Title :        Financial Chicanery
   Author : By Mark L. Cheffers*  

The company's balance sheet looks weak and something needs to be done to make it appear strong very quickly. What does management do? It gives the company a quick fix - records a onetime gain to prop-up what is actually ailing. To an untrained eye the company may appear to be healthy. To those who have their hands on the pulse of the company will know that the company's ailment was just temporarily masked not cured. There are no true "quick fixes". We all know that to cure an unhealthy corporation it takes a well thought out plan and execution of that plan to recuperate an unhealthy company.

Quick fixes or the recording of one-time gains are not derived from a company's core business or earnings flow. They are derived from non-operating activities. Thus, to truly analyse a company's undistorted financial condition the fixes/gains must be removed from one's analysis of the company.

Sources for a "Quick Fix"

There are several sources which management can tap to obtain their quick fix.

By selling undervalued assets to boost current profits1

Example : Last February IBM was accused of selling an asset (an optical unit to JDS Uniphase) to meet analyst's expectation and boost their weak earnings. According to an article in the February 15, 2002, New York Times, by Gretchen Morgenson entitled "As It Beat Profit Forecast, I.B.M. Said Little About Sale of a Unit" she wrote: "When I.B.M. announced in mid-January that it had beat Wall Street's profit forecasts in the fourth quarter, it did not disclose that the sale of a business had generated $300 million that the company used to lower its operating costs.

The company did not provide details of the transaction to investors or account for it as a one-time gain, as is the practice. Instead, I.B.M., during a conference call about fourth-quarter earnings, said that its profits had grown - even as revenue in most categories had declined - because of increased productivity and higher sales of certain products.

To be sure, I.B.M. has not filed its fourth- quarter and annual financial statements with the Securities and Exchange Commission, which the company does not have to do until March. Its scant disclosure of the sale was made in comments in a conference call with analysts and investors, not in a federal filing. But the S.E.C. has recently begun cracking down on companies that have incomplete or misleading disclosures, even in their press releases. One-time gains like I.B.M.'s are supposed to be identified as nonrecurring charges.… The transaction that generated $300 million for I.B.M. came just as a dismal quarter was ending.… Still, I.B.M.'s profits beat Wall Street's estimates for the quarter by the all-important penny a share."

By reporting investment income or gains as a reduction in operating expenses

Example : Non-operating and/or one-time gains can be hidden as a reduction in operating expenses. The past Bull market allowed companies to capitalise on this fix, especially in the area of pensions. With a Bull market pension assets were generating income greater than the pension expense Lucent technologies is an

1. Recording gains from the sale of appreciated assets is acceptable per GAAP. Why it is important that the reader identify such sales is that if the company has weak profits and is constantly trying to prop up their earnings with non-core business revenues it may be indicative that the company's core business model is not adequate to sustain growth. example. According to Lucent's press release, Lucent announces benefit accounting change - 8-1-1999 - Lucent Technologies (NYSE: LU) today announced an accounting change that will allow it to better represent pension and post-retirement benefit expenses in its financial statements. The modification and update under SFAS (Statement of Financial Accounting Standards) 87 will result in a one-time, after-tax gain of $1.3 billion, or approximately 97 cents a share, in the quarter ended 31-12-1998. This one-time gain reflects the cumulative effect of this change for all periods from 1986 through fiscal year 1998.

According to the Center for Financial Research & Analysis, if Lucent did not change the way it had accounted for its pension plan, earnings for fiscal 1999 would have been cut by approximately 283 million or per share income would have been reduced by 75 from $1.22 to $1.13.

By reversing previous accruals

Example : Simula, Inc., 2001, Earnings - Actual and Pro-Forma Results

Net income and net income per share for the fourth quarter was approximately $101,000 or $0.01 per diluted share. This compares to net loss and net loss per share of ($8.8) million or ($0.72) per diluted share for the fourth quarter of 2000. The quarter includes operating losses of approximately $435,000 from the Company's Atlanta operation which was sold in November and an additional tax provision of approximately $800,000. Fourth quarter 2001 net income includes the benefit of $775,000 related to the reversal of employee health plan reserves. Pre-tax operating income in the fourth quarter was $1.4 million.

By selling assets or collecting assets after being written off

Many companies have sold assets after they have been written-off or collected assets after being written-off. An example would be a semiconductor manufacturer's excess inventory. In a subsequent period the inventory may be sold. The sale of the assets should be disclosed because otherwise it would distort the company's cost of goods sold.

By including investment income or gains as part of revenue

This is probably the most egregious fix of all the fixes previously discussed. This is a blatant misrepresentation of a company's core revenue.

One way which one can identify the employment of any of the above methods is through a detailed analysis of a company's financial statements. This is where it is essential to understand a company's core business and its operations. A fluctuation analysis of balance sheet and income statement accounts will help the reader identify whether any of the above fixes were used.

e e e

If a program is useful, it will have to be changed.


*Mark L. Cheffers, CPA, ABV, is the founder of `'. He is a former PWC manager, Harvard MBA and highly experienced litigation consultant.


Disclaimer : The views in this article are author's point of view. may or may not subscribe to the views of the author. This article is not intended to substitute the legal advice. No portion of this article may be copied, retransmitted, reposted, duplicated or otherwise used, without the express written approval of the author.
The Copyright of the article is with the author.