Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, 3rd Edition (17 page)

Watch for Companies That Constantly Record “Restructuring Charges.”
Struggling companies often enter restructuring plans, in which they incur nonrecurring costs. For example, if a company closes down one of its offices, it may have to pay severance to employees or a fee to break the office lease. Companies often strip out charges related to a restructuring plan and present them below the line. If done appropriately, this treatment is helpful for investors, as it provides insight into the performance of the company’s recurring operations. In general, with proper disclosure of restructuring charges by management, investors should be better armed to assess the more important recurring activities of a company.

Some companies, however, abuse this presentation by recording “restructuring” charges in virtually every period. Investors should view these charges with skepticism, as the company may be bundling normal operating expenses into these charges and trying to pass them off as one-time in nature. For example, telecom network equipment supplier Alcatel (now Alcatel-Lucent) has recorded below-the-line restructuring charges in just about every quarter since the early 1990s, according to a RiskMetrics Group study. Annually, these charges amounted to hundreds of millions of dollars, and occasionally billions.

If you encounter a company with frequent “one-time” or “restructuring” charges listed in its Statement of Income, investigate these charges more closely to understand what exactly the company is trying to keep out of its operating income. A quick way to understand the economic reality at a company like Alcatel that records restructuring charges every quarter is to simply reduce operating income by the amount of those charges.

Watch for Companies That Shift Losses to Discontinued Operations
. A fairly easy trick that can magically improve a company’s operating profits starts with an announcement of plans to sell off a money-losing division. Consider a struggling company with three divisions producing the following operating results: Division A, $100,000 income; Division B, $250,000 income; and Division C, $400,000 loss. The company would report a $50,000 net loss—unless it had decided to put Division C up for sale at the beginning of the period and account for it as a “discontinued operation.” In so doing, that entire $400,000 loss would be moved below the line and most likely be ignored by investors. Magically, although the company still operates all three divisions at a combined loss of $50,000, it would report all-important operating income of $350,000 and an “unimportant” $400,000 below-the-line loss. We consider this trick no different from a dishonest golfer who counts only those shots that he likes and ignores those that wind up in the water or completely off the course. Using that approach, all golfers would shoot under par.

Shifting Nonoperating and Nonrecurring Income Above the Line

As we pointed out, bundling normal operating expenses into a restructuring charge would be a relatively easy game to play. Management would simply need to convince the somewhat pliant auditor that a write-off would produce more conservative earnings. Shifting nonoperating income above the line, in contrast, is a bit more complicated and might sometimes be harder for management to put past careful investors. But that won’t stop companies from trying. As we illustrated with IBM, inflating operating income by including a one-time gain from selling a business could mislead investors about a company’s true underlying economic health.

Watch for Companies That Include Investment Income as Revenue.
Investors should be particularly alert when companies include nonoperating gains or investment income in revenue. Boston Chicken, the franchisor of the Boston Market restaurant chain, camouflaged its deteriorating business by including in revenue its interest income and various fees charged to the franchisees. While treating interest income as revenue clearly would be appropriate for banks and other financial institutions, it certainly sounds a bit unusual for a restaurant.

Boston Chicken’s inclusion of investment income as part of revenue cleverly hid its dire financial situation. As a result, many investors failed to notice that Boston Chicken had been losing money in its core restaurant operations. Indeed, all of the company’s profits came from noncore activities, such as interest income on loans or various service fees charged to these same franchisees. One huge (but apparently ignored) warning in the 1996 annual report was that franchisee-owned restaurants were losing a ton of money. The losses grew to $156.5 million in 1996 from $148.3 million during the prior year.

With franchisees losing so much money, investors should have wondered how Boston Chicken, the franchisor and owner of some of the restaurants, could be reporting such strong profits itself. A little digging would have answered that question. The main source of revenue and operating income was not restaurant customers but
the franchisees themselves.
Boston Chicken initially raised capital (equity and debt) from the market and lent the money to franchisees. As the franchisees began paying off the loans, Boston Chicken recorded large amounts of interest income and other fees and classified such inflows as
revenue
. Ominously, this ancillary revenue and income was becoming the predominant portion of the company’s reported operating income. Because this income had been bundled with restaurant sales revenue, detection was difficult, but not impossible for careful investors.

WARNING SIGNS AND LESSONS FROM BOSTON CHICKEN

Boston Chicken cleverly hid signs that its business was deteriorating by including noncore sources of income in revenue. The company reported that 1996 pretax income doubled to $109.9 million, yet CFRA calculated that it had actually lost $14.7 million on its core operations. (We define income from core operations to include revenues from company-operated stores and from royalties and initial franchise and area development fees, but not from activities such as interest, real estate, and software fees. Expenses deducted include cost of products sold, salaries and benefits expenses, and general and administrative expenses.)

Be Suspicious of Inflated Operating Income Related to Subsidiaries.
Companies can produce misleadingly strong revenue and operating income growth simply by benefiting from one of the quirks of consolidation accounting. Without going into unnecessary complexity, let’s look at the accounting if a company decided to form several majority-owned joint ventures, owning 60 percent of each. Accounting rules require that the units be consolidated and that the “parent” report as its own all of the revenue and operating expenses as operating income (that is, above the line); the 40 percent owned by others would be subtracted later on the Statement of Income (shown below the line). Consider this hypothetical situation assuming a subsidiary with (1) total revenue of $1,000,000 and (2) total expenses of $400,000. Under accounting rules, the parent that owns 60 percent of the subsidiary still reports 100 percent of the revenue and operating expenses, or a $600,000 operating profit. Since in reality it owns not 100 but 60 percent, the 40 percent difference, or $240,000 (40 percent of $600,000), is subtracted below the line. Thus, investors will see operating profit of $600,000, not the real economic profit of $360,000 (or 60 percent of $600,000), which unfortunately would be less visible. Is it any wonder that so many subsidiaries are 51 percent owned? Surely, including 100 percent of the revenue above the line and subtracting those 49 percent profits owned by others below the line seems an awfully enticing prize.

Pay Attention to Where Companies Classify Joint Venture Income.
Health-care information company Medaphis improperly included in revenue its $12.5 million share of the profits from an investment joint venture. Under the equity method of accounting for investments, if an investor possesses the “ability to exercise significant influence” (generally held to be at least a 20 percent stake), its proportionate share of the profits should be included as nonoperating investment income, not as revenue. Although it met the 20 percent test, Medaphis erred by including this gain—a below-the-line item—as revenue. The misclassification resulted in sales being overstated by 10 percent and, more important, operating profit being inflated by 108 percent.

Using Discretion Regarding Balance Sheet Classification to Boost Operating Income

The final part of this section shows how companies might produce misleadingly attractive income by offloading losses to or uploading income from the Balance Sheet.

As we pointed out in the last example involving Medaphis, nonconsolidated joint ventures require management to assess whether it possesses the ability to exercise significant influence, often using a 20 percent stake as a general guideline. If management believes that such influence exists, the company’s proportionate share of the joint venture’s income or loss should flow to the Statement of Income (i.e., the equity method of accounting). Conversely, if the company lacks such influence, the Balance Sheet account related to the joint venture is simply adjusted to fair value. Thus, shenanigan opportunities abound for managements that wish to push income onto the Statement of Income by asserting that they possess that influence in periods when the income from the joint venture is strong, or to push losses off to the Balance Sheet by stating that no significant influence exists when the joint venture’s operations are weaker.

Oracle Changes Its Accounting for a Struggling Affiliate
. Consider a somewhat odd transaction at software giant Oracle and an affiliated company. Liberate had been a unit of Oracle until it was spun off as an initial public offering (IPO) in the late 1990s. After several additional stock sales by Oracle, the company still retained a 32 percent stake in Liberate. Since Oracle also concluded that it maintained an ability to exercise significant influence, it used the equity method of accounting for this investment in Liberate, thereby reporting its pro rata share of Liberate’s earnings. At the time, Liberate had been moderately unprofitable. (Please refer to the discussion of the equity method in the accompanying accounting capsule on the next page.)

Then one sunny day in January 2001, Oracle made a curious change in the structure of its ownership of Liberate (red flag!). Oracle created a trust into which it placed its entire ownership interest in Liberate. Under the trust agreement, trustees would be obligated to vote on any shareholder issues in the same proportion as all other shareholders. Despite this change in Oracle’s voting rights, the trust structure failed to affect Oracle’s monetary stake in Liberate or its right to sell the shares and collect the proceeds. In other words, Oracle’s economic stake in the business remained unchanged.

While the economics of this investment remained unchanged, the same cannot be said for Oracle’s accounting for it. Oracle determined that it should stop using the equity method to account for its ownership interest because it no longer had voting influence over Liberate. As a result, while its ownership stake still remained at 32 percent, Oracle abruptly began accounting for the investment as if it no longer had the ability to exercise significant influence. This change to the cost method (designating the investment as “available for sale”) meant that Oracle would no longer record its pro rata share of Liberate’s earnings (or losses) on the Statement of Income; instead, Liberate’s periodic results would not affect Oracle’s earnings at all.

And the timing could not have been more fortunate. It just so happens that the decision to cease using the equity method (which affects the Statement of Income) came at the exact time when Liberate’s earnings were plummeting and would have dramatically hurt Oracle’s profits. During that fiscal year, Liberate posted a $306.4 million net loss, a huge drop from the $80.6 million loss the previous year. The following year, the loss expanded to $325 million, and by 2004, Liberate was bankrupt.

For the record, Oracle did indeed record significant impairment charges on its investment when Liberate was in free fall in 2002– 2003. However, these charges to earnings would have come much earlier and would have appeared to investors as a recurring drag on earnings had Oracle not made this one-time accounting change.

Accounting Capsule: Accounting for Investments in Other Companies

For a small investment in a company (typically under 20 percent), the owner presents the investment at fair value on its Balance Sheet. If the investment is designated as a trading security, changes in fair value are reflected on the Statement of Income. If it is instead designated as available for sale, changes in fair value are presented as an offset to equity, with no impact on earnings (unless permanent impairment exists).

For a medium-sized investment in a company (typically 20 to 50 percent), the owner reports its proportional share of the investment’s earnings as a single line on the Statement of Income. This is called the
equity method
.

For a large investment in a company (typically over 50 percent), the owner fully merges the investment’s financial statements into its own. This is called
consolidation
.

Enron Boosted Operating Income by Shifting Losses on Joint Ventures to the Balance Sheet.
Our friends at Enron understood perhaps better than anyone the benefit of using nonconsolidated joint ventures to offload debt and losses. In the mid-1990s, Enron began building out a series of new ventures that would require massive infusions of capital and would probably produce large losses during their early years. Management no doubt contemplated the potentially damaging impact of including the debt on the Balance Sheet and the big losses on the Statement of Income. Enron knew that lenders and credit rating agencies would blanch if it showed bulging loans payable, and that investors would be none too pleased with the big losses or earnings dilution if the company used its stock to finance these projects. Since these traditional forms of financing seemed problematic, Enron developed a somewhat unique and certainly very unorthodox strategy. It created thousands of partnerships (ostensibly under accounting rules) that it hoped would not be consolidated and, as a result, would keep all this new debt off its Balance Sheet. Moreover, Enron believed that this complicated structure would also help it hide the expected economic losses (or, whenever possible, pull in gains) from these early-stage ventures.