MIT 15 535 - How Companies Cook the Books (14 pages)

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How Companies Cook the Books



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How Companies Cook the Books

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Pages:
14
School:
Massachusetts Institute of Technology
Course:
15 535 - Business Analysis Using Financial Statements
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Class 7 How Companies Cook the Books 15 535 Class 7 1 Announcements Optional Review Session for Quiz 1 Tentatively scheduled for Wednesday March 5 Quiz 1 In Class on Thursday March 6 The quiz will be approximately 50 minutes long Team Projects Provide hints guidance today and during Tuesday s class E mail me and your due diligence counterparty part 1 of your Team s Project Report by noon on Friday March 7 I will be in on Sunday starting by noon to answer questions about Part I of the project 15 535 Class 7 2 Guidance on Part I of Project Cash Flow Projections Earnings Quality Provide an descriptive analysis of your company its strategy for generating profit cashflow growth potential competition technological risks etc Ie How cashflows will be generated Then based on this strategic analysis use techniques we discussed in class and for the Dell case to provide estimates of FCFE for Current Year Next 5 Years Years 5 10 or 20 If necessary Cash flows in perpetuity growing perpetuity 15 535 Class 7 3 Guidance on Part I of Project Cash Flow Projections Earnings Quality Provide robustness analysis CF projections Differing growth rate estimates Different assumptions on Working Capital Accruals CapEx Depreciation Financing changes Analyze Earnings Quality using discussed in this and next class techniques Excessive accruals Wedge between CFO and Operating Income Growth in receivables that exceeds growth in sales Aggressive accounting techniques compared to competitors SEE PROJECTS FROM PRIOR YEARS ON WEB 15 535 Class 7 4 Cooking the books and earnings management manipulation Central theme Firms managers often have incentives to misstate earnings balance sheet items Contracting incentives Avoid violating accounting covenants in loan agreements Avoid taxation Progressive tax scheme Maximize bonus managers Avoid regulatory government union intervention understate profits Avoid detection of managerial shirking or outright stealing Stock market incentives Meet analysts targets Stock options issuing equity in near future 15 535 Class 7 5 Outcome of Accounting Manipulation at Oracle in early 1990 s What happened after the revelation of overlyaggressive accounting Stock market impact What happened to executives Litigation SEC fines In the end there usually is a settling up Do companies learn from mistakes of others Fast forward to now 2001 Lucent Technologies 2002 Worldcom 15 535 Class 7 6 Types of Possible Manipulation Unacceptable methods Too liberal Not writing off the cost of unsaleable inventory Depreciation of long lived assets over longer period than they will be useful to the business Recording sales before they final or failure to recognize the likelihood of returns or bad debts Unacceptable methods Too conservative Expensing cost of inventory that will not be sold until future Over depreciating assets with long lives Delaying recording sales that have already occurred 15 535 Class 7 7 Red Flags Warnings signs to watch out for Reported NI grows faster than CFO AR growth faster than sales growth Sales slow while inventories pile up Bad debt reserves debt cut Methods for calculating revenue costs change Sales are booked before payments received Dramatic change in gross margin Turnover of auditor key execs or lawyers 15 535 Class 7 8 Industry Specific Manipulation Warnings for your company analysis Computer Telecom Hardware Technological change impact on receivables inventory appropriate depreciation allowances Retailing Are accounts receivables questionable Do sales factor on rebate programs Warranties liabilities Subscription Services How are promotion costs treated capitalizes i e AOL Subscriptions paid in advance quality of deferred revenues Real Estate Carrying values for real property 15 535 Class 7 9 Problems with New Economy Firms Recognizing sales before they exist iVillage Net vs Gross Priceline Barter transactions Starmedia Coupons discounts loss leaders AOL Fulfillment costs Amazon com Swap Transactions See Handout 15 535 Class 7 10 Tricks of the Trade Big Bath Take big write off today to set up the books for the future PROBLEM Investors may forget write off Expenses are understated in the future and earnings are overstated Example of Kodak with Special items Vendor Financing Make loans to customers with questionable ability to repay loans Understate bad debt reserves ie Lucent Profits too high today Big potential losses in future Booking Revenues Too Early Check again SEC SAB 101 Statement Classic cases of Cendant and Microstrategy 15 535 Class 7 11 Tricks of the Trade Defined Benefit Pension Plan Games What is a defined benefit plan Fund assets are separate from the company Funds are used to pay present and future pension obligations to retirees It must be properly funded ERISA ACT 1974 Is there enough money Need to know Who are beneficiaries and amount required Rate of return of investments Attrition rate Growth rate in future retiree benefits Company must make periodic payments if plan is underfunded BIG QUESTION Is it underfunded or overfunded This vagueness creates the cookie jar for managers 15 535 Class 7 12 Expectations Management of Analysts Earnings Forecasts Forecast Error Actual EPS Forecast EPS 15 535 Class 7 13 Continue with Earnings Management Next Class We will discuss actual techniques for detecting earnings management for your team project Reminder about Review Session for Quiz 1 on Wednesday 15 535 Class 7 14


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