Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, 3rd Edition (24 page)

Remember to Review Off-Balance-Sheet Purchase Commitments.
Existing obligations that result from past transactions are reported as liabilities on the Balance Sheet. Additionally, liabilities for certain contingent payments are accrued in some circumstances. However, what about future obligations and contingencies that companies have? For instance, a company may have agreed to purchase inventory over the following two years. Alternatively, a company may have committed to funding a project or renting real estate.

While these purchase obligations often cannot be rescinded, they are typically excluded from the liability section of the Balance Sheet and thus are considered “off-balance-sheet” liabilities. However, management often discloses their presence in the footnotes. Despite not being reflected on the financial statements, these obligations could doom the company. Investors who fail to notice them could be in serious jeopardy.

NONACCRUED LOSS CONTINGENCIES

Some obligations require only footnote disclosure and have no impact on reported earnings. However, investors should pay close attention to any commitments and contingencies discussed in the footnotes or the management discussion and analysis section of the financial report. Sometimes unrecorded liabilities for commitments and contingencies are more significant than the liabilities reported on the Balance Sheet.

Tip:
Companies often provide helpful detail about their purchase commitments in the footnotes to their financial statements. Investors should always review this disclosure to get a better understanding of a company’s true obligations.

Sometimes dishonest management will be less than forthcoming in disclosing purchase obligations. Consider the case of Columbia Gas Systems. When Columbia released its first-quarter financial statements for 1991, most investors were bullish about the company. Within weeks, Columbia dropped a bombshell: it was on the hook to purchase hundreds of millions of dollars of natural gas at above-market prices. Investors reacted quickly to this news and sent the stock price down 40 percent, erasing $700 million in market capitalization in one day. Soon thereafter, Columbia filed for bankruptcy.

The company was criticized for having failed to highlight the significance of its future obligations to purchase a large amount of natural gas under “take or pay” contracts. As investors later learned, after Columbia committed to purchase gas at a certain price under these contracts, gas prices plummeted and Columbia could not sell the gas at a price anywhere near its cost. While Columbia had to live up to its commitments to producers, its utility customers were free to buy gas from the cheapest source.

3. Failing to Record or Reducing Expenses by Using Aggressive Accounting Assumptions

This technique demonstrates how management’s flexibility in selecting accounting policies and estimates can be a tool for hiding expenses. Companies that provide pensions and other postretirement benefits to employees can change their accounting assumptions in ways that reduce the recorded expense. Similarly, companies that lease equipment make a variety of estimates that will have a bearing on the reported liabilities and expenses. Management can manipulate earnings (and reduce liabilities) by changing accounting or actuarial assumptions.

Boosting Income by Changing Pension Assumptions

Companies that provide pensions for employees must record an expense each quarter to account for the incremental costs incurred under the plan. Pension expense generally is not shown explicitly on the Statement of Income; instead, it is simply grouped with other employee salary costs (usually as a component of cost of goods sold [COGS] or selling, general, and administrative [SG&A] expense). Investors should carefully scrutinize the pension accounting assumptions in the footnotes, as they allow for considerable management discretion that might be used to reduce (or even eliminate) the expense.

Accounting Capsule: Pension Expense

Pension expense is essentially calculated by (1) taking the incremental annual costs of running a pension plan and (2)
subtracting
the (expected) investment return on pension plan assets. Management can exercise great influence on the underlying assumptions of both measures.

The investment return on pension plan assets (the second element) is not simply the actual return earned that year. Rather, accounting rules state that the investment return is a
smoothed
return that consists of two components: (1) the
estimated expected return
on the asset base (this is the estimate we are currently discussing) and (2) the amortization of the cumulative difference between the estimated return and the actual return (a slow “catch-up”).

Watch for Aggressive Assumptions for the Expected Return on Plan Assets
. One of the most important estimates in pension accounting is the expected return on pension plan assets. To understand why, let’s take a quick peek at how one aspect of pension accounting works. As discussed in the accounting capsule, the expected return serves to reduce pension expense. If management chooses a more aggressive expected return (say 10 percent when a 6 percent rate is a more reasonable estimate of market returns), the recorded pension expense will be smaller, and profits will be inflated. Thus, companies that consistently overestimate investment returns on plan assets are hiding the true economic costs associated with their obligations to both current and former employees.

Such aggressive assumptions might persist for years, with actual returns falling far short of expectations, leading to suppressed pension expense and inflated earnings year after year. Additionally, by simply
increasing
the expected return assumption, management can provide a nice little boost to earnings. Regardless of the legitimacy of increasing the expected return, this change reduces pension expense and provides a one-time boost to earnings. As a result, investors should monitor expected return assumptions closely for (1)
increases
in the rate of return and (2) an
aggressively high
assumed return. A representative case in point would be Delphi’s estimated return of 10 percent during the down-market years of 2001 and 2002.

What expected return rate should companies use? Well, that is an unfair question to ask investors, since they lack knowledge of the detailed components of pension investment portfolios. However, investors should certainly be aware of and ask questions about companies that use estimated return rates that are higher than those used by their peers. According to a recent RiskMetrics Group study, the average 2008 and 2007 expected return assumption used by U.S. companies was 8.1 percent. Using that figure as a benchmark, it is easy to spot outliers. Two companies in the study had rates higher than 9 percent in 2008 (Titanium Metals Corp. at 10 percent and General Mills Inc. at 9.43 percent), and another 25 companies had rates of 9 percent (including Alcoa Inc., Caterpillar Inc., Eli Lilly & Co., ExxonMobil Corp., and Johnson & Johnson). By using a higher rate, these companies get to record lower pension expense, and therefore higher income.

Watch for Changes in Other Estimates and Assumptions.
Many actuarial assumptions must be used to calculate pension expense, including discount rates, mortality rates, and compensation growth rates, among others. Companies usually disclose changes to these assumptions in their footnotes. Simply read the pension footnote to find the changes. For example, Navistar International Corp. disclosed a restructuring of its pension plan in 2003, in which the company changed its assumption for the life expectancy of plan participants from 12 years to 18 years. By increasing the life expectancy assumption, Navistar spread “unrecognized losses” over a longer period, and in doing so, reduced its pension expense (and inflated its income) by $26 million.

Watch for Changes in Measurement Date
. Just a simple change in the month designated as the measuring date for the pension plan can inflate profits. For example, in 2004, Raytheon Co. changed the date on which it measured its pension plan from October 31 to December 31. This simple change provided a $41 million ($0.09) bottom-line boost, which accounted for about 10 percent of Raytheon’s earnings for the entire year.

Watch for Outsized Pension Income.
Sometimes companies wind up with results that seem to make no sense at all—like a
negative pension expense
. This phenomenon arises when expected gains from investing the plan assets become larger than the incremental annual costs of running the pension plan, resulting in
pension income
. What circumstances would lead to this outcome? Oversized gains for a company with very large plan assets could produce a sizable amount of pension income. Usually, these situations arise at companies with large legacy pension plans and few (or no) new employees entering the plan.

Lucent, for instance, recorded more than $1.1 billion in pension income during 2004, accounting for virtually all (91 percent) of its operating income. Moreover, from 2002 to 2004, Lucent’s
pension income
totaled $2.8 billion while it reported a cumulative operating loss of $6.0 billion. Like most companies, Lucent chose not to break out pension expense (or income) separately on its Statement of Income. As a result, investors who failed to read its pension footnote would have missed this critically important piece of information.

Tip:
The pension footnote is required reading for any company with a large pension plan. Investors should monitor key assumptions and assess the impact of pension expense on earnings.

Boosting Income by Changing Lease Assumptions

Lease accounting provides management with another massage parlor (
not
that kind of massage parlor) in which it can knead estimates to help inflate earnings. Recall our discussion in Chapter 3 of how Xerox accelerated the recognition of lease revenue in the late 1990s. At the same time it was playing that trick, the company also massaged certain estimates to reduce lease expenses.

One of the estimates that Xerox manipulated was the residual value on certain leases. The residual value is a company’s estimate of what the leased equipment will be worth when it is returned by the customer at the end of the contract. When leasing equipment to customers, Xerox recorded revenue for the lease payments as well as a cost for the equipment provided, which is essentially depreciation on the equipment. Since equipment would be depreciated only down to its residual value, companies can boost profits by having a high residual value, as this would lower the amount that would be subject to depreciation. Xerox decided to increase the residual value on certain leased equipment, allowing it to record less expense each period. The SEC alleged that increases in the residual value inflated Xerox’s operating earnings by $43 million from 1997 to 2000.

Self-Insurance Reserves

Some companies balk at paying expensive business insurance premiums (for example, for employee health-care or disability insurance), and decide instead to “self-insure” certain risks. Companies that self-insure essentially operate like mini-insurance companies: they create a fund that they believe will be sufficient to pay out insurance claims, and record expenses each period for the amount needed.

How large should the self-insurance liability be, and how much self-insurance expense should be accrued each quarter? Well, of course, the answer is dependent on estimates. With a simple tweak of those estimates or a change in assumptions, management can provide itself with a nice boost to earnings.

Be Alert for Changes in Self-Insurance Assumptions.
Rent-A-Center Inc., a large rent-to-own retail store operator, self-insures for workers’ compensation, general liability, and auto liability insurance policies. In June 2006, Rent-A-Center decided that it would change the actuarial assumptions used to calculate its self-insurance accrual for that year. Rather than the previous approach of using only general industry loss assumptions, Rent-A-Center would now also include internally developed assumptions based on its own loss experience. Regardless of the legitimacy of this change, it seemed to provide Rent-A-Center with a nonrecurring boost to earnings. A report by RiskMetrics Group estimated that this change alone produced virtually all of Rent-A-Center’s earnings growth over the subsequent four quarters by adding approximately $0.24 to $0.30 to the bottom line.

Dollar Thrifty Grabs Two Cookies: Self-Insurance and Doubtful Accounts.
Rental car company Dollar Thrifty Automotive Group assumes the liability for bodily injury and property damage claims resulting from accidents involving its rental cars. Rather than pay expensive premiums to an insurance company, Dollar Thrifty created its own self-insurance fund. Like Rent-A-Center, Dollar Thrifty reduced its expenses (and boosted earnings) in 2006 as a result of changes in assumptions related to its claims history. CFRA estimated that the earnings boost amounted to about $0.19, or a whopping 95 percent of total earnings growth in 2006. Conveniently, Dollar Thrifty also reduced its allowance for doubtful accounts, providing another $0.10 in earnings that year. Do you recall our advice from the previous chapter about heading for the hills if you see many reserves moving in the wrong direction?