Some representative examples can help illustrate some of the more common methods for managing and manufacturing earnings and manipulating stock price.
Revenue Overstatement
Certainly the most straightforward method of overstating earnings is to overstate revenue. It’s also one of the most typical financial statement fraud techniques, according to a research report issued by the Committee of Sponsoring Organizations of the Treadway Commission. The research, which set out to analyze financial fraud occurrences, found that in the companies studied, more than half of the frauds involved overstating revenues by recording them prematurely or fictitiously. This practice comes in several forms.
Timing of revenue recognition. The simplest way to goose earnings is to allot revenues to a given quarter even though they were not made during that period. Sensormatic Electronics, a security system manufacturer, provides a startlingly simple example. According to an August 1998 report in USA Today, on the last day of each quarter, the time clocks that stamped Sensormatic’s product shipment dates would stop at 11:45 a.m. The company continued making and shipping product, however, until they had reached their quarterly earnings targets. Then the clocks would start up again. In March 1998, Sensormatic settled fraud and false-reporting charges with the SEC, without admitting or denying any wrongdoing.
More recently, Computer Associates, a software maker based in Long Island, New York, came under investigation as a result of claims by former employees that the company routinely backdated and forward-dated customer contracts to move earnings from one quarter to the next in an effort to meet earnings targets. One former employee said, “It was a longstanding practice at CA to keep the articles open for weeks after the end of the quarter” to allow finance officials latitude to shift revenue between periods. The investigation was still ongoing as this article went to press.
Channel stuffing. Used primarily by manufacturers of tangible goods, channel stuffing essentially means flooding distributors and resellers with more product than they can or plan to sell. This boosts revenue in the current quarter by stealing it from future quarters.
One of the most benign, and perfectly legal, methods of channel stuffing is to offer customers greater incentives to order at a specific time, for example by discounting prices on larger orders or by simply discounting at the end of the month. Some channel stuffers, however, conspire with customers and distributors to take shipments of product that will never be sold in the future. After these sales have been articleed, the customer returns the unsold product to the manufacturer for a full refund. A variation on the theme: Don’t bill the customer for the goods, and then write off the receivable as a bad debt expense at some point in the future.
Sunbeam Corp., the Florida-based company once headed by “Chainsaw” Al Dunlap (who got his nickname by cutting the companies he headed to the bone), was accused of channel stuffing in 1996 and 1997. Mr. Dunlap purportedly offered substantial discounts to retailers who placed orders for goods that they would not take delivery of for several months. Many times the product never left Sunbeam’s warehouses. Mr. Dunlap was fired from the company and ordered to pay $15 million (without admitting or denying guilt) to settle investor lawsuits and SEC charges.
The Wall Street Journal reported that former executives at Bristol-Myers Squibb Co. outlined how the company used channel stuffing and other accounting tricks to boost current quarter earnings to meet financial targets. The company allegedly offered wholesalers incentives to buy more drugs than dictated by prescription demand. In the spring of 2002, Bristol-Myers admitted to the practice and, finding a scapegoat, promptly dismissed the executive in charge of the medicines group. During the year in which revenues were inflated, the former CEO sold stock from exercised options for over $70 million. Subsequently the company paid a $670 million fine to settle litigation related to illegally blocking generic competition. Both the head of research and the CFO quit.
Sportswear retailer Cutter & Buck revealed in August 2002 that it had padded sales figures in 2000 by recording $5.8 million in shipments that were mostly returned, according to the Seattle Times. The article goes on to point out that one of the cofounders of the business, Joey Rodolfo, accused the company of shipping orders months before customers were expecting to take delivery. Mr. Rodolfo made this allegation just prior to leaving the company in 1997. Some customers and former employees say early shipments continued for years after Rodolfo left. For example, one sales representative indicated that clients in Florida, Georgia, and the Carolinas received shipments of fleece garments in May, although they had ordered them for delivery the next fall.
Channel stuffing is very easy to detect. Proving that it is part of a fraudulent scheme is much more difficult. If growth in accounts receivables significantly outpaces the rate of sales growth, a good chance exists that some sort of forward sales have taken place. Of course, offering discounts on products at the end of a quarter or fiscal year is not an illegal practice. Asking clients to take delivery of products that they have every intention of never selling and are expecting to return is.
According to an October 2002 U.S. General Accounting Office report, the number of listed companies restating financial statements has increased every year since 1997.
Churning revenues. Dynegy, CMS Energy, Reliant Resources, El Paso, Duke Energy, and others have all been accused of bogus round-trip energy trades designed to boost revenues. These trades are noteworthy for several reasons. First, many of the trades involved three or more participants. In more traditional revenue cases, only two parties would be involved. They were making trades at no profit and no loss to article trading volume (revenue) at each company, making it seem that there was a lot of activity. In many of the trading cases in question, three, four, or more companies conspired to inflate the revenues of all. Second, in many of the trades, the inflated revenue did not impact earnings, but had a very material impact on cash flow, and this is an industry judged on its top-line growth. Dynegy restated its 2001 financials, reducing cash flow from operations by $300 million.
Cookie Jar Reserves
Companies may legitimately set aside monies in reserve accounts to allow for bad debts or other costs, such as restructuring charges that often occur in the operation of a business. When the company puts more money into the reserve account than it knows it will need, the money becomes “cookie jar reserves.” When the reserve is created, it is classified as a one-time, non-recurring event. The company can then dip into the overage and add it back to operating earnings in future quarters. Xerox Corporation was accused of using cookie jar reserves to appear more profitable than it really was. The company was disciplined by the SEC for manipulating earnings (using this among many other techniques) and settled with the SEC without admitting wrongdoing.
On November 4, 2002, The Asian Wall Street Journal, reported that the SEC was investigating whether Lucent intentionally overstated the size of a $2.6 billion pretax restructuring charge recorded in 1995, before its spin-off from AT&T, setting up a resere account that could be dipped into later to bolster its bottom line.
Microsoft used similar measures to understate its earnings by as much as $900 million over a four-year period, according to a June 4, 2002, report in the Washington Post. The SEC alleged that the use of the reserve accounts caused Microsoft to overstate its profits in some quarters and understate it in others. Microsoft settled by agreeing to stop the practice but did not admit or deny guilt. The SEC stated that it did not charge the company with fraud in part because the financial statements for the periods in question were more than three years old. The regulators couldn’t prove that improper articlekeeping misled investors “to their detriment.” One might interpret this to mean that they could not identify harm with respect to specific investors.
Companies can also use reserve accounts to hide ill-gotten gains. Enron, for example, used undisclosed reserves to keep as much as $1.5 billion in trading profits off its income statement during the energy crisis in California. The reserves would have doubled the company’s profits at a time when the California State and Federal governments were accusing energy companies, such as Enron, of price gouging. Enron then went on to use the huge reserves to smooth earnings reported to Wall Street and the credit rating agencies. Kenneth Lay and Jeff Skilling both claimed to know about the reserve accounts but stated the accounts were proper and used to guard against the likelihood of various California utility companies declaring bankruptcy.
Assumptions and Estimates
Another way companies can manufacture earnings is by manipulating the assumptions and estimates that are integral to earnings calculations. Often they will disclose the changes, but rarely will they explain in reasonable detail the impact that the change will have.
A company ought to consider changing estimates and assumptions based on management’s best judgment of reality. Sometimes they should be changed; at other times a change is not justifiable. These are judgment calls. Baruch Lev, an accounting professor at New York University who has testified before Congress on accounting reform, uses Cisco Systems’ bad debt reserves as an example of changing estimates and assumptions. In May 2002 the company reduced earnings by $346 million in anticipation of defaults, but it is impossible to tell if those defaults ever occurred. Actual defaults are buried in the next quarter’s reserve. Somewhat with tongue in cheek, Lev notes, “That’s the beauty of accounting. You don’t see; they don’t tell.”
Earnings assumptions and pension funds. Earnings assumptions are critical to pension fund accounting, but typically companies make very little data available to investors. A pension fund is considered to be underfunded or overfunded based on assumptions of future earnings on the stocks and bonds in the pension fund portfolio and the expected future benefits to be paid. If the fund is underfunded according to these assumptions, companies must record a liability to reflect that fact. The company can report some of the extra amount as income.
Throughout the 1990s, many companies assumed that earnings rates on pension funds would remain high or even rise. Granted, stock prices were rising, however interest rates were falling precipitously. (A significant portion of pension assets is in debt instruments.) When interest rates were at historical highs in the 1970s many pension funds purchased 30-year debt instruments with double-digit yields. Everyone knew that such yields could not be replaced in a low-interest environment using debt. However, based on the soaring equity markets, many companies not only continued to assume high earnings rates, but actually raised them and were able to report inflated earnings growth. Credit Suisse First Boston estimates that in 2000, 14 percent of reported earnings growth of the Fortune 500 came from pension income.
Rather than creating a reserve earnings bucket by accounting for operations, some companies manufacture earnings through a one-time accounting treatment for one-time events such as acquisitions. They find it relatively easy to inflate earnings and growth rates, especially in rising markets, by issuing overpriced securities while overpaying for the businesses they acquire. Revenues and earnings per share show favorable growth rates until it becomes clear that the acquirer overpaid. Management then, of course, takes a one-time write-off and repeats the cycle by doing more deals. They continue to claim high growth “from operations,” which of course is not from operations at all.
This play obviously ends as these overpayments for past deals catch up with the company. The acquirer’s share price declines to real value levels. Reported growth then decelerates rapidly because new deals cannot be completed. The alternatives then are to sell assets or to take write-offs of goodwill. As companies become very large it is increasingly difficult to maintain growth through acquisitions because they must engineer bigger and bigger deals to maintain reported growth.
Example: one large deal. One high-profile example of overpaying for a large enterprise with inflated stock is JDS Uniphase Corp., which purchased SDL, Inc. in July 2000 for $41 billion in stock, increasing JDS’s assets from $25 billion to $65 billion. The next year JDS took a one-time $50 billion write-off, decreasing its GAAP earnings by that amount, but carefully reported pro forma earnings that did not include the write-off. The company argued that the pro forma number better reflected ongoing earning power. That’s possible, but JDS Uniphase investors were diluted by $41 billion in a company that produced less than $6 billion of revenues in the previous five years. In this case, one transaction made reported earnings meaningless. An even higher-profile example would be AOL Time Warner, which in 2002 wrote off a total of $98 billion following the $106 billion merger of the two companies.
Example: many small deals. Tyco achieved similar earnings growth using many small transactions. In late December 2002, the internal investigation concluded that its acquisition binge over the previous years had not resulted in a conglomeration of synergistic high-growth businesses, as the company claimed. Based largely on acquisitions, Tyco had reported earnings growth of approximately 20 percent for most of the previous decade.
Many acquisitions were not even disclosed. In the three years prior to Tyco’s dramatic share price decline in the summer of 2002, the company completed more than 700 deals with an aggregate value in excess of $8 billion. This was not disclosed because each deal alone was deemed “not material.” An average transaction size of $11.5 million may or may not be material, but surely $8 billion is. In addition, after Tyco acquired Raychem, a large West Coast company, e-mails indicated that Tyco had asked Raychem just prior to the acquisition to accelerate payments to its suppliers to reduce cash flow so that under Tyco’s ownership cash flow would appear to accelerate. Tyco’s response to all these revelations was typical and unsatisfying: “Accounting practices were consistent with generally accepted accounting practices.”
The premiums Tyco paid for acquisitions are telling. Tyco spent an average 3.2 times revenue for companies it purchased but didn’t disclose compared to 1.6 times revenue for the larger, disclosed transactions. While smaller deals often carry slightly higher multiples of revenue, the large spread clearly implies that management was more concerned with buying revenue and not having to disclose it than with spending shareholder money wisely.
A study for the Wall Street Journal by Thomson Financial revealed that stocks of the top fifty acquirers in the late 1990s fell approximately three times as much as the Dow Jones Industrial Average. Should investors conclude that all acquisitions bode trouble? Of course not, but executives and directors certainly must bear the burden of explaining and justifying why they spend shareholder money to expand the business, especially into new businesses that weren’t part of an investor’s original “buy” calculation.
Other acquirers. There’s a long list of other very aggressive acquirers. Cisco, for example, completed more than seventy acquisition deals in the 1990s. Its stock in 2003 was down about 80 percent from its high. General Electric spent more than $18 billion in 2001 and would have spent much more if it had been allowed to complete the acquisition of Honeywell (which was vetoed by the European Commission on Competition).
A change in accounting practices does not necessarily indicate earnings manufacture, but an undisclosed accounting change that comes to light later usually does.
Vivendi Universal spent more than $100 billion on media companies and tried to unload many of them after its stock fell from $83.43 to $13.18 between June and late October 2002. Under French GAAP, the company incurred a noncash, one-time charge of 12.64 billion euros (roughly the same amount in U.S. dollars) of amortization of goodwill in certain acquired assets, including 6 billion for Canal+ and 1.3 billion for Universal Studios Group.
WorldCom’s share price declined 95 percent after the company made more than seventy acquisitions. The company’s accounting practices (among many other activities) are under investigation. WorldCom has responded to criticism saying, “The company did not rely solely on acquisitions for growth” (emphasis added).
Big Baths and Restructuring Charges
Companies take “big baths” for one of three reasons. They find themselves in a bad financial situation that they can no longer hide from investors. Or, after an outgoing CEO has pushed earnings manufacture to the limit, the new CEO needs a reserve to assure his own success (and perhaps wealth). More seriously, financial results may already be so dismal that it makes sense to take all possible write-offs to build up cookie jar reserves for the future.
In all three cases, the stock first is beaten down by the write-off, which allows options to be issued at lower prices, and then future growth is promised to make the options appreciate. The logic here is that analysts and investors are going to beat up the stock anyhow, so why not include more expenses in the charge and work off of a smaller base next year? In most cases companies do not include the write-offs in the calculation of ongoing earnings reported to investors. They label them as one-time charges and not part of core or ongoing performance.
One common example of a big bath maneuver is an inventory write-down. In late April 2001, Cisco Systems reported that it would take a huge $1 billion plus write-down, basically stating that component parts in inventory were worthless because the company couldn’t sell or use them. The write-down was considered an extraordinary, one-time item. Analysts therefore did not include the loss in earnings estimates or the valuation models that determine the price at which the company’s stock should trade. Over time, as the components are built into switches, routers, and hubs, and those goods are sold, the inventory gradually gains its value back, adding to earnings of the company.
More telling, Scott Sullivan, former CFO of WorldCom, planned to “take care of” many expenses that had been capitalized inappropriately by using a write-down of some sort. If Cynthia Cooper, vice president of internal audit, and her audit group had not uncovered the fraud, the ploy might have worked.
In the acquisitive 1990s, many companies simply paid too much for the businesses they bought. With the decline in the stock market in the early 2000s, they chose to admit tacitly that they overpaid and to write-down the difference between the purchase price and the actual or article value of the company. Investors have a limited understanding of the extent of write-offs and their impact. In 2001, for all stocks in the S&P 500, companies wrote off income equal to about 40 percent of all reported profits. Goldman Sachs estimated that write-offs for the Fortune 500 would be 60 percent of income reported in 2002, up from the 10 to 20 percent that prevailed for much of the 1990s. The average for the decade of the 1990s was around 20 percent, which means that about one-fifth of all reported profits in that ten-year period were later written off.
Glimmers of hope have begun to appear that investors will no longer tolerate this practice and that companies have realized that their integrity has suffered. Procter & Gamble announced that it would end an ongoing restructuring program it had begun in 1999. By June 2003, the company was expected to have written off as one-time restructuring charges between $3.6 billion and $3.7 billion that was previously reported as operating profit. Beginning with the next fiscal year, Procter & Gamble will charge future restructuring expenses to income, estimated at $150 million to $200 million per year.
Hiding Interest Expense
Yet another way companies increase earnings—by hiding interest payments—is to either increase the company’s financial leverage without disclosing it, or to report declining leverage when it is not actually declining. They do this most often through “special purpose subsidiaries.” The case study of Coca-Cola earlier in this chapter describes the method in detail. Like Enron, Coca-Cola held debt and articleed interest expense in nonconsolidated, but effectively controlled, companies recognizing income at the parent level. Similar to Enron, Coca-Cola not only obfuscated the level of financial risk and hid interest expense, but also inflated profits by articleing income through transfer pricing or by mispricing assets.
Capitalization of Costs
Accounting 101 teaches that capital costs, such as equipment, property, and other major purchases, can be depreciated over long periods of time. Operating costs such as salaries, benefits, and rent are subtracted from income on a quarterly basis and have an immediate impact on profits. If a company chose to capitalize an expense that was actually an operating cost, it would improve its current earnings by decreasing expenses in the current period. Generally speaking this rule leaves very little room for interpretation.
WorldCom, however, in an effort to boost flagging profits, classified certain line costs—expenses used to purchase time on communications wires—as capitalized costs, when they should have been treated them as operating expenses. When this scheme came to light, the company restated its earnings by more than $9 billion and ultimately sought Chapter 11 bankruptcy protection.
Investors have a limited understanding of the extent of write-offs and their impact. In 2001, S&P 500 companies wrote off income equal to about 40 percent of all reported profits.
Pro Forma Earnings
Pro forma earnings are a close cousin to manufactured earnings. In some instances, when pro forma earnings are carefully defined, reported consistently over time, and not as a replacement for reported GAAP earnings, they can be valuable to knowledgeable investors. On the other hand, pro forma earnings can also be used to divert investor’s attention to a different definition of earnings numbers when the opportunities for earnings manufacturing start running out and the traditional definition of earnings will no longer result in favorable comparisons. While GAAP earnings can be gamed and vary widely, they are at least constrained by some rules. Pro forma earnings have no rules, and the increasing use of them over the past few years has been nothing short of dramatic as Figure 5-2 shows.
According to SmartStock Investor.com, companies in the Nasdaq 100 reported a loss for the first three quarters of 2001 of $82.3 billion. For the same period, these companies also reported pro forma earnings profit of $19.1 billion, a difference of more than $100 billion. Applying any incremental price earnings multiple to $100 billion results in the possibility of a substantial correction when investors focus on GAAP or even adjusted GAAP numbers instead of whatever numbers are most favorable to the company.
In addition to managing earnings, companies boost earnings per share by controlling the number of shares outstanding through stock buybacks. When companies consistently issue options to management, resulting in additional shares outstanding, share buyback programs are necessary to mask dilution to providers of capital as a group.
A secondary purpose of stock buyback programs is to support the company’s stock price and hopefully to bid it up, create momentum, and to bolster investor confidence with a continuing trend of stock price appreciation. In short, the stock buyback strategy is to spend existing shareholder money to encourage other shareholders to invest or existing shareholders to invest more.
This has not always been the case, and undoubtedly some companies are employing stock repurchases responsibly today. Buybacks were legitimized in the 1980s as a way to return cash to some shareholders in a tax-efficient way. Because dividends, the traditional method of returning cash to shareholders, are taxed at regular income rates, it was argued that investors who wanted cash could realize it at capital gains rates through a buyback program.
Proponents of buybacks argued that companies that were obligated to reinvest cash to earn the best risk-adjusted return (and to provide cash returns to shareholders tax-effectively) could accomplish both by conducting ongoing buyback programs over time. If the company’s management and board of directors determined that in their judgment the purchase of the company’s stock at prevailing price levels would offer the best risk-adjusted return, then a stock buyback was reasonable and in the best interests of shareholders. Remaining shareholders benefited from a proportionally larger call on the income and assets of the business, and selling shareholders received relatively favorable tax treatment. Many would argue that this original justification has been stretched past reasonable limits. Consider the following:
- In practice, executives announce stock buybacks to signal their confidence in future earnings growth, and stock price increases, making buybacks a powerful weapon in their spin-control arsenals. The number and dollar volume of buybacks has increased dramatically, mirroring the increase in options granted. In 1991 approximately $25 billion in buybacks was made, compared to $200 billion in 2001. In July 2002 alone, as the market sank, more than 100 companies initiated over $43 billion in announced buyback programs.
- Both announcements and actual stock purchases accelerate dramatically in overall market downdrafts, and usually within a day or so. Are investors to believe that when the entire market declines precipitously, and thousands of stocks trade lower, that boards can determine that purchasing their stock reasonably represents the best available investment? Following the October 1987 decline, 777 public companies announced repurchase programs. In September 2001, 193 companies announced buybacks totaling $54 billion.
- Buybacks also serve to offset and mask the impact of dilution from employee option exercises. If employee stock is repurchased, the result is similar to simply paying employees more cash. If investor shares are repurchased, the result is that investors have transferred ownership to employees and at depressed prices if that is when buybacks are initiated.
- The opportunity for executives to time option grants and stock sales to benefit from price changes influenced by buyback programs is obvious. Because companies do not disclose the precise timing of either option grants or stock buybacks, it is difficult for investors to monitor such activities. Numerous services attempt to quantify such activity. One such study indicates that senior executives of IBM sold $35 million of IBM shares for a $14 million profit, selling 2.5 times as many shares as they acquired from new options, between October 1996 and March 1997. During those two quarters IBM bought $3.9 billion of its own stock, contributing significantly to its rise. The response of some of these executives was that nothing was illegal, and it is not. Whether it was ethical was not discussed.
In the past, at least there was the pretense of a legitimate value-based decision in instituting stock buyback programs. Many large companies have reinvented them as a way to manipulate earnings per share, to meet their whisper numbers, and, in a few instances, to influence short-term price movements for the benefit of insiders.