Sarbanes-Oxley [the accounting-reform act passed in 2002] is one of a number of attempts over the years by the government to make it less likely there would be financial fraud. But if you think there's no incentive to play games with accounting today, then you're in a dream world. There's complacency, and that's when bad stuff happens.
Before we start discussing specifics, keep in mind, first, that these examples I give may not be a violation of the law or even a technical violation of the accounting rules. Second, auditors are important. I recently had lunch with a veteran auditor, and to any accounting problems I described to him, he replied: "Was it disclosed? If it is disclosed, then we did our job." A company might change its revenue recognition that took a loss to a profit—but the auditors' concern is disclosure. Who is sitting there reading footnotes? People are making their decisions on a press release or a database. In general, the auditors' focus is on a legalistic interpretation. So, if you tied up your neighbor and robbed his house, but you disclosed it in footnote No. 23, it's okay.
In the fiscal year ended June 2010, Ulvac, a semiconductor-equipment company, changed from straightforward revenue recognition, under which revenue is recognized when a product is sold and delivered, to percentage-of-completion accounting. The latter is part of generally accepted accounting principles (GAAP), but isn't meant for every company. It's more used by construction firms, among others, where parts of a project are completed over time. So this company, which always used an appropriate revenue recognition method, turns on a dime in a year when business is very weak and says: 'Now would be a good time to move to percentage-of-completion. Wow, we pick up revenue as the production process is ongoing. How cool is that?'
This is a semiconductor-equipment maker. We are not talking about a five- year construction period for what it does. It helps Ulvac by allowing it to pick up revenue much earlier [then it otherwise might have]. In fiscal 2010, Ulvac reports that their sales are down 1% and profits up 38%. But the fine print in the footnotes says they changed their revenue-recognition, and that in the absence of that change, sales declined 21%, and they would have had a loss. It should say: 'We had a 21% decline in revenue from sales to customers, yet because we had a 20% increase in revenue from changing our accounting, we could still report that sales only declined 1%.'
At the beginning of 2011, Rakuten disclosed that it had changed its depreciation method from the straight-line method to the declining-balance method. Over the life of the asset, depreciation will basically be the same number. Straight-line depreciates an equal amount to each period; the other takes bigger deductions in the early years, and small ones later on. In U.S. dollars, that change added $13 million to Rakuten's operating profit, through a lower depreciation expense. Is there any place in the GAAP rule book that says: 'Thou shall never change your depreciation method?' No. But, in my interpretation, that stinks. It had nothing to do with selling additional products or having stronger margins.
Let's move to China.
China Yurun Food Group is a meat company that is taking gains on asset acquisitions, instead of on asset sales. You can't do that in the U.S. or under International Financial Reporting Standards (IFRS).
When you buy a company, if you pay more than its fair market value, you have to put goodwill on your books; conversely, if you pay less than fair market value, you put negative goodwill on your books. If you buy the asset at a big discount to fair market value, the negative goodwill is not going to be picked [as a gain] immediately under U.S. accounting rules. But in Hong Kong, they let companies pick up that negative goodwill immediately, as operating income.
Yurun drove a Mack truck through that accounting [loophole]. It appraised asset values much higher than what I believe is a reasonable fair market value. In fiscal 2010, Yurun made three acquisitions using appraised value at what I believe were inflated fair market values, and they took an immediate gain of 186 million Hong Kong dollars (about $24 million). They understood that the accounting allowed them to book a gain, which represented the difference between what they paid—in most cases, a tiny number—and what the appraiser says it's worth. [The company] got a good deal on all of these acquisitions, and accounted for it with negative goodwill. What the assets are really worth, we don't know. It's as if you bought a condo in Miami for $400,000, and it was worth $1 million before the housing crash.
So, on the day you buy it, you [report that you've made] $600,000. But you don't book income, whether it is sales revenue or investment on securities, on the day you buy the asset; you do it on the day you sell it. The most logical way to express it is that there is a connection between revenue and income when cash comes to you, not when cash is being spent. The more the appraiser says this thing is worth, the more enormous the opportunity for gains. This [type of] accounting is also used in Japan.
How about some domestic examples?
Green Mountain Coffee Roasters(GMCR). In past quarterly statements, such as the third quarter of fiscal 2010, the company made a point of things like 11 consecutive quarters of 40% net sales growth and 24 quarters of double-digit growth. If you do some compounding, the numbers start to get enormous.
There were two important changes in the footnotes describing its accounting policies over the past five years or so. In 2007, Green Mountain recorded revenue when the product was delivered to the customer. Then, it gave rebates; For example, if you buy 1,000 of those little K-Cups, they may give you a 5% rebate. They accounted for rebates as a reduction from gross sales. Fine. Then, when they started having difficulty getting to that magical 40%—this is my interpretation—the revenue-recognition wording in the footnotes became longer; in some cases, revenue was recognized upon shipment. That's not the same thing. Then, instead of treating the rebates as a reduction to sales, in some cases it was treated as an operating expense. Now, my friendly auditor will say: 'They disclosed it all.' But investors would say: 'That stinks.'
Because it flatters sales growth?
When you are telling me the business is still booming, but in order to make that assertion, you changed how you are accounting, that's just not fair play. Is it illegal? No. The auditors signed off on it. But the auditors are part of the problem.
For the fiscal year ended September 2011, Green Mountain reported net income [at] a shade over $201 million before items, up from almost $80 million [a year earlier]. Compare that to the cash flow from operations from that same year. Both measure the business's profitability. Cash flow from operating activities was $790,000 in fiscal 2011, versus a negative $2.3 million in 2010. That is a huge difference. The quality of earnings here looks suspect, because the cash flow should follow along with the net income.
Any other examples?
A recent interesting change to accounting rules was related to earn-outs [payments to the seller] in acquisitions. In the accounting, the acquirer debits intangible assets and credits something called a contingent consideration liability, which is the present value of what you expect to pay for the earn-out from the acquisition. It's a soft number, because in the case of drug companies, for example, buying research and development, you don't know if you're going to be able to get the regulatory approvals [for these products to come to market]. There are many hurdles along the way.
Mylan(MYL), a generic drug maker, in December acquired the rights to a Pfizer (PFE) inhalation technology platform for $348 million. The deal included rights of negotiation for certain Pfizer compounds in various stages of development. Acquirers on a regular basis reassess whether that number is correct. In the fourth quarter, Mylan recorded an earn-out liability of $376 million, most of which is related to the Pfizer deal. That was enormous, compared with the cash it paid in the acquisition, about $22 million. If the numbers were flipped, where they paid close to $400 million, and then there could be another 5% on the table or 10% for the earn-out, that would seem to be reasonable. But here, almost everything is non-cash.
What's the advantage of that?
Let's take a hypothetical scenario: A year from now, approvals don't come, or there are delays. Mylan knocks the contingent consideration liability down to $300 million, from $376 million. Perfectly reasonable.
What's the bookkeeping entry? You have to reduce your contingent consideration liability by $76 million, and you put that amount as a credit to income. You have created, out of thin air, a possibility of bleeding back into income some $376 million. You control the timing of it. Mylan obviously ran this through with the auditors. It is a stupid accounting-rule change.
I'm teaching people to watch for these earn-outs, and look at their accounting for the contingent liability. This could be the big abuse in the next few years, because abusive practices very often stem from accounting changes.
So, what's the lesson?
Don't let your guard down. If you are buying individual securities, you have to do some work. If you don't have the time or the interest or the expertise, buy an index.
What's your perspective now that you are back in the business? Will the next big accounting scam be outside the U.S.?
Frankly, there will be big ones in every market. It's partly human nature. It becomes more and more difficult for the auditors to stop, because the accounting rules across the world were largely written 50 years ago, in an industrial society. As the business models have changed, the accounting rules haven't really been rethought for certain type of transactions.
My goal is to find the companies where there is a disconnect between the underlying economics and how the company presents them, using whatever accounting they choose. Many times, it is completely legal, and in accordance with the rules. But the auditors interpret the rules a certain way, and don't have the imagination to just ask: "Does this reflect the underlying economics of the company?"
Here is how the auditors look at the world: They think of themselves and their legal liability issues first; if it's in the rule book and disclosed, you are covered. Second, they think of their clients. The client asked them to do something, and they want to please the client. A very distant third is they may occasionally ask: How does this look from the perspective of the investor? Investors would be astounded if they realized that this is how the party that is supposed to protect them views the world.