Earnings Magic & the Unbalance Sheet

1. Earnings Magic & the Unbalance Sheet The Search for Financial Reality

2. What the Book is About • The focus of this book is on earnings management and other factors related to transparency (complete disclosure based on financial reality) • The Big 8 are the major items that can distort financial reality, from revenue recognition to stock options and off-balance sheet items • The Dirty 30 are the Big 8 plus a host of other issues that can distort financial reality

3. Sections of the Book • Section 1 provides background on what earnings magic is all about, a bit of financial scandal history, and new regulatory requirements since Sarbanes-Oxley • Section 2 reviews the Big 8 and Dirty Thirty is some detail, focusing on the Dow 30 • The final section puts is all together to reevaluate financial reality and rate companies on earnings magic and transparency; the focus is again on the Dow 30

4. Section 1 Background on Earnings Magic

5. Content of Section 1 • 1. What is Earnings magic? Definition & overview, particularly incentives • 2. Caught in the Act! History of current scandals • 3. The New Accounting. Thanks to the scandals, new regulations are in place & more are on the way • 4. Wading Through the Earnings Numbers. Strategies for reviewing financial disclosures

6. Chapter 1 What is Earnings Magic?

7. What is Earnings Magic? • Earnings magic: all the factors that limit understanding financial reality • Earnings management: Operating & discretionary accounting methods to adjust earnings to a desired outcome; the incentives of management to modify earnings in their own best interests • Earnings manipulation includes aggressive earnings management and fraud • Earnings manipulation is at the heart of earnings magic—how companies can recast financial information to avoid financial reality

8. Conservative vs. Aggressive Accounting & Fraud • Conservative accounting generally is close to financial reality; firms can move toward aggressive accounting (with fraud being the extreme case) to make earnings look better • Conservative revenue recognition: revenue recognized after sale, delivery, & acceptance; that is, the earnings process is complete • Aggressive revenue recognition example: bill & hold (that is, revenue is recognize although goods have not been shipped) • Fraud example: nonexistent or other fraudulent sales

9. Incentives for Earnings Magic • “It pays to do it, it’s easy to do, and it’s unlikely that you’ll get caught” (Schilit) • Opportunism: self-interest with guile—violating normal ethical boundaries for personal gain • Executive incentives include bonuses and stock options: executives can increase compensation by making the performance look great through earnings magic • Many contracts (e.g., lending & employee contracts) are based on accounting numbers, which can be fudged to “make the numbers” • See Exhibit 1.4

10. Institutional Framework (1) • The purpose of the various market & financial institutions is to facilitate economic transactions and protect the key constituents, especially stakeholders • Generally, the institutional players are expected to ensure market efficiency and financial transparency (including fiduciary responsibility) • The institutions can be classified as (1) regulatory (e.g., SEC, FASB) & (2) private (e.g., board of directors, auditors, investment banks, attorneys)

11. Institutional Framework (2) • Corporate governance: The board of directors and the structure in place to oversee the management of an organization • Auditors: evaluate appropriate financial accounting and reporting according to generally accepted accounting principles (GAAP). Auditors must have the ability to discover significant discrepancies with GAAP (competence) & willingness to report the discrepancies to the audit committee or other relevant bodies (independence)

12. Institutional Framework (3) • Securities & Exchange Commission (SEC): primary financial regulator of financial disclosure (with oversight over securities markets) • Financial Accounting Standards Board (FASB): sets accounting standards (generally accepted accounting principles or GAAP) for U.S. firms

13. Institutional Framework (4) • Investment banks: Investment banks issue new securities and other financial instruments. Financial analysts provide research on equity investment, including earnings forecasts and buy-hold-sell recommendations. Analysts have incentives to recommend buys on investment banking clients and brokers are encouraged to sell the new issues • Attorneys: Attorneys often write and review contracts, particularly those that are complex and controversial. Other law firms write legal opinion letters. The auditor can normally approve complex contracts based on attorney opinion letters

14. Institutional Signals of Earnings Magic Environment • Strong CEO (who is also chairman of the board) with substantial perks • Board made up primarily of insiders • Poor board committee structure, especially audit committee • Audit problems, including non-audit fees • Executive compensation problems, including huge (& poorly structured) incentives packages • Investment banking problems, including non-independent analysts

15. What is Financial Reality? • Transparency—complete disclosure attempting to approximate financial reality • Financial statements are a potential summary of financial reality • Complex disclosures in the notes, MD&A, etc. can be used to better measure reality • What bottom line measure is the best measure: net income, income from operations, comprehensive income? • Income from continuing operations is a possible starting point

16. Detecting Earnings Magic • Standard Financial Analysis (including ratios & other quantitative analysis • Industry analysis (e.g., occupancy rates are important to hotels) • Detailed accounting analysis (found in notes, proxy statements, etc) • Importance of multi-period analysis

17. Detecting Earnings Magic using Multi-period Analysis • A longer- term perspective, looking for recurring patterns or negative trends • Quarterly patterns than may signal intra-year earnings management • Balance sheet issues • Income statement issues • Focus is on signals of earnings magic, not absolute proof

18. Chapter 2 Caught in the Act!

19. Capitalism in Action • Crises—unsustainable booms followed by calamitous busts—have always been with us, and with us they will always remain. … The very things that give capitalism its vitality—its powers of innovation and its tolerance for risk—can also set the stage for asset and credit bubbles and eventually catastrophic meltdowns whose ill effects reverberate long afterward. Nouriel Roubini and Stephen Mihm

20. What is a Scandal? • Like the terms speculation or corruption, the idea of a business scandal is loosely defined • According to Wikipedia: “A scandal is a widely publicized incident that involves allegations of wrongdoing, disgrace, or moral outrage” • How corruption and scandals are defined has changed over time, but bribery, speculation, greed, and power seem to be common in all periods • A corporate scandal often involves accounting fraud

21. 19th & 20th Century Scandals • Panics of 1792, 1819, 1837, 1857, 1873, 1893, 1907. • Credit Mobilier (transcontinental railroad) • Raiding the Erie • Boss Tweed & Tammany Hall • Teapot Dome • Charles Ponzi • Great Depression: markets rigged, lack of disclosure (Krueger & Toll), stock pyramiding, excessive leverage • McKesson & Robbins (auditing deficiencies) • Conglomerates (merger magic) & hostile takeovers • Michael Milken: junk bonds, insider trading, savings & loan crisis • Derivatives (1987 Crash, Mexico to Long-term Capital Management)

22. Waste Management (1997) Sunbeam (1998) Enron (2001) Global Crossing (2002) WorldCom (2002) Tyco (2002) Adelphia (2002) Imclone (2002) Merrill Lynch & other investment banks (2002) HealthSouth (2003) Fannie Mae (2004) AIG (2005) Key Scandals Through 2005

23. The Wisdom of Crowds (Surowiecki) • Trust is central to economic systems because of cooperative behavior • Corruption is very damaging to the system • Current scandals: short-term gains from corruption were immense • Institutions designed to limit corruption were ineffectual (or perhaps facilitated corruption)

24. Scandal “Theory” • Rotten apple theory—sleazy leaders establishing illegal conspiracies • Specific cultural issues; e.g., speculation in the 1920s, conglomerate mergers in the 1950s, hostile takeovers in the 1980, stock options and earnings forecasts in the 1990s • Institutional theory—the business & regulatory structure in place • Corporate governance practices • Survival of the fittest • Importance of excessive leverage • Incentives of key players, especially compensation

25. Reasons for the 1990s/2000s Scandals • Euphoria: Booming stock market, with a focus on internet, telecom, & other high-tech industries • Large number of initial public offerings (many with no evidence of ability to make money) • Underfunded SEC & FASB & political pressure NOT to regulate effectively • Emphasis on meeting quarterly earnings estimates (largely because of executive compensation incentives) • Poor corporate governance practices were common • Accommodating investment bankers, attorneys, and auditors

26. Historical Perspective on Scandals • Corporate fraud, bankruptcies, and various illegal acts have always been part of the business environment • Every time fiascos erupt seems a shock, but business history records dozens of failures, frauds and other measures of massive corruption each decade • The big ones often hit during recessions or periods of other economic problems • The high-risk firms are the most vulnerable to economic shocks

27. Why the Scandals? • The obvious corporate greed—is it more widespread than in earlier periods? • Incredible incentives to cheat, especially stock options • Earnings manipulation is part of (and usually central to) most of the scandals • Prominent industries included energy companies and telecommunications (+ accommodating investment banks)—importance of deregulations • Scale: these were big firms involved

28. Enron (1) • Stogy gas transmission company started with massive debt • Formed a gas trading company, expanded into electricity, risk mgt. & telecom; expanded internationally • Based on economic reality, many of these were failures • Based on earnings magic, all were successful

29. Enron (2) • Gas trading: deregulated & volatile, need for spot market purchases & related derivatives, volatility increased trading profits • Problem of massive debt & potential junk bond ratings • Use of special purpose entities (SPEs) to reduce perception of too much debt • Substantial reliance on stock options and bonuses

30. Enron (3) • Importance of meeting quarterly earnings, initially through cost savings, then increasingly more gimmicks • Scheme 1: revalue physical assets using “fair value” models (SFAS 125, designed for financial assets)—front-loading profits • Scheme 2: using SPEs in virtually any complex context to record earnings

31. Enron (4) • SPEs were mishandled • CFO Andy Fastow manipulated these for his own enrichment + independence problem • Particularly shady SPEs approved by auditor Arthur Andersen, attorneys, & board of directors; accommodated by investment banks & no obvious oversight by SEC—failure of the gatekeepers

32. Enron (5) • Some operations were successful, others were major blunders; the net effect was to dramatically increase financial risk, & Enron’s unwillingness to disclose real losses as they occurred • Mid-2001: stock price dropped, executives bailed out of stock options, bond ratings back to junk status • Enron restated earnings in 3rd quarter 2001 • With no credibility, Enron declared bankruptcy in December 2001, the biggest bankruptcy until …

33. WorldCom (1) • Bernie Ebbers started long-distance telecom company in 1983 (name changed to WorldCom in 1995) • Growth through merger strategy (note earnings magic of business combinations) • WorldCom “looked” solid, with total assets of $104 billion & debt-to-equity of 79.3%, but half the assets were goodwill & other intangibles • In 2002 internal audit found operating expenses capitalized

34. WorldCom (2) • New auditor KPMG reviewed the books, old auditor Arthur Andersen was fired; Ebbers resigned in April • In June 2002 WorldCom announced $3.8 billion in accounting errors, mainly by capitalizing “line costs” (fees to other telecom companies for network access rights—these are operating expenses)

35. WorldCom (3) • WorldCom restated earnings, CFO was fired • Actual capitalization misstatements totaled over $11 billion • WorldCom filed for bankruptcy in July 2002, replacing Enron as the largest bankruptcy in US history

36. Tyco (1) • Started as a research lab, Tyco became a conglomerate through acquisitions • CEO “Deal a Day Dennis” Kozlowski acquired 750 companies, using the earnings magic of combination accounting • Acquisition of CIT Group particular fiasco, resulting in big losses (& extra financial reporting that showed many of Tyco’s manipulation shenanigans

37. Tyco (2) • Big loss on sale of CIT & total $9.4 billion loss for 2002 • Kozlowski indicted for evading taxes & “raiding” Tyco • Tyco did not go bankrupt • Despite obvious manipulation & deception on a vast scale, it’s not clear that the company actually engaged in criminal acts

38. Adelphia • John Regas transformed a cable franchise into a communications empire • Restated earnings in 2002, including billion in off-balance-sheet “co-borrowing agreements” • Filed for bankruptcy in June 2002 • Regas & others charged with financial fraud—pilfering the company

39. What do Enron, WorldCom & Tyco Have in Common • Deception on a massive scale—manipulation at the highest levels of the companies • Growth through acquisitions plus related Business combination accounting abuse • Importance of meeting quarterly earnings targets at all costs—related enrichment of senior executives • Accommodating auditors, attorneys & boards of directors • All three restated earnings

40. What Happened at Arthur Andersen? • One of original Big 8, founded in 1913, stressing integrity & consistency • Especially since the 1980s, AA had a history of “aggressive auditing,” clients became too valuable to defy (Toffler) • Associated with many of the big scandals: Sunbeam, Waste Management, Enron, WorldCom & Global Crossing • Found guilty of obstruction of justice in Enron case (later overturned by Supreme Court)

41. Other Scandals • Stock option backdating—back up the issue date to the lowest security price data; this increases the value of the options; this apparently has been going on a long time, but only surfaced when academics discovered & named the process. About 140 companies are now under investigation • Related issues: spring-loading: give options just before good news; Speed-vesting: make sure the options vest before expensing in 2006; Exercise backdating: backdate when options are exercised—to a lower stock price

42. Scandals (2) • Corporate governance at Hewlett-Packard—”pretexting” used to determine source of board of director leaks • Hundreds of companies have restated earnings, a likely sign of substantial earnings magic • Fraudulent accounting practices at Fannie Mae totaled some $16 billion; Fannie has restated several years of financial statements & paid substantial fines

43. Scandals (3) • Insider trading at UBS & Bear Stearns (note major scandals in 1980s) • Related insider trading based on prearranged stock trading plans (10b5-1 plans) by executives: gaming the system by stopping, restarting & amending the plans • Front running: trading ahead of big buy and sell orders based on insider information.

44. Scandals (4) • Robert Nardelli canned at Home Depot & received a $210 million exit package; Home Depot executives fired for taking kick backs from Asian vendors; Nardelli resurfaced to become CEO of Chrysler • Bernie Madoff, a $50 billion ponzi scheme • Allen Stanford ponzi scheme, somewhat smaller • See the Earnings Magic web page

45. Sub-Prime Loan Crisis • Mortgage loans are among the safest lending categories because the property is used for collateral and can’t get away. As long as a reasonable down payment is made and credit is good, default chances are low. • Sub-prime loans are made to people with relatively poor credit, often requiring little down payment, and made at higher interest rates • “Just about anyone in America can afford no money down” (Michael Lewis)

46. Sub-Prime Loans (2) • How do you make a huge market in sub-prime loans? Banks packaged hundred or thousands of them using structured finance into bonds. The key was an investment grade rating (because of1970s regulations plus later foreign regulations). Moody’s & Standard & Poor’s used models that indicated that diversified portfolios of these had low default rates & rated the highest tranches AAA & even low tranches got investment grade ratings. [Bond rating models at the time did not have any equation that included the possibility that housing values could go down!]

47. Sub-Prime Loans (3) • How does a bank make money on these bonds? With a AAA rating, these bonds sold for large premiums over the face value of the underlying mortgages. As long as housing values kept climbing, default rates stayed low. In addition, various forms of “insurance” were available: credit default swaps (think AIG) & liquidity puts (Citi)

48. Sub-Prime Loans (4) • Sub-prime loans packaged into tranches by risk---AAA to BAA & sold as bonds. The low-tranche bonds are accumulated as collateralized debt obligations (CDOs), again by risk tranche; amazingly a large percentage of these are given AAA ratings. Synthetic CDOs are another financial innovation.

49. Sub-Prime Loans (5) • What happened? Cheap credit fueled this environment, but prices were rocketing up after about 2004 (about the time American had a negative savings rate). Housing prices stopped going up. This started about 2006 and became an obvious problem in 2007. The number one problem: LEVERAGE.

50. Sub-Prime Loans (6) • Credit default swaps (CDSs): A premium is paid by the buyer & will pay off if he underlying financial instrument defaults. It’s a derivative & not technically insurance (insurance is regulated, CDSs were exempted from regulation by the Commodity Futures Modernization Act of 2000); CDSs were used as hedges by buyers of CDOs. • Smart hedge funds & others started buying CDSs to speculate (rather than sell short mortgage companies, investment banks & home builders). These are the people making a fortune in the current crisis. • Investment banks packaged CDSs (they are an asset to them) & sold them as synthetic CDOs • Why are there $50 trillion in CDSs when the total US mortgage market is $10-$12 trillion? Part of the explanation: synthetic CDOs