What Investment Bankers Should Know about When Companies Understate Their Expenses
In investment banking, one of the most basic principles of accounting is the matching principle. GAAP are based on the premise that a company should match expenses incurred to produce revenues with revenues in order to accurately report a company's profitability during a specific time period.
In addition to overstating revenues, companies that understate expenses appear more profitable than they actually are. Firms may defer expenses from the current period to future periods in order to understate expenses and make the current period look better. The most common example of this is extending the depreciation period for assets beyond that which is reasonable.
What a waste
The waste disposal business is commonly portrayed in movies and TV series as being corrupt and controlled by organized crime. One of the biggest accounting scandals was allegedly perpetrated not by members of the Soprano family, but by the NYSE-listed firm Waste Management.
The details of this scandal may be less salacious than typically portrayed in mob movies — nobody got whacked — but the ramifications of the scandal were far reaching and so economically significant than the Soprano family would've been proud of the turmoil that it caused.
At the most basic level, garbage disposal is a fairly simple business, one that doesn't appear on the surface to be particularly ripe for abuse. Firms in this business collect and dispose of rubbish. Among other assets, Waste Management owns garbage trucks and landfills.
However, in the late 1990s, profits were allegedly inflated to the tune of $1.7 billion by some fairly unsophisticated accounting machinations that went undetected by corporate auditors who were asleep at the switch. So, how did the executives at Waste Management pull off a multi-billion-dollar fraud?
Garbage trucks are assets the value of which is depreciated over time. Companies must estimate the useful lives of their depreciable assets and take annual charges to recognize that those values have declined. If a garbage truck costs $100,000 and can be expected to be used for ten years and have no residual or salvage value, then the firm is required to take a depreciation charge of $10,000 per year.
This isn't a cash expense and doesn't require any outlay of funds, but the charge will reduce net income before taxes by $10,000. If a company wanted to make net income appear better in the current year, it could depreciate the truck over a longer period — say, 20 years — and the reduction in net income before taxes would be only $5,000.
This is exactly what Waste Management did. It simply extended the assumed useful lives of certain assets to an unsupported age.
Waste Management also failed to account for some other expenses that are common in the waste-disposal business. A landfill is an asset of a waste-disposal company. But, as the landfill gets increasingly filled with garbage, the value of the landfill declines.
In addition to overstating the useful lives of its garbage trucks, Waste Management also failed to account for the fact that its landfills were filling up. It should've been taking charges against the value of the landfills. Those charges would've reduced net income and made the firm appear less profitable.
Astute investment bankers should examine the assumed depreciable lives of the firm's significant assets to understand if the firm is making conservative or aggressive accounting assumptions — or, if it's just making plain unrealistic and fraudulent assumptions.
The SEC investigated Waste Management, and the firm principals agreed to a settlement that involved multiple millions of dollars in payments and banned the executives from serving as officers or directors of any public company. The firm's auditing firm, Arthur Andersen, was also fined by the SEC for being complicit in the fraud.
Crazy like a fox
Crazy Eddie was a U.S. retailer of electronic goods. The firm was founded in 1971 by CEO Eddie Antar and primarily operated in the New York City area. Many people remember the firm because of its unusual radio and television commercials telling consumers, Crazy Eddie, his prices are insane!
The firm became part of the popular culture, and the commercials were even parodied in a Seinfeld episode. The company went public in 1984, and the stock price increased rapidly from its IPO price of $8 to over $75 per share by 1986. Crazy Eddie was getting rich, and his shareholders were thrilled.
Things changed dramatically in just a few years. By 1989, the firm was in bankruptcy, and Antar fled the country. He was later caught and sentenced to eight years in prison. So, what happened and what were the clues that analysts could've used to determine that Eddie was perpetrating a fraud?
The accounting game that Antar was playing involved understating the cost of goods sold — the cost of the stereos and eight-track players that the firm was selling — thus, overstating his profits.
In fact, Crazy Eddie overstated inventory by $65 million — more than the cumulative profits since the company went public — in order to report higher profits, please his shareholders, and line his own pockets. The overstatement of earnings resulted in an overstatement of owners’ equity. The accounting equation balanced because inventory was also overstated, and no one was the wiser.
But, the overstatement of inventory was so dramatic that it should've drawn the attention of even the most inexperienced junior investment banking analyst. One of the most common ratios utilized by analysts is days inventory outstanding, which helps determine how efficient a firm is in managing its inventory of goods for sale. It simply measures the average number of days a company holds its inventory before selling it.
An examination of Crazy Eddie's days inventory outstanding shows that it nearly doubled from 80 days to over 146 days from 1984 to 1987. The increasing number of days worth of inventory on hand is indicative of a significant problem — either problems selling inventory or an overstatement. In this case, it was an overstatement.