Friday, September 29, 2006

Creative accounting

In recent times, honesty has eroded. It was once pretty easy to tell the good guys from the bad. Back in the 60s, virtually all of America's most-admired firms avoided deception. And most investors at that period knew who was playing game.

Now, many major corporations still play things straight, however a significant and growing number of executives have come to the view that it's fine to manipulate earnings to satisfy what they believe are Wall Street's desires. In fact, many think this kind of action is their duty with the intention of so-called "maximizing shareholder's value."

These managers too commonly start with the assumption that their jobs is to encourage the highest stock price possible - something which I adamantly disagree. To achieve this aim, at first, they strive for operational excellence. But when operations don't produce the desired result, unadmirable accounting tricks - alternatively known as creative accounting - take place. This either manufacture the "desired outcome or earnings" or set the stage for them in the future when needed.

Creative accounting is not illegal. As what Michael Kinsley said: "The scandal isn't in what's done that's illegal but rather in what's legal."

Managers rationalize this behaviour oftenly by saying that shareholders will be hurt if their stock is not fully-priced, and they also argue that in using creative accounting, shareholders are getting what they want. Once such an "everyone is doing it" attitude takes place, ethical misgivings vanish.

An instance of a legitimate accounting entry that is highly questionable is one-time expenses such as "restructuring charges", an accounting entry that is often a device for manipulating and misleading real earnings. In some cases, a large chunk of costs that should rightly be attributed to a number of years is dumped into a single quarter or year, usually one that is already fated to disappoint investors. In other cases, the aim is to clean up earnings misrepresentations of the past, and in others, it is to prepare the ground for future misrepresentations. Many times, wreaks like these are often swept under the carpet discreetly under the nose of innocent and ignorant investors. In both cases, the size and timing of these charges are dictated by the cynical proposition that Wall Street will not mind if earnings fall short of $5 per share in a given quarter, just as long as this shortage ensures that quarterly earnings in the future will constantly exceed expectations by 5 cents per share.

In the acquisition arena, restructuring is often an art form. In many cases of leverage buyouts, business is acquired wholly, then brought private, spruce up with condiments, and then take it public again. In this short period, they can turn a dollar into 3 dollars easily when they sell the business back to investors. Acquisitions and mergers are all about rearranging the value of assets and liabilities in ways that will allow them to both smooth and swell future earnings. An instance will illuminate the case. When a business is acquired, the buyer sometimes simultaneously increases its loss reserves, often substantially. This boost may reflect the previous inadequacy of reserves. But such moves set up the possibility of "earnings" flowing into income at some later stage, as reserves are release later when they explain the earlier reserves were overestimated. When deals occur in which liabilities are increased immediately and substantially, simple logic tells us at least one of the virtues have been lacking or the acquirer is setting the framework for future infusion of "earnings."

As pointed out by Warren Buffett on a true story that happened in the 90s: "Here's a true story that illustrates an all-too-common view on corporate America. The CEOs of two large banks, one of them a man who'd made many acquisitions, were involved not long ago in a friendly merger discussion (which in the end didn't produce a deal). The veteran acquirer was expounding on the merits of the possible combination, only to be skeptically interrupted by the other CEO: 'But won't that mean a huge charge,' he asked, 'perhaps as much as $1 billion?' The 'sophisticate' wasted no words: 'We'll make it bigger than that - that's why we're making the deal.'"

So, in a great and honest management, they would rather disappoint you with earnings than with their accounting. Meeting Wall Street earnings forecast does not play much of a factor to them. They will spend more time on work that increases the real earnings of the business than to spend more time attending to investor relationship answering to what Wall Street wants to hear.

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