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Additional Praise for

Financial Statement Analysis, Fourth Edition

“This is an illuminating and insightful tour of financial statements, how theycan be used to inform, how they can be used to mislead, and how they canbe used to analyze the financial health of a company.”

—Jay O. Light, Dean Emeritus, Harvard Business School

“Financial Statement Analysis should be required reading for anyone whoputs a dime to work in the securities markets or recommends that others dothe same.”

—Jack L. Rivkin, Director, Neuberger Berman Mutual Funds and Idealab

“Fridson and Alvarez provide a valuable practical guide for understanding,interpreting, and critically assessing financial reports put out by firms. Theirdiscussion of profits—‘quality of earnings’—is particularly insightful giventhe recent spate of reporting problems encountered by firms. I highly rec-ommend their book to anyone interested in getting behind the numbers as ameans of predicting future profits and stock prices.”

—Paul Brown, Associate Dean, Executive MBA Programs,Leonard N. Stern School of Business, New York University

“Let this book assist in financial awareness and transparency and higherstandards of reporting, and accountability to all stakeholders.”

—Patricia A. Small, Treasurer Emeritus, University of California;Partner, KCM Investment Advisors

“This book is a polished gem covering the analysis of financial statements.It is thorough, skeptical, and extremely practical in its review.”

—Daniel J. Fuss, Vice Chairman, Loomis, Sayles & Company, LP

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FinancialStatement

Analysis

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Founded in 1807, John Wiley & Sons is the oldest independent publish-ing company in the United States. With offices in North America, Europe,Australia and Asia, Wiley is globally committed to developing and marketingprint and electronic products and services for our customers’ professionaland personal knowledge and understanding.

The Wiley Finance series contains books written specifically for financeand investment professionals as well as sophisticated individual investorsand their financial advisors. Book topics range from portfolio managementto e-commerce, risk management, financial engineering, valuation and fi-nancial instrument analysis, as well as much more.

For a list of available titles, visit our Web site at www.WileyFinance.com.

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http://www.WileyFinance.com



FinancialStatement

AnalysisA Practitioner’s Guide

Fourth Edition

MARTIN FRIDSONFERNANDO ALVAREZ

John Wiley & Sons, Inc.

iii



Copyright c© 2011 by Martin Fridson and Fernando Alvarez. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted inany form or by any means, electronic, mechanical, photocopying, recording, scanning, orotherwise, except as permitted under Section 107 or 108 of the 1976 United States CopyrightAct, without either the prior written permission of the Publisher, or authorization throughpayment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Webat www.copyright.com. Requests to the Publisher for permission should be addressed to thePermissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030,(201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions.

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used theirbest efforts in preparing this book, they make no representations or warranties with respect tothe accuracy or completeness of the contents of this book and specifically disclaim any impliedwarranties of merchantability or fitness for a particular purpose. No warranty may be createdor extended by sales representatives or written sales materials. The advice and strategiescontained herein may not be suitable for your situation. You should consult with aprofessional where appropriate. Neither the publisher nor author shall be liable for any loss ofprofit or any other commercial damages, including but not limited to special, incidental,consequential, or other damages.

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Library of Congress Cataloging-in-Publication Data

Fridson, Martin S.Financial statement analysis : a practitioner’s guide / Martin S. Fridson and Fernando

Alvarez. – 4th ed.p. cm. – (Wiley finance ; 597)

Includes bibliographical references and index.ISBN 978-0-470-63560-5 (hardback); ISBN 978-1-118-06418-4 (ebk);ISBN 978-1-118-06419-1 (ebk); ISBN 978-1-118-06420-7 (ebk)

1. Financial statements. 2. Ratio analysis. I. Alvarez, Fernando, 1964– II. Title.HF5681.B2F772 2011657′.3–dc22

2010054229

Printed in the United States of America

10 9 8 7 6 5 4 3 2 1

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http://www.copyright.com

http://www.wiley.com/go/permissions

http://www.wiley.com



In memory of my father, Harry Yale Fridson, who introducedme to accounting, economics, and logic, as well as the fourthdiscipline essential to the creation of this book—hard work!

M. F.

For Shari, Virginia, and Armando.F. A.

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Contents

Preface to Fourth Edition xi

Acknowledgments xv

PART ONEReading between the Lines

CHAPTER 1The Adversarial Nature of Financial Reporting 3

The Purpose of Financial Reporting 4The Flaws in the Reasoning 8Small Profits and Big Baths 11Maximizing Growth Expectations 12Downplaying Contingencies 18The Importance of Being Skeptical 20Conclusion 24

PART TWOThe Basic Financial Statements

CHAPTER 2The Balance Sheet 29

The Value Problem 30Comparability Problems in the Valuation of

Financial Assets 32Instantaneous Wipeout of Value 34How Good Is Goodwill? 35Losing Value the Old-Fashioned Way 38True Equity Is Elusive 40Pros and Cons of a Market-Based

Equity Figure 41

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viii CONTENTS

The Common Form Balance Sheet 43Conclusion 45

CHAPTER 3The Income Statement 47

Making the Numbers Talk 47How Real Are the Numbers? 52Conclusion 77

CHAPTER 4The Statement of Cash Flows 79

The Cash Flow Statement and theLeveraged Buyout 81

Analytical Applications 86Cash Flow and the Company Life Cycle 87The Concept of Financial Flexibility 99In Defense of Slack 104Conclusion 106

PART THREEA Closer Look at Profits

CHAPTER 5What Is Profit? 111

Bona Fide Profits versus Accounting Profits 111What Is Revenue? 112Which Costs Count? 114How Far Can the Concept Be Stretched? 116Conclusion 117

CHAPTER 6Revenue Recognition 119

Channel-Stuffing in the Drug Business 119A Second Take on Earnings 123Astray on Layaway 127Recognizing Membership Fees 128A Potpourri of Liberal Revenue

Recognition Techniques 131Fattening Earnings with Empty Calories 132Tardy Disclosure at Halliburton 138Managing Earnings with Rainy Day Reserves 141



Contents ix

Fudging the Numbers: A Systematic Problem 143Conclusion 147

CHAPTER 7Expense Recognition 149

Nortel’s Deferred Profit Plan 149Grasping for Earnings at General Motors 154Time-Shifting at Freddie Mac 157Conclusion 159

CHAPTER 8The Applications and Limitations of EBITDA 161

EBIT, EBITDA, and Total Enterprise Value 162The Role of EBITDA in Credit Analysis 166Abusing EBITDA 169A More Comprehensive Cash Flow Measure 171Working Capital Adds Punch to Cash

Flow Analysis 174Conclusion 176

CHAPTER 9The Reliability of Disclosure and Audits 179

An Artful Deal 180Death Duties 183Systematic Problems in Auditing 184Conclusion 189

CHAPTER 10Mergers-and-Acquisitions Accounting 191

Maximizing Postacquisition Reported Earnings 191Managing Acquisition Dates and

Avoiding Restatements 195Conclusion 197

CHAPTER 11Is Fraud Detectable? 199

Telltale Signs of Manipulation 199Fraudsters Know Few Limits 201Enron: A Media Sensation 201HealthSouth’s Excruciating Ordeal 210Milk and Other Liquid Assets 217Conclusion 221



x CONTENTS

PART FOURForecasts and Security Analysis

CHAPTER 12Forecasting Financial Statements 225

A Typical One-Year Projection 225Sensitivity Analysis with Projected Financial Statements 237Projecting Financial Flexibility 242Pro Forma Financial Statements 245Pro Forma Statements for Acquisitions 246Multiyear Projections 253Conclusion 263

CHAPTER 13Credit Analysis 265

Balance Sheet Ratios 266Income Statement Ratios 275Statement of Cash Flows Ratios 280Combination Ratios 283Relating Ratios to Credit Risk 290Conclusion 304

CHAPTER 14Equity Analysis 307

The Dividend Discount Model 308The Price-Earnings Ratio 313Why P/E Multiples Vary 316The Du Pont Formula 324Valuation through Restructuring Potential 328Conclusion 334

APPENDIXExplanation of Pro Forma Adjustments for Hertz GlobalHoldings, Inc./DTG 335

Notes 341

Glossary 353

Bibliography 367

About the Authors 369

Index 371



Preface to Fourth Edition

T his fourth edition of Financial Statement Analysis, like its predecessors,seeks to equip its readers for the practical challenges of contemporary

business. Once again, the intention is to acquaint readers who have alreadyacquired basic accounting skills with the complications that arise in apply-ing textbook-derived knowledge to the real world of extending credit andinvesting in securities. Just as a swiftly changing environment necessitatedextensive revisions and additions in the second and third editions, new con-cerns and challenges for users of financial statements have emerged duringthe first decade of the twenty-first century.

A fundamental change reflected in the third edition was the shift of cor-porations’ executive compensation plans from a focus on reported earningstoward enhancing shareholder value. In theory, this new approach alignedthe interests of management and shareholders, but the concept had a darkside. Chief executive officers who were under growing pressure to boost theircorporations’ share prices could no longer increase their bonuses by goosingreported earnings through financial reporting tricks that were transparentto the stock market. Instead, they had to devise more opaque methods thatgulled investors into believing that the reported earnings gains were real.

To adapt to the new environment, corporate managers became far moreaggressive in misrepresenting their performance. They moved beyond exag-geration to outright fabrication of earnings through the use of derivativesand special purpose vehicles that never showed up in financial statementsand had little to do with the production and sale of goods and services.This insidious trend culminated in colossal accounting scandals involvingcompanies such as Enron and WorldCom, which shook confidence not onlyin financial reporting but also in the securities markets.

Government responded to the outrage over financial frauds by enact-ing the Sarbanes-Oxley Act of 2002. Under its provisions, a company’schief executive officer and chief financial officer were required to attestto the integrity of the financial statements. They were thereby exposed togreater risk than formerly of prosecution and conviction for misrepresenta-tion. Sarbanes-Oxley did create a deterrent to untruthful reporting, but ascase studies in this new edition demonstrate, users of financial statementsstill cannot breathe easy.

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xii PREFACE

To help readers avoid being misled by deceptive financial statements,we continue to urge them to combine an understanding of accounting prin-ciples with a corporate finance perspective. We facilitate such integrationof disciplines throughout Financial Statement Analysis, making excursionsinto economics and business management as well. In addition, we encour-age analysts to consider the institutional context in which financial reportingoccurs. Organizational pressures result in divergences from elegant theories,both in the conduct of financial statement analysis and in auditors’ inter-pretations of accounting principles. The issuers of financial statements alsoexert a strong influence over the creation of the accounting principles, withpowerful politicians sometimes carrying their water.

As in the third edition, we highlight success stories in the critical ex-amination of financial statements. Wherever we can find the necessary doc-umentation, we show not only how a corporate debacle could have beenforeseen through application of basis analytical techniques but also howpracticing analysts actually did detect the problem before it became widelyrecognized. Readers will be encouraged by these examples, we hope, to un-dertake genuine, goal-oriented analysis, instead of simply going through themotions of calculating standard financial ratios. Moreover, the case studiesshould persuade them to stick to their guns when they spot trouble, despitemanagement’s predictable litany. (“Our financial statements are consistentwith generally accepted accounting principles. They have been certified byone of the world’s premier auditing firms. We will not allow a band of greedyshort sellers to destroy the value created by our outstanding employees.”)Typically, as the vehemence of management’s protests increases, conditionsdeteriorate, and accusations of aggressive accounting give way to revelationsof fraudulent financial reporting.

A new chapter (Chapter 11) titled “Is Fraud Detectable?” serves as acautionary note. Some companies continue to succeed in burying misrepre-sentations in ways that cannot be detected by standard techniques such asratio analysis. They manage to keep their auditors in the dark or succeedin corrupting them, removing a key line of defense for users of financialstatements. By reading the case studies presented in this chapter, readerscan observe corporate behavior that puts companies under suspicion byseasoned financial detectives such as short sellers. We also highlight recentresearch linking financial misreporting to words and phrases used by corpo-rate managers in conference calls with investors and analysts.

As for the plan of Financial Statement Analysis, readers should not feelcompelled to tackle its chapters in the order we have assigned to them.To aid those who want to jump in somewhere in the middle of the book,we provide cross-referencing and a glossary. Words that are defined in theglossary are shown in bold-faced type in the text. Although skipping around



Preface xiii

will be the most efficient approach for many readers, a logical flow doesunderlie the sequencing of the material.

In Part One, “Reading between the Lines,” we show that financial state-ments do not simply represent unbiased portraits of corporations’ financialperformance and explain why. The section explores the complex motiva-tions of issuing firms and their managers. We also study the distortionsproduced by the organizational context in which the analyst operates.

Part Two, “The Basic Financial Statements,” takes a hard look at theinformation disclosed in the balance sheet, income statement, and statementof cash flows. Under close scrutiny, terms such as value and income begin tolook muddier than they appear when considered in the abstract. Even cashflow, a concept commonly thought to convey redemptive clarification, isvulnerable to stratagems designed to manipulate the perceptions of investorsand creditors.

In Part Three, “A Closer Look at Profits,” we zero in on the lifeblood ofthe capitalist system. Our scrutiny of profits highlights the manifold ways inwhich earnings are exaggerated or even fabricated. By this point in the book,the reader should be amply imbued with the healthy skepticism necessaryfor a sound, structured approach to financial statement analysis.

Application is the theme of Part Four, “Forecasts and Security Anal-ysis.” For both credit and equity evaluation, forward-looking analysis isemphasized over seductive but ultimately unsatisfying retrospection. Tipsfor maximizing the accuracy of forecasts are included, and real-life projec-tions are dissected. We cast a critical eye on standard financial ratios andvaluation models, however widely accepted they may be.

Financial markets continue to evolve, but certain phenomena appearagain and again in new guises. In this vein, companies never lose their re-sourcefulness in finding new ways to skew perceptions of their performance.By studying their methods closely, analysts can potentially anticipate thevariations on old themes that will materialize in years to come.

MARTIN FRIDSON

FERNANDO ALVAREZ



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Acknowledgments

Mukesh AgarwalJohn BaceMimi BarkerMitchell BartlettRichard BernsteinRichard ByrneRichard CagneyGeorge ChalhoubTiffany CharbonierSanford CohenMargarita DecletMark DunhamKenneth EmeryBill FalloonSylvan FeldsteinDavid FittonThomas Flynn IIIDaniel FridsonIgor FuksmanRyan GelrodKenneth GoldbergSusannah GrayEvelyn HarrisDavid HawkinsEmilie HermanAvi KatzRebecca KeimJames KenneyAndrew KrollLes LeviRoss LevyMichael LiskDavid LuggJennie Ma

Stan ManoukianMichael MaroccoTom MarshellaEric MatejevichJohn MattisPat McConnellOleg MelentyevKrishna MemaniAnn Marie MullanKingman PennimanStacey RiveraRichard RolnickClare SchiedermayerGary SchienemanBruce SchwartzDevin ScottDavid ShapiroElaine SismanCharles SnowVladimir StadnykJohn ThieroffScott ThomasJohn TinkerKivin VargheseDiane VazzaPamela Van GiessenSharyl Van WinkleDavid WaillSteven WaiteDouglas WatsonBurton WeinsteinStephen WeissDavid WhitcombMark Zand

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PART

OneReading between

the Lines

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CHAPTER 1The Adversarial Nature of

Financial Reporting

F inancial statement analysis is an essential skill in a variety of occupations,including investment management, corporate finance, commercial lend-

ing, and the extension of credit. For individuals engaged in such activities,or who analyze financial data in connection with their personal investmentdecisions, there are two distinct approaches to the task.

The first is to follow a prescribed routine, filling in boxes with standardfinancial ratios, calculated according to precise and inflexible definitions.It may take little more effort or mental exertion than this to satisfy theformal requirements of many positions in the field of financial analysis.Operating in a purely mechanical manner, though, will not provide much ofa professional challenge. Neither will a rote completion of all of the properstandard analytical steps ensure a useful, or even a nonharmful, result. Someindividuals, however, will view such problems as only minor drawbacks.

This book is aimed at the analyst who will adopt the second and morerewarding alternative, the relentless pursuit of accurate financial profiles ofthe entities being analyzed. Tenacity is essential because financial statementsoften conceal more than they reveal. To the analyst who embraces thisproactive approach, producing a standard spreadsheet on a company is ameans rather than an end. Investors derive but little satisfaction from theknowledge that an untimely stock purchase recommendation was supportedby the longest row of figures available in the software package. Genuinelyvaluable analysis begins after all the usual questions have been answered.Indeed, a superior analyst adds value by raising questions that are not evenon the checklist.

Some readers may not immediately concede the necessity of going be-yond an analytical structure that puts all companies on a uniform, objectivescale. They may recoil at the notion of discarding the structure altogetherwhen a sound assessment depends on factors other than comparisons of

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4 READING BETWEEN THE LINES

standard financial ratios. Comparability, after all, is a cornerstone of gen-erally accepted accounting principles (GAAP). It might therefore seem tofollow that financial statements prepared in accordance with GAAP neces-sarily produce fair and useful indications of relative value.

The corporations that issue financial statements, moreover, would ap-pear to have a natural interest in facilitating convenient, cookie-cutter anal-ysis. These companies spend heavily to disseminate information about theirfinancial performance. They employ investor-relations managers, they com-municate with existing and potential shareholders via interim financial re-ports and press releases, and they dispatch senior management to periodicmeetings with securities analysts. Given that companies are so eager to maketheir financial results known to investors, they should also want it to be easyfor analysts to monitor their progress. It follows that they can be expectedto report their results in a transparent and straightforward fashion . . . or soit would seem.

THE PURPOSE OF F INANCIAL REPORTING

Analysts who believe in the inherent reliability of GAAP numbers and thegood faith of corporate managers misunderstand the essential nature offinancial reporting. Their conceptual error connotes no lack of intelligence,however. Rather, it mirrors the standard accounting textbook’s idealisticbut irrelevant notion of the purpose of financial reporting. Even HowardSchilit (see the MicroStrategy discussion, later in this chapter), an acerbiccritic of financial reporting as it is actually practiced, presents a high-mindedview of the matter:

The primary goal in financial reporting is the dissemination offinancial statements that accurately measure the profitability andfinancial condition of a company.1

Missing from this formulation is an indication of whose primary goal isaccurate measurement. Schilit’s words are music to the ears of the financialstatements users listed in this chapter’s first paragraph, but they are notthe ones doing the financial reporting. Rather, the issuers are for-profitcompanies, generally organized as corporations.2

A corporation exists for the benefit of its shareholders. Its objective isnot to educate the public about its financial condition, but to maximizeits shareholders’ wealth. If it so happens that management can advancethat objective through “dissemination of financial statements that accuratelymeasure the profitability and financial condition of the company,” then in



The Adversarial Nature of Financial Reporting 5

principle, management should do so. At most, however, reporting financialresults in a transparent and straightforward fashion is a means unto an end.

Management may determine that a more direct method of maximizingshareholder wealth is to reduce the corporation’s cost of capital. Simplystated, the lower the interest rate at which a corporation can borrow or thehigher the price at which it can sell stock to new investors, the greater thewealth of its shareholders. From this standpoint, the best kind of financialstatement is not one that represents the corporation’s condition most fullyand most fairly, but rather one that produces the highest possible creditrating (see Chapter 13) and price-earnings multiple (see Chapter 14). Ifthe highest ratings and multiples result from statements that measure prof-itability and financial condition inaccurately, the logic of fiduciary duty toshareholders obliges management to publish that sort, rather than the typeheld up as a model in accounting textbooks. The best possible outcome isa cost of capital lower than the corporation deserves on its merits. Thisadmittedly perverse argument can be summarized in the following maxim,presented from the perspective of issuers of financial statements:

The purpose of financial reporting is to obtain cheap capital.

Attentive readers will raise two immediate objections. First, they willsay, it is fraudulent to obtain capital at less than a fair rate by presenting anunrealistically bright financial picture. Second, some readers will argue thatmisleading the users of financial statements is not a sustainable strategy overthe long run. Stock market investors who rely on overstated historical profitsto project a corporation’s future earnings will find that results fail to meettheir expectations. Thereafter, they will adjust for the upward bias in thefinancial statements by projecting lower earnings than the historical resultswould otherwise justify. The outcome will be a stock valuation no higherthan accurate reporting would have produced. Recognizing that the practicewould be self-defeating, corporations will logically refrain from overstatingtheir financial performance. By this reasoning, the users of financial state-ments can take the numbers at face value, because corporations that act intheir self-interest will report their results honestly.

The inconvenient fact that confounds these arguments is that financialstatements do not invariably reflect their issuers’ performance faithfully. Inlieu of easily understandable and accurate data, users of financial statementsoften find numbers that conform to GAAP yet convey a misleading impres-sion of profits. Worse yet, outright violations of the accounting rules cometo light with distressing frequency. Not even the analyst’s second line of de-fense, an affirmation by independent auditors that the statements have beenprepared in accordance with GAAP, assures that the numbers are reliable.




A few examples from recent years indicate how severely an overly trustinguser of financial statements can be misled.

Interpubl ic Tries Again . . . and Again

Interpublic Group of Companies announced on August 13, 2002, that ithad improperly accounted for $68.5 million of expenses and would restateits financial results all the way back to 1997. The operator of advertisingagencies said the restatement was related to transactions between Europeanoffices of the McCann-Erickson Worldwide Advertising unit. Sources indi-cated that when different offices collaborated on international projects, theyeffectively booked the same revenue more than once. In the week beforethe restatement announcement, when the company delayed the filing of itsquarterly results to give its audit committee time to review the accounting,its stock sank by nearly 25 percent.

Perhaps not coincidentally, Interpublic’s massive revision coincided withthe effective date of new Securities and Exchange Commission (SEC) certifi-cation requirements. Under the new rules, a company’s chief executive officerand chief financial officer could be subject to fines or prison sentences if theycertified false financial statements. It was an opportune time for any com-pany that had been playing games with its financial reporting to get straight.

The August 2002 restatement did not clear things up once and for allat Interpublic. In October, the company nearly doubled the amount of theplanned restatement to $120 million, and in November, it emerged thatthe number might go even higher. By that time, Interpublic’s stock wasdown 55 percent from the start of the year, Standard & Poor’s had down-graded its credit rating from BBB+ to BBB, and several top executives hadbeen dismissed.

Like many other companies that have issued financial statements thatsubsequently needed revision, Interpublic was under earnings pressure. Ad-vertising spending had fallen drastically, producing the worst industry resultsin decades. Additionally, the company was having difficulty assimilating ahuge number of acquisitions. Chairman John J. Dooner was understandablyeager to shift the focus from all that. “The finger-pointing is about the past,”he said. “I’m focusing on the present and future.”3

Unfortunately, the future brought more accounting problems. A fewdays after Dooner’s statement, the company upped its estimated restatementto $181.3 million, nearly triple the original figure. Another blow arrived aweek later as the SEC requested information related to the errors that gaverise to the restatement. It also turned out that the misreporting was not lim-ited to double-counting of revenue by McCann-Erickson’s European offices.Other items included an estimate of not-yet-realized insurance proceeds,



The Adversarial Nature of Financial Reporting 7

write-offs of accounts receivable and work in progress, and understated lia-bilities at other Interpublic subsidiaries dating back as far as 1996. Doonercommented, “The restatement that we have been living through is finallyfiled.”4 He also stated that he was resolved that the turmoil created by theaccounting problems would never happen again.

Fast-forward to September 2005. Dooner’s successor and the third CEOsince the accounting problems first surfaced, Michael I. Roth, declared thathis top priority was to put Interpublic’s financial reporting problems behindit. For the first time, the company acknowledged that honest mistakes mightnot have accounted for all of the erroneous accounting. Furthermore, saidInterpublic, investors should not rely on previous estimates of the restate-ments, which also involved procedures for tracking the company’s hundredsof agency acquisitions. That proved to be something of an understatement.Interpublic ultimately announced a restatement of $550 million, three timesthe previous estimate, for the period 2000 through September 30, 2004. InMay 2008, the company paid $12 million to settle the SEC’s accusationthat it fraudulently misstated its results by booking intercompany chargesas receivables instead of expenses.

MicroStrategy Changes Its Mind

On March 20, 2000, MicroStrategy announced that it would restate its 1999revenue, originally reported as $205.3 million, to around $150 million. Thecompany’s shares promptly plummeted by $140 to $86.75 a share, slashingChief Executive Officer Michael Saylor’s paper wealth by over $6 billion.The company explained that the revision had to do with recognizing revenueon the software company’s large, complex projects.5 MicroStrategy and itsauditors initially suggested that the company had been obliged to restateits results in response to a recent (December 1999) SEC advisory on rulesfor booking software revenues. After the SEC objected to that explanation,the company conceded that its original accounting was inconsistent withaccounting principles published way back in 1997 by the American Instituteof Certified Public Accountants.

Until MicroStrategy dropped its bombshell, the company’s auditors hadput their seal of approval on the company’s revenue recognition policies.That was despite questions raised about MicroStrategy’s financials by ac-counting expert Howard Schilit six months earlier and by reporter DavidRaymond in an issue of Forbes ASAP distributed on February 21.6 It wasreportedly only after reading Raymond’s article that an accountant in theauditor’s national office contacted the local office that had handled the audit,ultimately causing the firm to retract its previous certification of the 1998and 1999 financials.7




No Straight Talk from Lernout & Hauspie

On November 16, 2000, the auditor for Lernout & Hauspie Speech Prod-ucts (L&H) withdrew its clean opinion of the company’s 1998 and 1999financials. The action followed a November 9 announcement by the Belgianproducer of speech-recognition and translation software that an internal in-vestigation had uncovered accounting errors and irregularities that wouldrequire restatement of results for those two years and the first half of 2000.Two weeks later, the company filed for bankruptcy.

Prior to November 16, 2000, while investors were relying on the audi-tor’s opinion that Lernout & Hauspie’s financial statements were consistentwith generally accepted accounting principles, several events cast doubt onthat opinion. In July 1999, short seller David Rocker criticized transactionssuch as L&H’s arrangement with Brussels Translation Group (BTG). Overa two-year period, BTG paid L&H $35 million to develop translation soft-ware. Then L&H bought BTG and the translation product along with it.The net effect was that instead of booking a $35 million research and devel-opment expense, L&H recognized $35 million of revenue.8 In August 2000,certain Korean companies that L&H claimed as customers said that they infact did no business with the corporation. In September, the Securities andExchange Commission and Europe’s EASDAQ stock market began to inves-tigate L&H’s accounting practices.9 Along the way, Lernout & Hauspie’sstock fell from a high of $72.50 in March 2000 to $7 before being sus-pended from trading in November. In retrospect, uncritical reliance on thecompany’s financials, based on the auditor’s opinion and a presumption thatmanagement wanted to help analysts get the true picture, was a bad policy.

THE FLAWS IN THE REASONING

As the preceding deviations from GAAP demonstrate, neither fear of an-tifraud statutes nor enlightened self-interest invariably deters corporationsfrom cooking the books. The reasoning by which these two forces ensurehonest accounting rests on hidden assumptions. None of the assumptionscan stand up to an examination of the organizational context in whichfinancial reporting occurs.

To begin with, corporations can push the numbers fairly far out of jointbefore they run afoul of GAAP, much less open themselves to prosecutionfor fraud. When major financial reporting violations come to light, as inmost other kinds of white-collar crime, the real scandal involves what is notforbidden. In practice, generally accepted accounting principles countenancea lot of measurement that is decidedly inaccurate, at least over the short run.

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