LESSON 15 SEEING HOW SOME COMPANIES LIE CHEAT amp STEAL THEIR WAY TO THE TOP Investment Banking 2 nd edition Beijing Language and Culture University Press 2013 Investment Banking for Dummies Matthew ID: 358221
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Slide1
INVESTMENT BANKING
LESSON
15 SEEING HOW SOME COMPANIES LIE, CHEAT & STEAL THEIR WAY TO THE TOP
Investment Banking (2
nd
edition) Beijing Language and Culture University Press, 2013
Investment Banking for Dummies, Matthew
Krantz
, Robert R.
Johnson,Wiley
& Sons, 2014Slide2
WHAT’S IN THE NEWS OR WHAT’S THERE TO LEARN?
IF CHINA STUMBLES, THE WORLD FALLS!
MORGAN STANLEY CEO STILL UPBEAT ON CHINA
Slide3
LESSON 15 TOPICS
A
.
INTRODUCTION
B. “Did you really sell that!” OVERSTATING REVENUE – Example of “Cooking the books” and “Chainsaw Al”!C. “Lucy, you got some explainin to do!” UNDERSTATING EXPENSES – Examples of Crazy Eddie and Waste Management Slide4
LESSON 15 TOPICS
D. OVERSTATING THE FINANCIAL POSITION
E. THE USE OF OFF-BALANCE SHEET FINANCING AND OFF-BALANCE SHEET ACTIVITIES – THE ENRON SCANDAL
F. WHAT’S IN INVESTMENT BANKER TO DO?
Slide5
LESSON 15 A. INTRODUCTION
INTRODUCTION –
Compare these 2 sayings 1. “
FOR
THE LOVE OF MONEY IS THE ROOT OF ALL KINDS OF EVIL!” 2. “MONEY IS THE ROOT OF ALL EVIL” What do you think of these statements? Discuss for a few minutes with a partner or group.Slide6
LESSON 15 A. INTRODUCTION
As we have learned, investment bankers deal with lots of money, billions of dollars and they also make lots of money.
H
ow much do you think the ability to makes lots of money effects your thinking?Slide7
LESSON 15 A. INTRODUCTION
These are questions you will all think about in your lifetime. Especially as China moves up in the creation of wealth for it’s citizens.Slide8
LESSON 15 A. INTRODUCTION
So, when you have
opportunities to make lots of money
, the
temptation is to make things look better than they are or perhaps overlook details that can make or break a deal. You may think your deal is the one that will be the blockbuster of the year! Well, in this lesson we are going to look at the bad side of IB. And when it’s bad, it’s really bad with all the money IB deal with!Slide9
LESSON 15 A. INTRODUCTION
There are 3 main temptations that executives can use to mislead people, even smart people like IB. They are:
B. Overstating
revenue –
making earnings appear greater than they are.C. Understating expenses – To make the “bottom line” look better, some companies understate or either ignore certain expensesD. Overstating the financial position – Some use accounting tricks to make financial statements look better than they really are!Slide10
LESSON 15 B.
“
DID
YOU REALLY SELL THAT
!” Overstating Revenue“COOKING THE BOOKS!” – The story of CEO “Chainsaw Al” Dunlap. He didn’t get that name as a forester chopping down trees! While at Scott Paper he fired 1000’s of employees, closed plants and cut costs all around. After downsizing the company and making it look like a great buyout target he sold the company and walked away with over $100 million.Slide11
LESSON 15 B. DID YOU REALLY SELL THAT!
One
year later “Chainsaw Al” was hired by Sunbeam, a maker of microwave ovens, coffee makers, etc. He
increased inventory and was counting sales as revenue on the books by only sending an invoice but not shipping the goods – accounts receivables were way up – should have been a sign!So, the company was booking sales on their financial statements but not delivering the goods – accounting fraud. Al Dunlap was fired and banned by the SEC, never allowed again to serve as a director of a company.Slide12
LESSON 15 B. DID YOU REALLY SELL THAT!
Chainsaw Al – In 1996 he reported negative net income. 1997 his company reported large positive net income. What actually happened?
Inventories went up 59% and accounts receivables up 38%. Revenues only went up 19%. All these should go up at about the same percentage.Slide13
LESSON 15 C.
“
LUCY, YOU GOT SOME EXPLAININ’ TO DO!
” Understating Expenses
A company that understates their expenses makes it look like they are more profitable than they really are. Firms may wait to put their expenses on their books till a future time which makes their revenues look great today!“What a Waste!”Example of the firm, WASTE MANAGEMENT, a waste disposal business. A fairly simple business of picking up and getting rid of trash.Slide14
LESSON 15 C. UNDERSTATING EXPENSES
Waste management
owns
trucks
and landfills (place to dump garbage). In 1990’s their profits were reported at $1.7 billion. Garbage trucks (cost $100,000) have a useful life of 10 years depreciating at $10,000 per year. Instead they depreciate over 20 years at $5000 per year only reducing net income $5,000. The firm also did this with landfills that would fill up over time but they extended the time on the books to make net income look better.Slide15
LESSON 15 C. UNDERSTATING EXPENSES
Summary of
Waste Management’s
cheating:
What a Waste! - Trucks and Landfills are assets that should go down in value every year due to depreciation. When less is deducted, net income is higher. Analysts should be able to catch this by examining accumulated depreciation.Slide16
LESSON 15 C. UNDERSTATING EXPENSES
Crazy Eddie
was a seller of electronic goods. He went public in 1984 and his IPO price of $8 went up to $75 per share. He was getting rich! But in 1989 he filed for bankruptcy. What happened?
By understating (lowering) the amount of cost of goods sold – the costs of the stereos and music equipment he was selling – he was overstating his profits. In fact, his
inventory was overstated by $65 million, more than the profits the company made, which also overstated owner’s equity. Slide17
LESSON 15 C. UNDERSTATING EXPENSES
Crazy Eddy,
by understating his costs & overstating his profits, earnings looked great & shareholders were pleased while Eddie “lined his pockets
”.
But, the overstatement of inventory was so much that even junior IB should have seen this. A common ratio used by analysts is days inventory outstanding. This helps analysts determine how efficient a firm is managing its inventory of goods for sale. The inventory almost doubled from 80 days to 146 days from 1984 to 1987.Slide18
LESSON 15
D.
OVERSTATING THE FINANCIAL POSITION
The accounting trick examples given –overstating revenue and understating expenses – are income statement falsifying net income. Companies can also overstate assets or understate liabilities.
The example of longtime CEO, Bernie Ebbers and Worldcom. This telecommunications company was a “darling” of Wall Street and Ebbers was praised as innovative and influential. He was a billionaire and lived a high life.Slide19
LESSON 15
D.
OVERSTATING THE FINANCIAL POSITION
The problem with WorldCom was
expenditures were on the balance sheet as long-term investments instead of being expenses as they were. The firm made normal expenses like fees to other companies for use of their phone lines as assets (property, plant and equipment), instead of expenses. To investors and analysts this looked like WorldCom was growing it’s asset base to produce revenue.Slide20
LESSON 15
D.
OVERSTATING THE FINANCIAL POSITION
By
common size analysis of the income statements, revenue was falling from 55% in 1996 to 40% in 2001. At the same time, property, plant and equipment was rising from 20% to 45%. Comparing with other same industry companies, each of these items was about 50%.Slide21
LESSON 15
E
.
OFF-BALANCE SHEET FINANCING
You would think that by looking at a balance sheet, you get a good picture of all the firm’s assets and liabilities and know how strong a company is. Unfortunately, off-balance sheet activities are used by firms to remove some liability items from the balance sheet in order to make the company look stronger. Slide22
LESSON 15
E
.
OFF-BALANCE SHEET FINANCING
The creation of off-balance sheet companies & removing liabilities from the balance sheet was a major factor in the 2008 crisis.An example:A firm chooses to rent rather than buy assets – an OPERATING LEASE. The firm records only rental payments & not the whole cost of the asset as a liability. By keeping this asset & debt off the balance sheet the firm looks good – can then take on more debt.Slide23
LESSON 15
E
.
OFF-BALANCE SHEET FINANCING – THE ENRON SCANDAL
The Enron scandal was one of the largest and filled with greed and mistrust. As a result, the accounting firm of Arthur Andersen was dissolved, investors lost billions, employees lost jobs and retirement savings, all due to accounting tricks! Even a law (regulation), the Sarbanes-Oxley Act, was created to enforce reporting requirements. WHAT HAPPENED?Slide24
LESSON 15
E
.
OFF-BALANCE SHEET FINANCING – THE ENRON SCANDAL
ENRON was natural gas energy company & also a wall street favorite. The firm was considered the most innovative firm for 6 years in a row.A more complex off-balance sheet activity than an operating lease is a special-purpose entity (SPE). The SPE has played a role in many accounting scandals.WHAT IS AN SPE?Slide25
LESSON 15
E
.
THE ENRON SCANDAL
A special-purpose entity is a subsidiary company. Let’s first look at what a subsidiary is.A subsidiary - A company whose voting stock is more than 50% controlled by another company, usually referred to as the parent company. From a legal view subsidiaries have their own assets & liabilities but have a purpose for the parent firm.Slide26
LESSON 15
E
.
OFF-BALANCE SHEET FINANCING – THE ENRON SCANDAL
ENRON grew fast from 1996-2000 with the help of many subsidiaries or SPE’s. Revenues increased by 750%. That alone should have been a warning! Each SPE was created to fund a project.What’s an example of an SPE created by Enron?Slide27
LESSON 15
E
.
OFF-BALANCE SHEET FINANCING – THE ENRON SCANDAL
One SPE was to fund a pipeline and keep the debt off the balance sheet. When the pipeline (asset-a capital expenditure) was transferred to the SPE, Enron would add the projected profits from the pipeline on it’s books, even if the pipeline was not operating. Enron was involved in 100’s of these partnerships. Slide28
LESSON 15
E
.
OFF-BALANCE SHEET FINANCING – THE ENRON SCANDAL
How could an IB have figured out that Enron was an accident waiting to happen?The clue was in related-party transactions.A related-party transaction is a deal between two parties that have a special relationship before the deal. A note in the financial statements showed that many of the related parties were senior executives at Enron.Slide29
LESSON 15
E
.
OFF-BALANCE SHEET FINANCING – THE ENRON SCANDAL
Enron was partnering with itself. What is this called – conflict of interest!!How do you explain this? Many analysts did not want to admit they didn’t understand Enron’s business model, because of their long and detailed reports. But, If a firm cannot explain it’s purpose in a paragraph or two, that should be a warning sign.Slide30
LESSON 15
F.
WHAT’S AN INVESTMENT BANKER TO DO?
If there is one thing to learn from these scandals, its that IB need to perform
due diligence on the companies they are working with. Three things to learn:1. TRUST BUT VERIFY – an accounting firm may sign off on the documents but they may not accurately reflect the realities of business.Slide31
LESSON 15
F.
WHAT’S AN INVESTMENT BANKER TO DO?
2.
IF IT LOOKS TOO GOOD TO BE TRUE, IT PROBABLY IS! Make sure you know why the company is outperforming other firms in the same industry.3. DON’T INVEST IN ANYTHING YOU DON’T UNDERSTAND!