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Beyond Financial Statements: The Art of Detecting Obviously Distressed Companies

Introduction:

In November 8, 2001, one month before Enron applied for bankruptcy that resulted in a loss of $70 Billion to investors, from the 15 analysts that followed it, 11 recommended it as a “strong buy” and the rest recommended it as a “hold”.  At 2002 Governmental Affairs Committee hearings analysts stated that they were fouled, just like us, and they couldn’t have detected the fraud.  However, Howard Schilit, president of the Center for Financial Research & Analysis, an independent research house, who testified at the hearing, stated that the fraud was in plain sight:  negative cash flow despite $1B in profits; $1B in related party revenue; and, the most obvious, a two thirds of company profits in one quarter coming from special-purpose entities [1].

Other signs of red-flags that we all read in the press-releases were: its 46 years old CEO retired suddenly, and in April 2001, eight months prior to bankruptcy, Enron announced its earnings but did not release its balance sheet or cash flow.  None of these signs require knowledge of financial statement.

In fact, many financial frauds against investors can be detected early, and require simple deduction and basic math skills.  Even Madoff two decades billion dollars ponzi schemes had red flags all over that required simple deduction skill and no math.  He charged no management fees; its auditor was a three-person accounting firm with only one active accountant; or that in 2001 Barron, weekly Wall Street newspaper, questioned his results and contained the following statement from one very satisfied Madoff’s investor: “Even knowledgeable people can’t really tell you what he’s doing,”[2].  Of course, with knowledge of statistics one could have seen that his high returns followed a pattern that implied manipulation.

These examples are not the exception but the norm.  They show that even non-professional investors can detect fraud, and protect their investment with some deduction, and some reading skills. This paper helps the investors learn to pin point red flags from news or press releases, 10(K) or annual reports, and companies and executives’ actions and inactions.

 

News/Press Releases:

Many of us lack the ability discerning important news or press releases from noise.  An upgrade of a company recommendation can be only noise, while a company downgrade is most likely important fact to consider when investing.  Investors must look out for missing or distorted facts and figures, timing of press releases.

 

Missing or Distorted Facts and Figures

Company releases its earnings but does not release its balance sheet or its cash flow statements.  Without Cash Flow Statement and Balance sheet investors and analysts cannot make an informed investment decision.   If a company released its earnings without balance sheet, or cash flow statement you should take time to evaluate your investment decision. What triggered Chanos, who is he, to analyze Enron was Enron releasing its earnings without a balance sheet, or cash flow.  

A company may decide to postpone releasing its financial results to delay possible fall of its stock value, or report and label its earnings as pro forma, operating, as reported, normalized, or core instead of net earning.  In all these cases one can come up with one possible conclusion:  the company is either in financial trouble or is hiding something. Professional investors translate these labels as garbage in garbage out; Meaningless labels that add little knowledge to the investors.

 

Time, Exits, and Short-Sellers

Some events may appear insignificant.  A company may decide to release a bad news on the eve of a holiday or during the holiday hoping that the investors will be too busy to notice it.  For instance, to cover its bad news, Computer Associate (CA) decided to post a warning about lower-than-expected profit a day before July 4th, 2000 at midnight.  CA hoped that investors would be too busy celebrating or vacationing to notice such news.  Unfortunately, when the market opened on July 5th, investors sold their shares and CA stock price plunged 42% [i]. 

In 2001, what triggered Wall Street Journal journalists, Rebecca Smith and John R. Emshwille authors of “24 Days: How two Wall Street Journal Reporters Uncovered the Lies that Destroyed Faith in Corporate America” to check Enron was CEO Jeffrey Skilling, then only 46 years old, sudden retirement after just 6 months on the job [ii].

Chanos, a prominent short-seller, confirmed that professional investors do see that a sudden leave of a CEO as a reason to check if the company is in trouble. He stated: “We look for any abrupt senior management changes or resignations…That is usually a big red flag for us that something is a miss, particularly when it is abrupt and hasn’t been telegraphed for quarters or months end.” iii. CEO, just don’t leave million dollar jobs for no good reason except when they are fired or they are aware of some shenanigans.    

A prominent short-seller is looking at the company you are looking at, and short positions on the company have increased.  You can find short interest in Wall Street Journal, www.wsj.com, under Company Research. 

All these possible signs that a company is in trouble require the investors to become inquisitive and a skeptic.  While news can trigger you to suspect a company from cooking the books, one can confirm ones suspicion only through reading the company financial reports.  SEC requires that all public companies to publish financial reports: annual and quarterly reports called 10K and 10Q, respectively; in turn SEC in its website, provides the reports for download.

 

10(k) and the Annual Report

Taking separately, Earnings, balance sheet, income statement, and cash flow give a partial view a company financial health.  In most cases you have to look at all of them as an integrated group instead of disconnected parts.  Sometimes each can reveal major cracks in a company, and in this instance, we the individual investor can detect the problems with ease.             

Narratives in the Annual reports or 10(K) provide a deeper understanding of the company business model, structure, accounting practices, and, of course, the numbers in the financial statements.  You will find the answer to the following questions:  Is the CEO truthful? Did the Auditors found anything that should make me suspicious of the company numbers?  If a company decided suddenly to change its accounting practices, why did the company change its accounting practices?  Who are its subsidiaries, clients, or suppliers? What are special purpose entities? What is the definition of entities in this context?

 Notes to Consolidated Financial Statement, to explain entries in the financial statement and accounting policies. Professional investors know that companies hide all their shenanigans in the financial reports.  Companies know that few investors bother reading reports, and they know that by SEC requirement they have to reveal any problems in the financial reports under also called footnotes.  Hence, they will hide their problems deep into footnotes and use elaborated unintelligible statements that are incoherent to even professional investors.   “Footnote is where companies hide the bad stuff they didn’t want to disclose but had to… they bury the bodies where the fewest folks find them in the fine print.”

One can look at the footnotes to have a better understanding of the financial numbers.  Beside an explanation of financial numbers, footnotes can have information about a company’s subsidiaries, executives’ compensation, the company credit rating, or possible lawsuits. What is the company accounting policy? What are the risks that are lurking in the company shores?  Who are its clients? How much are its executives compensated? How does it expect to grow? Who are its partners? What is its credit rating?  They are all important questions whose answers are hidden in the financial reports. 

A company with one client, unless the client is a Blue Chip or the government, may be poor investment.  The success of the company depends entirely on the client.

A company that decides to follow non-standard accounting principle may, most probably, hide its ailment: it decides to recognize revenue when the goods are shipped, not when they are accepted, or lengthen the depreciation horizon to enhance earnings, or create new meaningless entries.  In the 1990’s many companies were caught enhancing their income statement by shipping more goods than clients ordered and entering the shipment as revenue.  Cisco is one example to come to mind. 

In case of depreciation, the company decides to change from conservative depreciation to more liberal policies, and hence, reduces the annual depreciation expenses that it reported in its income statement. [iv] By doing so, it boosts the value of if income statement, and by the same token it gives the investors a shifted idea of the company performance.  For instance, Union Carbide, a company that existed in the 1970’s and early 80’s, reported an earning increase by $217 million.

New entries to financial statements must project miss-trust from investors.  For instance it may have “unbilled revenue” or “unbilled receivable” when dissected mean “we will never get paid for our service, but we will pretend that we assume that we get paid so our earnings look stellar.” [3]  A company may state “strategic chance” and may have an entry in the financial statement called extraordinary.  In this instance, it may want investors to believe these are one-time expenses with no relevance to the company bottom line, when in fact, it is trying to cover what is a usual business expense as a one-time expense, also called one-time charge, and hence enhancing their revenue. 

For instance, Tyco bought a financial group called CIT for almost $10Billion and few months later, sold it through an IPO for $4.6Billion.  The one time $10Billion expense became the permanent $5.4Billion loss. This $5.4 billion was real money not monopoly money, it could have been used to expend other department within the company, to acquire new markets, or just to keep it in the reserve for future loss. 

 

Auditors Opinion

Law requires auditors, even if they failed us during the 90’s, to report any inaccuracy of the company accounting practice.  As the auditors finding are only in the 10K, annual report, under the title Report of Independent Registered Public Accounting Firm, it is vital that investors read it before even contemplating investing in the company. A company is in trouble if its auditors do not include a statement about the accuracy of the accounting practices.  We have included the example of auditors opinion produced by KPMG about Adobe Systems, producer of Photoshop and Acrobat software, financial reporting.

 In our opinion, management’s assessment that Adobe Systems Incorporated maintained effective internal control over financial reporting as of December 2, 2005, is fairly stated, in all material respects, based on criteria established in Internal Control—Integrated Framework issued by COSO. Also, in our opinion, Adobe Systems Incorporated maintained, in all material respects, effective internal control over financial reporting as of December 2, 2005, based on the criteria established in Internal Control—Integrated Framework issued by COSO.

In contrast, auditors of CardioDynamics International Corporation, developer of non-invasive technology to monitor the heart ability to deliver blood to the body, 2004 annual report Report of Independent Registered Public Accounting Firm found and published their concern about this company financial. 

 

Our report dated March 28, 2005, on management’s assessment of the effectiveness of internal control over financial reporting and the effectiveness of internal control over financial reporting as of November 30, 2004, expresses our opinion that CardioDynamics International Corporation did not maintain effective internal control over financial reporting as of November 30, 2004 because of the effect of material weaknesses on the achievement of the objectives of the control criteria and contains an explanatory paragraph that states that management identified a material weakness in internal control over financial reporting related to the Company‘s accounting for income taxes and a material weakness related to the calculation of the Company‘s allowance for doubtful accounts.

 

The most important part of this section is the last paragraph where the auditors, KPMG LLP, express concern about the company inability to CardioDynamics International Corporation did not maintain effective internal control over financial reporting as of November 30, 2004.    From this paragraph you can deduct that the company has taken non-conforming approach to assess its income taxes and its allowance for doubtful accounts estimated money that the company is owed and doesn’t expect to be paid back.  What the auditor is stating here is that the company has under estimated its income taxes, and its allowance for doubtful accounts. 

 

President Statement in the Annual Report

Annual report is what the company sends to its investors, and 10K is a detailed representation of the company annual financial standing without graphs, fluff, or president statement.  Annual report will contain president statement, and graphs to clarify issues or financial numbers.  Some companies in trouble will go to great length to present a beautiful annual report with a lot of graphs and a very upbeat CEO letter to investors.  The purpose of the graphs and the wording of the CEO letter are to give the impression that the company is doing better than the reality.  Although the president introductory statement cannot be a strong reason to shun from a company, some professional investors read it thoroughly looking for smoke.  For instance, Professor Martin Kellman found that the word challenging when it is uttered more than three times in the front page of the annual report it means “your company has lost money, is losing money, and will continue to lose money.” [v] Another hint if the president statements contradict the numbers in the financial statement than one should pass the company. 

 

People:

What many people forget when analyzing potential investment in companies to look at their executives and board members.  They forget or ignore the fact that companies’ success depends entirely on its people.  People create companies, destroy it, or deceive others in investing in it.  Companies are just shells that house people to work for a common purpose.  What is common in investment world but poorly known among us is the creation of wall and mirror. Thanks to their sharp executives, and lack of governance by the board members, these companies are transformed to appear healthy.  The only way to discover the real health of the companies is through news reading.

For instance, Mr. Howard Schiltt, in his April 2002 interview in Money magazine, stated that in Global Crossing’s proxy one would have found that it CEO had a private company that leased aircraft to Global Crossing.  Twice the Global Crossing had paid the CEO: it was paying him directly and indirectly—though the hiring of his aircrafts.

In many cases, action and inaction of executives can be found in the public domain: news, blogs, press releases, annual reports, etc.  Sometimes gathering facts from various public domain venues about a company, its executives, and its directors can provide clues on a company mischief.  Representing such news in a network can help detect conflict of interest quickly.

Fast Search Transfer Company

For instance, in 2006, Fast Search and Transfer, a Norwegian search technology company, sold itself to Microsoft for $1.2 Billion. Afterward, it was found out that Fast revenues were phantom. The phantom revenues were created by booking free software trials as revenues, and through an elaborated network created by Fast CFO and a board member (see figure).

From the figure one can see how Fast was able to create phantom revenues. Its executives owned companies that were also customers of Fast. Through this scheme, its executives siphoned $6 million from Fast, in spite that all these facts were in the public domain.  Microsoft eagerness to buy the Fast stopped short in its due diligence and, consequently, overpaid.

Fast’s CFO, Ali Riaz, co-owned Archtech LLC with Sunwest Group, LLC, a company owned by Shuk Lai, wife of Peter Bauert–a Fast board member. Archtech acquired Convera, that pretended to have a plan to acquire Fast.  Consequently, Microsoft decided to buy Fast. 

Unlike Fast, Enron executive (Andrew Fastow) created companies to hide Enron losses.  The Scheme was genius.  In 1993, Enron and the California Public Employees Retirement System (Calpers) created Joint Energy Development Investment Limited (JEDI)—a 50-50 joint partnership.  As neither was majority stakeholder, Enron didn’t have to include it in the earnings. 

In 1997, Enron increased its stake in JEDI.  In normal circumstances, this should have resulted in Enron having to include JEDI in its earnings.  However, Enron under its CEO, Fastow, created Chewco, a partnership, and put Michael J. Kopper—Enron Global Finance employee—in the position of manager.  Chewco bought Calpers’ stake in JEDI, and consequently increased Enron stake in JEDI.  With the 2-degree of separation, Enron was able to keep the entire partnership off its books, more precisely, it kept $600 millions of debts off its books with this move. 

Sadly, all these facts were in public domain. And these are only two examples on how executives can and will, given their greed level, help keep investors invested and investing.  Investors faulted by putting too much faith on some financial numbers.  The consequences of their belief that numbers cannot lie they performed shallow or no due diligence and missed big red flags, and they lost their investment.

 

Conclusion:

Financial numbers can and will be manipulated in the hand of unscrupulous executives.  Fortunately for the investors, these executives will leave clues scattered allover the public domain: news or press releases, annual reports or 10(K), proxies, and action or inaction of the executives.  It is up to the investors to dig them out and read them.  In fact, investors need to be vigilant in keeping with any news or facts about their investment or potential investment.  I hope that investors can see the value of looking beyond numbers and understanding how crook executives can and will hide their mischief.

 

 [1] Dan Ackman,”Enron Analysts: We Was Duped”, Forbes,  February 27, 2002.

 [2] Erin E. Arvedlund, “Don’t Ask, Don’t Tell”, Barron, May 7, 2001

 [3] Ron Isana, “Looking For Weird” Accounting sleuth Howard Schilit tells how to dig for earnings dirt, Money, April 2002.

 [i] Martin Howell, pp. 110-111.

 [ii] Rebecca Smith, Emshwiller J. R., 24 Days:How Two Wall Street Journal Reporters Uncovered the Lies that Destroyed Faith in Corporate America, Harper Collins, New York, 2003

 [iii] Martin Howell, Predators and Profits: 100+ Waysfor Investors to Protect Their Nest Eggs, Prentice, Hall, 2003, p. 49.

 [iv] Schilit, p.27.

 [v] Shenanigans, p29.

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