Accounting Fiction?

A recent article in the Wall Street Journal notes that as of May 26, 77 percent of the 485 companies in the S&P 500 that had reported earnings beat earnings, compared to the historical rate of 66 percent. What is even more surprising is that the earnings beats are 6.9 percent above expectations, compared to a 4.1 percent historical average. But accounting choices, which have been labeled as potential earnings manipulation, may be the cause. For example, Google extended the life of its server infrastructure from four years to six years. The extension added 6 cents per share to earnings due to lower depreciation. The company also shifted employee stock awards from January to March, which also increased reported earnings. And Carvana, which was expected to lose $2.03 per share only lost $1.51 per share. The company had taken charges in the previous quarter when used car prices had plummeted and expected to sell cars for less. When used car prices increases, the company unwound those loses, increasing earnings per share by $.48, almost all of the earnings beat.

Cash Versus Earnings

A recent article in the Wall Street Journal notes that banks sharply increased their loan loss reserves in 2020 in response to the pandemic. Increasing such reserves reduces a bank’s reported profit, and decreasing them improves the profit picture. By 2021, the loan losses had not emerged at the level the banks anticipated, so their profits will be rising as the loan reserves are decreased. According to the WSJ, “U.S. banks are sitting on a pile of cash that could turn into billions of dollars of profits.” There’s only one problem. Loan loss reserves are just accounting entries. Increasing and decreasing them impacts reported profits, but has no cash flow implications. As JPMorgan CEO Jamie Dimon said "It's ink on paper . . .we don't consider that earnings." We recommend a review of Chapter 2 for the WSJ reporter.

Book Value Versus Market Value

Rental car giant Hertz recently filed for bankruptcy. The bankruptcy is for the rental car company, while Hertz Vehicle Financing, which owns and finances the purchases of vehicles, is not included in the bankruptcy. While we will discuss bankruptcy later in the text, this filing does allow us to show the difference between book values and market values, a concept that can cause confusion for students. The 6th full paragraph of an article about the bankruptcy states:  

"A major factor in the timing of the bankruptcy filing was the $389.5 million monthly lease payment that included an additional $135 million "true-up" payment for difference between the depreciated value compared to the book depreciated value."

If you read this carefully, the timing of the bankruptcy was chosen because Hertz car rental could not make the additional payment of $135 million to account for the difference between the book value and market value of the cars it leased from Hertz Vehicle Financing. In other words, the combined market value of the cars leased by Hertz car rental was $135 million less than book value. 

Starbucks Profit

We are sure that you are familiar with store gift cards and the frustration of have 43 cents left on the card. In retail, gift card balances are known as stored value liabilities. Each year Starbucks recognizes that a portion of its stored value liabilities will be permanently lost. This is known as breakage. Starbucks recognizes this amount as profit. In 2018 the company recognized $155 million in breakage, around 10% of all stored value balances. Wow! Starbucks already pays just 0% on its debts to customers, but add in breakage and that equates to a roughly negative 10% interest rate!

Taxes, Taxes, Taxes

While you are likely familiar with large salaries sometimes earned by professional athletes, like everyone else, taxes can take a big bite out of that salary. For example, Seth Curry earned an NBA record $34.7 million during the 2017-2018 season. Unfortunately, he only got to take home about 44 percent of that figure. The biggest bite was $11.7 million in Federal income tax, followed by $4.1 million in city and state tax. Of course, he was estimated to have earned $35 million in endorsements for the year, so his earnings effectively doubled, as did his tax liabilities. 

McDonald's Negative McEquity

A negative book value of equity is generally a bad sign as it often indicates a company has accumulated losses that have exceeded shareholder capital contributed. However, as with any other accounting number, it must not be taken at face value. For example, hamburger giant McDonald's has an interesting shareholder equity that indicates something entirely different. If you take a look, McDonald's Treasury stock has exceeded its retained earnings since 2016, which indicates that the company has repurchased more of its stock than it has reinvested from earnings. While this is a good thing for investors, it does create a problem when evaluating the company's financial ratios. For example, the ROE as calculated is negative, which is generally not good, but the 28 percent profit margin in 2018 is a very good sign.

GE's Loss Of Goodwill

General Electric just announced a $22 billion write-off related to the company's 2015 acquisition of the power grid business from Alston SA. The Alstom purchase was made for $10.1 billion, so GE wrote off more than twice the original purchase price. What makes this is write off unique is that GE is writing off previously unrecognized intangible assets. This means that previously misvalued or unrecognized intangible assets were not recognized in accounting for the acquisition.

Cash Flow Rises

According to a recent study, free cash flow for 20 industries increased to 4.97 percent last year, meaning that for every dollar of sales, companies generated 4.97 cents in cash flow. An increase in operating efficiency generated .89 percent, a decrease in working capital contributed .69 percent, and lower capex contributed .17 percent. The lower capex spending may be worrisome as it is an indication of lower investment in fixed assets.

The (Partial) Effects Of Tax Reform

With the U.S. corporate tax rate being among the highest among developed economies, there is discussion of corporate tax reform that would reduce the corporate tax rate from 35 percent to 20 percent, as well as the possibility of eliminating the deduction of interest expense entirely. So how would this affect corporate finance? A cut in the corporate tax rate on interest would reduce the attractiveness of debt as a form of financing, thereby reducing the amount of debt in the optimal corporate capital structure. One estimate is that the U.S. average debt-to-EBITDA ratio would drop from 4.1 to about 3 times, which would also affect the other financial leverage ratios. And the non-deductibility of interest expense would affect the calculation of the weighted average cost of capital. And, finally, at least for now, the decline in corporate debt will likely increase the credit rating for the remaining debt, driving the yield down on debt that does remain. All in all, major changes to U.S. based corporations.

Accounting Cash Flow Makeover

The Accounting Statement of Cash Flows received a makeover as FASB updated the treatment of eight different cash flows. As you will read, whether the updates provide any meaningful change is not clear, as two Accounting professors interviewed have differing opinions on the update. Unfortunately, FASB did not address what we feel is a glaring weakness in that interest expense is still considered an operating cash flow, rather than being included correctly in the financing cash flow section.

A Critical Examination Of Earnings

A recent article made us think about the importance of definitions. The article states: "After all, in the long-run stocks are fundamentally driven by earnings and expectations for earnings growth." While we agree in part with this statement, we bet most people reading the article automatically think of earnings as net income and EPS. In reality, "earnings" is often used loosely to relate more to cash flow, which is a more important driver of stock price than accounting earnings. Remember, accounting numbers can be distorted much more easily than cash flow. There is another factor that is equally, if not more important, that is the required return. In increase in the required return on the market or a stock can often have a large impact on stock prices.

American Airlines Political Risk

Although we don't delve deeply into political risk as it is beyond the scope of the textbook, it is a risk borne by multinationals as American Airlines found out. American recently announced that it would take a $592 million special charge in the fourth quarter as a result of Venezuelan currency controls. Venezuela's socialist government forces airlines to sell airfares in bolivars, but makes conversion of the bolivars into U.S. dollars difficult. As a result, American has bolivars trapped in Venezuela.

Buybacks And Bonuses

A recent article discusses how buybacks at Humana earned CEO Bruce Broussard a $1.68 million bonus in 2014. Humana was on target to miss its target EPS of $7.50. However, the company announced a stock buyback of $500 million, which increased EPS to $7.51, triggering the bonus. In all, 255 of the S&P 500 companies have executive performance tied in part to EPS. As we have discussed, in our opinion, EPS is not an appropriate measure of performance as it is easily manipulated. Executive bonuses should be tied to measures that better align with increases in shareholder value. As an example of EPS manipulation, the article reports that, in 2012, then-CEO of Humana Michael McCallister received a $1.63 million bonus because the Board of Directors removed litigation expenses from the EPS calculation.

Clawbacks And Restatements

A major provision of the Dodd-Frank Act requires corporate executives to certify the accuracy of financial statements, in part to help reduce restatements. Another provision of the Act requires that all public companies have a "clawback" provision that permits the recovery of any incentive compensation paid to executives if the restated financial statements show that the incentive compensation should not have been paid. In 2012, 87 percent of publicly traded companies had a clawback provision. Previous research has found that companies with a clawback provision are less likely to have restatements. This was attributed to executives doing a more diligent job when certifying the original financial statements. However, new research indicates that the drop in restatements may also be due to executives fighting restatements. Often, restatements are the result of auditors disagreeing with the original financial statements because of the accounting choices made. Since a restatement that reduces the company's reported performance can cause the initiation of the clawback, corporate executives appear more likely to fight restatements.

International Corporate Ethics

It often seems that many people believe corporate ethics problems are limited to U.S. companies. Unfortunately, ethical problems are a worldwide problem. Toshiba, which is base in Japan, just announced that it had overstated profits by ¥151.8 billion ($1.22 billion) over the past several years. The CEO of Toshiba, Hisao Tanaka, and his predecessor Norio Sasaki, were both apparently aware of the accounting fraud. It is believed that both men, along with the board, will be replaced.

Mark-To-Market Accounting And FedEx

FedEx announced that it would take a $2.2 billion charge as it would be changing the way it accounted for pensions. The company will use mark-to-market accounting for the assets in its pension account moving forward. Mark-to-market accounting means that the assets are recorded at "fair value", or market value, rather than historical value.

RBS Goodwill Writeoff

An expected writeoff by the Royal Bank of Scotland (RBS) is further evidence that acquisitions are an inexact science. It is believed that RBS will announce a £4 billion ($6.2 billion) writeoff related to its acquisition of Citizens Financial. The writeoff will almost entirely erase the company's 2014 profit. RBS has already sold 29 percent of Citizens Financial in a public offering, and plans to sell more of the company. RBS purchased Citizens for $130 billion in 1988, but the current market capitalization of Citizens is a much smaller $13.7 billion.

Amazon's Leasing Cash Flow

In the textbook, we argue that cash flows are most often a better measure of company performance than net income. Amazon fully exploits this concept. In most recent quarters, the company has shown an operating loss, but has touted its positive operating cash flow as the measure that investors should examine. Now, it appears that Amazon may have been glossing over a more negative reality for the company. In the company's most recent earnings announcement, it disclosed another cash flow, which is the operating cash flow minus the capital leases. Amazon has a large number of capital leases. Ignoring the cash flows necessary to pay these leases ignores a significant outflow each year to which Amazon has committed to paying. 

FASB And IFRS Diverge

For several years, FASB and IFRS have been working toward the convergence of U.S. and international accounting polices. Now, it appears that a split has occurred. Several cultural differences appear to have led to divergence, including the informal relationship between stakeholders and FASB, which contrasts to the more rigid international relationship. Additionally, the lack of support for internationalization of accounting standards from U.S. corporations and investors appears to have been a major influence. IASB chairman, Hans Hoogervorst, believes that convergence was successful as convergence has been reached on several topics. In either case, it appears the push to homogenize U.S. and international accounting standards is at a standstill for now.

The SEC And Financial Reports

Financial scandals always seem to draw headlines, from Enron to Parmalat. Regulations such as Sarbanes-Oxley have been enacted to help reduce the likelihood of future financial scandals. With the additional tools, the SEC has become more focused on efforts to uncover financial fraud. For example, if a company impairs an asset, the SEC will ask why a company didn't impair the asset earlier. The SEC is also making sure that as company's financial statements have year-to-year consistency, as well as whether a company's accounting is consistent with industry practices.As a result, company management must be familiar with the company's accounting procedures and internal controls. Remember, the goal of the SEC is that a company accurately disclose its financial condition and risks