Finding truth in the numbers

Finding truth in the numbers
How aggressive accounting practices can hurt your portfolio
By Kim Shannon, Chief Investment Officer and Senior Vice-President, Investments, Merrill Lynch Investment Managers

You would like to believe that in financial reporting, of all places, what you see is what you get. Accounting practices that can best be described as aggressive are increasingly commonplace.

The link between dubious accounting practices and the speculative mania over technology companies is too strong to overlook. Since the forces that are driving the growing popularity of these practices--greed, desire for accolades, hubris--are not going away, investors, professional or not, have to be cognizant of their existence and know what to look for.

Several new phrases have slipped quietly into financial statements. These terms should raise hairs on the necks of astute analysts and investors everywhere. Old reliables such as "operating income" now turn up as "pro forma net income" and "pro forma earnings." These new terms refer to new metrics that management would prefer you to focus on. Unfortunately, they fall rather heavily into the "count-your-chickens-before-they've-hatched" school of accounting.

Deciding at which moment a sale is complete and can be recognized as revenue is not as obvious as many of us would imagine. Do you count the sale at the time of the sale, before the product is delivered, once the product is delivered or once the customer's options to void the sale have expired? This ambiguity creates a grey zone where companies can present a financial picture that is, let's say, highly optimistic.

The Ontario Securities Commission released its initial results from a review of accounting and revenue recognition practices of Toronto Stock Exchange-listed technology companies on March 14. The review uncovered "a need for significant improvement in the nature and extent of disclosure."

One method of improving the revenue picture is to take it from the future. Increased revenue spread over ordinary levels of expenses results in rising income. Companies that want to pad their financial statement like this can offer cheap vendor financing to encourage sales today, rather than tomorrow. However, if their sales force gets too aggressive in selling the product to financially weak customers, future earnings can be jeopardized by significant bad debt expense and the risk of future cash flow problems. Ask the telecom sector about this little problem today.

Vendor financing, as it is practiced today in the technology, media and telecommunications sector, has had explosive results. These financing agreements are typically over six to seven years, with three-quarters of the capital repayment occurring after five years. That's a big problem if the customer runs into cash flow problems--which has been known to happen in this sector--and goes bankrupt. Previously recorded revenue will never be realized.

Understating expenses is the next most obvious method of enhancing financial appearances. Generally accepted accounting principles (GAAP) accepts that accrual accounting is more appropriate than cash accounting for expenses. Many expenses are apportioned equally over the period of time that they are useful, not just when they are paid for. The goal is to make reasonable assumptions about how expenses are really used up. However, in the hands of less than scrupulous management groups, these rules can be bent to best suit the company's needs, and then justified in the name of GAAP accrual accounting.

For instance, costs that should properly be expensed in the period when they occurred, are sometimes capitalized and expensed over a period of time. As for expenses that are normally expensed over a period of time, management teams might argue that they should be expensed over a much longer time period, perhaps a period longer than their useful life.

Stock options have grown in popularity as a form of employee compensation--in large part because they are not reflected in income statements. Over the last few years, the U.S. experienced an employment miracle--unemployment fell to historic lows, but there was no wage inflation. Why? Wage gains went off income statements.

As reported in The Economist on Jan. 27, 2001, Smithers and Co. examined the true profits of America's biggest companies and found that--adjusted for stock options--profits were only 37% of those reported in 1998.

Mergers present their own trouble spots. Not only have academic studies shown that most mergers do not achieve the synergies and economies of scale anticipated, many of them are wound up in subsequent years.

At the time of an acquisition, companies can set up reserves for implementation of the acquisition. By adding the expected expenses of implementing the merger to the total cost of the merger, it is possible to make the merger appear profitable or accretive from day one. Having discovered this opportunity to create earnings, some companies have recognized that annual acquisitions permit the creation of annual earnings growth.

Buying research and development can look cheaper than doing your own. Internal R&D is usually expensed as incurred, and therefore affects earnings immediately. However, an acquisition of R&D--even if it is far more expensive--doesn't impact the income statement.

Canadian GAAP permits more subjectivity than U.S. GAAP, and thus provides more leeway for companies to design favourable accounting systems. A potential signal for accounting manipulation is to compare any differences in results between Canadian and U.S. GAAP.

The bottom line is that financial statements are not immune to abuse, even within the accepted rules and even with an auditor's sign-off. It is the job of the investor to analyze and interpret those statements to determine the accuracy of the picture they portray.

Contex Group