cash flow.” This metric removes line costs from cash flow, regardless of whether they are presented in the Investing or the Operating section of the SCF. Let’s examine Table 1-7, which gives free cash flow. During 1999, the period just before the company began capi- talizing line costs, WorldCom generated almost $2.3 billion in free cash flow. Let’s contrast that to the following year, when World- Com experienced a $3.8 billion decline in free cash flow—a stag- gering deterioration of over $6.1 billion. Noting this dramatic and troubling turnabout, WorldCom investors should have concluded that the business was in deep trouble, fraud or no fraud.

Table 1-6. WorldCom’s Cash Flow from Operations versus Net Income (as Originally Reported)

($ millions) Q1,

3/01 Q4,

12/00 Q3,

9/00 Q2,

6/00 Q1,

3/00

Cash flow from operations (CFFO)

1,596 1,743 2,060 2,069 1,794

Subtract: Net income 610 732 967 1,291 1,301

CFFO less net income 986 1,011 1,093 778 493

Accounting Capsule: Free Cash Flow

Free cash flow measures the cash generated by a company, including the impact of cash paid to maintain or expand its asset base (i.e., purchases of capital equipment). Free cash flow typically would be calculated as follows:

Cash flow from operations minus capital expenditures equals free cash flow

As Bad as It Gets ��

Key Lesson: When free cash flow suddenly plummets, expect big problems.

WORLdcOM: FiNaNciaL ShENaNigaNS idENtiFiEd

Earnings Manipulation Shenanigans

Recording Bogus Revenue Shifting Current Expenses to a Later Period Employing Other Techniques to Hide Expenses or Losses Shifting Future Expenses to an Earlier Period

Cash Flow Shenanigans

Shifting Normal Operating Cash Outflows to the Investing Section Inflating Operating Cash Flow Using Acquisitions or Disposals Boosting Operating Cash Flow Using Unsustainable Activities

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Table 1-7. WorldCom’s Free Cash Flow

($ millions) Total 1999

Q4, 12/99

Q3, 9/99

Q2, 6/99

Q1, 3/99

Cash flow from operations 11,005 3,228 3,271 2,581 1,925

Subtract: Capital expenditures (8,716) (2,877) (2,165) (2,035) (1,639)

Free cash flow 2,289 351 1,106 546 286

Total 2000

Q4, 12/00

Q3, 9/00

Q2, 6/00

Q1, 3/00

Cash flow from operations 7,666 1,743 2,060 2,069 1,794

Subtract: Capital expenditures (11,484) (2,707) (3,580) (2,678) (2,519)

Free cash flow (3,818) (964) (1,520) (609) (725)

�� Chapter One

Tyco: Most Shameless Heist by Senior Management Similar to WorldCom, Tyco International Ltd. loved doing acquisi- tions, making hundreds of them over a few short years. From 1999 to 2002, Tyco bought more than 700 companies for a combined total of approximately $29 billion. While some of the acquired companies were large businesses, many were so small that Tyco did not even bother disclosing them to investors in its financial statements.

Tyco probably liked the businesses that it was buying, but more than that, the company loved to be able to show investors that it was growing rapidly. However, what Tyco seemed to like best about these acquisitions was the accounting loopholes that they pre- sented. The acquisitions allowed the company to reload its dwin- dling reserves, providing a consistent source of artificial earnings boosts. Moreover, the frequent acquisitions allowed Tyco to show strong operating cash flow, even though it merely resulted from an accounting loophole. (We will come back to this in Cash Flow Shenanigan No. 3: Inflating Operating Cash Flow Using Acquisi- tions or Disposals.) Indeed, Tyco loved the acquisition accounting benefits so much that it even used them when no acquisitions at all occurred.

Tyco’s Clever Accounting Games Consider how Tyco accounted for payments that it made in solic- iting new security-alarm business in its ADT subsidiary. Rather than hire additional employees, Tyco decided to use an indepen- dent network of dealers to solicit new customers. Tyco was so enamored with acquisition accounting that it decided to use this technique to record the purchase of these contracts from agents. In so doing, Tyco inflated its profits by failing to record the proper

Key Metrics Shenanigans

Showcasing Misleading Metrics That Overstate Performance Distorting Balance Sheet Metrics to Avoid Showing Deterioration

•

•

As Bad as It Gets ��

expense. Moreover, Tyco inflated its operating cash flow by re- cording these payments in the Investing section of the Statement of Cash Flows.

But Tyco had many more tricks up its sleeve. It increased the price paid to dealers for each contract, and in return, required the dealers to pay that increased amount back to it as a “connec- tion fee” for doing business. While this arrangement clearly had no impact on the underlying economics of the transaction, Tyco inappropriately decided to record this connection fee as income, providing an artificial boost to both earnings and operating cash flow. The boosts really added up when you consider that Tyco played this game with hundreds of thousands of contracts that it purchased.

The SEC Charges Tyco with Fraud The SEC reviewed Tyco’s arrangements with dealers and gave the company a “thumbs down” for its creative accounting. As part of an overall billion-dollar fraud, the SEC alleged that Tyco used inappropriate accounting for ADT contract purchases to fraudu- lently generate $567 million in operating income and $719 million in cash flow from operations. Moreover, the SEC charged that Tyco engaged in improper acquisition accounting practices that inflated operating income by at least $500 million. Such practices included undervaluing acquired assets, overvaluing acquired liabilities, and misusing accounting rules concerning the establishment and uti- lization of reserves. If that were not enough, the lawsuit charged that Tyco had improperly established and used various reserves to enhance and smooth publicly reported results and meet Wall Street expectations.

The Tyco Piggy Bank Unfortunately for Tyco and its investors, the problems were far from over. During this period, senior executives (mainly CEO Dennis Kozlowski and CFO Mark Swartz) had been using the company’s cash account as their own piggy bank. The government charged that these executives had been stealing hundreds of millions of dol- lars from Tyco by failing to properly disclose to shareholders the existence of back-door executive compensation arrangements and related-party transactions. With the board unaware or asleep at the

�� Chapter One

wheel, senior executives granted themselves loans for personal ex- penses, many of which were secretly forgiven, effectively produc- ing a large unreported compensation expense.

Enormous Penalty and Jail Time The larcenous executives at Tyco paid an enormous price. On top of a $50 million SEC penalty, the company agreed to pay a record- breaking $3 billion in restitution to settle shareholder lawsuits. Moreover, Kozlowski and Swartz were convicted of looting the company and inflating its stock price, and both were sentenced to up to 25 years in prison.

Warning for Tyco Investors—Negative Free Cash Flow, Net of Acquisitions Detailed cash flow analysis would have helped investors notice problems at Tyco. For acquisitive companies, however, we sug- gest computing an adjusted free cash flow that removes total cash outflows for acquisitions. By adjusting the free cash flow calcula- tion for acquisitions, investors would have a clearer picture of a company’s performance. As a theme discussed throughout the book, acquisitions present numerous opportunities for companies to inflate earnings and both operating and free cash flow. In the case of Tyco, we spotted big drops in adjusted free cash flow. As shown in Table 1-8, between 2000 and 2002, Tyco generated a cu- mulative negative free cash flow (net of acquisitions), although it reported very large operating cash inflows for those years.

Table 1-8. Tyco’s Free Cash Flow after Acquisitions (from Continuing Operations)

($ millions) 2002 2001 2000

Reported cash Flow from Operations 5,696 6,926 5,275 Subtract: Capital Expenditures (1,709) (1,798) (1,704) Subtract: Construction-in-Progress (1,146) (2,248) (111)

Free cash Flow 2,841 2,880 3,460 Subtract: Acquisitions (3,709) (11,851) (4,791)

Free cash Flow after acquisitions (868) (8,971) (1,331)

As Bad as It Gets ��

tYcO: FiNaNciaL ShENaNigaNS idENtiFiEd

Earnings Manipulation Shenanigans

Recording Bogus Revenue Shifting Current Expenses to a Later Period Employing Other Techniques to Hide Expenses or Losses Shifting Current Income to a Later Period Shifting Future Expenses to an Earlier Period

Cash Flow Shenanigans

Shifting Financing Cash Inflows to the Operating Section Shifting Normal Operating Cash Outflows to the Investing Section Inflating Operating Cash Flow Using Acquisitions or Disposals Boosting Operating Cash Flow Using Unsustainable Activities

Key Metrics Shenanigans

Showcasing Misleading Metrics That Overstate Performance Distorting Balance Sheet Metrics to Avoid Showing Deterioration

•

•

•

•

•

•

•

•

•

•

•

Symbol Technologies: Most Ardent and Prolific Use of Numerous Shenanigans Although much smaller in size, Long Island–based Symbol Tech- nologies Inc., a maker of bar code scanners, earned its rightful place as a winner of our As Bad as It Gets Award in creative ac- counting for its audacious use of all seven Earnings Manipula- tion Shenanigans, all four Cash Flow Shenanigans, and both Key Metrics Shenanigans—an impressive and rare distinction. Even Enron, WorldCom, and Tyco could not match the breadth of Symbol’s feat. (Of course, these three companies distinguished

�� Chapter One

and disgraced themselves by “specializing” in a few gigantic shenanigans.)

Some Tricks Used Symbol seemed to be obsessed with never disappointing Wall Street. For more than eight consecutive years, it either met or exceeded Wall Street’s estimated earnings—32 straight quarters of sustained success. In hindsight, though, such steady and pre- dictable performance (particularly during the technology col- lapse of 2000–2002) should have alerted investors to take a closer look.

Symbol never wanted its earnings to get too high or too low, so it would record bogus adjustments to the company’s financial state- ments at the end of each quarter in order to align its results with Wall Street expectations. In very strong periods, for example, the company would take charges to create “cookie jar” reserves that could be used to boost earnings during weaker periods. That oc- curred in the late 1990s when Symbol won a large contract from the U.S. Postal Service that accounted for 11 percent of the com- pany’s 1998 revenue. Symbol cleverly used restructuring charges to dampen its reported growth, and in so doing, both lowered the bar to meet future-period Wall Street expectations and created reserves that could be released when needed.

If, instead, Symbol’s business slowed and Wall Street targets went unmet, the company would “stuff the channel,” or ship prod- ucts to customers too early in order to record additional revenue. Symbol also allegedly inflated revenue by shipping products that its customers did not want. The company even sold products to customers in order to record revenue, then repurchased the goods at a higher price (a bizarre arrangement in which Symbol actually lost money in order to create revenue growth).

Moreover, if Symbol’s operating expenses got out of control and needed some trimming, there was a ready solution. In one case, when paying bonuses in early 2001, Symbol conveniently (and improperly) deferred the related Federal Insurance Contributions Act (FICA) insurance costs, thereby inflating operating income. The company also tidied up messy issues that surfaced on the Balance Sheet, like accounts receivable that were not getting col- lected. In 2001, Symbol was concerned that Wall Street would re-

As Bad as It Gets ��

act unfavorably to surging receivables, so it simply moved them to another section of the Balance Sheet where they would be hid- den from investors’ view. (More on this in Part 4, “Key Metrics Shenanigans.”)

And Justice for All—But One The regulators finally caught up with Symbol after all those years of duping investors. The SEC accused Symbol of perpetrating a massive fraud from 1998 until 2003. Unlike the scoundrels running Enron, WorldCom, and Tyco, however, Symbol’s senior executive followed a different (and somewhat bizarre) course. After being in- dicted on securities fraud charges, CEO Tomo Razmilovic fled the country and was declared a fugitive. He even made the U.S. Postal Inspection Service’s “most-wanted” list, with a $100,000 reward of- fered for his arrest and conviction. (At that time, he was the only white-collar crime suspect on the agency’s most-wanted Web site, which included rewards for the anthrax mailer, certain bombing suspects, and post office robbers.) He is still on the lam, apparently living comfortably in Sweden.

Warnings for Symbol Technologies Investors In addition to Symbol’s unusually steady and predictable perfor- mance, there were many warning signs for investors about the company’s struggles. Our forensic research firm, the Center for Fi- nancial Research and Analysis (CFRA, and now part of RiskMetrics Group), issued six separate reports between 1999 and 2001, warn- ing investors about Symbol’s aggressive accounting practices. Spe- cific issues raised in our reports include the following:

1. Unusually large one-time charges seemed to be designed to cre- ate bogus reserves that could be used in future periods to benefit earnings. For example, when acquiring Telxon in 2000, Symbol wrote off 68 percent of the purchase price. Symbol also wrote off inventory that may have subsequently been sold, providing a boost to margins.

2. Symbol showed signs of aggressive cost capitalization, includ- ing a doubling of capitalized software and a surge in soft assets to 21 percent of total assets in Q2 2000 (from 11 percent the prior year).

20 Chapter One

3. Inventories jumped dramatically, raising concerns about mar- gin pressure in future periods, possible product returns, or cus- tomers losing interest in the company’s product.

4. Accounts receivable surged from early 1999 to 2001, signaling aggressive revenue recognition (stuffing the channels at the end of the period).

5. Symbol’s allowance for doubtful accounts continuously declined as a percentage of accounts receivable, providing a benefit to earnings.

6. Symbol frequently fell half a penny short of earnings per share (EPS) targets, but kept its Wall Street “success” streak alive by rounding up (for example, rounding up $0.1167 to achieve the target of $0.12). We considered it highly unlikely that manage- ment was this lucky and consistent, instead seeing it as a sign of earnings manipulation.

7. Cash flow from operations routinely lagged behind net income, a sign of poor earnings quality.

SYMBOL: FiNaNciaL ShENaNigaNS idENtiFiEd

Earnings Manipulation Shenanigans

Recording Revenue Too Soon Recording Bogus Revenue Boosting Income Using One-Time or Unsustainable Activities Shifting Current Expenses to a Later Period Employing Other Techniques to Hide Expenses Shifting Current Income to a Later Period Shifting Future Expenses to an Earlier Period

Cash Flow Shenanigans

Shifting Financing Cash Inflows to the Operating Section Shifting Normal Operating Cash Outflows to the Investing Section Inflating Operating Cash Flow Using Acquisitions or Disposals Boosting Operating Cash Flow Using Unsustainable Activities

•

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•

•

•

•

•

•

•

•

•

As Bad as It Gets 2�

Key Metrics Shenanigans

Showcasing Misleading Metrics That Overstate Performance Distorting Balance Sheet Metrics to Avoid Showing Deterioration

•

•

Looking Ahead Many investors in Enron, WorldCom, Tyco, and Symbol Technolo- gies paid heavy prices for failing to spot early signs of operating problems that had been camouflaged by financial shenanigans. Fortunately, investors, auditors, and other stakeholders can learn lessons from these debacles and better arm themselves with the knowledge of how to detect similar warning signs in the future.

Chapter 2 establishes the foundation for understanding the three categories of financial shenanigans: Earnings Manipulation (Part 2), Cash Flow (Part 3), and Key Metrics (Part 4), and where they are most likely to occur.

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23

2 Just Touch Up

the X Rays

I can’t afford the operation, but would you accept a small payment to touch up the X rays? —warren buffett, CEO of Berkshire Hathaway

Legendary investor Warren Buffett generously uses his annual let- ter to investors as a vehicle to educate all interested parties about the art of investing. In one such letter, the Oracle from Omaha, as he is affectionately known, gave a particularly poignant lesson con- cerning a subject that is near and dear to us: companies that use financial shenanigans to hide the unpleasant truth from investors. This letter described a conversation between a seriously ill patient and his doctor, just after an X ray revealed the bad news about his condition. Rather than accept the information about his deteriorat- ing health, the patient’s immediate response to the dreadful news was to ask the doctor to touch up the X rays. Buffett uses this story to warn investors about managements that try to hide the truth about a deteriorating business’s economic health by touching up the finan- cial statements. Buffett then prophetically adds, “In the long run, however, trouble awaits managements that paper over operating problems with accounting maneuvers. Eventually, managements of this kind achieve the same result as the seriously-ill patient.”

24� Chapter�Two

No doubt, a company’s use of financial shenanigans to paper over its poor economic health would be no more effective than a doc- tor touching up X rays to improve a patient’s physical health. Such gimmicks are pointless, as the truth of the company’s deterioration will remain unchanged and will ultimately come to light one day.

This book provides readers with the skills necessary to iden- tify companies that are simply papering over their financial per- formance and economic health problems. Chapter 2 establishes the foundation for development of these skills by answering ba- sic questions, including what financial shenanigans are and where they are most likely to occur.

What Are Financial Shenanigans? Financial shenanigans are actions taken by management that mis- lead investors about a company’s financial performance or eco- nomic health. As a result, investors are often tricked into believing that a company’s earnings are stronger, its cash flows more ro- bust, and its Balance Sheet position more secure than are really the case.

Some shenanigans can be detected in the numbers presented by carefully reading a company’s Balance Sheet, Statement of In- come, and Statement of Cash Flows. Proof of other shenanigans might not be explicitly provided in the numbers and therefore requires scrutinizing the narratives contained in footnotes, quar- terly earnings releases, and other publicly available representa- tions by management. We classify financial shenanigans into three broad groups: Earnings Manipulation Shenanigans (Part 2), Cash Flow Shenanigans (Part 3), and Key Metrics Shenanigans (Part 4).

Earnings Manipulation Shenanigans (Part 2) Investors judge corporate executives harshly when they fail to meet Wall Street’s earnings expectations when reporting each quarter. Share prices often suffer dramatic declines when disappointing earnings are reported. Not surprisingly, then, in order to steer the share price (and the executives’ compensation package) higher,

Just�Touch�Up�the�X�Rays� 25

some companies engage in a variety of shenanigans to manipulate earnings. We have identified the following seven Earnings Ma- nipulation (EM) Shenanigans that result in misrepresentations of a company’s sustainable earnings.

EM Shenanigan No. 1: Recording Revenue Too Soon EM Shenanigan No. 2: Recording Bogus Revenue EM Shenanigan No. 3: Boosting Income Using One-Time or

Unsustainable Activities EM Shenanigan No. 4: Shifting Current Expenses to a Later

Period EM Shenanigan No. 5: Employing Other Techniques to Hide

Expenses or Losses EM Shenanigan No. 6: Shifting Current Income to a Later

Period EM Shenanigan No. 7: Shifting Future Expenses to an Earlier

Period

Cash Flow Shenanigans (Part 3) The plethora of financial reporting scandals and earnings restate- ments in recent years has left many investors questioning whether reported earnings can ever be free of management manipulation. Increasingly, investors have expanded their focus to include the Statement of Cash Flows and, more specifically, the section that highlights cash flow from operations (CFFO).

Investors are beginning to harbor a troubling suspicion about corporate financial reporting: that management now plays tricks to pollute cash flow from operations. Sadly, these suspicions are well founded. Investors can no longer trust that management will report its cash flow honestly and without discretion. To help inves- tors navigate through the cash flow deception, we have identified the following four Cash Flow (CF) Shenanigans that may result in misrepresentations of a company’s ability to generate cash flow from its operations.

26� Chapter�Two

CF Shenanigan No. 1: Shifting Financing Cash Inflows to the Operating Section

CF Shenanigan No. 2: Shifting Normal Operating Cash Outflows to the Investing Section

CF Shenanigan No. 3: Inflating Operating Cash Flow Using Ac- quisitions or Disposals

CF Shenanigan No. 4: Boosting Operating Cash Flow Using Un- sustainable Activities

Key Metrics Shenanigans (Part 4) So far we have addressed shenanigans that investors can generally identify by a careful reading of the numbers in the financial reports. Management, naturally, faces some restrictions under the account- ing rules (called GAAP, or generally accepted accounting prin- ciples) on how it presents financial results to investors. To bypass many such restrictions and put on a positive spin, management has become more active and deceptive in creating and manipulating key non-GAAP metrics to impress investors. Such financial report- ing misrepresentations tend to improperly highlight strong or con- sistent growth and robust health. Part 4 introduces two categories of Key Metrics (KM) Shenanigans.

KM Shenanigan No. 1: Showcasing Misleading Metrics That Overstate Performance

KM Shenanigan No. 2: Distorting Balance Sheet Metrics to Avoid Showing Deterioration

Using a Holistic Approach to Detect Financial Shenanigans Importance of “Checks and Balances” What began in June 1972 as a bungled burglary of the Demo- cratic National Committee office located in the Watergate Hotel in Washington culminated in the unprecedented resignation of a

Just�Touch�Up�the�X�Rays� 27

U.S. president in August 1974. The fact that President Nixon was driven out of office confirmed that our system of checks and bal- ances really does work. Both the judicial and legislative branches played important roles in stopping a chief executive who abused his constitutional powers. The Supreme Court ruled unanimously that President Nixon could not plead executive privilege to prevent investigators from gaining access to White House tapes that were believed to contain damaging evidence, and the Judiciary Com- mittee of the House of Representatives recommended impeach- ment to the full House. Facing the likely prospect of losing the impeachment votes in the House and the Senate, Nixon resigned the presidency.

More recently, in 1999, President Bill Clinton brought the execu- tive office to the brink with another constitutional crisis over poor presidential behavior. The House of Representatives voted to im- peach Clinton for lying under oath about his relations with a White House intern, stating that the president “willfully corrupted and manipulated the judicial process of the United States for his per- sonal gain and exoneration.” However, with Supreme Court Chief Justice William Rehnquist presiding, the Senate had trouble finding an impeachable offense under “high crimes and misdemeanors,” and Clinton was found not guilty.

Whether the goal is preserving a democracy or upholding the integrity of financial reporting, a system of checks and balances is paramount for preventing, uncovering, and punishing im- proper behavior. And much like the U.S. government, financial reporting has three separate “branches”: a Statement of Income, a Statement of Cash Flows, and a Balance Sheet. When one of these financial statements contains shenanigans, warning signs generally appear on the other ones. Thus, Earnings Manipu- lation tricks can often be detected indirectly through unusual patterns on the Balance Sheet and the Statement of Cash Flows. Similarly, deciphering certain changes on the Statement of In- come and the Balance Sheet often can help investors sniff out Cash Flow Shenanigans. (Part 5, “Putting It All Together,” sum- marizes how various checks and balances could have helped investors detect many of the shenanigans illustrated in this book.)

28� Chapter�Two

What Environment Breeds Shenanigans? Clearly, not all companies use tricks in reporting to investors. In- deed, we believe that the vast majority of companies report hon- estly. Nevertheless, when researching companies, investors must always be vigilant and actively search for warning signs of prob- lems, since shenanigans occur with sufficient frequency and cause significant pain if left undetected.

Companies with structural weaknesses or inadequate oversight provide a fertile breeding ground for shenanigans. Investors should probe a company’s governance and oversight by asking these ba- sic questions: (1) Do appropriate checks and balances exist among senior executives to snuff out corporate misdeeds? (2) Do outside members of the board play a meaningful role in protecting investors from greedy, misguided, or incompetent management? (3) Do the auditors possess the independence, knowledge, and determination to protect investors when management acts inappropriately? and (4) Has the company improperly taken circuitous steps to avoid regulatory scrutiny?

Let’s assume that a deceitful management team wishes to raise capital and prepares misleadingly glowing financial reports with inflated profits intended to trick investors. To successfully dupe investors, corporate management often tries to avoid unnecessary scrutiny and remain below the radar. Such management will create an organizational structure that avoids unwanted scrutiny by other corporate executives, board members, auditors, and regulators, who typically must sign off on offerings sold to investors. Here are some important red flags.

Management Teams Devoid of Checks and Balances In the best companies, senior executives can freely criticize and disagree with one another—sort of like a good marriage. In unde- sirable companies, a single dictatorial leader runs roughshod over the others—not unlike a bad marriage. Investors face great risks if that dictatorial leader is also bent on creating misleading financial reports. Who can stop him when a culture of fear and intimida- tion exists? (No marriage analogies here, as our wives will be read- ing this book.) It is important for investors that sufficient checks

Just�Touch�Up�the�X�Rays� 29

and balances exist among senior management to prevent bad behavior.

Be Alert for Companies That Lack Checks and Balances Among Management. Investors are best served when the senior man- agement team includes strong, confident, and (hopefully) ethical members who will thwart a dishonest CEO or CFO and report im- proper behavior to the board of directors and the auditor. Too of- ten, though, financial shenanigans arise when no such checks and balances exist. For example, an organizational structure in which a small group of family and friends hold key executive positions may embolden management to engage in financial reporting trickery. Additionally, a powerful and bullying CEO, such as Sunbeam’s Al Dunlap or HealthSouth’s Richard Scrushy, along with weak com- plicit or conflicted underlings, raises the risk profile for investors.

Be Particularly Alert When a Single Family Dominates Management and the Board. You would have to search long and hard to find a public company with weaker checks and balances than Adelphia Communications. Members of founder John Rigas’s family made up a majority of the executive office and the board of directors, and they held a large percentage of the voting shares. Table 2-1 shows the family players, their roles, and the incestuous nature of the management team and the board.

Not surprisingly, this family management team was at the helm as a massive fraud that looted Adelphia and its investors of hun- dreds of millions of dollars was perpetrated. Today, John Rigas, leader of the clan, and his dutiful CFO son Tim are behind bars and will remain so for many years.

Table�2-1.� Adelphia:�The�Rigas�Family�Business

The Player The Role The Relationship

John Rigas Founder, chairman, and CEO Pops Tim Rigas CFO and board member Son Michael Rigas EVP and board member Son James Rigas EVP and board member Son Peter Venetis Board member Son-in-law

30� Chapter�Two

Tip: An incestuous family-dominated company with weak checks and balances may be acting entirely properly, but don’t count on it. Without independent checks and balances within the management ranks and on the board of directors, the risk for investors grows materially.

Watch for Senior Executives Who Push for Winning at All Costs. HealthSouth CEO Richard Scrushy was renowned for pushing hard to meet or beat Wall Street estimates. Such a “win at all costs” culture can lead to aggressive accounting practices and, in some cases, fraud- ulent reporting. The Securities and Exchange Commission’s (SEC) description of what went on behind closed doors at HealthSouth (HRC) reveals much about the culture of fear and intimidation:

If HRC’s actual results fell short of expectations, Scrushy would tell HRC’s management to “fix it” by recording false earnings on HRC’s accounting records to make up the shortfall. HRC’s se- nior accounting personnel then convened a meeting to “fix” the earnings shortfall. By 1997, the attendees referred to these meet- ings as “family meetings” and referred to themselves as “family members.” At these meetings, HRC’s senior accounting personnel discussed what false accounting entries could be made and recorded to inflate reported earnings to match Wall Street analysts’ expectations. [Italics added for emphasis.]

Be Skeptical of Boastful or Promotional Management.  Inves- tors should be particularly careful when a management publicly boasts about its long consecutive streak of meeting or exceeding Wall Street’s expectations. Invariably, tough times or speed bumps emerge, and such a management may feel pressured to use ac- counting gimmicks and perhaps fraud to keep the streak alive, rather than announcing that its run of success has ended. This was certainly the case at Symbol Technologies and its 32-consecutive- quarter “winning streak” that we discussed in the previous chapter. Companies engaged in many other blockbuster frauds had similar winning streaks, including supermarket giant Royal Ahold, auto parts maker Delphi Corporation, industrial conglomerate General Electric Company, and doughnut shop Krispy Kreme Doughnuts Inc. Royal Ahold, one of Europe’s largest frauds, enjoyed boasting about its streak on its earnings calls with investors:

Just�Touch�Up�the�X�Rays� 31

This is the thirteenth consecutive year in which our net earnings have grown significantly. Ahold has always met or exceeded expectations during this 13-year period and we intend to continue to do so. [Italics added for emphasis.]

Warning Sign: An extended streak of meeting or beating Wall Street expectations.

Boards Lacking Competence or Independence It may be the best part-time job in the world. Sitting as an outside director on a corporate board brings prestige, perks, and a nice paycheck, with cash and noncash compensation often exceeding $200,000 per year.

While we know that this situation works out just fine for the lucky directors, often it is less clear whether investors receive the necessary and expected protection from these fiduciaries. Investors must evaluate board members on two levels: (1) do they belong on the board, and are they qualified for the committees on which they sit (e.g., audit or compensation), and (2) are they appropriately per- forming their duties to protect investors?

Inappropriate or Inadequately Prepared Board Members Baseball fans surely remember longtime Los Angeles Dodgers manager and later corporate pitchman Tommy Lasorda. For sure, Tommy possessed talent on the baseball diamond and a person- ality and charisma that helped companies hawk their products. But as a board member for publicly traded Lone Star Steakhouse, Tommy may have been out of his league. While his seven decades in baseball are quite impressive, they probably did not provide him with strong financial analysis skills. Worse yet, former Heisman Award–winning running back and National Football League grid- iron great (and later convicted felon) O. J. Simpson was assigned the duty of faithfully protecting investors’ interests by serving on the audit committee of Infinity Broadcasting in the 1990s. It’s difficult to imagine O. J. navigating his way through the intricacies of a Bal- ance Sheet, let alone overseeing financial reporting and disclosure. Investors should ensure that outside board members have the es- sential skills and serve only on appropriate committees that suit their technical skills.

32� Chapter�Two

Failure to Challenge Management on Related-Party Transactions Management at India’s information technology giant Satyam de- cided to make an acquisition in 2008 that needed board approval. The board met and acquiesced to management’s request, despite the fact that the CEO’s sons controlled the target company. Specifi- cally, Satyam’s board approved the recommendation to invest $1.6 billion for 100 percent of Maytas Properties and 51 percent of May- tas Infrastructure. (The word Maytas is Satyam spelled backward— another clue for all you Sherlock Holmeses about the related-party nature of the deal.)

The board should have raised objections not only because of the related-party nature of the acquisition, but also because it made little sense. Any Satyam director should have been puzzled that the company was proposing to invest $1.6 billion in related-party real estate ventures at a time when its core business was under pressure and additional investments should have been poured into staving off the competition.

While the board agreed to the acquisition, it was aborted the next day after an investor uproar. Satyam’s CEO later told authorities that the deal was the last attempt to replace Satyam’s fictitious as- sets with real ones. A sign of a healthy and effective board is when a dissenting view overturns a management-driven consensus. That clearly did not happen at Satyam.

The “SportS IlluStrated Jinx” equivalenT for inveSTorS

The Sports Illustrated Jinx is a myth that states that individuals or teams that appear on the cover of Sports Illustrated magazine are tempting fate and will soon experience bad luck.

It seems that there are similar “indicators of doom” in the corporate world for accolades given to public companies and their executives. Exhibit A: Ernst & Young’s prestigious En- trepreneur of the Year award for 2007 was given to Satyam’s CEO, Ramalinga Raju (currently in jail). Exhibit B: Recipients of CFO magazine’s respected Excellence Awards include the 1998 winner, WorldCom’s Scott Sullivan (currently in jail); the 1999 winner, Enron’s Andrew Fastow (currently in jail); and the 2000 winner, Tyco’s Mark Swartz (currently in jail).

Just�Touch�Up�the�X�Rays� 33

Failure to Challenge Management on Inappropriate Compensation Plans Setting appropriate compensation falls squarely on the shoulders of outside directors, specifically those who serve on the compensation committee. Management may propose some outlandish scheme that inappropriately rewards executives far beyond reason. For example, in the mid-1990s, Computer Associates instituted a plan that later paid senior executives more than $1 billion in additional stock as a reward for keeping the stock price above a designated threshold for a 30-day period. Shockingly, the board went along with this excessive compensation plan.

Even more outrageous than the Computer Associates scheme was another compensation-related swindle that ripped off millions of investors in many different companies: the options backdating scandal. Hundreds of companies played this game, which was ac- tually quite simple: the companies would grant stock options to ex- ecutives and other employees, and “backdate” the options to reflect a price that was much lower than the one on the date the options were granted. As a result, employees received substantial unre- corded and undisclosed compensation in the form of bogus stock price gains. (We discuss the audacious option backdating scandal more completely in Chapter 7.)

When evaluating outside directors, investors must always ask whose interests they are favoring—management’s or investors’. In- vestors should also always question compensation plans that could easily be abused to improperly inflate executives’ wallets.

Need for Outside Directors to Avoid Inappropriate Actions That Lessen Their Independence In addition to being engaged and challenging management over acquisition decisions, outside directors should refrain from any conflicting activities. For example, receiving loans or being per- mitted to purchase products from the company for less than the market price would be inappropriate. Moreover, even receiving remuneration for providing professional services to the company would cloud an outside director’s objectivity and appearance of independence.

Consider the relationship between Satyam and one of its independent directors, Professor Krishna Palepu of Harvard University. Palepu, a Satyam director since 2003, is considered

34� Chapter�Two

a leading authority on corporate governance. Among the execu- tive education programs he has taught is Audit Committees in a New Era of Governance. He also co-led Harvard’s Corporate Governance, Leadership, and Values initiative, launched in re- sponse to the recent wave of corporate scandals and governance failures.

Professor Palepu seemed to have had a lapse in good governance judgment. While serving on Satyam’s board, he also accepted “spe- cial remuneration” of nearly $200,000 in 2007 for providing profes- sional services. While we are not questioning either the quality of the professor’s services or the fairness of the amount of remunera- tion received, it is hard to see how Palepu can be considered “in- dependent.” We believe that independent directors should not be involved in such related-party arrangements, as they may impair their objectivity and the appearance of independence on important decisions.

In December 2008, Satyam’s board approved the related-party Maytas acquisition described earlier. Shortly thereafter, Palepu re- signed as a director along with several other board members. Just nine days later, Satyam’s massive fraud was publicly revealed. Palepu stated that he learned about the fraud only after resigning from the board.

Auditor Lacking Objectivity and the Appearance of Independence The independent auditor plays a crucial role in protecting inves- tors from dishonest management and an indifferent and ineffec- tive board of directors. Chaos would ensue if investors ever came to question the competence or integrity of the independent audi- tors. That is indeed exactly what happened in 2002 after Enron and WorldCom collapsed, Arthur Andersen disbanded, and the finan- cial markets nosedived.

The auditor, however, can be either a friend or a foe of investors: a friend if the auditor is competent, independent, and fastidious in sniffing out problems; a foe if he is incompetent, lazy, or a rub- ber stamp for management. Sometimes the very high fees and close personal relationships built up over years lead to botched audits

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and big losses for investors. Here are the key factors to consider when evaluating in which camp the auditor actually falls—friend or foe.

Astronomical Fees Lead to a Conflicted Independent Auditor Arthur Andersen, with its 85,000 employees in 84 countries, gener- ated $9 billion in revenue in 2001, the year Enron collapsed and declared bankruptcy. Arthur Andersen had served as Enron’s sole auditor for 16 years, also performing internal audits and provid- ing consulting services. According to Enron’s SEC filings, Arthur Andersen earned a whopping $52 million ($25 million for audit and $27 million for nonaudit services) in 2000.

As the investigation into the auditors’ role in the Enron collapse proceeded, Arthur Andersen fired its lead audit partner for Enron, David Duncan, after learning that he had destroyed documents from the audit file. Subsequently, a federal jury convicted Arthur Andersen of destroying Enron-related materials to impede an in- vestigation by securities regulators. It vowed to appeal, but before the appeal and its subsequent exoneration, Arthur Andersen ceased auditing public companies and disbanded.

Too Long and Close a Relationship Prevents a Fresh Look at the Picture The fraud and collapse of Parmalat, the Italian dairy behemoth, has been referred to as the “European Enron.” While the businesses and accounting issues differ, both Enron and Parmalat had one obvious similarity: independent auditors missed the fraud.

One intriguing fact in this case concerns Parmalat’s change in primary auditors from Grant Thornton to Deloitte & Touche. In- deed, Parmalat’s chicanery might have continued longer had it not been for an Italian law that requires companies to switch audit firms every nine years. Deloitte & Touche replaced auditor Grant Thornton in 1999 and may have been the first to scrutinize certain nonexistent offshore accounts (many of which were still audited by Grant Thornton, as they were not subject to Italian law). As a result, fraudulent offshore entities were exposed, including Bonlat, a Cay- man Islands subsidiary of Parmalat and one of the primary vehicles used to hide fake assets.

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inveSTorS Should demand audiTor roTaTion every feW yearS

The fact that Italian regulations concerning auditor change pre- cipitated the discovery of the Parmalat fraud lends strength to the argument that this type of policy should be more broadly implemented. Auditor term limits were nearly included in the Sarbanes-Oxley legislation, but they were ultimately excluded in favor of rotating audit partners within the same accounting firm. In light of Parmalat’s crimes, risk managers might wonder if Sarbanes-Oxley is missing a very important component, given that auditor complacency or collusion may contribute to inap- propriate financial reporting.

Opponents of auditor limits point to the benefits of having a long-term relationship with an auditor who knows the com- pany’s business, but Parmalat has shown that such a relation- ship can breed complacency and that an auditor may overlook or encourage behavior (either by design or by accident) that can prove fatal to the business.

Like Parmalat, the biggest recent accounting fraud to hit Japan went undetected for far too long because the auditor had too long and cushy a relationship with company management. Kanebo, a cosmetic and textile company, had been audited by an affiliate of PricewaterhouseCoopers for at least 30 years. When one of the com- pany’s consolidated subsidiaries hit a very bad stretch, the auditors allegedly advised management to reduce its shareholding in the subsidiary and deconsolidate it. The auditors also allegedly turned a blind eye to the booking of fictitious sales to pad the revenue numbers during slack periods. Kanebo reported about $2 billion in nonexistent profits from 1996 to 2004. The regulators were so in- censed with the treacherous behavior of the auditors that they im- mediately brought legal action against these auditors and imposed a two-month business suspension.

Incompetent Auditors Can Serve as Shills for Management As you have no doubt seen from these vignettes, financial she- nanigans and audit failures are not just an American affliction.

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The United States gave the world Enron and WorldCom and the meager effort by the auditor of both companies, Arthur Andersen; Italy’s contribution was Parmalat and its auditors Grant Thornton and Deloitte & Touche; and Japan’s gift to investors was Kanebo and the compliant work of auditor PricewaterhouseCoopers. And the most recent entrant to the “Hall of Shame,” India’s contribu- tion, Satyam, provides another wonderful effort by Pricewater- houseCoopers.

Satyam ironically means “truth” in Sanskrit. But with CEO Ramalinga Raju’s admission of the company’s bald-faced lies to in- vestors for years, maybe he was a bit confused when he selected the company name. Perhaps he really had planned to use the more apt Sanskrit name Asatyam, meaning “untruth.”

PricewaterhouseCoopers, which had been Satyam’s auditor since 1991, failed to detect inflated cash and bank balances on the order of over $1 billion, according to Raju’s own confession. Current allega- tions claim collusion between Satyam and its auditor. According to a member who joined Satyam’s board after the scandal broke out, the documents were “obvious forgeries” and would have been vis- ible as such to anyone.

Management Schemes to Avoid Regulatory Scrutiny As we pointed out, shenanigans tend to breed freely in environ- ments in which no checks and balances exist among senior man- agement, when the outside board of directors lacks the skills and the desire to protect investors, and when the auditors fail to de- tect signs of problems. One other substantial line of defense for investors exists in the form of regulators. In the United States, the SEC oversees setting reporting requirements and reviews their content. If the reports don’t pass muster, the SEC can pre- vent the securities from being issued or suspend any future stock trades.

While the SEC has mostly served investors well over the years, it has occasionally failed to catch serious reporting infractions. For this it deserves some criticism. Moreover, some companies truly go out of their way to avoid SEC reviews and scrutiny. The following section shows just how this is done and when investors should be especially cautious.

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Lack of Usual Regulatory Scrutiny before Going Public If management really wants to avoid serious scrutiny from SEC reviewers, it will first sidestep the normal registration process for an initial public offering (IPO) by merging into an already- public company. This is a backdoor approach to becoming a pub- lic company and avoiding the typical detailed review that is part of the normal IPO process. Thus, investors should be particularly wary of companies that avoid SEC review by merging into a “shell company” using either a reverse merger or a “special-purpose ac- quisition company” partner and immediately becoming a public company.

Techniques to Detect Investment Manager Shenanigans Clients of Bernie Madoff’s investment firm were shocked and sad- dened to learn in early December 2008 that they had been the vic- tims of a Ponzi scheme and that their investment account balances were completely wiped out. Madoff had a sterling reputation as a money manager for delivering consistently strong returns, and for years investors had poured tens of billions of dollars into his coffers, only to learn later that the funds were used to support a Ponzi scheme in which early investors were paid back with later investors’ funds. In June 2009, Madoff was sentenced to a 150-year prison term after acknowledging the fraud and asserting that he had acted alone.

While this book mainly addresses the analysis of financial re- ports of public companies (rather than detecting crooked money managers), it teaches investors how to analyze companies, in- cluding a privately held investment firm like Bernard L. Madoff Investment Securities. In evaluating any company, a stakeholder should (1) understand the nature of the business and assess whether the numbers make sense, (2) assess the competence and ethics of management, and (3) evaluate the adequacy of checks and balances.

Understand the Business to Assess whether the Numbers Make Sense Two glaring warning signs would emerge in evaluating the key numbers related to Madoff’s business, investment returns and fees

Just�Touch�Up�the�X�Rays� 39

charged to investors. First, monthly investment returns seemed un- usually consistent over many years. Despite volatile bull and bear markets over these years, Madoff rarely reported a monthly loss— an illogical and impossible feat. Legitimate investment managers generate uneven returns, with certain periods of outperformance and others of underperformance.

Second, the fees typically charged to investors like Madoff’s in- clude a management fee (1 to 2 percent of assets managed) and, for hedge funds, an incentive payment based on positive returns (as much as 20 percent). Curiously, Madoff charged investors neither fee. Instead, he apparently was happy to receive only the puny brokerage commission of a few cents per share trading securities in the customers’ accounts. On the face of it, investors should know that there is “no free lunch.” Madoff lured investors to come in droves and keep funds with him by reporting con- sistently strong returns and charging customers virtually noth- ing. Remember the adage about something that seems “too good to be true”? Investors should know that they should never give an investment manager their money when the manager’s perfor- mance looks too good to be true. Madoff’s investors should have understood that an equity investment with no volatility in per- formance and no management or other fees made absolutely no sense.

Assess the Competence and Ethics of Management As discussed earlier in the chapter, structural weaknesses or inade- quate oversight provide a fertile breeding ground for shenanigans. Like Adelphia’s family business, Bernard Madoff’s investment firm included many family members in the executive office. Specifically, Madoff’s brother, two sons, and a niece held key management roles at the firm. Such an environment clearly represents a potential breeding ground for bad behavior and should be looked at with a skeptical eye by any potential investor.

Moreover, whenever someone boasts about being highly ethical, investors should be put off and do further investigation. Ethical people rarely brag about such virtues, as it is unbecoming and in- appropriate; others should reserve judgment on who acts honor- ably. Consider the following boastful passage found on the Madoff Web site.

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Clients know that Bernard Madoff has a personal interest in maintaining the unblemished record of value, fair dealing and high ethical standards that has always been the firm’s hallmark.

Evaluate the Adequacy of Checks and Balances Investors should also expect their money managers to have other checks and balances in place, such as competent independent au- ditors and third-party bank or brokerage custodians to safeguard their assets. For Madoff investors, it seems that neither of these safeguards existed. For one thing, Madoff’s independent auditor, Friehling & Horowitz, was a tiny unknown shop, which certainly should have seemed odd given the size of Madoff’s investment funds. The SEC charged this auditor with helping to enable Madoff’s fraud by, among other things, pretending to conduct an audit on Madoff’s investment firm and signing off on Madoff’s financial statements as if it had done so. Another obvious warning sign for Madoff investors was the absence of a third-party custo- dian to safeguard cash and securities for the investors to prevent theft. Without such an intermediary, investors have no indepen- dent assurance that the assets actually exist. A word of caution to any investor who outsources money to an investment manager— always require a third-party custodian to handle your money.

Looking Back

Warning Signs: Breeding Ground for Shenanigans

Absence of checks and balances among senior management

An extended streak of meeting or beating Wall Street expectations

A single family dominating management, ownership, or the board of directors

Presence of related-party transactions

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An inappropriate compensation structure that encourages ag- gressive financial reporting

Inappropriate members placed on the board of directors

Inappropriate business relationships between the company and board members

An unqualified auditing firm

An auditor lacking objectivity and the appearance of independence

Attempts by management to avoid regulatory or legal scrutiny

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Looking Ahead Now you are ready to jump in and learn about the three catego- ries of Financial Shenanigans: Earnings Manipulation (Part 2), Cash Flow (Part 3), and Key Metrics (Part 4).

Earnings Manipulation (EM) Shenanigans highlight tricks used by management to inflate or smooth out earnings and portray a healthy company with predictable profits. Each of the seven EM Shenanigans we have identified is discussed in the next part, so please turn the page to begin the lesson.

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part two Earnings

Manipulation Shenanigans

Investors rely on the information that they receive from corporate executives to make informed and rational securities selection de- cisions. This information is assumed to be accurate, whether the news is good or bad. While most corporate executives respect in- vestors and their needs, some dishonest ones hurt investors by mis- representing the actual company performance and manipulating the company’s declared earnings. Part 2 fleshes out the seven most common Earnings Manipulation (EM) Shenanigans and suggests how skeptical investors can ferret out these tricks to avoid losses.

Earnings Manipulation Shenanigans

Chapter 3 EM No. 1: Recording Revenue Too Soon Chapter 4 EM No. 2: Recording Bogus Revenue Chapter 5 EM No. 3: Boosting Income Using One-Time or Un-

sustainable Activities Chapter 6 EM No. 4: Shifting Current Expenses to a Later

Period

Chapter 7 EM No. 5: Employing Other Techniques to Hide Ex- penses or Losses

Chapter 8 EM No. 6: Shifting Current Income to a Later Period Chapter 9 EM No. 7: Shifting Future Expenses to an Earlier

Period

Management may use a variety of techniques to give investors the mistaken impression that its company is performing better than the underlying economic reality. We have categorized all of these earnings manipulation tricks into two major subgroups: inflating current-period earnings and inflating future-period earnings.

Inflating Current-Period Earnings Quite simply, in order to inflate current-period earnings, manage- ment must either push more revenue or gains into the current pe- riod or shift expenses to a later one. Shenanigans No. 1, 2, and 3 push revenue or one-time gains into current-period operations, and No. 4 and 5 shift expenses to a later period.

Inflating Future-Period Earnings Conversely, to inflate tomorrow’s operations, management would simply hold back today’s revenue or gains and accelerate tomor- row’s expenses or losses into the current period. Shenanigan No. 6 describes techniques to improperly hold back revenue, and She- nanigan No. 7 accelerates expenses into an incorrect earlier period.

Earnings can be improperly inflated by inappropriately including revenues or gains and by excluding rightful expenses or losses of that period. Conversely, earnings can be improperly deflated by in- appropriately excluding revenues or gains of that period and by including expenses or losses that really pertain to another period. Of course, when management deflates current-period earnings, it plans to “release” those pent-up earnings into another (and more advantageous) period.

Of the seven Earnings Manipulation Shenanigans identified to distort earnings, the first five inflate earnings, and the last two de-

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flate them. For most readers, the desire to use Shenanigans No. 1 through 5 to exaggerate earnings might seem logical or intuitive. After all, higher reported profits often lead to a higher stock price and higher executive compensation. The logic of using Shenanigans No. 6 and 7 may be less intuitive in that a company that chooses to report less than its actual profits does not stand to gain any sort of obvious advantage. Management’s scheme, quite simply, would be to shift earnings from one period (with excess profits) to another (in need of profits). Alternatively, management may simply be at- tempting to smooth out volatile earnings in order to portray a more steady business.

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3 Earnings

Manipulation Shenanigan No. 1:

Recording Revenue Too Soon

Thirty days has September, April, June, and November; Of twenty-eight there is but one, And all the rest have thirty-one. —A modern version of the fifteenth-century medieval British rhyme

As young children, many of us were taught this useful rhyme by parents and teachers to help us remember the number of days in each month. Frankly, it still comes in handy as a reminder well into our adult years. Only fairly recently did we learn that February was not necessarily the only exception to the 30- or 31-day rule. In fact, every month could be the exception for companies that wish to inflate their revenue. Computer Associates has become the poster child for this revenue inflation trick, regularly stretching out its

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months to 35 days on the books. That scheme worked well for a while—or at least until the company was caught and CEO Sanjay Kumar was sent to jail.

Stretching out the number of days in a month is but one of the creative techniques that management may use to improperly record revenue too early. Chapter 3 describes a variety of ways in which management attempts to accelerate revenue to earlier periods and how investors can spot signs of this transgression.

Techniques to Record Revenue Too Soon

1. Recording Revenue Before Completing Any Obligations un- der the Contract

2. Recording Revenue Far in Excess of Work Completed on the Contract

3. Recording Revenue Before the Buyer’s Final Acceptance of the Product

4. Recording Revenue When the Buyer’s Payment Remains Un- certain or Unnecessary

1. Recording Revenue Before Completing Any Obligations under the Contract Some companies go to great lengths to record sales before the clock strikes midnight on the last day of the quarter. Sometimes they get creative in how they mark the quarter’s end and push a future pe- riod’s sale into the current period.

Computer Associates and the Endless Month Executives at Computer Associates regularly stretched out the last month of the quarter to as much as 35 days and both backdated and forged sales contracts to trick their auditor and their investors into believing the company’s fictitious sales growth.

But, Boy, Did They Have a Billion Good Reasons.� What may have led management to embark with such great zeal on pushing sales

Earnings�Manipulation�Shenanigan�No.�1� 49

and Computer Associates’ stock price higher and higher? The obvi- ous answer would be oversized bonuses and stock options; how- ever, the extent of this compensation defies the imagination. Let’s go back to the terms of the company’s 1995 Key Employee Stock Ownership Plan (KESOP), which would reward Computer Associ- ates’ top three executives with millions of additional shares if the share price reached certain levels and remained above those levels for at least 30 consecutive days.

The August 1995 plan initially authorized the grant of up to 6 million shares to three senior executives: Chief Executive Of- ficer Charles Wang (60 percent), Chief Operating Officer Sanjay Kumar (30 percent), and Executive Vice President Russell Artzt (10 percent). After a certain amount of time (and a certain num- ber of stock splits), more than 20 million shares were actually issued. Then finally it happened—drum roll, please! On one not-so-ordinary day in 1998, they hit the $1.1 billion jackpot when the company’s share price closed at just over $55, with Wang receiving 12.15 million shares, Kumar 6.075 million, and Artzt 2.025 million (worth $669.8, $334.9, and $111.6 million, respectively).

But They Must Have Done an Unbelievable Job.  Well, not really. The price did appreciate significantly, but remember that this oc- curred within the great bull market of the late 1990s. From the date of the plan in 1995, the annual return looked impressive; however, the appreciation was not much greater than that of the S&P 500 during this raging bull market. Good results, sure, but certainly not All Star or Hall of Fame worthy. Oh, and one other small point—the results were achieved through cheating!

Let’s go back to the terms of this bizarre plan. If management can figure out a way to produce good news so that the stock price jumps to the designated level and remains at that new higher level for a month, the house pays out. In the end, these execu- tives split more than a billion dollars in bonuses. If investors had read about the bizarre arrangement in the 1995 Securities and Exchange Commission (SEC) filing, they surely would have realized that temptation existed for the company to use every trick in the book to manipulate earnings and inflate the stock price.

50� Chapter�Three

Accounting Capsule: Revenue Recognition

According to accounting guidelines, four conditions must be met in order for revenue to be recognized: (1) evidence of an arrangement exists, (2) delivery of the product or service has occurred, (3) the price is fixed or determinable, and (4) the col- lectibility of the proceeds is reasonably assured. Failure to meet any one of these conditions requires deferral of revenue until all requirements have been satisfied.

Be Wary of Companies That Extend Their Quarter End Date. Not surprisingly, Computer Associates was not alone in improperly accelerating revenue by stretching its quarter end date. During the mid-1990s, “Chainsaw Al” Dunlap and his minions at Sunbeam changed the company’s quarter end from March 29 to March 31 to make up for a revenue shortfall. The two additional days per- mitted Sunbeam to record another $5 million in sales from its operations and $15 million from the newly acquired Coleman Corporation.

Not to be outdone by Computer Associates and Sunbeam, San Diego–based software maker Peregrine also routinely kept its books open well after the official quarter ended. The practice became so common at the company that officers joked about this ploy, char- acterizing these late transactions as having been completed on “the thirty-seventh of December.”

2. Recording Revenue Far in Excess of Work Completed on the Contract The first technique reveals how companies improperly recognize revenue before the sale even happens. Next, we discuss revenue recognition in situations in which the seller has started to deliver on the contract; however, management records a far greater amount than is warranted. Our friends at Computer Associates were savvy at playing both tricks. Not only did the company extend its quarter to capture more revenue, but it also pulled forward license sales that would not actually be earned for many years to come.

Earnings�Manipulation�Shenanigan�No.�1� 51

Up-Front Recognition of a Long-Term License Contract Computer Associates sold long-term licenses allowing customers to use its mainframe computer software. Customers paid an up- front licensing fee for the software, as well as an annual charge to renew the license in subsequent years. Despite the long-term nature of these agreements (some contracts lasted as long as seven years), the company would recognize the present value of all li- censing revenue for the entire contract immediately. Since all li- censing revenue was recorded at the beginning of the contract, and cash was not collected for many years to come, Computer Associ- ates recorded large amounts of long-term receivables on its Bal- ance Sheet.

A November 1998 report by the Center for Financial Research and Analysis (CFRA) disagreed with Computer Associates manage- ment and deemed it aggressive for a company to record all this revenue up front. Economic reality dictates that revenue should be deferred until the billing period for each installment sale.

RED  FLAG! A sharp jump in accounts receivable, especially long-term and unbilled ones.

Regulators Also Strongly Disagreed with the Approach. The SEC charged that from at least January 1998 through October 2000, Computer Associates prematurely recognized over $3.3 billion in revenue from at least 363 software contracts with customers.

Computer Associates’ bulging long-term receivables should have alerted investors to the company’s aggressive revenue recog- nition. The CFRA report highlighted the firm’s surging long-term and total receivables at September 1998. Investors should use a measure called days’ sales outstanding (DSO) to evaluate whether customers are paying their bills on time. A higher DSO could in- dicate aggressive revenue recognition in addition to simply poor cash management. With the company’s long-term installment re- ceivables soaring at September 1998, its DSO reached an unsettling 247 days (based on product revenue)—a year-over-year increase of 20 days. Furthermore, total receivables, including both current and long-term, increased to 342 days—a jump of 31 days.

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Accounting Capsule: Days’ Sales Outstanding (DSO)

Days’ sales outstanding (DSO) is generally calculated as follows:

Ending receivables/revenue × number of days in the period (for quarterly periods, 91.25 days is a normal approximation)

Since DSO is a metric outside of generally accepted account- ing principles, companies may present their DSO calculated in a different way (for example, by using average receivables instead of the ending balance). However, for financial shenanigan detec- tion purposes, we advise using our calculation. We will discuss DSO in greater detail, including its uses and abuses by manage- ment, in Part 4, “Key Metrics Shenanigans.”

Changing the Revenue Recognition Policy to Record Revenue Sooner Like Computer Associates, software maker Transaction Systems Architects, Inc., jump-started its sluggish revenue growth by shift- ing future-period sales into earlier periods. Reported sales growth in 1999 excited investors; however, several cautionary signs were emerging. The company changed its revenue recognition policy to record the entire value of five-year customer contracts up front, as compared to its previous approach of spreading the revenue over the five-year contract period. And, did this ever change the results.

In March 1999, Transaction Systems Architects reported a mis- leading 26 percent jump in license revenue and a 21 percent in- crease in total revenue, as shown in Table 3-1. Virtually all of this impressive growth, however, came from the new and more aggres- sive revenue recognition approach, according to a CFRA report. Had