The Financial Numbers Game

Detecting Creative Accounting Practices

Charles W. Mulford, Eugene E. Comiskey

• Publisher: Wiley
• Year: 2011
• ISBN:
  9780470495315
• Edition: 1
• Topic: Business
• Subtopic: Revisione contabile
• Index: Business

Praise for The Financial Numbers Game "So much for the notion 'those who can, do-those who can't, teach.' Mulford and Comiskey function successfully both as college professors and real-world financial mercenaries. These guys know their balance sheets. The Financial Numbers Game should serve as a survival manual for both serious individual investors and industry pros who study and act upon the interpretation of financial statements. This unique blend of battle-earned scholarship and quality writing is a must-read/must-have reference for serious financial statement analysis." --Bob Acker, Editor/Publisher, The Acker Letter "Wall Street's unforgiving attention to quarterly earnings presents ever increasing pressure on CFOs to manage earnings and expectations. The Financial Numbers Game provides a clear explanation of the ways in which management can stretch, bend, and break accounting rules to reach the desired bottom line. This arms the serious investor or financial analyst with the healthy skepticism required to drive beyond reported results to a clear understanding of a firm's true performance." --Mark Hurley, Managing Director, Training and Development, Global Corporate and Investment Banking, Bank of America "After reading The Financial Numbers Game, I feel as though I've taken a master's level course in financial statement analysis. Mulford and Comiskey's latest book should be required reading for anyone who is serious about fundamentally analyzing stocks." --Harry Domash, San Francisco Chronicle investing columnist and investment newsletter publisher

CHAPTER ONE
Financial Numbers Game

I’d like to talk to you about another widespread, but too little-challenged custom: earnings management. This process has evolved over the years into what can best be characterized as a game among market participants. A game that, if not addressed soon, will have adverse consequences …¹

With an all-too-frequent occurrence, users of financial statements are shaken with disclosures by corporate managements that certain “accounting irregularities” have been discovered and, as a result, current- and prior-year financial results will need to be revised downward. Consider these examples:

Sybase’s shares dropped an additional 20% when the company reported improper practices at the Japanese subsidiary, which Sybase said included booking revenue for purported sales that were accompanied by side letters allowing customers to return software later without penalty.²

Bausch & Lomb oversupplied distributors with contact lenses and sunglasses at the end of 1993 through an aggressive marketing plan…. The company said yesterday that in the fourth quarter of 1993 it “inappropriately recorded as sales” some of the product it sent to distributors.³

Nine West Group Inc. said its revenue-booking practices and policies are under investigation by the Securities and Exchange Commission. The company’s shares plunged 18% on the news.⁴

MicroStrategy Inc., the high-flying software company… announced it would significantly reduce its reported revenue and earnings for the past two years. … Shares of Micro-Strategy plummeted 62%, slicing about $11 billion off its market value.⁵

In a long-awaited restatement, Sunbeam Corp. slashed its reported earnings for 1997 by 65%…. Sunbeam said the robust profit reported for 1997 resulted largely from an overly large restructuring charge in 1996, premature booking of revenue, and a variety of other accounting moves that have been reversed.⁶

California Micro Devices Corp., a highflying chip maker, disclosed that it was writing off half of its accounts receivable, mostly because of product returns. Its stock plunged 40% after the announcement on August 4, 1994, and shareholders filed suit alleging financial shenanigans.⁷

Waste Management Inc., undoing years of aggressive and tangled accounting, took $3.54 billion of pretax charges and write-downs, and said more conservative bookkeeping going forward would significantly crimp its earnings.⁸

The once-highflying stock of Cendant Corp. plunged 46.5%, knocking $14 billion off the company’s market value, after the marketing and franchising concern said accounting problems would require it to reduce last year’s earnings and would hurt this year’s results.⁹

Aurora Foods Inc.’s chief executive and three other top officers resigned as the company disclosed an investigation into its accounting practices that it said could entirely wipe out 1999 profit.¹⁰

Baker Hughes Inc. said it discovered accounting problems at a business unit that will result in pretax charges of $40 million to $50 million, a disclosure that sent its stock falling 15% and revived Wall Street’s questions about the company’s performance.¹¹

Every one of the above examples entails, in one form or another, participation in the financial numbers game. The game itself has many different names and takes on many different forms. Common labels, which depend on the scope of the tactics employed, are summarized in Exhibit 1.1.

While the financial numbers game may have many different labels, participation in it has a singular ultimate objective—creating an altered impression of a firm’s business performance. By altering financial statement users’ impressions of a firm’s business performance, managements that play the financial numbers game seek certain desired real outcomes.

REWARDS OF THE GAME

Expected rewards earned by those who play the financial numbers game may be many and varied. Often the desired reward is an upward move in a firm’s share price. For others, the incentive may be a desire to improve debt ratings and reduce interest costs on borrowed amounts or create additional slack and reduce restrictions from debt covenants. An interest in boosting a profit-based bonus may drive some. Finally, for high-profile firms, the motivation may be lower political costs, including avoiding more regulation or higher taxes. These rewards are summarized in Exhibit 1.2 and discussed below.

Share Price Effects

Investors seek out and ultimately pay higher prices for corporate earning power—a company’s ability to generate a sustainable and likely growing stream of earnings that provides cash flow. That cash flow either must be provided currently, or there must be an expectation among investors that it will be provided in future years.

Firms that communicate higher earning power to investors will tend to see a favorable effect on their share prices. For the firm, a higher share price increases market valuation and reduces its cost of capital. For managers of the firm with outright equity stakes or options on equity stakes, a higher share price increases personal wealth. Playing the financial numbers game may be one way to communicate to investors that a firm has higher earning power, helping to foster a higher share price.

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Exhibit 1.1 Common Labels for the Financial Numbers Game

Label	Definition^a
Aggressive accounting	A forceful and intentional choice and application of accounting principles done in an effort to achieve desired results, typically higher current earnings, whether the practices followed are in accordance with GAAP or not
Earnings management	The active manipulation of earnings toward a predetermined target, which may be set by management, a forecast made by analysts, or an amount that is consistent with a smoother, more sustainable earnings stream
Income smoothing	A form of earnings management designed to remove peaks and valleys from a normal earnings series, including steps to reduce and “store” profits during good years for use during slower years
Fraudulent financial reporting	Intentional misstatements or omissions of amounts or disclosures in financial statements, done to deceive financial statement users, that are determined to be fraudulent by an administrative, civil, or criminal proceeding
Creative accounting practices	Any and all steps used to play the financial numbers game, including the aggressive choice and application of accounting principles, fraudulent financial reporting, and any steps taken toward earnings management or income smoothing

^aRefer also to the glossary at the end of this Chapter and to Chapter 2 for additional elaboration.

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Strong earning power and higher earnings were expected from Centennial Technologies, Inc., in the quarters and months leading up to a peak share price of $58.25 on December 30, 1996. However, playing a role in the company’s supposedly bright future were many creative and fictitious accounting practices that boosted the company’s prospects. Among the accounting practices employed were the overstatement of revenue and such assets as accounts receivable, inventory, and investments. As the company’s true financial position came to light over a two-month period following its share-price peak, investors bid the share price down 95%.¹²

During 1997 and early 1998, Twinlab Corp. saw a dramatic increase in its share price. From just under $12 per share at the beginning of 1997, the company’s share price increased to the high $40s per share in July 1998. However, during that time period, the stellar results that investors grew to expect from the company were not entirely real. The company later announced that it would restate its results for 1997 and for the first three quarters of 1998 because “some sales orders were booked but not ‘completely shipped’ in the same quarter.”¹³ By the end of 1998, the company’s share price had declined back to $12.

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Exhibit 1.2 Rewards of the Game

Category	Rewards
Share-price effects	Higher share prices Reduced share-price volatility Increased corporate valuation Lower cost of equity capital Increased value of...