Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, 3rd Edition (45 page)

The bottom line is that for financial shenanigan detection purposes, we advise calculating DSO using ending balances, even if a company tells you otherwise.

Watch for Changes in DSO Calculations
. Be especially wary if a company
changes its own DSO calculation
in a way that conceals deterioration, as Tellabs Inc. apparently tried to do in December 2006. Tellabs had been calculating DSO based on the ending receivables balance, but it then changed to using its quarterly average receivables balance. Since receivables surged in the quarter in which the change was made, the average receivables balance naturally would be much lower than the ending one, allowing for a much more favorable presentation of DSO on the earnings call with investors.

As a result, Tellabs disclosed that DSO in December 2006 had increased only 5 days sequentially (to 59 days from 54 days in the previous quarter). Had management made no changes in its calculation, Tellabs would have reported an increase in DSO of 16 days (to 82 days from 66 days the previous quarter). The change in the DSO calculation was not difficult to find. In fact, management was kind enough to disclose it during its quarterly conference call with investors. Learning of the change in calculation was the easy part; in this case; knowing that it was a big deal, was the key for alert investors to realize that management was playing games and trying to hide its bulging receivables.

Tip:
Alert investors who learn of a change in the calculation of DSO should immediately become concerned, when management changes how it computes operational metrics, it is attempting to hide some deterioration from investors.

2. Distorting Inventory Metrics to Hide Profitability Problems

Investors typically view an unexpected rise in inventory as a sign of upcoming margin pressure (through markdowns or write-offs) or falling product demand. Some companies with inventory problems seek to avoid this negative perception by toying with their inventory metrics.

Covering Up a Cover-Up.
Symbol Technologies sold products aggressively, offering customers very generous return conditions. Moreover, some purported sales turned out to be completely bogus because customers sent back products that they had never desired and, based on a side agreement with Symbol, could return them at any time and pay nothing. These returns became more than a minor nuisance, as they increased Symbol’s inventory levels, an obvious warning sign for investors. So, as one cover-up often leads to the next, Symbol created an “inventory reduction plan” designed to reduce inventory levels. The plan (as described by the Securities and Exchange Commission [SEC]) included recording fictitious accounting entries to reduce inventory, leaving product deliveries on the receiving docks without recording them as inventory, and selling inventory to a third party, but agreeing to repurchase it.

Watch for Inventory That Moves to Another Part of the Balance Sheet.
Companies will sometimes reclassify inventory to a different account on the Balance Sheet. Pharmaceutical giant Merck & Co., for example, in 2003 began reporting part of its inventory as a long-term asset, included in the “other assets” line on the Balance Sheet. A footnote revealed that these oddly classified inventories related to products that were not expected to be sold within one year. In December 2003, the long-term portion of Merck’s inventory represented 13 percent of the total, and the next year, it jumped to 25 percent. Investors should certainly have included these long-term inventory totals when analyzing Merck’s inventory trends. A sudden spike in long-term inventory warrants concern by investors.

Be Cautious about New Company-Created Metrics.
Inventory balances at mall retailer Tween Brands Inc. had been bulging in late 2006 and early 2007, and management correctly assumed that investors would be less than overjoyed. Specifically, days’ sales of inventory (DSI) jumped to 60 days in the May 2007 quarter from 52 days the preceding year, marking the third consecutive quarter of increase. Moreover, inventory per square foot (a non-GAAP metric often cited by Tween) increased by 18 percent.

To address potential investor concerns about inventory, management began highlighting a new metric: “in-store” inventory per square foot. In May 2007, management tried to further assuage these concerns by claiming that the surge in inventory should not be a source of worry because “in-store” inventory had increased only a modest 8 percent ($27 per square foot versus $25 last year). Despite the irrationality of this statement, Wall Street bulls were pleased; all they needed was an explanation, no matter how absurd.

Tween’s explanation should have given astute investors pause on two grounds. First, it would be completely inappropriate for Tween to simply ignore inventory that it owned and included on its Balance Sheet, but that was not on store shelves. “Out-of-store” inventory qualifies as inventory and has no less markdown risk than “in-store” inventory. Second, and even more troublingly, Tween tricked investors by providing an “apples-to-oranges” comparison of its inventory growth. Specifically, the $25 cited by management as the prior year’s
in-store
inventory per square foot actually reflected total inventory per square foot, according to a 2007 report by RiskMetrics Group. By definition, comparing the current year’s in-store number with the prior year’s total number would understate inventory growth; of course it was up only 8 percent! Since the in-store metric was new, the prior year’s number was not previously disclosed, which made it difficult for investors to notice the inconsistency. However, diligent investors would have been
skeptical enough about the creation of a new inventory metric
at a time when inventory was increasing, and they would have tested its veracity and usefulness as a measure of company health.

3. Distorting Financial Asset Metrics to Hide Impairment Problems

Financial assets (such as loans, investments, and securities) are significant sources of income for banks and other financial institutions. Therefore, assessing the “quality” or strength of these assets should be a key part of understanding the future operating performance of such companies. For example, it is crucial for investors to understand whether a bank’s investment portfolio consists of risky, illiquid securities and to know if its loan portfolio is weighted toward dicey subprime borrowers.

Consider two banks that are identical in every way, except for the composition of their loan portfolios. One bank’s loan portfolio consists entirely of loans to subprime borrowers, 20 percent of which have failed to pay their bills on time. The other bank’s loan portfolio consists mainly of loans to prime borrowers, only 2 percent of which have failed to pay on time. It does not take a banking expert to realize that the second bank’s operating performance will be steadier, and that the first one may be in deep trouble.

Financial institutions will often present extremely helpful metrics that allow investors to understand the strength and performance of their assets. For example, a bank might report delinquency rates (as we did in the previous example), nonperforming loans, and loan loss reserve levels. However, sometimes management dresses up or conceals important metrics that would show a deterioration in order to present itself to investors in a more favorable light and to preserve the perception that the firm’s economic health is sound.

Watch for Changes in Financial Reporting Presentation.
Consider the case of New Century Financial Corp., once the largest U.S. independent nonprime lender, whose risky mortgage lending culminated in its April 2007 bankruptcy. In Chapter 6, we discussed how New Century kept its earnings afloat in September 2006 by
reducing
its loan loss reserve, instead of increasing it, in the face of higher delinquencies and bad loans. However, when it released its September 2006 earnings, the company was less than completely honest with investors about its reserve level. Most investors reading the earnings release came away thinking that New Century had actually
raised
its loan loss reserve.

Here’s why. New Century realized that investors would be seriously spooked if they knew that the company had reduced its reserves while its subprime loan portfolio was souring, and that this reduction was the primary driver of earnings. Indeed, analysts who followed New Century were monitoring the company’s allowance for loan losses closely as the subprime market started to crack. So, when the company released its September 2006 results, management quietly changed its reserve presentation.

Previously, New Century’s earnings release had presented the loan loss reserve on a stand-alone basis. However, in September 2006, the company grouped the loan loss reserve with another reserve (allowance for real estate owned) and presented the two together as one unit (see the associated box). By combining the two reserves, New Century was able to say in its release that reserves increased from $236.5 million in June to $239.4 million in September. However, the number on which investors had previously been focused—the loan loss reserve—actually
declined
from $209.9 million to $191.6 million, according to a November 2007 RiskMetrics Group report. The loan loss reserve fell because bad loans that had been written off (called charge-offs) had accelerated and New Century had failed to record a sufficient expense to refill the reserve; if it had done so, earnings in September 2006 would have been sliced to $0.47 from the $1.12 reported.

NEW CENTURY’S LOAN LOSS RESERVE DISCLOSURE

June 2006 Earnings Release

At June 30, 2006, the balance of the mortgage loan portfolio was $16.0 billion.
The allowance for losses on loans held for investment
was $209.9 million, representing 1.31 percent of the unpaid principal balance of the portfolio. This compares with 0.79 percent of the unpaid principal balance of the portfolio at June 30, 2005 and 1.30 percent of the portfolio at March 31, 2006. [Italics added for emphasis.]

September 2006 Earnings Release

At September 30, 2006, t
he allowance for losses on mortgage loans held for investment and real estate owned
was $239.4 million compared with $236.5 million at June 30, 2006. These amounts represent 1.68 percent and 1.47 percent of the unpaid principal balance of the mortgage loan portfolio, respectively. [Italics added for emphasis.]

By simply changing the presentation of a key metric, New Century (1) avoided a devastating announcement and tricked investors into thinking that its loan loss reserve had increased, (2) pretended that its asset quality had not been deteriorating (i.e., that charge-offs were steady), and (3) reported earnings that were much higher than reality. This charade probably bought the company some time before its bankruptcy several months later. Astute investors who were monitoring not only the level of the loan loss reserve, but also the presentation, would have had advance warning of the company’s demise. Investors who missed the presentation change in New Century’s earnings release, but read the 10-Q released several days later, would have seen the disaggregated loan loss reserve and had fair warning as well.

Executives at New Century eventually got into trouble for their tactics. In 2009, the SEC charged New Century’s former CEO, CFO, and Controller with securities fraud for misleading investors, alleging that the Company sought to assure investors that its business was not at risk and was performing better than its peers.

Be Wary When Companies Stop Disclosing Important Metrics
. Until 2007, California-based East West Bancorp Inc. had provided helpful additional disclosure about problem loans (i.e., loans that were about to go bad) and the change in reserve levels by loan category. This disclosure, while not required, gave investors extra insight into East West’s asset base. However, as the real estate market deteriorated in 2007, the company figured that it was better off not disclosing this additional data. By now you know that when important metrics disappear, you should also head for the exits.

4. Distorting Debt Metrics to Hide Liquidity Problems

A company’s cash obligations, such as debt payments, may have an impact on future operating performance as well. Large near-term debt obligations may prevent a company from funding its desired growth initiatives or, at worst, send it spiraling toward bankruptcy.

Maintaining Debt Covenants

In order to minimize the probability of loan defaults, many lenders lay out rules that require borrowers to maintain a certain level of economic health (called debt covenants). For example, lenders may require a borrower to maintain a certain level of sales, profitability, working capital, or book value. These covenants often pertain to non-GAAP measures of operating performance such as EBITDA (earnings before interest, taxes, depreciation, and amortization). Sometimes management’s motivation for fiddling with its numbers comes from the need to stay compliant with these debt covenants.

Investors should be alert to any shenanigans used by management that result in artificially meeting such covenants. Consider American Airlines’ bank credit facility, which required the company to maintain a minimum “EBITDAR to fixed charge coverage ratio.” (EBITDAR represented earnings before interest, taxes, depreciation, amortization, and rentals; and fixed charges generally included interest and total rentals.) In early 2003, American found itself in terrible financial condition and embarked on a significant restructuring plan to avoid bankruptcy. As a part of this plan, American’s lenders eased certain debt covenants, including this EBITDAR ratio.