Archives for posts with tag: SEC

Reported “Earnings” in Today’s World

July 6, 2018 //
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As an accountant and CPA, I always thought I understood basic financial concepts. Net Earnings was computed by deducting all your expenses from Sales. And Cash Flow was, well, cash flow, or your Net Earnings plus Depreciation. These were defined by generally accepted accounting principles or GAAP and used to publish a firm’s financial results.

Well, guess what? That is not the way it is anymore. I started to discover this when some of the young people I advise go to work for firms like Salesforce. For many high growth technology firms, like this one, there really aren’t much Net Earnings anyhow and they even report Sales in ways I was never taught!

So recently the Wall Street Journal had an article called “Fanciful Measures of Profit.” This trend does go back to my days in the 1990’s at USG Corporation. USG had borrowed huge sums of money and due to the interest expense (and a slump in the construction markets) we had no earnings. So we reported EBITDA, Earnings before Interest, Taxes and Depreciation. As their CFO, I would joke to investors that when you have no earnings, you report EBITDA instead. My old friend, Warren Buffet’s partner, Charlie Munger, called these “bullshit earnings”, and he was not far off. But the fun did not end there!

The Journal reported that this year alone, companies have filed 450 documents with the Security Exchange Commission, SEC, with variations of my old EBITDA. A popular one is EBITDAO which adds back the cost of stock options issued to management. There is also ones that add back pension cost, leasing cost, exploration costs and almost anything else you can dream up. Technically, all these so-called financial measures must be shown with the traditional GAAP reported earnings. But in quarterly earnings calls and meetings with investors, firms primarily stress these adjusted earnings calculations because it makes them look better. And stock analysts have adapted and now use many of these new earnings measures when they review a firm and recommend their stock.

I am having a hard time with all this. I was taught that, in the end, all firms need to make real net earnings and to generate cash flow to survive and grow. But today companies get around this by borrowing money and issuing more stock. And if the firm, like Salesforce, is in a trendy field like software platforms on the cloud and is growing rapidly, no one seems to care if they have GAAP profits or not. Salesforce stock has climbed over 80% in three years without much real Net Income at all. This was also the story of high sales and stock growth without earnings for years for companies like Amazon and Facebook.

So what to do? Every investor needs to decide for themselves. For every Amazon, Facebook or Salesforce that soars and succeeds, there are dozens of firms that fail. Or, heaven forbid, the next great idea comes along and wipes out the competitive advantage, market share and quickly the value of their stock!

But I have decided that even an old CPA needs to be open to the way this new economy of ours is working and to make some investments in firms that may not have met my conservative old standards. After all, my wife, Tricia, is the one who insisted in 2004 we buy stock in some small computer firm called Apple! (We should have bought more!)

Only time will tell if this new investment approach works!

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Quality Issues with CPA Firms Audits

January 30, 2018 //
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The Wall Street Journal recently ran a story about the government’s watchdog, the SEC, having concerns about the quality of audit reports issued by one of the Big Four CPA firms, KPMG. This resulted in an indictment of several people. What the government noted was poor audit quality based on their review. Big 4 CPA firms have also been charged with fraud in other high-profile cases. In fact, government test audits of all the Big Four firm’s work show that about 25% of all audits were what they call, “deficient”.

The issue is that investors rely on the outside auditors to check the accuracy of a firm’s financial reports. The SEC and the federal government has focused on this since the bankruptcies and accounting scandals involving Enron and World-Com in the early 2000s. And the Big Four CPA firms audit almost all the public firms in the Standard and Poor’s 500. So, this is not a good thing, no matter how you look at it.

As a former CPA in public accounting and a former CFO who worked with auditors for  decades, I have some thoughts for the Big Four CPA firms.

Training is first. Accounting firms send their new staff to a couple week training program. This is nowhere near enough. When I was an entry level staff person, I understood very little about internal controls, proper procedures, and really the whole auditing process. It took into my third or fourth year before I felt comfortable. More hands on training ever few months would have helped even though this is expensive.

Supervision is next. CPA firms have a very clear hierarchy of command where each layer above supervises and reviews the work of those below. The Senior on an audit might have a handful of staff reporting to them which does not sound unreasonable. But the Senior auditor also has work only they can do, like taxes, and rarely has enough time to supervise and help train their staff. Managers supervise Seniors but a bunch of them at once on often very different types of audits. More time needs to be allocated for review and supervision so that audit quality can improve.

Finally, we need a clear and mutually agreed understanding of what an audit is and what it is not. Audits are not meant to detect fraud yet many people believe they are. If fraud is found, however, it must be reported. As the government completes all these test audits perhaps the expectations versus the deliverables of an audit can become less fuzzy.  We also have whole new issues these days with technology,  cyber crimes and data security that did not exist that long ago. The responsibility of the auditor needs to be re-defined.

All of these items will take more audit time and thus audits will cost more. That will  become a reality. Historically, audit clients put constant pressure on their auditors to lower their fee. Going forward, if we want to improve audit quality and significantly reduce deficient work, audits will cost more. The investing public deserves it.

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Fraud and SEC Enforcement

December 29, 2017 //
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The Journal of Accountancy (yes, there really is such a publication) had an article about the Securities and Exchange Commission (SEC) bringing and enforcing fraud cases over the last decade. The largest cases involved either improper financial reporting or violations of the Foreign Corrupt Practice Act which deals with bribes to international officials. Not surprisingly the financial services industry had, by far, the most cases and fines followed by natural resource and energy firms (think mining and oil and gas).

But what was very surprising, and more than a bit disturbing to me, was who the SEC prosecuted and fined.  Corporations themselves were at the top of the list which made sense. But, what did not, was that Chief Financial Officers (CFOs) were second followed by a firm’s Chief Executive Officer (CEOs) as a far distant third. Worst of all was that the Board of Directors were barely fined at all! Now, I know I was a practicing (and never indicted CFO) and I know CFOs certainly play a major role in a fraud of any kind. But, let me tell you this: nine times out of ten when a CFO does something bad, his or her CEO not only knows about it but probably pressured the CFO to cook the books in the first place! I could understand if CFOs were fined a bit more than CEOs, but not ten times as much in this study. CEOs are always responsible and often behind what goes on, period.

And, the Directors in these firms should have know something was going on! I have written on several occasions about the often limited involvement or usefulness of many members of Boards of Directors. But remember the corporate officers from the CEO to the CFO all report to and are responsible to the Board. The buck, and on average, $250,000 per year of bucks for large company directors, stops with the Board.

As many readers know, I hate fraud and especially fraud committed by senior managers who are paid a lot of money. So I am all for prosecuting and fining those who commit fraud. But if the SEC and the U.S. Government focus the bulk of their efforts on CFOs and almost ignore CEOs and their Boards, the occurrence and magnitude of fraud will only continue and probably get worse.

Think of this like a National League Football team. When a team, like my Cleveland Browns go winless, they fire the coach. When the team only wins a few games in several years, you fire the General Manager, the Director of Player Personnel and everyone but the Owners. So, in corporate terms, when major fraud occurs, fire the Board. This is how you send a message and how things might have a chance to improve in the future.

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The End of Accounting

July 3, 2016 //
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No it is not dead yet, but my old world of Accounting is taking a lot of hits.

A new book is coming out called The End of Accounting and the Path Forward for Investors and Managers (Wiley Finance books). The premise, per an excerpt in the Wall Street Journal, is that accounting focuses on the past often using arcane rules and estimates. Historically, reported earnings contain a number of one time gains and losses for items like foreign currency or restructuring costs as well as estimates for useful lives of assets to depreciate or bad debt expense etc. And, of course, this is all true.

What the book’s authors are concerned about is that more forward looking information like new customers, new technology, capacity utilization or in retail, same-store sales, are not given the impact they deserve since these measures are often a better predictor of the future and thus a firm’s long term stock value. And, of course, this is all true.

The article brings up the idea that reported earnings (and especially losses) may make it hard to judge the real value of a firm. They cite Tesla who despite over a billion dollars in losses the last two years is considered, by some, as a great innovator and valuable firm. If you read my prior blog posting, you know how I feel about Elon Musk and his money losing, government subsidized businesses. But the point certainly could be valid for the early years of many tech startups like Facebook.

A separate Wall Street Journal article was titled, “Accounting Blurs Profit Picture”. The message here was that only about 6% of the Standard&Poor 500 firms exclusively use Generally Accepted Accounting Principles or GAAP to close their books. Theses firms include Home Depot and Apple, two very different companies and industries.

What most other public firms do is that besides reporting the required GAAP earnings information, they will separately report some other form of Cash Earnings which excludes a number of the one time charges mentioned above. This practice occurs in almost half of all published earnings reports. These firms are supposed to “reconcile” their GAAP results with their hybrid, customized results. The Securities Exchange Commission (SEC) is following up with eighty companies about if and how they accomplish this.

So, as an old CFO and CPA, where do I believe this is going and what should a typical investor do? To my old accounting profession, I would strongly suggest they find ways to either accommodate alternate earnings presentations or enforce the rules of GAAP even if it means adding some more forward looking, but meaningful, information. For the average investor, understanding financial statements has never been easy and now it is much harder. The key for an investor who is looking to invest in one of two companies like Home Depot or Lowes, is to spend more time reviewing their results to understand if you are comparing apples or oranges. In many cases, the security analysts who follow these firms may provide you the best information versus the firms’s own published reports.

Good lucking in sorting it all out and investing in a world where accounting is, if not dead, strongly abused!

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