Talk notes: NACD Director Professionalism: Identifying Issues In Financial Statements

Director Professionalism
Philadelphia, PA
June 8-9, 2010

Course description at at the NACD website here.

Identifying Issues In Financial Statements

Dwayne L. Cook
Mid-Atlantic Practice Leader, Partner, Tatum

Dwayne was a KPMG consultant, then became CFO of a client (before SOX, so it was allowed back then), then started working for Tatum.  Specializes in clients doing acquisitions or divestitures.

This was a fun talk. Basic accounting review, but Dwayne walked through an analysis of the Blackboard, Inc. financials.

Part of the talk was "stump the non-accountants" which didn't seem useful for spotting red flags, but watching the thinking process of dissecting a financial statement was absolutely fascinating and entertaining.

(Disclaimer: I'm not an accountant, so notes may not be accurate.)

• As a CFO, when he had to deal with company audit committee, there was a scripted dialogue: what were the questions, and there was a proper way to answer the questions.
  • Your job is to ask me questions.
  • Biggest mistake is not following-up
  • Most recent SEC enforcement action: Diebold
    • They went after usual suspects (CEO, CFO, controller)
    • They also went after board for "recklessly not knowing"
    • i.e., As an audit committee director, if you don't know something, you're liable
  • Cartoon: CEO whitewashing stock analysts, board of directors, accountants
• Basic SEC filings
  • Proxy: communications to shareholders of matters for shareholder action
  • 10-K: annual report to SEC: includes financial statements/other disclosures
  • 10-Q: quarterly report to SEC
  • 8-K: special report, such as major acquisitions, director resignation, change of auditors
    • Now includes "VIE" (variable interest entities), or SPE (is a type of VIE)
    • Why?  get things off their balance sheet
    • Bad loans? Sell it off to another entity, and now it's off the books -- and because you sell it, it book a gain (even though you didn't get cash)
    • Enron: created VIE; you want risk to go with the transaction; if they go bad, did you transfer the risk and reward?
    • Questions:
      • do we have VIE?
      • did we transfer risk and reward?  (if not, then it wasn't a "sale")
      • if you book a gain or sale, was it properly recorded?
      • what is the nature of "any continuing involvement?" (do we need to book a reserve?)
    • The SEC will ask: they will want a comment letter on it
    • Question: "what are valid uses of VIE?"
      • Answer: "tried/true tactic: separate bad assets from good, and VIE are a vehicle to do that, so the company can raise money.  If you really wanted to get rid of it, you'd sell it. But since you can't, you have to do a VIE."
      • "What you're really doing is enabling yourself to borrow against it. The last two years shows what happens when you go down that bad path."
    • Question: "what about spin-offs? no one actually bought it."
      • "Could be perfectly legitimate"
    • Question: "what about companies that pay down debt on the last day of quarter, then reborrow the money at the beginning of next quarter?"
      • "When you see transactions at quarter/year end, it's usually monkey-business"
  • S-1: basic form for the registration of new issues
• The annual report
  • non-audited information
    • letter to shareholders
    • description of firm activities
    • management discussion & analysis
  • audited
    • income statement (i/s)
    • balance sheet (b/s)
    • statement of stockholder equity (n/a for non-profits)
    • statement of cash flows (scf <--- most important, as companies thrive when they generate cash from operations)
      • "if company is not generating from operations, what's the point? you can borrow money, but only for so long..."
      • "banker is best friend, until he wasn't...  they wanted $20M right now."
    • footnotes
    • auditor's opinions
    • statement of managements' responsibilities
• Underlying concepts
  • Period concept
  • Method of accounting
• Balance sheet: format
  • assets: economic resources w/future benefits (depreciated over life: building lasts 40 years)
    • very subjective: why 40 years?
    • depreciated at cost; if it appreciates, no ability to record the increase, under GAAP (under IFRS? yes, but only through equity, not P&L)
    • US GAAP is very conservative: assets can go down in value, not up
    • Question: "what is difference between GAAP and IFRS?"
      • "IFRS allows much more judgement. asks, 'would it be prudent to record something this way?'."
      • "Judgement not compatible with litigious U.S. society"
      • "No one is prepared for IFRS: schools, CPAs, etc..."
    • Examples
      • current assets
      • long-term investments (pick valuation method: mark to market, fair value, cost; when you acquire the asset)
        • fair value: gain/loss recorded on income statements
        • costs: talk about it, but don't record on income statement; can become impaired asset, which you need to "write it down"
        • Question: "how long can you defer write-down of impaired asset?"
          • Answer: "SEC guidance: 'it's not years, it's months'"
      • property, plant, equipment
      • intangible assets
        • "this is almost as fun as 'goodwill': mostly you expense R&D. if it's acquired, then you capitalize it as an intangible asset."
        • "patents are intangible assets; so are trademarks, copyrights, customer relationships."
        • "websites? If you're Amazon.com, you want to capitalize it. If you're GE, you don't care. You can do initial set up and design, you can't capitalize modification."
        • "software that you develop for your own use? capitalize. I'm going to take their payroll and capitalize it, that used to be expenses. Until they have a bad year, then they take more developers out of SG&A and capitalize it. This is what Diebold did that got them in trouble."
          • This is one of the five things that Diebold did that got them in trouble: there are only a couple things you can do to hide worsening results.
      • other assets
      • deferred charges
      • Question: "what about goodwill?"
        • Answer: "SEC is saying, if you have significant declines in share price or earnings, whatever you bought must be written down, because it's not worth what you paid for it."
        • "Goodwill can only down."
  • liabilities
    • current liabilities
    • long-term liabilities
  • equity
• "When I look at a company, I look at Statement of Cash Flows: see where company is making money in daily operations"
  • Three sections: 
    • Operating: making money
    • Investing: bought something
    • Financing: if not making money from operations, then where did cash come from?
• Example: Dwayne pulled up Blackboard, Inc balance sheet: three years between 2005-2007
  • Observations
    • Lots of cash: $206M. where'd it come from?
    • If you're not making money: be careful.  Will likely affect/impair goodwill, intangibles, deferred tax assets (future taxable income which is not going to be realized -- if you're not making money, this is going to go away),
    • "Companies get away with this all the time": meaning, "they're not writing it down when they should"
    • "Finance team is not being adequately transparent and having adequate integrity"
  • Now we move to current liabilities
    • 'Oh, here's where the cash came from: convertible debt; today, there are covenants that they need to comply with. $160M.  They can call the money due. Or cash call due immediately."
    • "How do you account for liabilities? Cost or fair value? It depends."
    • Convertible debt: say for $150M, with "conversion option feature", converts into stock, diluting shares; 
      • Two instruments: it's an "embedded derivative", which are booked at fair value
    • "It actually happened: Many companies in Q3 2008 had record quarters because they adjusted down their own debt: $150M debt that market only valued at $100M, because it was fair value. Even though the companies were contractually obligated to pay back the entire $150M. Even though you didn't retire the debt."
• "The rest is just presentation"
• Let's move to P&L:
  • They're making a lot more money in 2007
  • Story: 
    • R&D way up (more than doubled)
    • Before revenue went up
    • Gap was closed through Financing
  • How does GM record loaning money to dealers: Operating (because their business is to sell cars. financing enables operations.)
  • How about factory making watches, and I insure the factory; the building burns down; how do you record the money spent insurance. SEC says Investing, because it should match the asset.
• Non-GAAP financial measure
  • SEC: if you talk about non-GAAP on website or analyst calls, then it should be on your financial statements, too.  Usually in MD&A.
• Issues of concern in financial statements
  • Fair value
  • Revenue recognition
  • expense matching
  • use of reserves
  • write-offs
  • off-balance-sheet accounting
  • derivitives
  • Former chief counsel of SEC: "what would I spot as red-flags? I'd ask about any accounting that has judgements and assumptions."
• Restatements by reason/cause
  • Most come from revenue recognition
  • Next, cost
    • Example: I invest in a REIT-owned property. I replace the roof of that building. How do you record cost? If roof lasts longer than the building, then you expense it.
      • "People want to capitalize it. It must increase capacity, increase useful life.  People don't want to expense it."
  • Question: "as board member, there are thousands of transactions, on both revenue and cost: so where do we focus?"
    • "SEC says Diebold charge was 'recklessly not knowing'. So, all the 'squishy' areas. Look at accounting policies, compare to others in the industry, and follow-up when you ask the question."
    • "Ask about revenue recognition, and then follow it to its conclusion."
  • Question: "if you're not on budget or audit committee, what is my responsibility?"
    • "This info is targeted to financial expert and audit committee."
    • "Every board member should make it their business to be on top of the financial statements."
• Fair value
  • beware "bill and hold" transaction: Diebold did this: they had inventory, booked revenue, but still had ATMs -- turns out customer didn't request it. It was fraud.
• Cost recognition
• Use of reserves or estimates