Financial Statement Analysis

Question 1

ASIAN FINANCIAL STATEMENT ANALYSIS - C H TAN

Question 2

Management may determine that a more direct method of maximiz- ing shareholder wealth is to reduce the corporation’s cost of capital. Simply stated, the lower the interest rate at which a corporation can borrow or the higher the price at which it can sell stock to new investors, the greater the wealth of its shareholders. From this standpoint, the best kind of financial statement is not one that represents the corporation’s condition most fully and most fairly, but rather one that produces the highest possible credit rat- ing (see Chapter 13) and price-earnings multiple

Question 3

Underperformance of key Asian equity indices in spite of resounding economic growth in both countries may be, in part, attributed to the lack of corporate gov- ernance in these markets.

Question 4

The most common case of fraudulent activity is an overstatement of profits— the first example above. In these cases, an overstatement of assets usually occurs through accounts receivable from customers, inventory, or some sort of intangible or other unique asset. As a result, a common method of detecting fraudulent activ- ity is to look for unusual increases in asset accounts that have not been adequately explained in the footnotes or by management.

Question 5

The most common result is an overstatement of assets. In the case where revenue is overstated, the most likely asset to be overstated is accounts receivable. In the most extreme case, the company is reporting fictitious revenue for which no cash is ever collected, and the accounts receivable balance grows continuously over time. In other cases, the company may be very aggressive about how it reports rev- enue and report it before a transaction has taken place or before the revenue is truly earned (e.g., reporting revenue when a contract is signed even though deliv- ery is to occur in the future or the contract relates to the use of the asset over time rather than an immediate sale). In such cases, accounts receivable will increase in the current period at a faster rate than it should but would (hopefully) be collected in a subsequent period. Since fraudulent behavior is repetitive, even in these latter cases, the accounts receivable balance will continue to grow at a faster pace relative to what it should.

Question 6

Satyam: revenue was growing at a very rapid pace, which would be a good thing if it was real. The problem is that the three receivables items on the balance sheet were all growing at a pace much greater than revenue. If the company is doing an adequate job of collecting from customers, then receivables growth should not be materially higher than revenue growth. The rapid growth here indicates a problem (perhaps not fraud, but it is a warning sign that more due diligence is necessary). The most unusual item on the bal- ance sheet is an amount that was reported separate from cash—Investments in Bank Deposits. This is quite unusual and is an indicator that perhaps the auditors were provided with different substantiation for these accounts than what they normally see for cash; there certainly must have been a reason why this amount was treated separately.

Question 7

In the case where expenses are understated, there is typically a corresponding overstatement of assets. One example is where a company sells goods (inventory) and reports the revenue on the income statement but fails to transfer the cost of that inventory (which is an asset on the balance sheet) to cost of goods sold (an expense) on the income statement. Earnings are therefore overstated, as are assets (inventory). Over time, this results in a large increase in the inventory balance on the balance sheet.
Another method of understating expenses is to defer their recognition on the income statement. This could be done by misclassifying an expense as a purchase of plant, property, and equipment resulting in an asset on the balance sheet or by creating another type of deferred asset. Some companies have created special cat- egories on their balance sheet for these deferred expenses such as “deferred customer acquisition costs.” Sometimes this may be legitimate such as in the insurance indus- try, but other times it is simply a way to avoid reporting marketing expenses on the income statement.

Question 8

Many analysts focus on subcomponents of earnings rather than the bottom line—net earnings or net profit. For example, it is common to focus on operat- ing earnings to see how the company is doing from its core business. While it is certainly good to understand how much of a company’s profits come from normal recurring operations, we must also understand that companies are aware of this and may try to mislead us. One common ploy of unscrupulous managers is to inappro- priately report non-operating gains as part of operating revenues (and to do so on a gross rather than net basis). (See Exhibit 1.10.) This overstates both revenues and operating earnings but has no effect on the bottom-line net earnings.

Question 9

Misuse of Related Parties and Acquisition Accounting

Olympus Corporation is a Japan-based manufacturer of precision machinery and instruments founded in 1919. In 2011, it was discovered that Olympus had engaged in a series of complex maneuvers to keep a significant loss, and hence a liability, off of its financial statements since the 1990s, making its financial position look better than it was for many years. It is estimated that the loss was slightly less than ¥100 billion in 1990. For many years Olympus kept the loss off of its own books by transferring financial assets that have declined in value to a series of companies that were not consolidated into Olympus’s balance sheet. The loss was transferred by having these other enti- ties purchase the financial assets for their accounting book cost rather than the fair market value. The funds used by these other entities came from bank borrowings arranged by Olympus. Olympus therefore did not report any gain or loss on the sale.
Many years later, when the accounting rules changed such that Olympus would need to consolidate these outside entities, Olympus engineered a plan to purchase these entities at a price much greater than their value (due to the embedded loss in those entities). Olympus recorded the excess of the pur- chase price over the fair value as goodwill. At the same time, Olympus over- paid for other acquisitions, apparently paying high “fees” that could be used to further obscure the losses. So, effectively, Olympus kept a liability and loss off of its books for many years (understating liabilities and overstating own- ers’ equity) and when they repurchased the entity and were forced to record the liability, they overstated assets (goodwill) to compensate. As with most accounting games, it came to an end when Olympus finally had to recognize the loss, which they initially did by calling it an impairment loss related to the numerous acquisitions.

Question 10

A company can try to make itself look better by trying to classify cash receipts as operating activities (rather than say financing) or classifying cash payments as investing activities (rather than operating). For example, a company might borrow money from a creditor using accounts receivable as collateral and report this as a sale of the receivables (operating) rather than a borrowing transaction. The difference between an outright sale and a loan is real. In the case of a sale, the buyer should not have recourse against the seller if all of the receivables are not collected. However, in the borrowing transaction, the company is still obligated for any noncollectible accounts.

Question 11

Corporate governance and related issues
The themes discussed so far relate to accounting games played to manipulate the financial statements of the company. Another category of problems associated with investing in companies run by others relates to their ability to exert undue influ- ence to benefit or enrich themselves (and sometimes their friends and family) at the expense of other shareholders. We will also include in this category other issues that are not strictly accounting related but should result in a heightened degree of skep- ticism about the company.
Good corporate governance provides a system in which controls are in place to make sure that the potential for conflicts of interests between insiders (principally management) and external shareholders is appropriately managed. An example of good corporate governance would be a strong slate (majority) of external, indepen- dent board members who act in the best interest of shareholders in overseeing the work of management. Good corporate governance also includes a sufficient level of transparency and disclosure such that external investors can best evaluate the finan- cial position of the company and the performance of management. If corporate governance is weak, investors have to raise the level of due diligence they perform when they consider making or continuing an investment in the company. Given the number of investment alternatives that exist, sometimes it is best to avoid compa- nies with poor corporate governance altogether, as the risks can be too high.

Question 12

Categorization of games businesses play with the Income Statement

Aggressive revenue recognition (too soon)
Deferral of expenses
Classification of non- operating income or non- recurring income as revenue
Classification of operating expenses as non- operating or “special”

Question 13

The analyst should determine if a company’s policies are consistent with their peers—other companies in the same industry. For example, if two companies are in the computer leasing industry as lessors and Company A structures leases as operating leases where they report income over a multiyear period, while Company B structures leases as capital/ sales type leases where they record all of the revenue at the inception of the deal (when the equipment is installed), then Company B is being more aggressive than Company A, even though they may both be following accepted accounting princi- ples. A more extreme example is when a company records the sale once the contract is signed even though they still have an obligation to deliver the equipment and make sure it is working at a later date. This would be more than aggressive, even improper. Further still would be the company that records a sale when no contract has been signed, no goods and services delivered, perhaps where no customer even exists—fraudulent revenue.

Question 14

Checklist of Warning Signs and Analysis Techniques:

Aggressive Revenue Recognition

• Examine revenue recognition policy in footnotes relative to peers.
• Are customer receivables growing faster than revenues?
• Is operating cash flow significantly lower than accounting earnings?
• Did significant revenues occur late in the year?

Question 15

Understating/ Deferring Expenses

• Are depreciation/amortization periods longer than peer companies’?
• Are there any deferred expenses listed as an asset on the balance
sheet (other than deferred taxes)?
• Are there any unusual assets or unexplained large increases in
assets such as inventory, particularly relative to revenues

Question 16

Classification of Non-Operating Income

• Were “gains” included in revenue?
• Is the company’s operating description appropriate?
• Were one-time or nonrecurring items included in revenue?
• Were any gains or revenue based on revaluation of assets?

Question 17

Classification of Operating Expenses

• Were any expenses or losses listed as “special,” extraordinary, or nonrecurring at the bottom of the income statement?
• Are there unusually high margins relative to peers (also applies to deferral of expenses)?

Question 18

Related Parties not disclosed, Transactions not arms length

Staffing model that allowed Longtop Financial to transfer the majority of its cost structure off balance sheet to Xiamen Longtop Human Resources (XLHRS).
• As of 31 March 2010, Longtop had 4,258 employees, of which 3,413 (80 percent) were employed by third-party human resources staffing companies. Of the employees at staffing companies, 95 percent (3,235) were from a sin- gle firm called Xiamen Longtop Human Resources Services Co. (XLHRS), but this entity had no verifiable business presence except for Longtop. (The remaining 5 percent were being serviced by Beijing FESCO and Randstad Shanghai Temp Staffing, both of which do have a verifiable business presence beyond Longtop.)
• On 26 April 2011, Citron reported that despite Longtop’s consistently claim- ing that XLHRS was an unrelated party, XLHRS contained the Longtop moniker, used the same e-mail server, and occupied the same building as Longtop, which is their only client. XLHRS was formed in May 2007, just months before Longtop’s IPO. XLHRS was never mentioned in the filings until the annual report filed July 2008, even though it is Longtop’s largest line expendi- ture. Further, Longtop did not have any long-term contracts and did not have to pay any penalties or minimums in its relationship with XLHRS. Longtop termi- nated the outsourcing agency and took all the employees in-house when the out- sourcing agency relationship was questioned. XLHRS had no website and did not appear to be soliciting customers even though it had just lost its only customer.
• Longtop claimed that the outsourcing arrangement was part of the justification of its outsized margins. However, after dumping XLHRS, the company claimed that there would be no financial penalty, no cost, and no margin loss associated with terminating the relationship.
• On 9 May 2011, Citron reported that Longtop’s legal department staff had been signing off on a variety of administrative filings with the government on behalf of XLHRS, which proves that they are related.
• The financials of XLHRS in the SAIC documents stated total revenues (or service fees) of merely RMB$5.1 million, while Longtop’s 20-F stated that XLHRS was to receive a service fee that would amount to RMB$400 to 500 million on a conservative basis. Other SAIC filings also show that XLHRS would be underpaying the government for benefits for Longtop employees.

Question 19

Longtop’s chairman transferred 70 percent of stock holdings to employees and friends in the first four years of the company’s going public.
• Citron believes that this transaction of 9 million shares, valued at over a quar- ter billion dollars, has an undisclosed “tail.” The money might have been used to pay off Longtop’s hidden liabilities or generate an undisclosed benefit to Longtop’s Chairman Jia.

Question 20

Key Lessons from the Longtop fraud:
• “Extreme outsourcing” obliterates transparency and is a common characteristic of other stocks in China that have collapsed under findings of fraud. For example, China Media Express claimed that the large advertising sales teams responsible for their huge reported income were outsourced; Duoyuan Global Water and Duoyuan Printing also claimed outsourced distributor networks.
• The outsource maneuver makes it difficult to deconstruct the numbers from an auditing standpoint and makes invisible a lot of metrics that would afford mean- ingful insight into how the company operates, such as ratios of revenues per employee, costs per employee, and so on. Since the entity appears to be a related party, this arrangement makes very little sense from a business standpoint.
• In cost-competitive China, if margins are spectacularly high, it is probably too good to be true.
• Do not rely on management forecasts of revenue and growth numbers.

Question 21

Sino-Forest:
Use of AIs lies at the heart of the allegations, as it allows the company to report sales, purchases, and forest reserves without third-party verification.
AI = Authorized Intermediaries which were third parties between suppliers on the one had and customers on the other. Many of these were the same and may have been related to Sino Forest enabling round tripping of cash and offset of receivables and payables.
Same companies with offset of payables and receivables
• Despite reporting positive cash flow from operations, cash expenditure on acqui- sition of timber holdings has consistently outstripped cash flow generation.
• Receivables account has registered significant increases over the past four years, as did investment in timber holdings. As the following table shows, while revenue was up 169 percent from 2007 to 2010, receivables were up over 500 percent and would have been up higher had the company not offset receivables and payables. Note that on a combined basis receivables and timber holdings were up almost 200 percent. Also note the similarity between receivables and payables balances over the four-year period.

Question 22

Key Lessons from Sino Forest:
• In hindsight, there were several red flags that should have alerted investors:
• Listing through reverse takeover, thus avoiding typical IPO due diligence. • Complex and opaque business structure with unidentified counterparty transactions.
• Consistently negative free cash flow generation.
• Repeated capital raisings since listing; no return of capital to shareholders.
• Limited management ownership; chairman owned less than 3 percent of the company.
• Presence of well-known investors no guarantee of safety:
• Paulson, Davis Advisors, and Capital Group were substantial shareholders pre-allegations.
• Richard Chandler and Wellington both bought substantial stakes after the alle- gations were published.

Question 23

A method of understating both assets and liabilities involves shifting accounts receivable (assets) off the balance sheet in a borrowing transaction. If a company sells its receivable to another entity at a discount for cash (called factor- ing) and the other entity has no recourse if it fails to collect, then this is a legiti- mate sale of receivables. Receivables are replaced on the balance sheet with cash. However, if a company borrows money against those same receivables and contin- ues to bear the credit risk of collections, then the receivables stay on the balance sheet and a loan is recorded. Some companies attempt to make a borrowing transac- tion look like a sale and hence understate assets (accounts receivable) and liabilities (the loan). This is sometimes accomplished through the use of special-purpose enti- ties to permit sale treatment under accounting standard

Question 24

Olympus Corporation incurred a loss in the early
1990s due to a decline in the value of financial assets. Rather than recogniz-
ing the loss recording the decline in value directly on the balance sheet of
Olympus, the financial assets and a corresponding amount of bank borrow-
ing were effectively transferred to another entity that was not consolidated.
Eventually, the company was forced to consolidate this entity and had to play
additional accounting games to disguise the loss.

Question 25

PP&E are initially recorded at cost upon acquisition. Subsequently, the com-
pany can then choose whether to measure the asset under either a cost model or a
revaluation model. The revaluation model is designed for those assets for which a
fair value can be measured reliably. For the cost model, the company maintains the
original cost, which is adjusted periodically for depreciation or impairments. For
the revaluation model, the asset is reported on the balance sheet at its current fair
value. If the value declines, the balance sheet is balanced by having the loss reported
on the income statement and included in retained earnings—assets go down and
owners’ equity goes down. If the value increases, the gain is reported in other com-
prehensive income—a holding account that is part of owners’ equity on the balance sheet. This permits the balance sheet to balance since the gain is not reported on the
income statements.4 In the case of property held for investment, there is a similar
choice of a cost of fair value model. If the fair value model is chosen for investment
property, then all gains and losses are reported in the income statement and hence
retained earnings.

Question 26

Intangible assets are initially recorded at their acquisition costs. Subsequently,
the company may report these assets using either a cost model or revaluation
model. Under the cost model, adjustments are made for any amortization or
impairment in future years. Under the revaluation model, they are reported in the
future at fair value, with gains and losses treated similarly to PP&E.

Question 27

Investments in financial assets (e.g., securities) are initially recorded at their fair
value. In subsequent periods, these assets are reflected on the balance sheet at either
fair value or amortized cost. Specific criteria are provided to determine which model
to use. In order to use the amortized cost model, the asset must be held in a busi-
ness unit, where the objective is to hold assets to collect contractual cash flows con-
sisting of principal and interest due on specified dates. Otherwise, it is measured at
fair value. Gains and losses from changes in value are reported in the income state-
ment unless they are related to securities held for hedging or where the company
has elected to report the gains and losses in other comprehensive income (available
only for equity investment not held for trading).

Question 28

Overstating the Quantity of Assets on the Balance Sheet

Companies may try to overstate their overall assets by claiming to have more assets
than they do. This is particularly true for assets like inventory, where there may be
many items that may be hard to observe. Often, this is associated with an over-
statement of income by understating costs of goods sold.

Question 29

Overstating Off-Balance-Sheet Assets
In the case of natural resources, the company may have ownership or control over
reserves that are not yet formally listed on the balance sheet and that are not even
observable—for example, underground reserves of oil or other commodities. These
represent potential future assets and revenues for the company, and the company
therefore has an incentive to overstate their quantity and/or value to make their
financial position appear stronger, even though they are not yet added to the bal-
ance sheet. This is easy to do since the quantities are not observable and since this
game does not require the balance sheet to balance (these assets do not even appear
on the balance sheet).
Furthermore, the company may be able to defer expenses by overstating these
reserves. Many expenditures related to discovery and production of these resources
are capitalized and amortized over the productive capacity/quantity of reserves.

By overstating future reserves relative to current production, the company can defer amortization to the future.

A classic example of this type of fraud was Bre-X, a Canadian company with
an alleged gold mine in Busang, Indonesia. This was a “penny” stock whose
price soared to C$286 per share after announcing significant reserves of gold
(70 million troy ounces). The price subsequently collapsed after it was dis-
covered that the gold did not exist. While Bre-X was an outright fraud, other
examples are companies that are aggressive in their reserve estimates. An
example is Shell Oil, which slashed its proven oil reserve estimates by 20 per-
cent after it was questioned by regulators about reserves not claimed by other
oil companies who partnered in the same projects.
Exxon and Chevron, Shell’s partners in its Barrow Island project off the
west coast of Australia, were conservative in not counting the island’s reserves
at the time (early 2000s) due to the area’s “protected” classification and
uncertainty. While the companies have more recently received approval to
develop these reserves, Shell’s reporting of its reserves at the time was exces-
sively aggressive.

Question 30

Checklist of Warning Signs and Analysis Techniques for Overstating Financial Position

Exclusion of Assets and Liabilities
• Is the company using operating leases to a greater extent than
similar companies?
• Is the company using the equity method of accounting for
affiliates? How would their financials look if these affiliates were
consolidated?
• Has the company shifted accounts receivable off the balance sheet in
a transaction that would be better classified as borrowing?
• Does the company have insufficient assets on its balance sheet to
support reported operations and revenues—particularly relative to
other, similar companies?

Off-Balance-Sheet Liabilities/Financing
• Are there financing or guarantee arrangements disclosed in the foot-
notes of press articles that are not reflected on the balance sheet?
• Are there discussions about contingencies or losses that are not cur-
rently reported on the income statement and for which no current
liability is accrued?

Overstating Assets
• Does the company have significant assets that are subject to
estimates or assumptions or where objective valuations are not
available?
• Does the company have unusual changes in the quantity or valua-
tion of intangible assets, commodities or biological assets (whether
reported on the balance sheet or not)?
• Were any gains or revenue based on revaluation of assets, and what
percentage of operating income comes from these activities?

Question 31

Deferred tax assets are less common as they arise when a company reports
higher income for tax purposes than investor reporting purposes (the opposite of
the preceding scenario). The most common deferred tax asset occurs when the com-
pany has a loss for accounting purposes that cannot currently be deducted for tax
purposes but can be carried forward to offset taxable income in later years.

If a company has deferred tax liabilities or assets, you should examine the
footnotes to make sure the reasons for their existence makes sense. You should be particularly skeptical about deferred tax assets and watch carefully for com-
panies where the related valuation allowance fluctuates dramatically from year
to year.

• Does the company’s net deferred tax impact on net income fluctuate from
a positive to a negative impact?
• Does the company have significant deferred tax assets? Is it plausible that
they will be usable in subsequent years?
• Did the company establish a valuation allowance for deferred tax assets,
and has it fluctuated in value over time?

Question 32

Red Flags beyond just the Financial Statements:
•WCC’s margins are fabricated. Despite selling a commodity in a hypercom-
petitive market, its margins are 20 percentage points higher than its H-share,
A-share, and local competitors.
•WCC appears to be massively overpaying for loss-making cement factories.
•WCC pursues expensive financing despite generating healthy free cash flow
from operations.
•WCC has had abnormally high auditor and management turnover.
•WCC’s corporate governance figureheads have been tainted by past scandal

Key Lesson: When a company has poor corporate governance, additional scrutiny must be
conducted when analyzing their financial data.

Question 33

China Biotics Case : Key Lessons
•The illusion of CHBT’s large cash balance formed the core of investors’ bullish
hopes for dividends, and share buybacks. However, it was local sources in China
that helped raise red flags on China Biotics.
Allowing for further research into local Chinese websites, and finding news
on the local papers would give added color on the business conduct of a com-
pany. This gives an added dimension on top of solely looking at the numbers.
•China Biotics had seen five CFOs in four years, with the first CFO, Song Jinan
(major shareholder), in the post for only eight months (from March to November
2006). The fifth CFO, Travis Cai, served for a year and a half.
Looking at the rate of change in a company’s CFO lineup will post questions
to an investor.

Question 34

A firm’s profitability on a cash flow basis relative to sales can be computed as an operating cash margin:
Cash Flow from Operating Activities/Sales Revenue
Cash Flow from Operating Activities/EBIT (In any one year, this ratio can be higher or lower than 1. Over the long term, how-
ever, the ratio should exceed 1. This is due to the fact that noncash charges (primarily depreciation) are deducted from net income but do not represent an operating cash out-flow. In fact, the cash flow related to depreciable assets occurs when the asset is acquired and is classified as an investing cash outflow. As with the preceding discussion, if this ratio is consistently below 1 or declining, it is indicative of a potential problem with earnings quality. Should this occur, special attention must be paid to accounting issues.

Taken together, the preceding ratios assess the company’s ability to generate cash flow. Comparing these ratios to their earnings-based equivalents also provides insight into the quality of the company’s earnings. For example, if the earnings-
based ratios show strong profitability but the cash flow–based ratios show an inability to generate cash flow, this could indicate poor earnings quality. However, it can also be indicative of a rapidly growing firm, so this analysis should serve only as a rstarting point. If earnings and cash-based ratios are out of sync, you should take a closer look at accounting methods and estimates used by the firm.

Question 35

Engaging in real activities to boost current cash flow can be done by accelerating cash receipts into the current year or delaying cash payments to later years.
Typical activities include:
• Aggressive encouragement of customers to pay their balances sooner than
required.
• Sale of accounts receivable in a factoring arrangement (outright sale where receiv-
ables are sold at a discount and without recourse).
• Delaying payments to suppliers, employees, and others.

Question 36

Companies can take this type of scenario one step further by engaging in
activities that convert (improperly) any borrowing from a financing cash flow into
an operating cash flow. The American company Enron did this by using financial
firms to create a series of special-purpose entities that were effectively borrowing
funds and “laundering” them through these other entities and recording as both
operating income and operating cash flow. You should examine footnote disclo-
sures and uses of special-purpose entities to explore any unusual financing-type
activities.

Question 37

Cash Flow Warning Signs

Acceleration of Cash Received for Revenues or Deferral of Cash Paid for Expenses:
Look for factoring, sales of receivables, or other transactions to bring cash flow in early.
See if the company is delaying payments to suppliers and others, such as an increase in accounts payable.

Borrowing Transactions Treated as :Operating Cash Inflow
Are there contingent or other off-balance-sheet liabilities disclosed (or not disclosed)?
Look for reciprocal or repurchase agreements/insurance-type contracts.
Is there any revenue from an unusual type of customer (financial services firm)?

Expenditures Improperly Classified as Capital Expenditures:
Are there abnormal increases in long-termassets?
Are there unusual assets?
Any abnormal changes in capital expenditures?

Question 38

Names of Research firms

Jonestown Research
Muddy Waters

Question 39

Corporate Governance According to the CFA Institute:
Corporate governance is the system of internal controls and procedures
by which individual companies are managed. It provides a framework
that defines the rights, roles, and responsibilities of various groups—management,
board, controlling shareowners, and minority or non-
controlling shareowners—within an organization.
At its core, corporate governance is the arrangement of checks,
­ balances, and incentives that a company needs in order to minimize and
manage the conflicting interests between insiders and external ­ shareowners.
Its purpose is to prevent one group from expropriating the cash flows and
assets of one or more other groups.
Good corporate governance includes a strong independent board of directors,
strong internal and external audit functions, transparent disclosures, incentives
for management to act in the best interest of shareholders and strong shareowner
rights. If corporate governance is not strong, management or the board may engage
in transactions that are not in the best interests of investors. These can include
related-party transactions, personal use of company assets, expropriation of assets,
excessive compensation, and decisions that keep management entrenched.

Question 40

Corporate Governance - Checklist of Warning Signs and Analysis Techniques

Board Governance and Independence
Examine board membership for external members. Corporate gov­ernance is weak for boards comprised of less than 50 percent independent non-executive directors.
Be wary when the CEO also serves as chairman of the board of directors.
Are there separate board audit, nomination, and compensation committees comprised primarily of independent directors? If not, exercise more due diligence.
Examine possible interlocking directors.

Shareowner Rights
Are there different classes of shares, and how do voting rights differ between them? If so, are there safeguards in its articles of organization or bylaws that protect the rights and interests of those shareowners whose shares have inferior rights?
Was the company recently privatized by a government or government entity with retained voting rights that could veto certain decisions of management and the board?
Are shareholders able to vote their shares by proxy if they are unable to attend a shareowners’ meeting, cast confidential votes, submit matters to a vote, and approve changes to corporate structure and policies?

Interlocking Ownership or Directorships
Are their interlocking ownership or directorship arrangements? If so, increase analysis and due diligence.

Related-Party Issues
Are there business transactions between company and management?
Are family members of management involved in the company or other companies with which the subject company does business?
Are there significant loans to management or affiliated companies either from the company or related entities?

Excessive Compensation and Personal Use of Assets
Are there sufficient and clear disclosures of compensation or perks of management so that they can be evaluated with reference to similar companies?
Are there sufficient internal controls to prevent personal use or expropriation of corporate assets?
Is there excessive use of stock-based compensation/options?

Lack of Transparency
Does the company resist making detailed disclosures or use language that obscures what is going on?

Auditor Issues
Are auditors truly independent and objective? Are there any conditions that may impair their objectivity? Is the audit firm large enough and possessing a sufficiently high-quality reputation to audit a public company?
Have there been resignations of, frequent changes in, or disagreements with auditors?
Is there a strong independent audit committee of the board and strong internal controls to mitigate other issues?

Question 41

Some Motivations for distorting financial results:
Accounting scandals have been around for as long as capital markets. Whenever you
have a separation of ownership and control—where the individuals running a com-
pany are not the same as those providing the capital for its operations—there is
an opportunity for the managers to obscure the true economic picture of what is
going on in the business. Sometimes it starts innocently enough. Perhaps there has
been a tough quarter and management makes some adjustments to avoid triggering
the violation of a debt covenant, with the intent of reversing the manipulation in the
subsequent period. However, if the economics do not improve in the subsequent
period, the company may have to make bigger adjustments to continue to hide
the prior manipulation, resulting in a snowball effect where the manipulations get
increasingly larger over time. In other circumstances, the managers may have incen-
tives, such as bonus arrangements, to make the reported results look better than
reality. In more extreme cases, managers may have set out to commit fraud and loot
as much as they can from the company and other shareholders.

Question 42

The articulation of financial statements shows how the three main financial
statements fit together: the income statement, the balance sheet and the cash flow
statement. If management manipulates one financial statement, the impact is likely to
be reflected on at least one other statement. The analyst is well advised to never
focus on an individual financial statement but to study them collectively to look for
imbalances or red flags.

The balance sheet is the core financial statement that connects the other two
primary statements: the income statement and the statement of cash flows. Net
income from the income statement is ultimately reflected in retained earnings on the
balance sheet. Any increase in net income needs to be balanced by either an increase
in assets, a decrease in liabilities, or a decrease in some other owners’ equity account.
Therefore, if managers want to manipulate net income, they must do so by also
manipulating the balance sheet, creating warning signs that the analyst can observe.

Question 43

The most common manipulations impacting the financial statements include:
• Overstating earnings or misclassifying components of the income statement.
• Overstating financial position.
• Managing earnings.
• Overstating operating cash flow.

Question 44

Aggressive revenue recognition might involve recording revenues too early, recording revenues for which collectability is doubtful, or, in the extreme case, recording revenues for fictitious sales.

Question 45

Cash flow manipulation most often involves an overstatement of operat-
ing cash flows (rather than investing or financing cash flows). Companies might
engage in “real” activities that provide a temporary boost to cash flow such as accel-
eration of cash to be received or deferring cash to be paid. They may also engage
in “artificial” means to overstate operating cash flows such as treating a borrowing transaction (a financing cash flow) as an operating cash flow or improperly classify-
ing a normal expenditure as a capital expenditure (an investing cash flow).

Question 46

A Recipe for Detecting Cooked Books

Understand the business. You should thoroughly understand the business the com-
pany is in and identify the major peer companies so that you can use them as
benchmarks. Understanding the business and peer companies will enable you to
observe discrepancies on the financial statements—things that appear out of the
ordinary for this type of company.

Gather and read through all of the financial statements and footnotes for the last
several years. This should include not just one set of financial statements that
includes several years of financial statements but the separate reports for each
of several years. You should read through these keeping in mind the checklist and highlight anything that appears on this checklist such
as unusual assets, accounting policies, related-party transactions, and audi-
tor changes, just to name a few. Also, watch for any changes between the sets
of financial statements over time and for any items on this list or any amend-
ments made to prior-year financial statements in any set of statements. Compare
accounting policies to those of peers to determine whether the subject company
is being aggressive. Look for items disclosed in the footnotes but not reflected
on the financial statements (losses or off-balance-sheet financing). Assess the
strength of corporate governance by examining information on the board, man-
agement, and auditors.

Prepare a common-size analysis of the income statement. This is done by dividing
all items on the income statement in each year by revenue for each year. Examine
any major changes in these percentages over time. Compare the company’s
expenses and subtotals as a percentage of revenue (gross margin, operating mar-
gin, profit margin) to peer companies, and ascertain the reasons for any differ-
ences. Look for any unusual income or gain items listed in the operating section
or unusual losses or expenses listed in the non-operating section.

Prepare a common-size analysis of the balance sheet. This is done by dividing all items
on the balance sheet for each year by total assets for that year. Examine major
changes in these percentages over time. Look for unusual assets or large increases
in assets. Compare the company’s common-size balance sheet percentages to peer
companies, and ascertain whether there are any items that are significantly differ-
ent. Examine the owners’ equity portion of the balance sheet in particular to deter-
mine if any losses bypassed the income statement and retained earnings.

Analyze the cash flow statement. Place the income statement and cash flow state-
ment for all years side by side and look for discrepancies between them (e.g.,
increasing earnings but decreasing operating cash flows). Examine all reconciling
items between net income and operating cash flow in the operating section of the
cash flow statement. Make sure you understand large items, and look for any sig-
nificant trends or changes over time. Ideally, you would like to see operating cash
flow higher than net income in the aggregate over all periods—if it is not, then
dig a little deeper to understand why.

Do a ratio analysis of the financial statements. Examine the trend in the company’s
ratios over time and relative to peer companies with a particular focus on:
• Receivables turnover or days’ receivable (indicating whether receivables are
growing faster than revenues).
• Inventory turnover or days’ inventory (indicating whether there might be a
buildup or overstatement of inventory).
• Total asset turnover and return on assets (with a particular focus on whether
the company’s balance sheet supports its operations).

Seek out independent information on the company. If the company must file
other types of reports (e.g., local sales tax returns) with other entities, such as
governmental or regulatory agencies, compare those reports to the information
in the financial statements. Compare information on asset ownership (e.g., real
estate records) where available to assets listed on the balance sheet. Examine
any financial statements of other entities the company does business with or
other companies where management or the directors have an interest. Look
for independent data on revenues, including personal visits and observations
if possible.

Question 47

Be wary of excess cash reserves, particularly when the company continues to bor-
row. This is an indicator that they need cash and the reported cash balances may
not exist.

Question 48

FINANCIAL STATEMENT ANALYSIS A PRACTITIONER’S GUIDE - MARTIN FRIDSON

Question 49

“The primary goal in financial reporting is the dissemination of financial statements that accurately measure the profitability and financial condition of a company.1
Missing from this formulation is an indication of whose primary goal is accurate measurement. Schilit’s words are music to the ears of the financial statements users listed in this chapter’s first paragraph, but they are not the ones doing the financial reporting. Rather, the issuers are for-profit companies, generally organized as corporations.2
A corporation exists for the benefit of its shareholders. Its objective is not to educate the public about its financial condition, but to maximize its shareholders’ wealth. If it so happens that management can advance that objective through dis “The primary goal in financial reporting is the dissemination of financial statements that accurately measure the profitability and financial condition of a company.1
Missing from this formulation is an indication of whose primary goal is accurate measurement. Schilit’s words are music to the ears of the financial statements users listed in this chapter’s first paragraph, but they are not the ones doing the financial reporting. Rather, the issuers are for-profit companies, generally organized as corporations.2
A corporation exists for the benefit of its shareholders. Its objective is not to educate the public about its financial condition, but to maximize its shareholders’ wealth. If it so happens that management can advance that objective through “dissemination of financial statements that accurately measure the profitability and financial condition of the company,” then in principle, management should do so. At most, however, reporting financial results in a transparent and straightforward fashion is a means unto an end.
Management may determine that a more direct method of maximizing shareholder wealth is to reduce the corporation’s cost of capital. Simply stated, the lower the interest rate at which a corporation can borrow or the higher the price at which it can sell[…]”

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Financial Statement Analysis
Martin S. Fridson
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Question 50

“Neither fear of antifraud statutes nor enlightened self-interest invariably deters corporations from cooking the books. The reasoning by which these two forces ensure honest accounting rests on hidden assumptions. None of the assumptions can stand up to an examination of the organizational context in which financial reporting occurs.
To begin with, corporations can push the numbers fairly far out of joint before they run afoul of GAAP, much less open themselves to prosecution for fraud. When major financial reporting violations come to light, as in most other kinds of white-collar crime, the real scandal involves what is not forbidden. In practice, generally accepted accounting principles support a lot of measurement that is decidedly inaccurate, at least over the short run.”

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Financial Statement Analysis
Martin S. Fridson
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Question 51

“Corporations routinely and unabashedly smooth their earnings. That is, they create the illusion that their profits rise at a consistent rate from year to year. Corporations engage in this behavior, with the blessing of their auditors, because the appearance of smooth growth receives a higher price-earnings multiple from stock market investors than the jagged reality underlying the numbers.
Suppose that, in the last few weeks of a quarter, earnings threaten to fall short of the programmed year-over-year increase. The corporation simply borrows sales (and associated profits) from the next quarter by offering customers special discounts to place orders earlier than they had planned. Higher-than-trendline growth, too, is a problem for the earnings-smoother. A sudden jump in profits, followed by a return to a more ordinary rate of growth, produces volatility, which is regarded as an evil to be avoided at all costs. Management’s solution is to run up expenses in the current period by scheduling training programs and plant maintenance that, while necessary, would ordinarily be undertaken in a later quarter.”

Excerpt From
Financial Statement Analysis
Martin S. Fridson
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Question 52

“Along with accounting professionals, the issuers and users of financial statements also have representation on the Financial Accounting Standards Board (FASB), the rule-making body that operates under authority delegated by the Securities and Exchange Commission. When FASB identifies an area in need of a new standard, its professional staff typically defines the theoretical issues in a matter of a few months. Issuance of the new standard may take several years, however, as the corporate issuers of financial statements pursue their objectives on a decidedly less abstract plane.”

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Financial Statement Analysis
Martin S. Fridson
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Question 53

“Suppose that corporate financial reporting followed the accountants’ idealized objective of depicting performance accurately. By the laws of probability, corporations’ quarterly reports would include about as many cases of earnings that barely exceed year-earlier results as cases of earnings that fall just shy of year-earlier profits. Instead, Zeckhauser and colleagues find that corporations post small increases far more frequently than they post small declines. The strong implication is that when companies are in danger of showing slightly negative earnings comparisons, they locate enough discretionary items to squeeze out marginally improved results”

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Financial Statement Analysis
Martin S. Fridson
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Question 54

“On the other hand, suppose a corporation suffers a quarterly profit decline too large to erase through discretionary items. Such circumstances create an incentive to take a big bath by maximizing the reported setback. The reasoning is that investors will not be much more disturbed by a 30 percent drop in earnings than by a 20 percent drop. Therefore, management may find it expedient to accelerate certain future expenses into the current quarter, thereby ensuring positive reported earnings in the following period. It may also be a convenient time to recognize long-run losses in the value of assets such as outmoded production facilities and goodwill created in unsuccessful acquisitions of the past. In fact, the corporation may take a larger write-off on those assets than the principle of accurate representation would dictate. Reversals of the excess write-offs offer an artificial means of stabilizing reported earnings in subsequent periods.”

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Financial Statement Analysis
Martin S. Fridson
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Question 55

“Zeckhauser and his associates corroborate the big bath hypothesis by showing that large earnings declines are more common than large increases. By implication, managers do not passively record the combined results of their own skill and business factors beyond their control, but intervene in the calculation of earnings by exploiting the latitude in accounting rules. The researchers’ overall impression is that corporations regard financial reporting as a technique for propping up stock prices, rather than a means of disseminating objective information.14”

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Question 56

“Limits to Continued Growth
Saturation
Sales of a hot new consumer product can grow at astronomical rates for a time. Eventually, however, everybody who cares to will own one (or two, or some other finite number that the consumer believes is enough). At that point, potential sales will be limited to replacement sales plus growth in population, that is, the increase in the number of potential purchasers.
Entry of Competition
Rare is the company with a product or service that cannot either be copied or encroached on by a knockoff sufficiently similar to tap the same demand, yet different enough to fall outside the bounds of patent and trademark protection.
Increasing Base
A corporation that sells 10 million units in Year 1 can register a 40 percent increase by selling just 4 million additional units in Year 2. If growth continues at the same “rate, however, the corporation will have to generate 59 million new unit sales to achieve a 40 percent gain in Year 10.
In absolute terms, it is arithmetically possible for volume to increase indefinitely. On the other hand, a growth rate far in excess of the gross domestic product’s annual increase is nearly impossible to sustain over any extended period. By definition, a product that experiences higher-than-GDP growth captures a larger percentage of GDP each year. As the numbers get larger, it becomes increasingly difficult to switch consumers’ spending patterns to accommodate continued high growth of a particular product.”

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Financial Statement Analysis
Martin S. Fridson
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Question 57

“there are periodic attempts to revive the notion of diversification as a means of maintaining high earnings growth indefinitely into the future. In one variant, management makes lofty claims about the potential for cross-selling one division’s services to the customers of another. It is not clear, “though, why paying premium acquisition prices to assemble the two businesses under the same corporate roof should prove more profitable than having one independent company pay a fee to use the other’s mailing list. Battle-hardened analysts wonder whether such corporate strategies rely as much on the vagaries of mergers-and-acquisitions accounting (see Chapter 10) as they do on bona fide synergy.”

Question 58

“there are periodic attempts to revive the notion of diversification as a means of maintaining high earnings growth indefinitely into the future. In one variant, management makes lofty claims about the potential for cross-selling one division’s services to the customers of another. It is not clear, “though, why paying premium acquisition prices to assemble the two businesses under the same corporate roof should prove more profitable than having one independent company pay a fee to use the other’s mailing list. Battle-hardened analysts wonder whether such corporate strategies rely as much on the vagaries of mergers-and-acquisitions accounting as they do on bona fide synergy.”

Question 59

“Bankruptcies connected with asbestos exposure, silicone gel breast implants, and assorted environmental hazards have heightened analysts’ awareness of legal risks. Even so, analysts still miss the forest for the trees in some instances, concentrating on the minutiae of financial ratios of corporations facing similarly large contingent liabilities. They can still be lulled by companies’ matter-of-fact responses to questions about the gigantic claims asserted against them.”

Question 60

“What generally sells best to individual investors is a story. Sometimes the story involves a new product with seemingly unlimited sales potential. Another kind of story portrays the recommended stock as a play on some current economic trend, such as declining interest rates or a step-up in defense spending. Some stories lie in the realm of rumor, particularly those that relate to possible corporate takeovers. The chief characteristics of most stories are the promise of spectacular gains, superficially sound logic, and a paucity of quantitative verification.”

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Financial Statement Analysis
Martin S. Fridson
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Question 61

“Transactions are no longer the basis for much of the value created and destroyed in today’s economy, and therefore traditional accounting systems are at a loss to capture much of what goes on,” argued Baruch Lev of New York University. As examples, he cited the rise in value resulting from a drug passing a key clinical test and from a computer software program being successfully beta-tested. “There’s no accounting event because no money changes hands,” Lev noted”

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Financial Statement Analysis
Martin S. Fridson
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Question 62

“the values assigned to huge amounts of financial assets on many companies’ balance sheets are not verifiable on the basis of continuously quoted prices determined in deep, liquid markets. Under Fair Value Accounting, an asset of this sort is valued at the amount at which it currently could be bought or sold in a transaction between willing parties, not including a liquidation sale. If no active market for the asset exists, a company can determine its balance sheet value on the basis of quoted prices for similar assets that do trade actively. In this case, the company must make assumptions about how the market would adjust for the fact that the actively traded and non-actively-traded assets are not identical. If no comparables exist, a company can use its own assumptions about the assumptions market participants would use to offer or bid for the asset it is valuing. Users of financial statements can reasonably expect that some companies’ assumptions about assumptions will be on the liberal side, potentially inflating the value of non-actively-traded assets. Abuse of this discretion was one element of the Enron fraud”

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Financial Statement Analysis
Martin S. Fridson
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Question 63

“issuers of financial statements have resisted the imposition of full-blown fair value accounting. Under the compromise embodied in Statement of Financial Accounting Standards (SFAS) 115, financial instruments are valued according to their intended use by the company issuing the financial statements. If the company intends to hold a debt security to maturity, it records the value at amortized cost less impairment, if any. (The amortization is the write-down of a premium over face value or write-up of discount from face value, over the remaining period to maturity. Impairment is a loss of value arising from a clear indication that the obligor will be unable to satisfy the terms of the obligation.) If the company intends to sell a debt or equity security in the near term, hoping to make a trading profit, it records the instrument at fair value and includes unrealized gains and losses in earnings. A third option is for the company to classify a debt or equity security as neither held-to-maturity or a trading security, but instead in the noncommittal category of available for sale. In that case, the instrument is recorded at fair value, but unrealized gains and losses are[…]”

“The essential point is that an asset may be valued on one company’s balance sheet at a substantially different value than an identical asset is valued on another company’s balance sheet, all based on the different companies’ representations of their intentions.”

Question 64

“Even leaving aside the possibility of a plunge in stock prices, it makes eminent sense to eliminate or sharply downplay the value of goodwill in a balance-sheet-based analysis of credit quality. Unlike inventories or accounts receivable, goodwill is not an asset that can be readily sold or factored to raise cash. Neither can a company enter into a sale-leaseback of its goodwill, as it can with its plant and equipment. In short, goodwill is not a separable asset that management can either convert into cash or use to raise cash to extricate itself from a financial tight spot. Therefore, the relevance of goodwill to an analysis of asset protection is questionable.”

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Financial Statement Analysis
Martin S. Fridson
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Question 65

“What financial analysts are actually seeking, but are unable to find in the financial statements, is equity as economists conceive of it. In scholarly studies, the term equity generally refers not to accounting book value, but to the present value of future cash flows accruing to the firm’s owners. Consider a firm that is deriving huge earnings from a trademark that has no accounting value because it was developed internally rather than acquired. The present value of the profits derived from the trademark would be included in the economist’s definition of equity but not in the accountant’s, potentially creating a gap of billions of dollars between the two.
The contrast between the economist’s and the accountant’s notions of equity is dramatized by the phenomenon of negative equity. In the economist’s terms, equity of less than zero is synonymous with bankruptcy. The reasoning is that when a company’s liabilities exceed the present value of all future income, it is not rational for the owners to continue paying off the liabilities. They will stop making payments currently due to lenders andtrade creditors, which will in turn prompt the holders of the liabilities to try to recover their claims by forcing “the company into bankruptcy. Suppose, on the other hand, that the present value of a highly successful company’s future income exceeds the value of its liabilities by a substantial margin. If the company runs into a patch of bad luck, recording net losses for several years running and writing off selected operations, the book value of its assets may fall below the value of its liabilities. In accounting terms, the result is negative shareholders’ equity. The economic value of the assets, however, may still exceed the “stated value of the liabilities. Under such circumstances, the company has no reason to consider either suspending payments to creditors or filing for bankruptcy.
The Western Union Company’s September 2006 spin-off from First Data Corporation demonstrated that negative equity in an accounting sense is not synonymous with insolvency. In connection with the spin-off, the provider of money transfer services distributed approximately $3.5 billion to First Data in the form of cash and debt securities. Net of other events during the period, shareholders’ equity fell to –$314.8 million on December 31, 2006, from $2.8 billion one year earlier. By producing solid earnings over the next three years, Western Union boosted shareholders’ equity to $353.5 million by December 31, 2009. Anyone who mistook the year-end 2006 negative figure as an indication of Western Union’s economic value would have deemed its stock grossly overvalued at $18.85 a share. Through the end of 2009, however, Western Union shares performed far better than the stock market as a whole. The Standard & Poor’s 500 Index fell by 21.4 percent versus a decline of only 15.9 percent for Western Union.”

Question 66

“To most individuals who examine a company’s income statement, the document is less important for what it tells about the past than for what it implies about future years.1 Last year’s earnings, for example, have no direct impact on a company’s stock price, which represents a discounting of a future stream of earnings (see Chapter 14). An equity investor is therefore interested in a company’s income statement from the preceding year primarily as a basis for forecasting future earnings. Similarly, a company’s creditors already know whether they were paid the interest that came due in the previous year before the income statement arrives. Their motivation for studying the document is to form an opinion about the likelihood of payment in the current year and in years to come.
In addition to recognizing that readers of its income statement will view the document primarily as an indicator of the future, a company knows that creating more favorable expectations about the future can raise its stock price and lower its borrowing cost. It is therefore in the company’s interest to persuade readers that a major development that hurt earnings last year will not adversely affect earnings in future years. One way of achieving this is to suggest that any large loss suffered by the company was somehow outside the normal course of business, anomalous, and, by implication, unlikely torecur.

“The most dangerous trap that users of financial statements must avoid, however, is inferring that the term restructuring connotes finality. Some corporations have a bad habit of remaking themselves year after year. For such companies, the analyst’s baseline for forecasting future profitability should be earnings after, rather than before, restructuring charges.

“Procter & Gamble (P&G) is a case in point. As of April 2001, the consumer goods company had booked restructuring charges in seven consecutive quarters, aggregating to $1.3 billion. Moreover, management indicated that it planned to continue taking these ostensibly nonrecurring charges until mid-2004, ultimately charging off approximately $4 billion.
Defending its reporting, P&G said that Securities and Exchange Commission (SEC) accounting rules precluded it from taking one huge charge at the outset of the restructuring program launched in June 1999. Instead, the company was required to record the charges in the periods in which it actually incurred them. Granting the point, the SEC did not compel Procter & Gamble to segregate the costs of closing factories and laying off workers from its other operating expenses. Indeed, the arguments were stronger for treating the charge-offs as normal costs of operating in P&G’s highly competitive consumer goods business, where countless products fail or become obsolete over time.”