Accounting Practices Read Financial Report First Generally this letter contains a clean opinion Watch for qualified Opinions Investors should be cautious about investing in any company that receives a qualified opinioneven more so if it is a going concern qualification ID: 295382
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Slide1
Introduction To "Watch Out"
Accounting PracticesSlide2
Read Financial Report
First
Generally, this letter contains a "clean" opinion.
Watch for qualified Opinions.
Investors should be cautious about investing in any company that receives a qualified opinion-even more so if it is a "going concern" qualification. Slide3
Next: Read Footnotes to Financial Statement
Provides wealth of information for assessing financial condition and quality of its reported earnings. accounting policies selected
pending or imminent litigation
long-term purchase commitments
changes in accounting principles or estimates
industry specific notes (e.g., unbilled receivables for a government contractor)
segment information showing healthy and unhealthy operationsSlide4
Back of Footnotes
The back of the report, the footnotes is where they hide the bad stuff they didn't want to disclose but had to
They bury the bodies where the fewest folks find them in the fine print.Slide5
Favor Companies With Conservative Accounting Policies
Footnotes can indicate signs of "creative" accounting or gimmicks.
Companies that fail to use conservative accounting methods might demonstrate a lack of integrity in their financial reporting process
.Slide6
Favor Companies With Conservative Accounting Policies
If a company does not cut corners in its accounting, there's a good chance it doesn't cut corners in its operations. You know you've got your money with a high quality managementSlide7
Next Read The
Letter from the President
After reading the footnotes, you should turn to the front of the annual report, where you are greeted with a picture of and some words from the president.
Tone of this letter is almost invariably
upbeatSlide8
Read The
Letter from the President
Watch the word "challenging"
"Your company has lost money, is losing money, and will continue to lose money."Slide9
Read The
Letter from the President
Wall Street Advice: "If the
C word
appears in any form three or more times in the front pages of any annual report-sell immediately!"
Read the Letter from the President with a Grain of Salt. Slide10
In Some Annual Reports
Your company is now poised for significant earnings growth."Slide11
TRANSLATION
"
We lost so much last year and wrote off everything possible, so earnings couldn't get much
worse”Slide12
In One Annual Report Years Back
These results were somewhat below the projections
management
had announced publicly during the quarter"Slide13
TRANSLATION
We liedSlide14
ANNUAL REPORT
"The quarter's earnings contained a substantial contribution from a settlement arising from the involuntary termination of operating equipment."Slide15
TRANSLATION
"If the plane hadn't crashed, we would have been in the red. Fortunately, only one was killed, and the insurance company paid off a helluva lot."Slide16
Signs of Misleading Financial Statements
MANAGEMENT DECISION
Choosing accounting policy
Changing accounting policies
Deferring expenses
Income smoothing
Recognizing revenue too soon
INVESTOR'S CONCERN
Too
Liberal
Unjustified
Profits are overstated
Profits understated
Profits are overstatedSlide17
Signs of Misleading Financial Statements
MANAGEMENT DECISION
Expense under accrued
Expense over
accrued
Changing discretionary cost
Low quality controls
INVESTOR'S CONCER
Profits overstated and Liabilities understated
Profits understated and Liabilities overstated
Manipulation
profits
Risk of financial statement manipulationsSlide18
Signs of Misleading Financial Statements
MANAGEMENT DECISION
Change in auditors on a frequent basis
INVESTOR'S CONCER
Risk of financial statement manipulationsSlide19
Where to look Concern Warning Signs: Assets
Cash
A portion is restricted
Currency uncertainty divisional levels
Receivables
Large overdue receivables
Large increase with sales flat
Overly dependent on one or two customers
Related-party Receivables
Slow Receivables turnover
Right of return exists
Slide20
Early Warning Signs on the Balance Sheet
Uncollectibility
of Receivables Warning Signs
Large amount of overdue Receivables
Large increase in Receivables with flat sales
Exaggerated dependence on one or two customersSlide21
Receivable Check List
Watch and work the
Average Collection Period (see chapter on ratios)
Business dispute with customer
Watch "channel stuffing"
making last minute sales to distributor just before quarters end.
Change one bad asset for
anotherSlide22
Inadequate Salability of Inventory Warning Signs
Large increase when sales are flat
Slow inventory turnover
Faddish inventory
Collateralized inventory
Insufficient insurance
Change of corporate inventory valuation
methodsSlide23
Inventory Note
Large inventory
of high tech products can
be disastrous
because improved products hit
the market every 6 to 24 months
Who
wants a 2,600 baud modem?
Watch
Inventory
turnoverSlide24
Fixed Assets Warning Signs
Old equipment and technology
Cash flow signals
High maintenance and repair expense
Declining output level
Inadequate depreciation charge
Change in depreciation method Slide25
Fixed Assets Warning Signs
Lengthening depreciation period
Decline in depreciation expense
Large write-off of assetsSlide26
Investments Watch Realization
Switching between current and noncurrent categories
Investments recorded in excess of costs
Risky investments that must be written offSlide27
Overstatement of Intangibles Warning Signs
Slow amortization period
Lengthening amortization period
High ratio of intangibles to total assets and capital
Large balance in goodwill even though profits are weakSlide28
Warning Signs:
Liabilities
Watch for understated liabilities
Amortize warranties quickly
Arbitrary adjustments
SmoothingSlide29
Warning Signs
: Equity
Treasury
Stock - large and frequent transactions
Large and unreasonable dividends
Unexpected and/or substantial reserves
Worrisome negative cumulative translation adjustmentsSlide30
Liabilities Examples
Example of one
firm’s
pension shenanigans
Play
around with calculation of the PV of future benefits and its estimate of how fast the pension assets are growing
.
Hide or "keep off the books" actual or probable liabilities.
This gimmick is often referred to as "off balance sheet financing" Slide31
Watch This:
The Profit and Loss Account
Revenue measured at fair value of consideration received or receivable.
Recognize revenue when:
significant risks and rewards are transferred to the buyer
managerial involvement and control have passed
revenue can be measured reliably
probable that benefits flow to firm
costs of transaction can be measured reliably
.Slide32
:
Reporting Financial Information By Segment
Breakdown of Segmental information meaning, analysis of trends,
cost of investments
obtaining information on international competitive markets and producers Slide33
:
Reporting Financial Information By Segment
How this information plays an important role later in the workshop when we analyze McKinsey’s restructuring pentagon.
The size and relative importance of diversified companies presented many problems for the users of accounts.Slide34
Reporting
Financial Information By Segment
Different industries and different countries have various profit potentials, degrees and types of risk and growth opportunities.
Different rates of return on investment and different capital needs are also likely to occur across the various segments of a business
.Slide35
Reporting
Financial Information By Segment
Segmental information allows shareholders to combine company-specific information with external information with a more accurate assessment of both risk and potential for future growth.
Compare segments to other industries
Default rate of industrySlide36
Fraud at Waste Management
Refused to record expenses necessary to write off the costs of unsuccessful and abandoned landfill development projects
Established inflated environmental reserves (liabilities) in connection with acquisitions so that the excess reserves could be used to avoid recording unrelated operating expenses
Slide37
Fraud at Waste Management
Improperly capitalized a variety of expenses
Failed to establish sufficient reserves (liabilities) to pay for income taxes and other expenses
Slide38
Fraud at Waste Management
The Company's revenues and profits were not growing fast enough to meet targets, so management inflated earnings by improperly eliminating and deferring current period expenses.
Employing
a multitude of improper accounting practices to achieve this objective, management
:Slide39
Fraud at Waste Management
Avoided depreciation expenses on their garbage trucks by both assigning unsupported and inflated salvage values and extending their useful lives
Assigned arbitrary salvage values to other assets that previously had no salvage value
Failed to record expenses for decreases in the value of landfills as they were filled with waste Slide40
Fraud at Waste Management
Waste Management used netting to eliminate approximately $490 million in current period operating expenses and accumulated prior period accounting misstatements by offsetting them against unrelated one-time gains on the sale or exchange of assets. Slide41
Fraud at Waste Management
They used geography entries to move tens of millions of dollars between various line items on the Company's income statement to, in Koenig's words, "make the financials look the way we want to show them." Slide42
Fraud at Waste Management
Some believe that Andersen would have survived Enron if not for the blatant acts at Waste ManagementSlide43
The Enron Scandal
November 1997
Enron
buys out a partner's stake in a company called JEDI and sells the stake to a firm it creates, called
Chewco
, to be run by an Enron officer. Thus begins a complex series of transactions that enable Enron to hide debts.
February
20, 2001
A
FORTUNE story calls Enron a "largely impenetrable" company that is piling on debt while keeping Wall Street in the dark.
Stock Close: $75.09Slide44
The Enron Scandal
August 14
CEO
Jeffrey Skilling resigns, becoming the sixth senior executive to leave in a year. Lay says in a conference call with stock analysts, "I never felt better about the company." He deflects analysts' pleas for more disclosure. They lower their ratings on Enron stock, which drops in after-hours trading to a 52-week low.
Stock Close: $39.55
October
12
Arthur
Andersen legal counsel instructs workers who audit Enron's books to destroy all but the most basic documents.
Andersen
acknowledges destroying Enron fileSlide45
The Enron Scandal
October 16
Enron
reports a third-quarter loss of $618 million. Moody's investors Service indicates that it is considering lowering its credit rating on Enron debt securities.
Stock Close: $33.84
October
22
Enron
discloses that the Securities Exchange Commission has opened an inquiry.
October
24
Chief
financial officer Andrew
Fastow
, who ran some of Enron's stealth partnerships, is replaced.
October 26
The Wall Street Journal reports the existence of the
Chewco
partnerships run by an Enron manager. Ken Lay calls Fed Chairman Alan Greenspan to alert him of the company's problems.
Stock Close: $15.40Slide46
The Enron Scandal
October 16
Enron reports a third-quarter loss of $618 million. Moody's investors Service indicates that it is considering lowering its credit rating on Enron debt securities.
Stock Close: $33.84
October 22
Enron discloses that the Securities Exchange Commission has opened an inquiry.
October 24
Chief financial officer Andrew
Fastow
, who ran some of Enron's stealth partnerships, is replaced.Slide47
The Enron Scandal
October 26
The
Wall Street Journal reports the existence of the
Chewco
partnerships run by an Enron manager. Ken Lay calls Fed Chairman Alan Greenspan to alert him of the company's problems.
Stock Close: $15.40
October
28
Lay
calls Treasury Secretary Paul O'Neill. In October and November, Enron's president phones an O'Neill deputy at least six times, seeking help.
October
29
Lay
calls Commerce Secretary Donald Evans, suggesting he help Enron.Slide48
The Enron Scandal
November 8
Enron
admits accounting errors,
inflating
income by $586 million since 1997.
November
9
Lay
again talks to Treasury's O'Neill.
November
29
The
SEC expands its investigation to include auditor Arthur Andersen.
December
2
Enron
files for bankruptcy.
Stock Close: 26
centsSlide49
The Enron Scandal
December 12
Andersen
CEO Joseph
Berardino
testifies his firm discovered "possible illegal acts" committed by Enron.
January
9, 2002
The Justice Department launches a criminal investigation.
January
10
Attorney
General John Ashcroft rescues himself from the investigation because of contributions he received Slide50
The Enron Scandal
December 12
Andersen
CEO Joseph
Berardino
testifies his firm discovered "possible illegal acts" committed by Enron.
January
9, 2002
The Justice Department launches a criminal investigation.
January
10
Attorney
General John Ashcroft rescues himself from the investigation because of contributions he received Slide51
The Tyco Accounting Scandal
Tyco International engaged for years in financial gimmickry to inflate its earnings, the company acknowledged yesterday, saying that it would erase $382 million in profits it had previously claimed.Slide52
The Tyco Accounting Scandal
Tyco said that a five-month internal investigation had uncovered a corporate culture that openly encouraged managers to push the rules of accounting to mislead investors about the company's results.
A
memorandum to employees at one division directed them to find cost savings by ''financial engineering.'' At another unit, employees were told to ''create stories'' to justify an accounting change that would improve Tyco's earnings.Slide53
The Tyco Accounting Scandal
The
integrity of the company's earnings suffered from ''a pattern of using aggressive accounting that, even when not erroneous, was undertaken with the purpose and effect of increasing reported results above what they would have been
.'‘
For the 2002 fiscal year, which ended Sept. 30, the company previously reported a net loss of $9.1 billion after a series of earlier write-offs.
T
Tyco's
accounting, tax and executive pay practices continue to be investigated by the Securities and Exchange Commission, the Manhattan district attorney's office, federal lawyers in New Hampshire and the Internal Revenue Service.Slide54
What
These Examples Teaches Us
There Is No Substitute For Accounting and Credit Due Diligence
There Is No Substitute For A Full and Complete Cash Flow Analysis.
Lenders Should
Not Accept Cash Flow In Annual Reports Without Good Old Fashioned Digging