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Welcome to USAGOLD's "Gilded Opinion" pages. We invite you to browse our index of outstanding gold-based commentary.
Storm Watch:
Breakdown -- Greed, Complexity, Conflicts of Interest and The
Moral Hazard
(Jan 25, 2002)
by James J. Puplava / Financial Sense Online
Kmart's Demise - The Writing Was On The Wall
On Monday of this week, another household name bit the dust. Kmart, once considered one of America's premier growth companies, filed for bankruptcy. It came as a surprise, but it shouldn't have surprised the financial markets. Evidence that the company was headed for trouble was in Kmart's financial statements. Over the last few years, gross margins did not cover general selling and administrative costs. The company was losing money, cash was dwindling, and the company's debt structure was understated on its balance sheet. The company listed capital lease obligations of $943 million on its balance sheet in 2000. On the surface, it looked like the Kmart's debt structure was reasonably healthy. The footnotes told a different story. Kmart had $7 billion of off-balance sheet debt in the form of operating leases. The retailing giant conducted most of its business in leased facilities with 25-year terms. Those leases were kept off the balance sheet as debt because the company choose to treat them as operating leases. Essentially, the debt became an expense, rather than a liability. This accounting adjustment made Kmart look much healthier than it appeared.
There were other problems that were evident in the company's cash flow statements. Most of its cash for operations was coming from tapping into the capital markets. The retailer was losing money, so cash flow needed to be supplemented by borrowing more money. Kmart also made a poor choice in its expenditure of cash. Management had undertaken a stock buyback program to reduce the number of shares in an effort to drive up earnings per share. Unfortunately, it undertook to do this at a time it was making major capital expenditure investments and losing money from operations. The company terminated its buyback program in June of last year, having spent $255 million to buy back 22 million common shares and an additional $84 million to buy back convertible shares. Their total buybacks amounted to $339 million, compounding their financial stress. There were other telltale signs in their financial statements, but these are the most glaring. Today, Kmart is launching an internal investigation of its accounting.
Behind The Mask
Kmart and Enron's bankruptcy point to a growing problem. The integrity of our financial system is breaking down. The Wall Street Journal's article nailed it right on the head. Even the regulators, as in the case of Enron, have let investors down. The SEC gave Enron waivers from two regulations that would have prompted more detailed financial disclosures. We live in a day where corporate accounting has become more complex. Company balance sheets are beginning to look more like financial institutions in their complexity. Off-balance sheet partnerships, vendor financing, the need to hedge through derivatives, compensation programs that use stock options, and cross-party equity stakes make deciphering a company's real business much more difficult. Numbers on the financial statements can no longer be taken at face value. Why? Because the numbers on the income and balance sheet may appear to mean one thing, when in reality, they may mean something entirely different. Their validity must be verified by a close examination of the footnotes. In many cases, the entire financial statements themselves must be reconstructed. Simple concepts like sales and earnings, once the yardsticks for making investment decisions, are now subject to multiple interpretations. These days, what you read and hear has become too complicated and subject to too much interpretation.
Black Box Accounting
In the financial world, this new math has given birth to a new term known as "Black Box Accounting." This term is used to describe financial statements that are opaque, complex and confusing. These financial statements have become so impenetrable, that individual investors aren't the only ones who can no longer understand them. Even the pros have difficulty. Wall Street analysts, corporate CEOs and even the company auditors have difficulty in understanding the numbers.
The business world is more complex today than it was 30 years ago. Most large companies have global businesses. The capital markets have become much more sophisticated as risk levels have risen due to a international monetary system that is no longer fixed and anchored to gold. Besides business risk, companies that operate internationally face interest rate and currency risk. This has led to an explosion in the use of derivatives as a means of hedging against that risk. Yet, the use of derivatives to hedge against risk has become an oxymoron. The very risk they were designed to hedge against has created even greater risk in the financial system. LTCM and Enron are recent examples of what happens when risk strategies turn to speculation. The pressure of competition and the need to perform has led many companies to become less than frank in reporting their financial results. Management often takes advantage of loose accounting rules to massage their numbers in efforts to beat estimates and drive the price of the stock of the enterprises they manage.
Stock Options and Fees Muddy the Waters
In a broader sense, the whole financial system has been infected with conflicts of interest. The argument of the complexity of today's modern corporation can account for only a part of the problem. Greed and avarice account for many of the other problems we see. The desire to gain wealth has come into conflict with moral responsibility. This emphasis on gaining wealth has invariably produced conflicts of interest that rationalize certain human action. Today's directors and executives who run corporations are more concerned about the performance of the price of the stock than the performance of the enterprise. This is because stock options have become a major source of compensation.
Auditors must now deal with their own conflicts of interest. This makes it more difficult to deal with management on accounting conventions when their major source of compensation is derived from consulting fees. In the case of Enron and its auditors, Arthur Andersen, the accounting firm's consulting revenue from Enron accounted for better than half of their $52 million in fees.
On Wall Street, where the most profitable end of the business comes from investment banking fees, analysts' recommendations may come into conflict with objective recommendations when large fees are involved with the companies they recommend. In the case of Enron, many high profile Wall Street firms continued to recommend Enron right up to the time of Enron's bankruptcy. Many of these same firms had strong investment banking relationships with the company. In fact, these conflicts of interest and the lack of homework on the part of analysts have become another part of the problem. When it comes to projecting earnings for companies, analysts now resemble stenographers echoing nothing more than what the companies tell them.
The pressure on quarterly earnings performance and the role that those earnings reports play in driving stock prices is leading to further obfuscation of earnings. What was once measured objectively is now up for interpretation. These days what we call earnings can resemble whatever companies want them to be. Quarterly earnings have moved from the category of non-fiction to fiction, reflecting the fantasies of the management. The insatiable desire to have access to immediate information has led to reporting numbers that aren't verifiable. Today's markets are momentum driven whereby investors jump from sector to sector and one company to another based on the latest earnings news. The fact that the numbers are open to a wide degree of interpretation doesn't matter. Investors don't want to be confused with the facts, so they are just as much to blame. Whether a company meets or beats estimates is all that matters. The fact that those earnings aren't really verified until much later when a company reports its 10-Q report to the SEC is oftentimes ignored. The bull markets of the 90's were earnings driven. When companies could no longer met expectations, they manufactured them through financial engineering. By the time the real numbers became known, the stock market was no longer interested.
So today we see numerous cases of companies having to restate their sales or earnings. Most of the time when this happens, the numbers are lower because of improper accounting for revenues, expenses or taxes. When corrections are announced, the stock price is taken to the woodshed and trashed, resulting in big losses for investors. The number of occurrences over the last few years has more than doubled. Many solid companies with brand names and held in high regard by investors were hit with high profile accounting problems. The list is made up of a Who's Who in the corporate world. Recent examples include Waste Management, Cendant, Rite Aid, Sunbeam, and Enron. With Enron and Sunbeam, those earnings revisions were a prelude to bankruptcy.
Do Conflicts of Interest Hinder Professional Judgment?
This earnings game has led to a crisis within the accounting profession that could set a course for a more serious crisis of confidence for investors and ultimately the financial markets. The accountants are the scorekeepers of the financial numbers. Until recently, they have been above suspicion and shrouded by a veil of creditability and confidence. For decades, they have convinced investors, analysts and the government that the numbers they blessed were free from sin. Yet over the years, what began as small venial sins have now led to mortal sins. Today, what accountants sign off on can no longer be read with confidence. This situation is most visible with Enron and its auditors, Arthur Andersen. Arthur Andersen was also Waste Management and Sunbeam's auditor. The Enron case is once again raising the long-standing debate of the decade of whether accountants are capable of policing themselves. Arthur Levitt, the former SEC Chairman, didn't think so. He felt that consulting fees conflicted with an accounting firm's ability to remain independent and objective. He wanted to separate the auditing side of the business from the consulting side of the practice. The accounting profession argued and lobbied against it. Now a new SEC Chairman, Harvey Pitt, must face the same problem. Pitt was an attorney before becoming Chairman of the SEC. In private practice, he spent much of his time defending large accounting firms. So, even here, there are questions of his objectivity.
There are many individuals outside the industry, including Lynn Turner, a former chief accountant with the SEC, that feel the time is right for a new independent body, similar to the securities industry's National Association of Securities Dealers which works with the industry and the government in self-policing the securities industry. There is nothing like that within the accounting profession that has the teeth to enforce discipline. The accounting profession is against it, but many feel the profession is incapable of self-control. Concerns are mounting that accounting firms are no longer independent. Like Wall Street firms that depend on investment banking fees, accounting firms have come to rely more on consulting fees, which have surpassed audits for their revenues. When revenues depend on large consulting fees, the temptation to look the other way when improper bookkeeping is suspected becomes more difficult.
A Crisis in Confidence
All of this degredation of professional integrity is leading to a crisis in confidence for the financial markets. Investors have come to the realization that they can't believe in anything that management tells them. They have also come to disbelieve in the numbers reported and signed off on by accountants in the financial reports. Confidence in analyst's recommendations is also waning. Do you ever hear analysts recommend selling a stock? On Wall Street, everything is a buy because it is in its own self-interest to keep investors fully invested. The system is breaking down and in danger of imploding. It is not just an issue of complexity. The larger issue is a moral one. How do you stop the lying, cheating and stealing? The government has never been good at legislating morality. When it comes to character and integrity, these are spiritual issues that rest in the hearts of men. To the financial world, spiritual issues are best left in the hands of priests, pastors, rabbis and clerics.
On the other hand, how do you make a complex world understandable? Financial transactions have become increasingly intricate as a result of globalization and floating exchange rates between currencies. Fiat money systems have always been unstable. The ability to print unlimited amounts of money out of nothing has always been a temptation of government. It has resulted in irreparable harm to the financial system. It is one of the mistakes of history that seems to repeat itself in every century. It is one of the larger immoralities of our current system and one I believe that is also breaking down. Just as there are concerns over who is policing the accountants, there is also concern over who is watching the government. Up to the present, that has been the role of the markets. In the end, it may be the markets that provide the final solution. But all of that is for the future. At the moment, we must deal with the present. We must learn to understand how complex and broken down the system has really become.
Questionable Practices
The recent events involving the bankruptcy of Enron and Kmart point to the investor's greater need for understanding of how earnings can be manipulated. There are three basic strategies for doing this. They are 1) increasing income, 2) taking big write offs in the current period to make the next accounting period look better, and 3) reducing earnings volatility by income smoothing.
Above and Below The Line
The first of these involves
pumping up sales. It is the easiest way to drive up the bottom
line. When the top number goes up, it can flow directly to the
bottom line. I've already highlighted many of these techniques
in a previous article, A Penny Less and a Penny More. Essentially,
management attempts to drive up sales or income through accruals
over several years rather than reverse those accruals all at once
with a one-time charge. If this sounds familiar, it is because
we see it done every quarter. The one-time charge is reported
below the line, which means analysts and investors will
probably ignore it. Good examples of this practice can be found
with Intel, Dell, and Microsoft. During the Internet and tech
mania of the late 90's, these companies consistently reported
investment-holding gains as part of their operating profits when
things were going well. When the boom ended and those investments
turned sour, the losses were treated as extraordinary expense
items and were removed from above the line to below the
line. They were included as profit and part of operating income
when they were at a profit, and extraordinary and non-operating
when they turned into a loss.
The Big Bath Charge
The "Big Bath Charge"
is one of the more egregious offenses by management to manipulate
earnings. It happens so often it almost has become routine. The
reason I mention it here is that it surfaced and became pronounced
in the third and fourth quarter of last year. This strategy
involves taking as many write-offs as possible in one period such
as we saw in the second half of last year. Management takes a
quarter that everybody knows is bad because of either recession
or some unusual event and then loads as much in expenses as possible. The
terrorist attacks on September 11 became the catalyst for many
companies to load up and write-down as much as they could in expenses.
The terrorist attacks became an ideal cover. The huge expense
is considered to be unusual and nonrecurring, so it is oftentimes
ignored. You might hear of a financial report that refers to pro-forma
numbers that excludes these charges. The pro-forma numbers are
given since they make the company look better. The real
numbers, which many times include big losses, are ignored because
they are considered to be temporary and unusual. So nobody pays
attention to them.
This practice had become so egregious, that it caused Warren Buffett to comment on it in a letter to shareholders back in 1998. Buffett stated,
"a significant and growing number of otherwise high-grade managers - CEOs you would be happy to have as spouses for your children or as trustees under your will - have come to view that it's okay to manipulate earnings to satisfy what they believe are Wall Street's desires. Indeed, many CEOs think this kind of manipulation is not only okay, but actually their duty. They also argue that in using accounting shenanigans to get the figures they want, they are doing only what everybody else does".
Buffett went on to elaborate the distortions created by this process with,
"In this bit of legerdemain, a large chunk of costs that should properly be attributed to a number of years is dumped into a single quarter, typically one already fated to disappoint investors. The purpose of the charge is to clean up earnings misrepresentations of the past, and in others it is to prepare the ground for future misrepresentations. In either case, the size and timing of these charges is dictated by the cynical proposition that Wall Street will not mind if earnings fall short by $5 per share in a given quarter, just as long as this deficiency ensures that quarterly earnings in the future will consistently exceed expectations by five cents per share."
Warren Buffett, Berkshire Hathaway 1998 Report, Chairman's Letter
Massaging
The Numbers
This practice is worth
highlighting now because so many charges were written off during
the third and fourth quarters of last year. This is setting the
stage for easier comparisons during the second half of this year.
It may be one reason why Wall Street is so confident of a second
half earnings recovery. Already this year, because of the change
in accounting rules involving the impairment of assets, it is
estimated that companies will write-off over $1 trillion in assets
that will be treated as extraordinary items and expensed below
the line. Each
write-off is a confession by management that investor wealth has
been destroyed. It may indicate
that future problems lie ahead as we have seen with Enron, Waste
Management, and JDS Uniphase.
Stock Option Accounting
Another practice that
distorts earnings through the lack of expense recognition is the
accounting for stock options. Stock options aren't treated
as an expense when they should be. They are a form of compensation.
If they aren't an
expense, then what are they?
They can dilute shareholder value when they are exercised, and
misrepresent payroll expense when they are issued generously in
lieu of compensation. When Berkshire Hathaway bought General Re,
their pro-forma numbers increased payroll expense by $63 million.
The pro-forma adjustment came about when Buffett replaced General
Re's stock option plan with cash that tied compensation to General
Re's operating achievements. Buffett said, "... what counted
for these managers was General Re's stock price; now their payoff
will come from the business performance they deliver".
Derivatives - Again an Issue
Another complexity that
investors will have to deal with this year is accounting for derivatives.
Derivatives are complex securities that are classified from an
accounting view based on the motivation of the company entering
into a derivative contract and the nature of the derivative security.
The derivative is classified as either a hedge or a speculative
transaction. Hedges are treated in one way; while speculative
transactions are treated in another way. Hedges are eligible for
special rules not afforded to speculative derivatives. Hedges
are further broken down and classified into fair value, cash flow
hedge, or foreign currency hedge. Regardless of classification,
all derivatives are now recorded at fair value on the balance
sheet. This is important to you due to their growing popularity
and their volatility. They can have major effects on the balance
sheet and income statements of companies. Ultimately, they affect
the stability of your holding.
In a theoretical world, where everything remains in perfect balance, derivative hedges should have no effect at all on financial statements. However, unlike regular investment securities held by companies, derivatives are marked to market with gains and losses that can flow directly into the income statement and balance sheet depending on the derivatives classification. If the hedge is effective, there should be no major impact. But in reality, that only takes place in a perfect world. In a perfect world, there is no September 11. Companies are allowed wide latitude in their disclosure of the amount of risk involved. They can use tabular presentations of risk, sensitivity analysis, or value-at-risk measures in disclosing information in their reports to shareholders and prospective investors. Suffice to say they are complex to understand and they raise the possibility for more variability of earnings and fluctuations in the balance sheet.
Off-Balance
Sheet Financing
Finally, there is an
issue that bears mentioning if for no other reason than to avoid
another Enron or Kmart. This issue involves off-balance sheet
financing. In the case of Enron, it was the complex nature of
their financial relationships with inter-company partnerships
that hid Enron's true debt picture. In the case of Kmart, it was
the lack of earnings and the understatement of debt by classifying
their store leases as operating leases rather than capitalizing
them. A lease is a contractual agreement between a lessor (OWNER)
and a lessee (USER). It gives the lessee the right to use the
asset in exchange for payments set for a term. A lease that
transfers most all of the risks of ownership is treated the same
as if the lessee actually owns the asset because of the liability
of future income payments. The lease is called a capital lease
and is treated as a liability on the balance sheet. Operating
leases, on the other hand, are not treated as a liability and
are treated as rental expense on the income statement. Capital
leases are treated a little differently. They are amortized over
time in much the same way as a mortgage on your home.
Lessees often structure a lease in such a way that it can be treated as an operating lease so it doesn't show up as a liability on the balance sheet. This can occur even though the lease closely resembles a capital lease. In the trade, this practice is often known as "off-balance sheet financing" because the lease doesn't show up on the balance sheet even though the risk of ownership is there. In the case of Kmart, their operating leases were substantial at $7 billion versus $943 million in capital leases. One advantage to Kmart in declaring bankruptcy is that through the bankruptcy court, Kmart may be able to walk away from future lease payments on the 400-500 stores it plans to close down.
So, Where Do We Go From Here?
If all of this is beginning to sound too complex, you are beginning to get the picture. Numbers given on financial statements can no longer be taken at face value. I am currently taking a course in what I call, "forensic accounting." Each week I pose questions in class on examples of the current topic under discussion. I'm amazed at how every number on the financial statement must be questioned and verified. Looking for black and white answers has left me frustrated. When I ask questions, my professor always begins with the word, "depends". It depends on this or it depends on that. There are very few straight answers.
Much of today's accounting is no longer black or white. It is gray. This is why the system is breaking down. There are no straight answers anymore. Accounting statements have become so complex that even Wall Street analysts, government regulators, corporate executives, and even the accountants themselves have difficulty understanding them. Imagine the unsuspecting investor. If the pros stumble upon accounting minefields, think of today's day trading investor who knows little about what he owns. The system is in desperate need of reform. Unless it is reformed, the financial markets are bound to pay a price. When investors no longer trust the financial system, the eventual outcome will be loss of confidence and lower stock prices. Stocks will truly be priced for the risk that they involve which will translate into investors demanding a higher risk premium.
As far as the moral problem is concerned, I believe it is much easier to deal with and reform. Simply remove the incentives for earnings management and the conflicts of interest and most of these problems will go away. Earnings won't be managed unless incentives are given for managing them. Remove the conflicts of interest and better judgments will be made. Want to modify behavior outcome? Change the reward system. Punish and reprimand those who break the rules and reward those who honor them. This means allowing companies and hedge funds that bend the rules or take large risks to pay the ultimate price by allowing them to fail. Too many times the Fed or the government intervenes and rescues companies from their bad decisions through a government bailout. This only encourages greater risk taking. If you are big enough, the government will in most cases absolve you of your sin. Regarding lying, cheating, and stealing by companies, CEOs, investment managers or auditors, treat them as criminals by the crimes they commit. Perjury and stealing is a crime punishable by imprisonment. It is high time it is applied to the financial world.
What Can The Individual Investor Do?
Given the complexities of today's modern financial world, there are several steps that an investor can take to make informed investment decisions. The first step is to learn how to read a financial statement. It is a blueprint of the company you own or are considering for investment. If you don't have time to take a class, go to the bookstore. There are plenty of "How To" books available that can help you begin to understand them. Secondly, don't buy on hype and earnings news. You shouldn't buy a stock just because a company met or beat analysts' estimates. That tells you nothing about the business. The company could have actually lost money. Moreover, the real financial numbers won't be available for weeks after the earnings report when the company files its form 10-Q with the SEC. You can read it on the company's web site or at Edgar Online. This is the report that will tell you the real story. If the company is doing well, the report will say so. If they aren't, you will clearly see it in the financial numbers. More importantly, you'll need to read the footnotes. Begin to read them so that you have a clearer understanding of the numbers you are reading.
There are also qualitative issues that should give you greater comfort in making your investment decisions. They deal with the quality of the financial statements. Look for incentives for earnings management such as the issuance of large stock options to top management. This creates a conflict and an incentive to "manage" earnings. You should also consider the reputation and history of the company. You are looking for management integrity. Look at past statements to see how well management has executed their business plan. Review SEC enforcements, audit reports, and recent financial press reports. Identify key accounting policies. If they keep changing, management is manipulating earnings by doing so. Look out for red flags as in the case of reported earnings being consistently higher than sales and cash flow. Read my Storm Watch article, A Penny less or A Penny More, for more on this subject. Finally, review management's plan of discussion for the business. Look for a plan of consistency. If they are losing money, or if earnings are going down, and they announce a share buyback, it should alert you to fact that there may be problems up ahead.
By taking these steps, you at least will be able to make an informed decision about your investments. More importantly, you can avoid making a decision because of hype and media and Wall Street spin. Remember, it's your money. If you don't want to take the time to manage your affairs, you only have two choices: stay out of the markets or find somebody you trust to do it for you. ~ JP
by James J. Puplava
January 25, 2002
Financial Sense (a Registered Trademark)
P. O. Box 1269
Poway, CA 92074 USA 858.486.3939
http://www.financialsense.com/
Please direct corrections and technical inquiries to webmaster@financialsense.com
Copyright © 2002 by James J. Puplava. All Rights Reserved.
Reprinted by USAGOLD with permission of Mr. Puplava. This article may NOT be reproduced without the expressed, written permission of the author. Selective quotations are permissible as long as the author, Jim Puplava, and his web site are acknowledged through hyperlink to: http://www.financialsense.com/
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