Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, 3rd Edition (20 page)

A careful review of the Statement of Cash Flows, however, would have highlighted the problem. Indeed, AOL’s $29.8 million of net income in June 1996 had been much higher than its operating cash outflow of $66.7 million, a staggering shortfall of $96.5 million. A CFRA report covering that period demonstrated the enormous impact of AOL’s disturbing accounting policies. That report restated 1996 operating income and net income for the aggressive capitalization of marketing costs and provided a sobering reminder of what many investors had missed. (See Table 6-4.) With more conservative expense recognition of solicitation costs, AOL would have posted huge operating and net losses ($154.8 million and $124.2 million, respectively), which would surely have led to massive investor selling. (Stay tuned for our revisiting of AOL in Chapter 9.)

Be Wary of Companies That Depreciate Assets Too Slowly
. By comparing depreciation policies with industry norms, investors can determine whether a company is writing off assets over an appropriate time span. Investors should be concerned when a company depreciates its fixed assets too slowly (thereby creating a boost to income), especially in industries that are experiencing rapid technological advances.

Be Particularly Concerned When a Company Stretches Out Its Depreciable Life.
A company that chooses an overly long depreciation or amortization period generally would be considered guilty of using aggressive accounting. A more serious offense, however, is a company’s
changing to a longer period
. This often suggests that the company’s business may be in trouble and that it feels compelled to change accounting assumptions to camouflage the deterioration. Regardless of how management tries to justify such changes, investors should always be wary.

Consider how Time Warner Telecom changed its depreciable life for fixed assets in 2007. As it described clearly to its investors in a footnote, the company’s March 2007 decision to lengthen the depreciable life on certain assets from 15 to 20 years inflated profits by about $4.9 million in that quarter, and was presumed to add a similar amount to quarterly profits for years to come. The $4.9 million represented nearly all of the company’s $5.4 million in operating income that quarter, and an annualized $19.6 million certainly helped the company to improve on the $16.3 million in operating income reported in the previous year.

Investors should be cautious when they see a company create profits simply by flipping an accounting switch. Let companies generate profits the old-fashioned way—by selling more product and controlling costs!

TIME WARNER TELECOM FOOTNOTE (MARCH 2007)—

CHANGE IN ACCOUNTING ESTIMATE

During the first quarter of 2007, the company evaluated the depreciable life used for fiber assets and determined that to better reflect the economic utilization of those fiber assets the lives were extended from 15 to 20 years, or the lease term, if shorter, for leased fiber assets. The change lowered depreciation expense and reduced net loss by $4.9 million for the three months ended March 31, 2007.

Be Wary of Improper Amortization of Costs Associated with Loans.
Mortgage giant Federal National Mortgage Association (usually referred to as Fannie Mae or Fannie) engaged in a massive fraud from 1998 to 2004. In 2006, Fannie Mae restated its financial statements, stripping away more than $6 billion in earnings and paying a $400 million fine to the SEC and the U.S. Treasury. One of the games played by Fannie involved its failure to appropriately amortize costs associated with loans.

First, some background. If you take out a mortgage from your local bank, Fannie Mae may purchase that loan from the bank. The price Fannie pays will be dependent on the movement in interest rates since the time you took out the mortgage. For example, if market interest rates had declined, Fannie would pay more for the loan (a “premium”) because it would still receive interest at the original, now above-market rate; conversely, if rates had increased, Fannie would pay less (a “discount”). To understand why, let’s assume that your original loan required paying 6 percent interest, and market rates later dropped to 5 percent. Unlucky for you, but that’s life. Fannie can easily lend to anyone in the market and charge the new lower market rate of 5 percent. If it wants to own your loan and its more attractive 6 percent payout, however, it surely will agree to pay a bit more for it. (If this is getting too complicated, simply remember that the mortgage value moves
inversely
with interest rates.)

Accounting rules (SFAS 91) require that any such premium or discount, as well as certain loan origination costs, be amortized over the life of the loan as an offset to interest income. In other words, when Fannie buys your loan at a premium, it amortizes that extra cost over the estimated life of the loan. However, the estimated loan life sometimes needs to be adjusted because borrowers pay off their loans more quickly or more slowly than was originally estimated (called the
prepayment rate
). If that happens, rules require that a “catch-up” adjustment be made in order to get the amortization back on schedule. With interest rates steadily dropping in the late nineties, many homeowners refinanced their loans at these lower rates, requiring Fannie to make catch-up adjustments. In December 1998, Fannie calculated that it would need to record a hefty $439 million catch-up charge. However, it decided to record only $240 million, providing an always-welcome $199 million boost to pretax income. This end-of-year stunt not only allowed Fannie to impress Wall Street, but also helped management hit the earnings targets necessary to trigger its maximum bonuses.

Watch for Slow Amortization of Inventory Costs.
In most industries, the process of turning inventory into expense is straightforward: when a sale takes place, inventory is transferred to the expense called cost of goods sold. In certain businesses, though, determining when and how inventory turns into expense can be more difficult.

In the film business, for example, the costs of making movies or TV programs are capitalized before the films’ release. These costs are then matched (charged as expense) against revenue based on the receipt of revenue. Since revenue may be realized over several years, however, a film company must project the number of years of anticipated revenue flow. If it chooses too long a period, the inventory and profits will be overstated.

Consider, for example, a film that cost $20 million. If the company assumed that revenue would be received evenly over two years, it would expense $10 million each year. If, instead, it assumed that revenue would come in over four years, it would expense $5 million each year. If the movie wound up generating revenue over only two years instead of the four that were estimated, the company would have inflated profits by $5 million during those early years. As a result, the company would be left with a useless $10 million inventory balance after two years. Since the film will no longer generate revenue, this inventory balance would need to be immediately expensed, or “written off.”

A classic example is provided by Orion Pictures’ now-famous problems with film accounting during the mid-1980s. The company had difficulty estimating future revenue and consequently amortized its film costs too slowly. Furthermore, it was slow in writing off the costs of failed films—in some cases waiting years before doing so. In 1985, for example, Orion posted a $32 million loss, half of it resulting from the write-off of 40 films released since 1982. Clearly, not all of these losses were from 1985; on the contrary, they represented the residual from Orion’s fictitious reporting of profits in the prior years.

One of the more questionable estimates that Orion made was related to the projected revenue from its TV syndication rights to the
Cagney and Lacey
series. Orion was amortizing the costs slowly, assuming that revenues would continue for many years and would eventually total $100 million. Unfortunately, revenues topped out at $25 million, meaning that Orion had expensed its inventory costs far too slowly.

3. Failing to Write Down Assets with Impaired Value

So far we have warned about two abuses of our two-step accounting dance. The first section discussed taking only one step when two steps would be required (i.e., improperly capitalizing a cost that should be expensed). The second section discussed taking the second step way too slowly (i.e., amortizing assets over a much longer life than was appropriate). In this section, we warn about a third abuse: freezing the dance between step 1 and step 2—that is, failing to record an expense for costs that had been properly capitalized but that diminished in value before the expected benefit was received.

Failure to Write Off Impaired Plant Assets

It is not enough for companies to simply depreciate fixed assets on a rigid schedule and assume that nothing can ever happen to change that plan. Management must continuously review these assets for possible impairment and record an expense whenever the assumed future benefits fall below book value. To illustrate, consider a piece of equipment that management first assumed would last for 10 years, but that breaks down permanently during year 5. Once it’s out of service, the original depreciation schedule should be abandoned, and the remaining asset balance must be moved to the expense section immediately. If the company instead chooses to continue depreciating the asset according to the original 10-year plan, it will have failed to write down an appropriately capitalized cost that had later become impaired. Not surprisingly, companies that announce big restructuring charges (EM Shenanigan No. 7) are often trying to “clean house” after failing to write off impaired assets in the appropriate earlier periods.

Failure to Write Off Obsolete Inventory

Companies naturally build up inventory in anticipation of selling product to customers. Sometimes, however, the demand for a product fails to meet a company’s lofty expectations. As a result, the company may have to lower its prices in order to move the less-desirable inventory. Or it may have to scrap (write off) the inventory completely. Management must routinely estimate its “excess and obsolete” inventory and reduce its inventory balance accordingly by recording an expense (often called inventory obsolescence expense). However, unlike the depreciation of fixed assets such as equipment, no predetermined rate would have been established for which inventory would be reduced. Thus, these adjustments are subject to a higher level of management discretion and potential manipulation.

Management can inflate earnings by failing to record a necessary expense for excess and obsolete inventory. However, this omission will come back to bite the company, as earnings will be pressured at the time when the inventory is sold at a deep discount (or thrown on the trash heap). Investors should monitor a company’s obsolescence expense (and the related inventory reserve) in order to ensure that the company does not inflate its profits by changing estimates. Regardless of the justification given by management for recording a lower expense, the impact is an artificial boost to earnings.

Vitesse Semiconductor conveniently decided to record no inventory obsolescence expense in 2003 after recording charges of $30.5 million in 2002 and $46.5 million in 2001. No doubt Vitesse’s decision to record no obsolescence expense in 2003 helped its gross profit double to $83.2 million from $41.6 million the prior year on a mere 3 percent increase in sales. We’ll check back in with Vitesse later in this chapter to see how things worked out for the firm.

Watch for an Unexpected Inventory Buildup.
Investors should monitor a company’s inventory level by calculating its days’ sales of inventory (DSI). Just as days’ sales outstanding (DSO), introduced in Chapter 3, standardizes receivables for the amount of revenue in a period, DSI standardizes the inventory balance for the amount of inventory sold (i.e., cost of goods sold) in a period. This calculation helps investors determine whether an increase in the absolute level of inventory is in line with the overall growth of the business, or whether it might be a harbinger of margin pressure.

Accounting Capsule: Days’ Sales of Inventory (DSI)

Days’ sales of inventory (DSI) is generally calculated as follows: