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CHAPTER THREE
FAITH IN CORPORATIONS TRICKS OF THE TRADE

CORPORATE EARNINGS DRIVE STOCK PRICES

STOCK PICKERS love to compare companies by analyzing easily obtainable financial statistics. One of the most popular measures is a simple ratio. It is calculated by dividing the current price of a stock by its last twelve months’ earnings per share, and is commonly referred to as the price to earnings (P/E) ratio.

Corporations with similar growth prospects usually have similar P/E ratios. The organizations that show the best earnings within the group are going to have the highest stock price.

The market price for a share of a growth company is rarely based on assets such as cash, land, and equipment but rather on current earnings and expectations of future earnings. Management fully realizes this and sees it as their mission to maximize earnings. Unfortunately there is a lot of leeway in determining how earnings are calculated. Some companies maintain strict and conservative accounting policies, while others stretch the rules to the limit and beyond.

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CREATIVE WAYS IN WHICH MANAGEMENT MANIPULATES EARNINGS

As we’ve seen, the higher the current earnings per share and expectations for future earnings, the higher the stock price. Regrettably, management has an overabundance of accounting tricks up their sleeves that bring into question the reliability of these earnings, even when the financial statements are audited by independent accountants. There are countless ways for unethical executives to window-dress financial reports and create a positive buzz about a company. Investors have to be watchful that they don’t get stung.

Stock Option Accounting

In 1950, after weeks of horse-trading, Congress sent President Truman the Revenue Act of 1950, and on September 23 he signed it into law. Buried deep within that bill was a section amending the tax code. That change, scarcely remarked upon at the time, made it legal and practical for companies to pay employees with an interesting form of currency called the stock option.

Though stock options have been available since 1950 as a means of compensating management and employees, they really didn’t become popular until the mid-1980s. This makes perfect sense since stocks essentially went nowhere from 1964 to 1984. Options during this period really didn’t get management excited. But once stocks took off, companies began delivering new option packages by the truckload.

The government got involved to address the problem of excess executive compensation by passing a law that essentially states that any cash paid to an executive over $1 million annually is nondeductible unless the excess is related to performance. Corporations responded by revamping their compensation schedules to get around the $1 million ceiling.

The use of stock options as a means of compensating 47employees grew exponentially in the 1990s. In theory, options sound like a great tool for giving management incentive and rewarding them for a job well done. This may possibly be true in the short run. However, over a long period of time stock options serve as a big drain on shareholders, as you will soon see.

A large corporation usually has a compensation committee that is appointed by the board of directors. This group decides on the structure and distribution of the employee stock option plan. In a company that has yet to offer its shares to the public, management and key employees will be granted options to buy the company’s stock for a specified time in the future at a specified price. The price may be at pennies per share, even though the future offering price to investors will most likely be much more. A company that has already gone public will usually grant options at a price that is closer to the current market price of the stock.

Options don’t require any outlay of cash by the corporation. From an accounting standpoint, exercised options are treated as additional issued common stock, which increases the capital of the organization. For example, if an employee exercises an option to buy 10,000 shares of XYZ stock at a price of $1 per share, the corporation will receive $10,000 from the issuance of stock. The company increases its cash by $10,000 and its shareholder equity by $10,000. It is irrelevant from the company’s standpoint whether the current market price of the stock is $2 or $200; the accounting treatment is the same.

Of course the current market price is very relevant to the employee. If the stock is at $2, the employee has a paper profit of $10,000 on the options transaction. If the stock is at $200 per share, the paper profit increases to $1,990,000. It’s considered a paper profit until the gain is actually realized when the stock is sold.

Options have become a major component of employee compensation programs for many corporations. They love it! These plans don’t use corporate cash and actually serve to increase 48the cash of the corporation. Even though this is admittedly compensation to the employee, it isn’t shown as such on the corporate books and records. Therefore corporate profits are not reduced, as they logically should be. The corporation then receives a tax deduction for the profit made by employees when they exercise the option and sell the stock within a certain period of time. From a corporate perspective, this actually increases after-tax profits.¹ The IRS views employee stock options as compensation expense, while it’s not an expense when reporting results to shareholders. How’s that for double-dealing? Pretty bizarre!

Today we have a situation in which some firms are admitting that, yes, there is a cost that should be recognized when giving stock options to employees and management. Yet many (mostly high-tech companies) are not conceding defeat on this issue.

The Individual Investor Finishes Last

From a corporate and employee standpoint, options are a win-win proposition. They don’t cost the corporation anything, and employees have a chance of making a huge profit on their stock without the risk of investing in the stock. That’s right— the option holder has the option and not the obligation to buy stock. If the stock goes up, yippee! The option holder cashes in. If the stock goes down, no money was lost. The big loser here is the long-term shareholder who has invested in the company’s common stock.

A simple example illustrates this point. Suppose a company has issued 1 million shares of common stock. Let’s assume that its market price is $10 per share, giving the company a total market value of $10 million. Let’s also assume that the company is making a profit of $100,000 per year. Earnings per share would be 10 cents ($100,000 divided by 1 million shares outstanding). The P/E ratio would be 100 ($10 per share divided by 10 cents of earnings). The board decides to implement 49an employee stock option plan that allows employees to purchase up to a total of 1 million shares of stock at a price of 10 cents per share. This is a great deal, so all of the employees participate in the option. A year later the company again reports profits of $100,000. However, this time there are 2 million shares outstanding because of the option exercise. This would cause earnings per share to drop to 5 cents. If the P/E ratio remains constant at 100, the market price of the stock will be closer to $5 per share because of the dilutive effect of the option. The long-term shareholder suffers a loss of 50 percent, while the insiders see their personal net worth jump by $4.9 million. Sounds like the deck is stacked against the investor in this game!

In 1998 Forbes published an article, “Stock Options Are Not a Free Lunch,” that covered a lot of ground. In the early 1980s the total shares allocated for management and employee stock options for the 200 largest U.S. companies amounted to less than 5 percent of shares outstanding. According to Paul Meyer and Partners, a compensation consulting firm, this figure increased to 6.9 percent in 1989. By 1997 this figure had jumped to 13.2 percent. Steven Hall at Paul Meyer said, “We used to advise companies that an allocation of 10 percent was too much dilution, but we blew through that level years ago.”

By 1998 fourteen of the largest companies had stock option allocations of greater than 25 percent of shares outstanding. Some of these included Delta Air Lines, Merrill Lynch, J. P. Morgan, and Transamerica Corp.² Smaller organizations, especially high-tech companies, have an even greater devotion to options. There are even companies that abandoned salary altogether for their chief executives. The CEO of Oglebay Norton & Co. was compensated entirely on stock option incentives.

Defenders of stock options insist that having options encourages managers to think like owner-shareholders. This couldn’t be further from the truth. Ordinary shareholders have paid for and own a stake in the company. If the stock goes up, 50they will benefit, but if the stock goes down, they will suffer real losses. Stock option holders get an entirely different deal. If the stock goes up, they can cash in and benefit from the increase without ever risking their own money. But if the stock price goes down, unlike purchased shares, options can be repriced downwards at a later date. If the stock goes down, the company may reduce the price on the option for the benefit of the option holder. Management could effectively run a company into the ground and grant themselves options at a lower price after the stock collapses. If the stock recovers, they make a fat profit, and if it doesn’t, the option holders never had their own money at risk anyway. In either case shareholders are left holding the bag.

Ulterior Motives

Given the potential for huge rewards, it would be astonishing if all managers focused on what was best for the long-term health of the company and its shareholders. It’s more likely that some executives will become obsessed with maximizing the stock price and—to the greatest extent possible—take steps to influence it. It takes a naïve view of human nature to think that some unprincipled executives won’t strive to increase their personal wealth at the expense of the shareholder or anyone else who gets in their way.

The Truth Comes Out, but Who Cares?

The Forbes article cited earlier revealed that in 1998 economic advisory firm Smithers & Co. of London released an in-depth study of the impact of stock options on the earnings of the 100 largest U.S. companies. Their conclusion was quite an eyeopener. In 1995 corporate profits would have been on average 30 percent less than reported if options were treated as a compensation expense. In 1996 full-cost accounting for options would have resulted in 36 percent lower earnings. Many companies that were showing profits were actually operating at a 51loss if the accounting were done properly. Other companies, including big names such as Coca-Cola, Gillette, Sun Microsystems, and Merrill Lynch, would have seen their profits cut by more than half had they treated employee stock options as the compensation expense that they are.

Parish & Company of Portland, Oregon, in a 1998 press release about employee stock option accounting, stated the opinion that the Financial Accounting Standards Board (FASB) should report to the Securities and Exchange Commission to institute accounting reforms in order to restore confidence and stability in the global capital markets. The report stated that in fiscal year 1998 Microsoft reported net income of $4.5 billion. If the employee options were reported correctly, the company would have lost $2.3 billion. The same applies to Cisco Systems. A profit of $1.3 billion was reported by Cisco. Proper option accounting would cause a restatement of earnings resulting in a loss of approximately $900 million. The study concluded that although Microsoft and Cisco are believed to be leaders in their industry, they were indeed unprofitable businesses.³

In the mid-1990s the FASB attempted to propose a method that would account for the costs of burgeoning stock option plans on a company’s financial statements. The board proposed a standard requiring companies to correctly account for option costs on their financial statements. Again, according to the Forbes article, Dennis Beresford, the former chair of the FASB, said, “It’s hard to argue that they’re any different from cash compensation or any other employee cost.”

Big accounting firms and much of corporate America lobbied heavily against reforming the accounting methodology for employee stock options. The brutal battle for accounting reforms was temporarily buried in 1995 with corporate America as the victor. “The argument was: reduced earnings would translate to reduced stock prices,” recalls Beresford. “People said to me, ‘If we have to record a reduction in income by 40 percent, 52our stock will go down by 40 percent, our options will be worthless, we won’t be able to keep employees. It would destroy all American business and Western civilization,’” he said.⁴

In essence, options are nothing more than a legal means of transferring wealth from shareholders to senior management and key employees of the corporation. In other words: they are a mechanism for siphoning funds from the owner-shareholders who have risked their money to the very individuals they have entrusted to mind the store.

ALICE-IN-WONDERLAND ACCOUNTING

The accounting treatment of employee stock options is only one of many controversial areas where liberal interpretation of accounting principles can lead to improper or misleading financial reporting.

What-if Statements

PRO FORMA ACCOUNTING

Pro forma financials were once used strictly as an internal tool by management to review what-if scenarios such as how earnings would be affected if the company got into or out of a business, or what effect a particular merger would have on financial statements. Today, companies are cranking out another set of figures for the public to see as well. These financials are created outside traditional accounting principles (which are still required when reporting to the SEC) and are confusing to investors.

Generally Accepted Accounting Principles (GAAP) have been hammered out over the years by accountants, corporations, and regulators. They attempt to provide a consistent and objective way to compare financial results between companies. The objective of GAAP is to provide a fair and true picture of a company’s financial position. It’s debatable whether or not this objective is being accomplished, but the use of GAAP 53makes it somewhat challenging for management to hype their results to investors.

Some executives don’t like to be restrained by accounting conventions. In pro forma accounting a company can present financial statements any way it desires. Management can use this as a tool to cast a more positive light on results. This is accomplished by conveniently ignoring selected expense items. Yahoo!, Inc. was one of the first to publicly emphasize pro forma figures. In January 1999 it presented results 35 percent better than GAAP by excluding a variety of costs related to buying other Internet companies. In 2000, Yahoo again released pro forma earnings that excluded additional expense categories.

An early version of pro forma reporting called EBITDA— earnings before interest, taxes, depreciation, and amortization—has become a popular number to report in earnings press releases. In a January 24, 2001, press release, telecommunications giant Qwest Communications reported $2 billion of EBITDA. Shareholders had to wait weeks for the GAAP reporting, which was found in a footnote to the annual results that showed Qwest actually lost $116 million.

The spread of pro forma earnings has plunged investors into an Alice-in-Wonderland world. In an article in Business Week in 2001 SEC chief accountant Lynn Turner called pro forma results “EBS earnings”—for Everything but Bad Stuff. “Way too often they seem to be used to distract investors from the actual results,” Turner said.⁵

Pretend Sales

VENDOR FINANCING

When a company lends customers money to purchase its products it’s called vendor financing. In moderation this can be a sound marketing technique. But the potential for abuse in this area is pretty obvious. Essentially, sales can be fabricated. In the short run the lending company books sales and profits. In 54the long run the company may be left with a questionable receivable. The financial worthiness of the customer-borrower may not be disclosed to investors at all or, if it is, the information is usually buried in the footnotes. If the customer doesn’t make good on the loan, the house of cards collapses and ultimately hurts—you guessed it—the shareholders!

According to the Business Week article cited earlier, at the end of 2000, telecom-equipment suppliers were collectively owed as much as $15 billion by customers, a 25 percent increase from the year before. Effectively, they were buying their own products with their own money and as a result drastically exaggerating the size and sustainability of their sales and earnings growth.

A story on sales fabrication wouldn’t be complete without the following report: On February 3, 2000, Motorola issued a press release announcing a $1.5 billion order from Telsim, Turkey’s number-two wireless carrier. It wasn’t until March 30, 2001, that investors found buried deep in a filing to the SEC that Motorola was owed $1.7 billion by Telsim. The fact that Motorola apparently lent Telsim 100 percent of the money to buy its products wasn’t mentioned in the press release a year earlier.⁶ On the day of the release the stock jumped by 5 percent to a split-adjusted $50 per share. It would have been useful for investors to be aware of this important fact at the time of the release.

It didn’t take long for this loan to go bad. In April 2001 Telsim missed a $728 million installment to Motorola. The Uzan family, which controls Telsim, was charged in a 2002 lawsuit by Motorola and Nokia alleging that they fleeced the two telecom giants “through an elaborate scheme of deceit and intimidation” out of $2.7 billion of cash and equipment. If these companies had bothered to do a simple credit check, they would have found that the Uzans have a contentious history. In Turkish courts they are involved in more than 100 criminal and civil cases, with allegations ranging from money laundering to libel.⁷

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A little over two and one half years after the initial press release announcing the “great news,” Motorola stock was at $8, a drop of 85 percent.

CONSUMER REBATES: THE REAL MOTIVE BEHIND THEM Have you noticed the increased number of consumer products that have mail-in rebates? I have seen rebate programs that essentially make the product free to the customer. The company usually makes it a hassle to actually get the rebate and then counts on the fact that not everyone will apply for it.

The use of rebates and how they are accounted for gives companies yet another tool for the short-term manipulation of earnings. By using the rebate as a promotional tool a company can advertise a much lower price for its product relative to the competition. Of course, the lower price will have an asterisk next to it with the words “after rebate.” The resulting increased sales for the period may make for a great press release and provide the desired temporary boost in the stock price.

However, the rebate is really a liability of the company that is incurred when the sale is made. Some organizations make a good-faith estimate of the percentage of customers that will actually apply for the rebate. Many simply overstate sales while ignoring the liability. Still others play with the estimate of how many will apply and show the rebates as advertising and promotion expenses instead of a reduction of sales. Investors like to see increasing sales, so the use of a rebate program is a way to artificially stimulate sales growth.

Hidden Liabilities

THE HYPOCRISY OF PENSION REPORTING “What’s good for General Motors is good for the country and what’s good for the country is good for GM,” stated Charles Wilson, former chairman of General Motors, at his senate confirmation hearing as secretary of defense in 1953. Three years 56earlier Wilson was credited with launching the first modern pension fund. During the industrial boom of the 1950s, corporations flush with cash but short on workers offered defined-benefit pension plans to their employees. Within a year of GM’s introduction, 8,000 similar plans were set up in America.

These plans guaranteed a specific monthly payment to employees at retirement. The companies put up all the money and invested a good chunk of it in the stock market to cover their future pension liabilities. Wilson felt that stocks were an ideal investment for the pension fund. Employees would have a direct interest in corporate profits and economic growth. In addition, such collective ownership, in theory, would soften people’s attitudes toward big business.

Today, in lieu of the paternalistic approach, many companies opt for cheaper alternatives such as 401(K) plans in which the employees put up the cash and take on the investment risk. Even though defined-benefit plans may be considered dusty remnants of a bygone era, the fact is that these plans are still material to many U.S. companies. Over 70 percent of companies that make up the S&P 500 offer defined-benefit plans, or are obligated to pay retirees from previous plans, according to a study conducted by Credit Suisse First Boston (CSFB). These plans have been great for rewarding dedicated employees but have become an albatross for corporations struggling to meet their pension obligations.

In addition to setting aside funds for pension liabilities, corporations are required by federal law to pay premiums to the Pension Benefit Guaranty Corporation (PBGC), the government agency that steps in to provide some of the promised benefits of bankrupt companies. So pensioners are likely to receive most of their money, even though the PBGA recently announced a record $3.6 billion shortfall as of year end 2002, resulting from corporate bankruptcies that included Bethlehem Steel and National Steel. It’s the shareholders who really stand to lose, followed by the federal government and its taxpayers.

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Consider this: businesses are required by law to set aside money for pensioners. During the market boom of the 1990s companies juiced earnings from investment gains as the plans were overfunded from the stock market boom. As a matter of fact, according to the New York Times, an astounding 12 percent of the earnings growth registered by S&P 500 companies in 2000 came from pension income. IBM and General Electric are two companies that have used pension adjustments to help manage earnings, according to Business Week.⁸ At year end 2002 it is estimated that pension plans in America owed $1.2 trillion to their current and future retirees, but because of the devastating carnage of an unrelenting bear market, there was only $892 billion set aside to foot the bill.

As if this isn’t bad enough news, a peculiar quirk in accounting rules allows companies to estimate their pension fund investment returns over time and report the guess as profit, regardless of what actually occurs. Management has been able to legally distort the numbers to pad reported earnings—the bottom line that helps to determine top executive bonuses. In 2001, it is estimated that fifty of America’s largest companies counted $54.4 billion of pension fund gains as profits, when in fact they lost $35.8 billion. If this kind of phantom accounting were used for other aspects of the companies’ operations, the accountants would be doing jail time.

Financial Accounting Standard 87 (FAS 87) is credited with legalizing fictional pension accounting. Under intense lobbying from corporate interests, accountants who drafted the rule were convinced that including actual returns on pension assets would subject company earnings to increased volatility, which stock market investors don’t like. As a result, companies can spread gains and losses over as long as five years. In addition, pension assets and liabilities are not listed on the balance sheet as such but rather as a “stub” amount that nets the two in the shareholder equity section. Pension accounting is a huge fiasco and brings back sour memories of Enron’s numerous off balance sheet manipulations.

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Let’s look at General Motors, which now has more than two retirees to every employee on company pension and health care plans. In 1999, GM’s pension plan enjoyed a healthy surplus with assets exceeding reported liabilities by 40 percent. Three years later the surplus turned into a colossal deficit. In early January 2003 GM announced that its pension assets were underfunded by $19.3 billion at the end of 2002, a $10.2 billion dollar increase from 2001. The GM plan has about $60 billion in pension assets compared to about $80 billion in reported liabilities.If we used commonsense accounting, GM should have reported an expense of at least $9.1 billion from the increase in its pension deficit. But common sense doesn’t apply these days. GM showed a pension expense of only $1 billion and an overall profit of $1.7 billion for 2002.

GM announced that its expected pension expense for 2003 would triple to $3 billion and that its expected return on pension assets would fall from 10 percent to 9 percent. The average company uses a rate of 9.2 percent, according to the CSFB report. In 2002 GM’s actual return on pension assets was a negative 7 percent.

The method used to calculate pension liabilities is an outrageous hypocrisy of corporate financial reporting that should be of even greater alarm to investors than the misreporting of pension expenses. The liability is a function of complex estimates of future pension payments based on factors such as the life expectancy of retirees and an estimated interest rate assumption. According to a study entitled “Pension Assumptions and Funding Levels: What Is Reasonable,” corporate pensions are even more underfunded than actually reported. The analysis, completed by Stephen Church, president of Piscataqua Research Inc. in Portsmouth, New Hampshire, and William Strauss, principal of FutureMetrics L.L.C. in Bethel, Maine, concludes that companies use a high interest rate assumption to calculate pension liabilities, and as a result the amounts are severely understated.

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A small change in the assumed interest rate can lead to huge changes in the reported pension liability. For example, in 2001 GM used a 7.3 percent interest assumption, similar to the median of 7.2 percent for all of the companies included in the study. The interest rate recommended by the Pension Benefit Guaranty Corporation in 2001 was 5.8 percent. At 7.3 percent, an $80 billion liability was estimated. If the recommended rate of 5.8 percent was utilized, the liability would balloon to approximately $100 billion, more than doubling the latest reported underfunding to $40 billion. Coauthor of the study Steve Church states that corporations “have used the full range of flexibility allowed in accounting rules to justify seemingly unreasonable assumptions.”

And what effect would another $20 billion in underfunding have on GM’s balance sheet? It would wipe out its entire shareholders’ equity. GM would have more liabilities than assets. GM and other major companies are counting on the stock market to bail them out of this mess. It can be argued that the movement of the stock market is even more important to GM than the relative performance of its core automobile business!

According to Employee Benefits Journal, the average pension fund has upped its allocation to stocks from 40 percent in 1990 to 61 percent in 2001. Corporate pensions now find themselves the target of unflattering comparisons to the old S&L industry. Both attempted to boost income by purchasing assets with a much higher expected return but with little correlation to their liabilities. Both were legally acting as fiduciaries but treated their fiduciary role as a source of profit. Both are accountable to a federal insurer for any shortfalls, making their management decisions of public concern and consequence. Both have responded to unfavorable market performance by reaching for riskier assets with higher expected returns. Both have used accounting rules to paint the desired picture and conceal their errors.

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PUBLIC RELATIONS FOR INVESTORS

We’ve now seen just a sampling of tools at corporate management’s disposal if they desire to manipulate earnings, but this is only part of the equation in determining the price of a stock. Investor expectations are important in determining how the market will “capitalize” these earnings. Higher expectations mean a better P/E ratio and as a result a higher stock price. It’s rare to see a company admit that its long-term future for success is not so bright.

The Big Bath

It may sound crazy that a company’s managers would exaggerate losses, but sometimes they decide to write off as much as possible in a quarter or year when the numbers aren’t good anyway. Of course the loss is downplayed and reported as an extraordinary (separate) item on the income statement. In essence the news release says something like “This write-off relates to past events and is not significant. It’s now behind us, and we can focus on the future.” These write-offs result from closing a division, the elimination of all the excess cost paid for an acquisition, or even the write-down of inventory. Anything that is listed as an asset on an organization’s balance sheet can be written off if it is no longer considered of value.

When a company takes a “big bath,” this means that assets are charged off as a one-time expense instead of being spread out over time. Therefore, future earnings will look relatively better because expenses will be reduced. It all comes down to creating the desired effect on the stock price. Believe it or not, the stock prices of some companies have rallied on the day of a press release announcing a big write-off.

Positive Spins on Negative News

On September 10, 2001, video renter Blockbuster Inc. issued a press release. The company stated that it would reduce its 61inventory on videocassette tapes by 25 percent and take a $450 million charge as a result. John Antioco, chairman and chief executive officer, stressed that it was a noncash charge and would result in no capital outlay. “The amount accounts for less than 1 percent of annual revenue,” according to Antioco.

“This is really all about creating room and accelerating exposure to the DVD market,” Antioco said. “It’s potentially the fastest growing consumer product that’s ever been introduced. This year’s coming of age for DVDs is a major role in Blockbuster’s strategy.”⁹ Corporate executives are often guided by public relations firms that have a technique for making bad news sound positive. There is an art to it.

I did a little “back of the envelope” accounting and came up with some interesting items that were not addressed in the Blockbuster press release. At the time of the release, the latest quarterly financial statements filed with the SEC, called the 10Q, were as of June 30, 2001. These are available to the general public on the SEC’s web site through a system called EDGAR (Electronic Data Gathering, Analysis, and Retrieval). After my own analysis here are some notes and observations:

1. According to the Balance Sheet dated June 30, 2001, Blockbuster had an accumulated comprehensive loss of $88 million. That’s a lot of money lost! With this announced write-off of the video inventory, I added another $450 million to the total losses. In other words, the company had lost $538 million of shareholders’ money from the sale and rental of videos and games since its inception. Not very impressive.
2. For the six months ended June 30, 2001, the company had a loss of $10.9 million. They were continuing to lose money even before the write-off.
3. The rental library was shown as an asset on the books for $609.8 million. A write-down of $450 million represents almost 75 percent of the reported value from just 62seventy days earlier. Yes, it may be less than 1 percent of sales, but this looks like a major event in my book. It was certainly downplayed as such by management.
4. As of June 30, 2001, the company had $8.1 billion in reported assets, $5.7 billion of which were intangibles such as goodwill. An intangible is usually worth nothing. It can’t be converted to cash. More than half of this company’s assets were worthless!
5. The company reported shareholders equity (assets minus liabilities) of $5.98 billion on June 30, 2001. At first glance this sounds like a company of substance. But wait a minute, what about that $5.7 billion of intangible assets? If you take that away, it leaves roughly $300 million of tangible shareholder equity as of June 30, 2001. Well, at least it’s a positive number.
6. If the accounting was done properly, the $450 million write-off should have been matched against income during the years these items were being rented. Shareholder equity as of June 30, 2001 needed to be adjusted down by approximately this amount. After that adjustment I came up with negative tangible shareholder equity of $150 million. This means that liabilities exceeded tangible assets by $150 million. I decided to give the company the benefit of the doubt relating to the actual value of the remaining tangible assets on June 30, 2001.
7. I went back to Blockbuster’s last press release relating to earnings to see if there were any clues about the upcoming write-off and the bad news about being, well, financially challenged. On July 24, 2001, the press release was extensive with lots of bold print: Blockbuster Reports Strong Cash Earnings and Free Cash Flow for the Second Quarter of 2001—EBITDA 63Increased to $118.4 million, on higher revenues of $1.23 Billion—Free Cash Flow Doubled to $75.2 million for the quarter; $175.1 million for the First 6 Months of 2001, Exceeding the Full Year Total for 2000.¹⁰ The press release was a total of nineteen paragraphs that reiterated all the good stuff. It never mentioned that on a GAAP basis the company lost $15.6 million for the quarter. That was found by sifting through the financial statements.
8. I always find it interesting when companies emphasize that a write-off is a noncash expense. The write-off on the Blockbuster video library was technically noncash, but only because the cash used to pay for the videos had already been paid by Blockbuster in previous accounting periods.
9. My last observation has to do with the stock price and resulting market capitalization of Blockbuster. The market capitalization of a company is the result of multiplying the outstanding number of shares of a company by its current market price. As of the date of making these observations, the market cap for Blockbuster was $3.6 billion. This means that the market was stating that Blockbuster was worth $3.6 billion, even though it had a tangible net worth of a negative $150 million.

I don’t want to pick on Blockbuster. It just happened to report a big bath and handled the PR like most other companies while I was working on this section of the book. However, just because Blockbuster is in the entertainment industry doesn’t mean it has an exclusive on using fantasy and imagination to report and interpret corporate results. Sorry to say, their story is not unique.

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NEW ISSUES OF COMMON STOCK

When a company issues common stock to the general public for the first time, it’s called an initial public offering (IPO). During the late 1990s the hunger for new technology stocks by investors became seemingly insatiable. In some cases, with nothing to show but a business plan, a company could raise millions of dollars from willing investors. This was an extraordinary period in financial history rivaled only by other historic bubbles such as the Dutch tulip craze. The one thing that IPOs have in common, regardless of whether the stock goes up or down in the aftermarket, is dilution.

We’ve already seen how an investor’s ownership in a company can become reduced or diluted by employee stock option plans. In an IPO the investor’s share becomes immediately diluted because the price for a share of stock is greater than the book value per share of the company 100 percent of the time. The Internet entrepreneurs of the late 1990s who became instant millionaires didn’t get that way by running profitable businesses. Their wealth was stolen from the multitudes of investors who were willing to suffer major dilution to own a part of their companies.

For example, ZZ Programmer establishes a company and puts together a business plan. He takes this plan to Wall Street, and the investment bankers like the idea and say it’s marketable. ZZ sells 25 percent of his company to investors via an IPO for $10 million. This implies that 100 percent of the company is worth $40 million. ZZ just increased his net worth from zero to $30 million. Instant multimillionaire! On paper anyway. Of course this all came from the investors, who suffered immediate dilution. Since the company only has $10 million, less underwriting fees and commissions, and the new shareholders own 25 percent, the book value of their shares is $2.5 million, an immediate drop of 75 percent.

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Of course companies don’t always trade at a discount to book value. Some companies have traded at huge multiples of book value, even without current earnings. Why? It’s fueled by investor expectations. During the “bubble” years of the late 1990s, huge multiples of book value were seen, as many investors seemed to lose touch with reality.

Confronting the Problem

In the past when executives went beyond the legal loopholes and committed fraud, we found that white-collar villains were in a class by themselves. The average jail sentence for corporate criminals in the S&L scandal of the 1980s was three years—twenty-nine months less than someone convicted for a first drug offense. And what about the three leading avatars of corporate greed during the 1980s—Michael Milken, Ivan Boesky, and Charles Keating? Keating spent less than five years in prison. Boesky spent two years behind bars and paid $100 million. Milken was sprung in less than two years, though he paid more than $1 billion in fines and settlements. But that’s not to say he is feeling a financial squeeze. In 2002, Milken was reportedly worth a cool $800 million.

Boesky won $20 million, a house worth $2 million, and $200,000 a year for life in a divorce settlement. Keating is “tanned and fit” and “cutting a social swath” in Phoenix.¹¹

In a baby step toward improving corporate governance, the Sarbanes-Oxley Act of 2002 requires the chief executive and chief financial officer to swear in front of a notary that “to the best of my (their) knowledge there is no untrue statement or omission of any material fact” within the financial statements. This should get management wondering whether the rewards for fraudulent accounting are outweighed by the prospect of a severe jail sentence. By providing a paper trail of evidence to 66the contrary, at least this takes away the defense that the chief executive had “absolutely no idea” that the company’s financial officers were manipulating the figures.

The act quadrupled the maximum prison term for common types of fraud from five to twenty years. According to President Bush, this law was designed to “expose and punish dishonest corporate leaders.” The sad thing about all of this is that the accounting for the majority of corporations is within the letter of the law. High-profile frauds such as what took place at Enron get plenty of press and attention, but the bigger underlying problem—lax accounting standards that give management too much leeway in financial reporting—goes on.

The proper accounting for pensions and stock options continues to be debated as companies use inconsistent methods to report on these items. According to Warren Buffett, the aggregate misrepresentation in just these two areas dwarfs the lies of Enron and Worldcom.¹² Today, some companies have opted to expense stock options, while others continue to insist these are not expenses. Many firms take advantage of pension accounting rules that allow them to record projected gains even when the values of their pension assets fall, while others take a more conservative route. And this is all within the framework of generally accepted accounting principles.

If we can’t have complete trust in the financial reporting of corporations, perhaps we can count on Wall Street analysts to interpret the data and give us advice to help choose the companies that would be good investments. Or can we?