Class #7 “How Companies Cook the Books” 15.535 - Class #7 1Announcements • 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. – by noon, questions of I will be in on Sunday starting to answer about Part I the project 15.535 - Class #7 2Guidance 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 3Guidance 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 techniques discussed in this and next class. • 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 4Cooking 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 5Outcome of Accounting Manipulation at Oracle in early 1990’s • What happened after the revelation of overly-aggressive 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 6Types 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 7Red 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 8Industry-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 9Problems 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 12Expectations Management of Analysts’ Earnings Forecasts Forecast Error= (Actual EPS – Forecast EPS) 15.535 - Class #7 13Continue 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