CategoryFinancial Reporting

(Un)Accountable Shell Games

A shell corporation often has no active business operations or hold any productive assets. Structured as an efficient financial vehicle, a shell corporation can serve as a convenient mechanism to raise funds, to complete a hostile acquisition or to take a company public. Nevertheless, these corporate structures can also be used for nefarious purposes some of which include disguising ownership from law enforcement or the public, or to evade taxes.

For instance, the “Panama Papers” leaks revealed that banks, political leaders and wealthy individuals had allegedly hidden billions of dollars in shell companies through a Panama law firm. The scheme allowed clients to evade taxes. Reportedly 214,000 shell companies were created to facilitate illegal activities.

Shell Games

Not all shell companies are creating to siphon off funds or to evade taxes. There can be merits to creating a shell company.

  • Fortunes
  1. A startup can use a shell corporation to safeguard its assets before officially launching its business.
  2. A company preparing for a merger or an acquisition can hold its assets in a shell company for legal reasons and keep those assets separately from the acquiring entity.
  3. Foreign companies can create shell companies in tax havens like Panama (Swiss private banking, Hong Kong, Belize are some of the other dubious and prominent tax havens) and lower their taxes at home. How so one may ask? Most tax haven countries do not mandate tax information for the funds being funneled into the tax haven countries via shell companies. Further, some tax havens do not report the existence of these shell companies to the government of the owners operating the shell companies thereby creating a “black hole.”
  • Misfortunes
  1. Shell companies are often set up to mask the identity of the individual owning assets in the company or to evade taxes.
  2. Occasionally, companies take advantage of the secretive nature of shell companies and engage illegal activities like money laundering.

Limited Games in the Land of the Free 

In the U.S., we are fortunate to have monitoring agents like the Securities and Exchange Commission, the Justice Department, and the Public Company Accounting Oversight Board (PCAOB) guarding the corridors of capital markets to ensure that public companies are not actively engaged in “shell games” to defraud minority shareholders.

In sharp contrast, and most inappropriately, in emerging markets and particularly in the BRICS countries, minority shareholders may not be as fortunate where the use of shell companies to hide business ownership or to evade taxes is rampant.

What is the auditors’ role in policing dubious shell companies which are actively created by publicly listed companies to siphon off funds and to dupe minority shareholders? 

Let the Games Begin in BRICS Countries

The Securities and Exchange Board of India (the counterpart of US SEC) is scrutinizing the functioning of auditors in various public companies in India, especially if the auditor has had a long-standing relationship with the client. Under the Companies Act of 2013, auditors, have greater responsibilities to ensure that financial statements of an Indian company are not materially misstated and that auditors red flag “dubious” transactions.

The Finance Ministry in collaboration with SEBI is taking actions against 331 listed suspected shell companies. More than 100,000 directors (holy cow!) may be disqualified for their association with shell companies. Investigations are in progress to identify professionals, chartered accountants, company secretaries and cost accountants associated with the defaulting companies.

The auditors are not exempt from these inspections. Authorities are looking at the possibility of having stricter scrutiny of global auditing firms (e.g., the Big 4 audit firms) and to make them more accountable when their auditors certify companies with a clean opinion even when clients are actively engaged in corporate misconduct.

Commentary on BRICS

Similar to the initiatives in India, China, where the problems of shell games are even more pervasive, under President Xi Jinping, has been actively confronting these problems. While these are modest steps, India and China can do more to bring the unaccountable or black money back into the mainstream economy for the betterment of their citizens.  

While India and China are at least attempting to tackle this social ailment, sadly not much can be said about the other 3 countries within the BRICS which include Brazil, Russia and South Africa where their top leaders appear to be the cause and not the solution to this social ailment.

http://timesofindia.indiatimes.com/business/india-business/auditors-come-under-lens-amid-crackdown-on-shell-companies/articleshow/60496210.cms

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Italian Job

BT shares, which trade in the US as ADRs (BT Group plc), have declined by more than 45% in less than a year. Around half of that descent was confined to a single day last month (Jan 23) when the company announced accounting improprieties associated with its Italy-based operations. The company also noted that some senior management personnel may have embezzled funds. UK’s parent BT shares have shed more than 8 billion pounds because of this accounting scandal.

Italian prosecutors have initiated their own investigation into BT Italia’s accounting fraud. BT Group Plc has been hit by at least two shareholder lawsuits in the U.S. A number of other US law firms specializing in shareholder class action suits are considering filing lawsuits against the company and senior management.

British Telecommunications (BT)

BT Group plc is a holding company which owns British Telecommunications plc, a British multinational telecommunications services company with head offices in London. The company has operations in around 180 countries. The company’s shares are among the most widely owned stocks in the UK. The ownership of BT shares is widely dispersed ̶ about 700,000 of its 827,000 shareholders own 1,600 or fewer shares of the company.

BT ADRs

American depositary receipts (ADRs) were introduced in 1927 as an easier way for U.S. investors to purchase stock in foreign companies. Non-U.S. companies also benefit from ADRs as it makes it easier to attract American investors. ADRs are negotiable certificates issued by a U.S. bank representing a specified number of shares (or one share) in a foreign stock traded on a U.S. exchange.

ADRs are denominated in U.S. dollars, with the underlying security held by a U.S. financial institution overseas, and holders of ADRs realize any dividends and capital gains in U.S. dollars, but dividend payments in euros are converted to U.S. dollars, net of conversion expenses and foreign taxes. ADRs are listed on either the NYSE, AMEX or Nasdaq but they are also sold OTC.

Italian Job

The fraudulent transactions related to BT-Italy emerged sometime during the summer of 2016 following an internal probe into its Italian business after a “whistleblower” flagged concerns. A whistleblower is an employee who discloses information about illegal acts, mismanagement, abuse of power, or general wrongdoing occurring in the company. If the company is publicly traded and subject to the filing requirements of the Securities and Exchange Commission, whistleblowers are protected by law from retaliation in the US. Some of the major US companies perpetrating accounting fraud were caught and brought to justice by their own employees (e.g., Enron, Freddie Mac, Madoff).

Upon investigation, BT discovered “inappropriate management behavior” within the Italian division. The expected cost of the rent extraction initiated by the Italian subsidiary was estimated to be around £145 million. Sometime in January this year, just days prior to the announcement of the third-quarter results, the company released a statement declaring that, according to an independent investigation by the Big 4 accounting firm KPMG, the losses to BT from the accounting irregularities related to Italian operations were being reassessed at £530m, which is almost 4 times larger than the previously estimated number.

The company suspended several BT Italy’s senior management team. BT has also appointed a new chief executive of BT Italy who took charge of Italy’s operations from Feb. 1.

Telecom Blues

What remains troubling is why wasn’t the accounting irregularity detected by UK’s parent company much earlier. Nick Rose, the chairman of the BT’s audit committee, flagged internal-control issues in Italy in every annual report since May 2013. Yet, the persistent accounting fraud was not detected until 3 years later. By blaming BT-Italy for all the current problems, the CEO of BT may be attempting to distance the parent company, and himself, from the Italian operations by censuring a few perpetrators.

What is even more worrisome is why didn’t the auditors detect this size of an accounting fraud earlier? Independent auditors are expected to provide an assurance that the financial statement are free of material misstatements. One would agree a misstatement exceeding $600 million is material.

Who was BT’s independent auditor? The answer is PwC, which a Big 4 global accounting giant. PwC has been BT’s auditor for the last 30-year since 1984. It is unclear whether BT intends to end its business relationship with PwC. The big accounting firms are renowned for rendering high audit quality so this type of an accounting fraud is likely to a huge set-back for PwC.

Moody’s has warned it may cut BT’s credit ratings. Analysts are skeptical whether the company can afford to maintain a 10 percent growth in its dividend.

Randoph, February 2, 2017

 

 

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Mardi Gras Float in Trouble: First NBC

mardigrasIn the absence of major national banks in New Orleans, regional banks have floated the NOLA (New Orleans, Louisiana) economy. Through its wholly-owned subsidiary First NBC Bank, First NBC Bank Holding Company provides a wide range of financial services in New Orleans, Florida, and Mississippi Gulf Coast with 39 banking offices.

Following Hurricane Katrina, First NBC invested heavily in New Orleans construction projects that included generous tax credits established by federal and state governments. These investments collectively helped propel First NBC to become the city’s largest bank based on assets under the leadership of CEO Ashton Ryan.

Halloween Scare: Stress Test

The Federal Reserve Bank of Atlanta and the Louisiana Office of Financial Institutions informed First NBC on Oct 11 that the bank is under “troubled condition.”  As troubled bank, it must seek regulatory approval before adding any new directors or senior executives or changing the responsibilities. The bank is also prohibited from increasing its debt, distributing interest on subordinated debt or paying dividends on its stock.

To add to the stress, the Federal Deposit Insurance Corp. (FDIC) recently declared that First NBC is no longer “well capitalized,” restricting its ability to take on certain deposits and pay interest. First NBC was recently downgraded to junk status by Kroll Bond Rating Agency Inc., which specializes in rating smaller lenders. HoldCo Asset Management, which owns the banks’s debt has shorted the bank’s stock and as a way to hedge its risk against a bank default has also publicly questioned the bank’s accounting policies.

Uncle Sam’s Subsidies: Tax Credits

First NBC invested heavily in New Orleans in construction projects following Katrina and thereby benefited from the generous tax credits from federal and state governments. Because the tax credits received by First NBC were more than the taxes being paid, the bank was able to use the unused portion of the tax credits to reduce future tax payments by offsetting future taxes against the unused portion. For instance, if the government gives a $1,000 tax credit to a single parent for raising a child alone, and the parent must pay $800 as federal income taxes based on his/her income, the parent does not pay any taxes for the current period because the tax credit fully offsets the $800 taxes payable for the current year. More importantly, even after the tax offset, the remaining $200 tax credit balance can be used to reduce future taxes.

Accounting rules allow this $200 future tax benefit to be capitalized (i.e., treated as an asset) and booked as a deferred tax benefit. As of the first quarter of 2015, the bank’s deferred tax assets—the benefits from reduction of future taxes—are $247 million, up from $95.8 million a year earlier.

In 2014, the company reported $28.6 million as income before taxes yet it reported a net income of $55.6 million because it had an income tax benefit of $27 million (instead of having an income tax expense which normally reduces net income).

Mardi Gras Float in Trouble: Recanting Previously Issued Statements

First NBC announced in August 2016 that it expects a delay in filing its 2015 Form 10-K (annual report filing with the SEC) because of restatement of previously issued financial results! The prior results included errors because of the following reasons:

  • Use of an inappropriate amortization method in accounting for investments in tax credit (Halloween Hullaballoo)
  • Consolidation of certain investments in Federal Low-Income Housing Tax Credit entities because such entities were determined to be variable interest entities in which the Company was the primary beneficiary (Enron Phantom).
  • The result of the consolidation has adverse effect on the financials (Hurricane)

Following the error corrections, the 2014 net income was now being restated (or reduced) by 20% ($55.6 million being revised to $44.7 million). Similarly, the 2013 net income was being restated (or reduced) by 18% ($40.9 million being reduced to $33.6 million). Accumulated earnings for 2012 and prior periods was being reduced by 16% from $59.8 million to $50.3 million. The company in its 2015 10-K stated “We determined that we had insufficient qualified personnel at both the executive management and staff levels with appropriate knowledge, experience and training on accounting and reporting matters, which contributed to the material weaknesses that resulted in the restatement, as well as the inability to timely file this report.”

To make matters worse, the bank was in violation of NASDAQ listing rules because it had not filed its 2016 quarterly statements. To avoid delisting from NASDAQ, First NBC submitted a plan to regain compliance with Nasdaq’s listing rules.

In a time-span of less than a year, the stock price of First NBC declined from a high of about $40 to around about $5.30, which is a cyclonic decline of around 86%. More than $600 million in shareholder wealth was destroyed because of the accounting related aggression.  

Grateful Dead Sings Aiko Aiko Ande

Ernst & Young (E&Y), a Big 4 auditor with international reputation and stature, has been the independent auditor of First NBC leading up to the 2015 financial statements. First NBC’s restatement is likely to bring considerable negative publicity, media scrutiny and regulatory intervention for E&Y. It will not be surprising to see class action lawsuits initiated by shareholders to recover losses.

In September 2, 2016, Ernst & Young declined to stand for reappointment as the company’s independent auditor for 2016. Is it a case of too little too late? A restatement is considered an audit failure.

Did E&Y fail the shareholders of First NBC? Only courts and the SEC can render a verdict on this matter. Until then, the accounting profession sings “Aiko Aiko Ande” in Cajun style.

 My spy boy saw you spy boy sittin by the bi-yo

My spy boy told your spy boy, Im gonna set you flag on fi-yo.

I said, hey now, hey now, Aiko aiko all day, jockomo feeno na na nay, jockomo feena nay.

My grandma and your grandma were sitting by the fire

Said my grandma to your grandma, gonna get your tail on fire.

Chatham- Helsinki; October 30, 2016

 

 

 

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Accounting’s Got Talent

accountingtoday-top-100Financial economics, as the title of the discipline suggests, is an embedded field within mainstream economic sciences. Therefore, it should not come as a surprise that quite a few Nobel Laureates in economics are finance professors who have done pioneering work in financial economics.

Closely linked with economics and finance, mainstream accounting research is derived from economics and financial economics. While there are a few strong delineators between finance, economics and accounting, the three fields intermingle and influence one another which is why it is difficult to have a strong grasp of one without at least a basic understanding of the other two.

Yet, accounting has never been considered part of mainstream economic sciences which is why no accounting researcher has won the Nobel Prize. Not to be outdone, the accounting profession has created a list of 100 most influential individuals, thought leaders, and visionaries who are responsible for shaping the accounting profession.

Requirements For Top 100

Gaining entry into the coveted top 100 Most Influential Person in Accounting is a daunting task. The Accounting Today complied the Top 100 list using the following criteria.

  • Innovator and creator. The individual must have created new ways to market the accounting/auditing professional services.
  • Educator. The individual must have taught the profession something the profession didn’t know already.
  • Regulator. The individual must have been involved in enforcing rules which had a game changing influence on the profession.
  • Elevator. Individuals who help achieve the ideals of the profession, or and those who are actively planning the future of the profession, are deemed the most influential of all.

What is the gender composition? Among the top 100 most influential accounting professionals, 70% are males and the remaining 30% are females.

Top 5

The top 100 most influential accounting professionals then voted to pick the Top 5 thinkers within the profession. The Superstars in Accounting are:

  1. Barry Melancon: President and CEO of AICPA
  2. Tom Hood: CEO and Executive Director of MACPA
  3. Mary Jo White: Chair, SEC
  4. Russell Golden: Chairman of FASB
  5. Ron Baker: Founder of VeraSage Institute

MIA

Surprisingly, no academic made it to the Top 100 list. Although academics meet the threshold requirement as an educator, presumably, Accounting Today does not consider academics to be influential enough to teach something to the profession that the profession didn’t know already. Academics are merely disseminating accounting/auditing knowledge that is already codified by the profession so academics are not deemed as innovators in the field.

We salute the Top 100 Most Influential Accounting Professionals!

Chatham; September 10, 2016

http://pages.marketing.accountingtoday.com/act_unsponsored_75635_sr_lp.html

 

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Equestrian Polo Designer Fails to Score

198_Polo_Ralph_Lauren_logo_profileThe stock price of Ralph Lauren, an upscale apparel company renowned for its Polo brand, has taken a thrashing lately. The stock has declined by about 50% over the past one year because of sluggish demand in the US and a decline in the value of its overseas sales from a strong dollar. In the third quarter of this year, the company reported a colossal 39% drop in  earnings.  The company also lowered its fiscal 2017 guidance numbers. Investors fear that the company may be at the vortex of a long-term slump.

End of an Era

To energize the polo pony, Mr. Ralph Lauren, the iconic designer-founder of Ralph Lauren and its sole Chief Executive Officer (CEO) and Chief Creative Officer, finally decided to step down as the CEO after being at the helm for almost 50 years. Mr. Lauren is hoping to inject some youthfulness into the septuagenarian polo team. Stefan Larsson, who is a former H&M executive and president of Old Navy, was hand-picked by Mr. Lauren to take charge of a company that is under attack.

Mr. Larsson will report to Mr. Lauren, although Mr. Lauren characterized their relationship as a “partnership” which is understandable considering that Mr. Lauren is the largest individual shareholder in his company and is expected to play a role in major decisions. Essentially, the company is separating the roles of the professional manager from that of the creative manager. The separation of the two roles will help assure Wall Street that the creative aspirations do not bleed the financial foundations of company.

Brutal Cost Cutting

Under the new strategy labelled as “New Plan Forward,” the incoming CEO intends to slash costs to fashion a reversal in downward profits. The company intends to close 50 stores, lay-off about 1,000 employees (or 7% of its workforce), and remove three of the nine layers of management that stand between the CEO and sales team.

The clothing production lead times will be amended from 15 to 9 months. Certain clothing lines will be on a hyper fast production time whereby it will be moved from the development stage to the shop floor within eight weeks.

The cost cutting strategy is bold and brutal, the Swedish CEO intends to slash costs by about $180 million to $220 million per year which is in addition to the $125 million in cost cutting completed last year.

Restructuring Costs

According to the plans, the company is projecting $400 million in restructuring charges and additionally the company intends to write off as much as $150 million in inventory that is scheduled to be liquidated. Evidently, near term earnings numbers are going to take a big hit before increasing.

Uncertain Prospects

The reasons for Mr. Lauren giving up some operational and financial control of the company after 50 years are notable and praiseworthy. Once a founder-owner company becomes sufficiently complex, the natural economic progression for the company is to retain a high quality professional manager who is responsible for supervising day-to-day operations, mange investments, and make optimal financing decisions with the objective of maximizing firm value. The advent of a professional managers also assures investors that the financial aspects of the company are not being compromised as creative side blossoms.

However, some of the restructuring plans are hard to assess. Some immediate concerns include,

  1. Why hire a CEO from outside the company? Why not hire an insider who understands the value of the brand?
  2. Can young CEO render value while being under the influence of a powerful founder-owner?
  3. Why pick a CEO from a low-priced apparel designer company that is not a direct competitor?
  4. Why are the business models that helped revive the fortunes at Old Navy and H&M likely to be useful for Ralph Lauren?
  5. Cost cutting strategies can only render value up to a point, eventually the principal driver of earnings is revenue growth.
  6. Too much cost cutting can also harm the brand value because of a loss in human capital.

Considering all these questions, the future of Ralph Lauren remains highly uncertain.

Helsinki, June 21, 12.48P.

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How Mobil(e) is ExxonMobil?

Losing Triple A Credit Rating

Losing Triple A Credit Rating

ExxonMobil Corp. had the honor and distinction of having a gold-plated AAA credit rating since the post WWII period. However, fortunes can change abruptly when one is trading products of mother nature. Last week, Standard & Poor’s (S&P) downgraded Exxon Mobil’s credit rating for the first time in almost 70 years from the coveted “AAA” rating to a “AA+” rating citing expectations of continuing low oil prices. ExxonMobil joins two other US companies with S&P AA+ credit ratings; General Electric Co. and Apple Inc. The two remaining US companies with the highest possible corporate AAA debt ratings are Johnson & Johnson and Microsoft Corp.

Exxon Mobil History

ExxonMobil is an American multinational oil and gas company based in Texas. It is the largest direct descendant of John D. Rockefeller’s Standard Oil Company. Exxon Mobil was formed in 1999 by the merger of Exxon (formerly Standard Oil Company of New Jersey) and Mobil (formerly the Standard Oil Company of New York). ExxonMobil is also the Fifth largest publicly traded company by market capitalization. ExxonMobil was the second most profitable company in 2014.

Downgrade Reasons

S&P stated that the “company’s debt level has more than doubled in the recent years, reflecting high capital spending on major projects in a high commodity price environment and dividends and share repurchases that substantially exceeded internally generated cash flow.”

S&P also said that while Exxon made efforts to reduce capital spending, the maintenance of production and replacing reserves will ultimately require the company to spend more. Because the company is returning cash to shareholders, instead of building cash or reducing its debt, the company faces limits on credit improvements even when oil prices recover.

S&P cautioned that it could further lower its rating on Exxon if the company is unable to sufficiently adapt to a prolonged period of low commodity prices. The downgrade is not a complete surprise. In February, S&P downgraded rival Chevron Corp and warned that such a move was also possible for Exxon.

Shareholder Payments

ExxonMobil paid out $325 billion as dividend and share repurchases over the last 11 years which exceeded its outlays for new property, plant and equipment of $272 billion over the same period. During the fourth quarter of 2015, the company paid out $3.6 billion in dividends and share repurchases, which is more than it earned in that quarter.

In February, Exxon Mobil changed its strategy and declared that it would only repurchase shares to offset dilution, and not pay back cash as dividend.  

Why Repurchase Over Dividend

Many companies prefer stock repurchase over dividends. One explanation is accounting based therefore cosmetic and the second explanation is more economic.

Investors tend to focus on accounting earnings, mostly earnings per share (EPS), which is computed as net income divided by number of shares outstanding. When a company buys back (repurchases) its own stock, it reduces the shares outstanding and thereby increases its EPS. This type of an increase in reported EPS is cosmetic (nip and tuck). Shareholders care about the pie (earnings) and not how the pie is being shared (EPS). So stock buyback initiated to increase EPS is a akin to a magician’s show intended to circumvent reality.

The advantage of stock buyback is that it is a one-time cash payout unless the company elects to announce future buybacks. Dividends, on the other hand, are more permanent in nature and investors expect continuation of dividend payments when one is announced. Therefore, companies wanting to preserve future cash prefer stock buyback over dividend.

ExxonMobil wants to buyback stock to offset the stock price decline from declining oil prices. Given the low oil prices, it has cut back on its planned investments or production capacity. However, when oil prices bound back, it wants to preserve cash to fund its future growth which is why it prefers stock buyback over dividend.

Stock Price

ExxonMobil’s stock price went down from a high of around $103 in 2014 to a low of $72 in 2015. The stock is back at around $90. With oil prices trending up, we can only expect ExxonMobil’s stock price to continue its upward trajectory.

Chatham; June 11, 2.11P

http://www.reuters.com/article/us-exxon-mobil-ratings-s-p-idUSKCN0XN26L?feedType=RSS&feedName=businessNews&utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+reuters%2FbusinessNews+%28Business+News%29

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The Mexican Wall (Mart) Spectacle

walmartWal-Mart Stores, the leading private employer in the world, operates in 25 countries with a strong presence in Mexico. Roughly about 20% of Wal-Mart’s 11,500 locations are based in Mexico. Over the last three years, the Justice Department has been investigating allegations that Wal-Mart paid bribes in Mexico to obtain permits. 

A group of beneficial Wal-Mart owners filed a complaint with the Securities and Exchange Commission (SEC) and the Public Company Accounting Oversight Board (PCAOB) that Wal-Mart’s auditor, Ernst & Young (E&Y) was aware of the bribery long before the company disclosed this irregularity to U.S. authorities in 2011. According to the complaint letter, E&Y as the independent auditor should have reported the suspected bribery to the SEC as soon as it became aware of such improprieties in 2006.

Bribery Act

The Foreign Corrupt Practices Act of 1977 (FCPA) makes it unlawful for persons and entities to make payments to foreign government officials to assist in obtaining or retaining business. The Act was amended in 1998. The anti-bribery provisions of the FCPA now applies to foreign firms and makes it illegal for foreign companies to pay bribes in the U.S.

The Act levies criminal and civil liability for paying bribes to foreign government officials. The Justice Department has jurisdiction over the FCPA.

Investigations

The Justice Department launched an investigation following a 2012 New York Times article about the alleged Mexican bribes. According to the article, Wal-Mart Mexico unit paid middlemen to obtain permits and that Wal-Mart executives chose not to pursue an internal inquiry into the suspicious payments.

Although the three-year investigation remains incomplete, according to Wall Street Journal, the case could be resolved with a fine and no criminal charges against Wal-Mart executives because the charges may not be as severe as previously anticipated.

Auditor’s Obligations

According to the auditing standards (AU section 317), auditors have a responsibility to design procedures that provide reasonable assurance of detecting illegal acts. In cases of bribery, the auditor is also implicated because bribing a foreign government official is illegal in the US and also because any bribery is likely to have a material effect on a company’s financial statements.

Companies that pay bribes generally record the underlying transactions in their accounting books as legitimate operating expenses to avoid detection. Since bribes often involve disbursements of cash, recording a bribe as a legitimate operating expense results in false reporting of expenses on the income statement.

What are the duties of the external auditor when it becomes aware that its client is suspected of violating FCPA provisions?

The answer may surprise you.

  • If an outside auditor discovers an illegal act, it is required to notify responsible authorities within the company including the company’s board and audit committee.
  • The external auditor is not required to notify the government.
  • Only when the company refuses to take corrective actions or the company’s books are compromised is the auditor obligated to notify the government.

Essentially, the rules and obligations are suggesting that the company has the obligation to correct improper acts and also inform appropriate government authorities.

Top Gun: Tom (Cruise) Ray

According to Chief Tom Ray, past Chief Auditor of PCAOB and my colleague at Baruch College,  external auditors are not legally obliged to inform outside regulators about potential scandals except in limited circumstances. Auditors are required to report those acts to management and the board’s audit committee, which is responsible for monitoring financial reporting and disclosure practices. The accounting firm also needs to evaluate whether the bribers would have a material impact on financial statements.

Top gun in auditing, Tom states that only when the company doesn’t take appropriate actions, an outside accounting firm may be legally required to report the problem to a federal agency,

Solipsism

Needless to say, Wal-Mart will become target of lawsuits. E&Y, with its deep pockets, is also likely to become a prime target. However, if the norm is to pay bribes to secure contracts, especially in developing and emerging countries, U.S. companies are at a disadvantage relative to almost all other countries that do not have anti-bribery provisions.  

Maybe it is time to have an anti-bribery world statute.

http://www.wsj.com/articles/shareholder-group-ctw-says-ernst-young-knew-about-wal-mart-mexico-bribery-allegations-1432580954

 

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The Curious Case of Elon Musk

TeslaIn the first quarter of 2016, Tesla Motors reported total revenues of $1.15 billion and an adjusted loss per share of 57 cents. Investors and capital markets rely on positive earnings, a measure of profitability, to value companies. Since 2010, the company has reported a loss every year. If positive earnings serve as a barometer for stock valuation, Tesla stock is unlikely to capture your imagination.

Yet, investors have driven up the price of Tesla as if they are driving the Aventador, the Italian stallion, on the Autobahn. The stock price of Tesla was around $20 in 2010 and today it is worth $207, which translates into a heart pounding growth rate of more than 900%. If you had bought 1,000 Tesla shares in 2010 for a modest investment of $20,000, the same investment would be worth almost a quarter of a million dollars.  

Irrational Exuberance

What is the basis for such irrational exuberance? Are investors assessing “value” of Tesla based on its revenues or expected future profits? The company’s total revenues grew from $117 million in 2010 to $4,030 million in 2015, which is an astounding growth of 3,400%. Estimating equity value based on revenues and disregarding economic profits is like chasing James Bond’s Aston Martin in a Cinderella Carriage. Could investors be arriving at intrinsic value using expected future profits. Sure, I could also win the New York lottery!

Most analysts have a sell recommendation on Tesla yet investors are treating the stock like Malva Pudding served with Witblits. So what is the rational explanation for the fascination with Tesla? Most likely, investors are really betting on the ingenuity and brilliance of Elon Musk.   

The Musk of Zorro

Elon Musk is a South African-born Canadian-American entrepreneur, engineer, innovator, and investor. He is the CEO and product architect of Tesla Motors. He is also the founder CEO of SpaceX, co-founder and chairman of SolarCity, co-chairman of OpenAI, co-founder of Zip2; and co-founder of PayPal. As of April 2016, he has an estimated net worth of US$14.2 billion, making him the 68th wealthiest person in the US.

Mr. Musk has stated that the goals of SolarCity, Tesla Motors, and SpaceX are based on his vision to change the world. His desired goals include reducing global warming through sustainable energy production and consumption, reducing the risk of human extinction, and setting up a human colony on Mars. He has envisioned a high-speed transportation system known as the Hyperloop, and has proposed a VTOL supersonic jet aircraft with electric fan propulsion, known as the Musk electric jet.

Tesla Models: Bevy of Beauties

The company caught the attention of the avant-garde driver when they produced Tesla Roadster, the first fully electric sports car. The company’s second vehicle was Model S, a fully electric luxury sedan, which was followed by the Model X, a crossover. Its next projected vehicle is the heavily hyped mass-market electric car Model 3.

The price of eco-friendly and curve enhancing beauties is not cheap. Models S and X are around $100,000. Only Model 3, a Musk gift for the masses, is priced around $35,000.  According to Tesla, reservations for Model 3 is approaching the 400,000 mark. The expected shipping date is not until the end of 2017. Many of the later orders fulfilled may not be available until 2019 or 2020. Model 3 should be renamed “Phantom of the Opera.”

Are you ready to test drive a Tesla or invest in the Tesla stock? You will certainly enjoy the “ride.”

Chatham, May 13, 2016; 12.30A

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GE, The Illuminati

Illuminati-Logo---BlackGeneral Electric, the giant American industrial conglomerate, filed its 2015 annual report (10-K) with the Securities and Exchange Commission (SEC) on February 16, 2016. The annual report document contains 276 pages of text, numbers, tabular presentations and pictures. Large accelerated filers, or large public companies, are required to file their annual financial reports, also termed as Form 10-K, within 60 days of their fiscal year-end unless they are smaller public firms in which case they have either 75 days (accelerated filers) or 90 days (non-accelerated filers) to file depending on their market capitalization.

In an effort to make annual reports more understandable to investors, in a game-changing disclosure strategy, the company released its first ever “Integrated Summary Report.” The key objective is to provide a comprehensive yet concise view of the company using the lens of the Board and management. The compact report contains only 66 pages with pertinent information from several mandated documents including 10-K, proxy statements, and sustainability report. The document establishes links between strategy, performance, board oversight, compensation and sustainability but it remains outside the realms of the heavily regulated financial reporting.

The Illuminati

Navigating through any 276-page document can be challenging for an individual, let alone one that is derived from a complex set of accounting rules and regulation. The Chairman and CEO of General Electric, Jeff Immelt, said “our priority is to provide meaningful information that all investors can readily access. For investors to make investment and voting decisions, we don’t believe that more information is necessarily better. Instead, we’ve challenged ourselves to provide better information. Over the past several years, we have already been enhancing our reporting in response to feedback from investors, and they have told us how much they like it. This year, we are taking it even further.”

According to a GE spokesman, investors downloaded the integrated and summary report 2,300 times in the first 24 hours after it was published. In contrast, GE’s combined downloads of its 10-K and proxy reports 24 hours after they were filed last year were only 638.

Contents

The integrated summary report includes a discussion on the following subjects:

  • Chairman’s Letter
  • Strategy and results
  • GE’s Businesses, Portfolio & Capital Allocation
  • Margins and Financials
  • Risk, Governance and Compensation
  • Audit
  • Shareowner Proposals
  • Sustainability
  • Annual Meeting
  • Forward-Looking Statements

 Simplification

It remains uncertain whether other large companies will follow GE’s pathway and start disclosing similar condensed annual reports. The SEC has been deliberating ways to simplify financial reporting so GE might become the vanguard of simplified annual reporting.

New York, April 7, 2016; 2.40P

http://www.ge.com/ar2015/integrated-report.

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Bank Bets on Black Gold Going Bad

BankThis year, S&P 500 financial stocks have fallen by more than 10%. Banks stocks have been hit even harder. What may appear as counter-intuitive is that banks stocks have taken a bigger beating than oil or energy stocks. Deutsche Bank stock has lost more than 30%, Unicredit stock is down 35%, and Credit Suisse is 30% down. Barclays, BNP Paribas, Societe General, and UBS have all lost about 20% of their values. Why?

Common Justifications  

One explanation is linked to the low interest rate environment. Low interest rates in most major economies are cutting into banks’ profit margins. To compound banks’ problems, investors are not expecting a change in the interest rates anytime soon. However, this is hardly a new explanation. Low interest rates have been descriptive for most major economies which is why investors are unlikely to react now to low interest rates.

Another explanation is linked to banks facing tougher regulations, which is why they may be forced to scale back on their investments. However, the current regulatory environment is very similar to the regulatory environment since the post-financial crisis period. Therefore, regulation is unlikely to be a key factor explaining current decline in banks’ stock prices.

Bank Loans to Finance Oil and Gas

There is another compelling explanation. Many banks invested heavily in oil production in North American companies when oil prices were high. Over the last five years, oil and gas companies in the United States and Canada have issued bonds and taken out loans that are together worth more than $1.3 trillion, according to Dealogic. Over the past five years, global banks have earned around $31 billion in fees by financing energy-company stock sales, borrowing and mergers-and-acquisition transactions.

However, the collapse of crude oil, or black gold, prices have turned the tables on banks. Profitable investments are now turning sour. The precipitous and sustained decline in energy prices is resulting in major economic losses for the banks as the oil and gas companies are unable to generate sufficient operating cash flows to meet their obligations.

In 2015 alone, at least 42 North American oil companies have filed for bankruptcy which is bad news for banks that loaned money to these oil companies.

Accounting for Bad Loans

Under GAAP, companies must book an accounting loss in the current period (known as “loan-loss reserves”) if they expect future loan defaults because of a decline in the credit worthiness of the debtor company. The largest banks in the U.S. including Wells Fargo, J.P. Morgan Chase, and Citigroup have been setting up large reserves as it becomes more and more apparent that many outstanding loans are unlikely to get repaid.

Wells Fargo & Co. set aside $1.2 billion in reserves for potential losses tied to oil and gas loans. Recent SEC filings indicate that, although about 2% of its overall loan portfolio is in oil and gas companies, more than 10% of the company’s loan-loss reserves are related to oil and gas. In 2014, the bank was unsure whether it would be able to collect $76 million of the loans extended to oil and gas companies. In 2015, the bank estimates that number to be around $844 million, an increase of more than 10 times.

Similarly, J.P. Morgan Chase disclosed $44 billion of total energy exposure to their loans. Bank of America Corp. said that it had about $22.6 billion in unfunded energy loans. Smaller banks are facing similar predicament.

European banks are not far behind. Banco Santander, eurozone’s largest bank by market value, booked €1.6 billion ($1.76 billion) losses for the fourth quarter of 2015. The losses included a €435 million charge for “goodwill” and “other items.”

The Future

If oil prices remain low for a prolonged period of time, expect more loan defaults in the future by debtor companies from the energy sector. This in turn is going to adversely affect the future performance as banks increase their losses from nonperforming loans or book credit losses.

One expectation is that oil prices and bank stock prices are likely to positive correlated, at least in the short run.

The moral of the story is beware of bank stocks – they are risky bets under the current economic environment.

March 13, 2016; 9.04P

http://www.nytimes.com/2016/01/20/business/oil-market-tests-banks-ability-to-weather-losses.html?_r=0

http://www.wsj.com/articles/banks-struggle-to-unload-oil-loans-1426728583

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