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Using Accounting Deception to Inflate Stock Price

August 14, 2015 / [email protected] / 0 Comments

The SEC is charging Miller Energy, a Houston-based company involved with exploration and production of oil in Alaska, its COO/CFO, and the company’s independent audit team leader with accounting fraud. Miller Energy was delisted from the New York Stock Exchange last month because its stock was trading under $1, which is in violation of NYSE rules. Upon acquiring the assets in Alaska’s Cook Inlet area in December 2009, Miller Energy overstated their values by more than $400 million, which allowed the company in 2010 to inflate net income and overstate assets. The company used accounting deception to propel its stock from less than a dollar to an all-time high of nearly $9 in 2013. The SEC is charging that “Miller Energy falsified financial statement information and that the company’s independent auditor failed to conduct an audit that complied with professional standards.”

Details of the Accounting Deception: Miller Energy paid $2.25 million in cash to purchase the Alaska properties and assumed another $2 million in liabilities. Yet through its reliance on fictitious accounting, Miller Energy reported the acquired assets at a value of $480 million in 2010. What are the odds that, in a competitive oil and gas market (and in an “arms-length” transaction), a property with proven oil and gas reserves valued at nearly $480 million is being sold for a meager $4.25 million!
What is the accounting outcome when an asset is purchased less than its fair market value? The company books a “bargain purchase gain” which is recognized in the income statement. The buyer benefits in two ways, (1) the assets are inflated and (2) an income/gain is recognized on the income statement. Miller Energy recognized a bargain purchase gain of $461 million in 2010. This gain resulted in the company increasing its income from $11.5 million in 2009 to $444 million in 2010, which translates into a 3,700% growth in income. What is noteworthy is that the cash flows in 2009 and 2010 were both negative. Therefore, by relying on inappropriate accounting, the company is claiming a growth in operations of 3,700% when it operations are resulting in negative cash flows for the same period.

The Auditor’s Role: How much did its auditors charge for this service? They charged a meager sum of $66,500 in 2009 and $128,500 in 2010. The SEC’ is seeking to bar the auditor from serving as an auditor of public company accounting (the auditing company has already been dissolved).
Miller shares closed down 3 cents at 14 cents last week.

http://www.sec.gov/news/pressrelease/2015-161.html

Mind the Gap (GAAP) in Pay, Please!

August 9, 2015 / [email protected] / 0 Comments

In the US, public registrants are required to report the compensation of the top 5 executives of the company including that of the CEO. Under the recently SEC approved rules, most public companies are now required to disclose the ratio of the CEO’s pay to that of the average employee. The SEC rule does not limit how much a CEO gets paid — a company must simply disclose the pay ratio in its SEC filings. For instance, the CEO of GE made $37.3 million last year. The SEC now wants investors to know how much larger is the pay of GE’s CEO relative to its rank-and-file (average) employee?

Rule Details: When calculating the median employee compensation, the SEC rule allows companies to choose statistical sampling methods over actual survey. Companies can also exclude up to 5% of their employees not based in the United States. The rule lets companies make a cost-of-living adjustment, which would most likely increase the median employee pay. The rule would not apply to “emerging growth” companies defined as those with less than $1 billion in annual gross revenue.

Expected Pay Ratio: What is the CEO-Median-Worker-Pay-Ratio? According to information posted on SEC’s website, median compensation for S&P 500 CEOs is $10.6 million. In contrast, the average annual salary for U.S. employees was $47,230 in 2014, according to the Labor Department. Using these numbers, the average pay ratio (not exactly measured according to SEC rule) is about 224. According to Economic Policy Institute, 50 years ago, CEOs were paid roughly 20 times as much as their employees, compared with nearly 300 times in 2013.

Outcome of the Rule: What will be the outcome of this disclosure? The expectation is that public outcry over excessively high pay ratio might lead to reductions in CEO pay. But how does this help the median/average employee? Wouldn’t it be better for the employees if we the rank-and-file employee starts making more money as a result of this “pay ratio” disclosure!
http://www.nytimes.com/2015/08/06/business/dealbook/sec-approves-rule-on-ceo-pay-ratio.html?_r=0

The Rise of the Slum Dog Millionaire – Jai Ho!

August 6, 2015 / [email protected] / 0 Comments

Given the box-office draw of Robert Downey Jr, it should not come as a surprise for cinema lovers that the “Iron Man” is being crowned as the “Godfather” of global stars. The thespian is the world’s best-paid actor for the third consecutive year. Marvel movies starring Robert Downey Jr, which include Iron Man and Avengers, have earned a whopping $4 billion at the global box office and millions more on home video and related merchandise. Box office draws are expected to be highly correlated with pay so we expect Robert Downey Jr to charge more for his histrionics.

However, there is a new masala-flavor in Forbes’ latest annual list of highest paid actors. There are four actors from Asia (Bollywood and China) who have sung, danced and fought their way into this top 10 list. The prominence of Asian actors may appear somewhat surprising because Chinese and Indian movies rarely feature on annual lists of the highest-grossing films across the globe. In the second place on the top 10 list is Jackie Chan, the Hong Kong-based “King-Fu Panda.” Amitabh Bachchan, Salman Khan and Akshay Kumar are the other three Bollywood megastars who choreographed their way into the Forbes’ top 10 list.

Given the box-office draws in Asia, which is dominated by movies from Bollywood and China, and considering the remarkable growth of the middle class in this region, it is inevitable that the top 10 list will include a bigger percentage of Asian superstars in the future years.

http://www.theguardian.com/film/2015/aug/04/robert-downey-jr-best-paid-actor-forbes-jackie-chan-amitabh-bachchan

Accounting for Failed Corporate Marriages

August 4, 2015 / [email protected] / 0 Comments

Under accounting rules, goodwill is recorded on the balance sheet when a company buys another company and pays in excess of the fair market value of the net assets of the company being acquired. Euphemistically, we call this excess payment as “synergistic gains” or “goodwill” which the acquiring company expects to realize over the period following a merger. This is a key reason why the excess payment gets recorded on the acquiring firms’ books as an asset. However, once it becomes apparent that the synergistic gains are no longer realizable, under accounting standards, the acquiring company must write-down the goodwill asset and take a hit on its income statement (a non-cash charge). In doing so, the acquirer is explicitly acknowledging that it overpaid for past acquisitions or that the past premium paid is no longer justifiable under current market conditions.

Duff & Phelps and the Financial Executives Research Foundation in 2014 conducted a study on goodwill impairments and found the following key results:

U.S. public companies recorded $21 billion of goodwill impairment in 2013, which was the lowest level seen since 2008, at the height of the financial crisis.
This decline in goodwill impairment is consistent with the U.S. economic outlook over the same period. S&P 500 Index level surged by 30% in 2013, which is its largest increase in percentage terms since 1997.
In 2013, Industrials had the largest percentage of companies that impaired goodwill (7%) followed by Consumer Discretionary and Information Technology (both at 6%).

What are the consequences of goodwill impairments or “failed corporate marriages”? My own research shows they are severe penalties when companies record goodwill impairments. The following is a link to the Duff & Phelps and FEI survey

http://www.duffandphelps.com/expertise/publications/Pages/NewslettersDetail.aspx?itemid=171

Lamborghini Races to Build an SUV

August 3, 2015 / [email protected] / 0 Comments

Lamborghini, the acclaimed Italian automobile manufacturer renowned for producing hand-crafted sports cars that customers compete to own, recently announced its plans to build a high-end SUV named “Urus” (Latin for wild ox). Currently, Lamborghini produces only two sports cars (Aventador and Huracan with an average starting price around $300K) in limited quantities (around 2,000 units per year). The production of Urus is expected to more than double the company’s annual output.

Lamborghini is trying to emulate the highly successful business strategy of Porsche, which entered the profitable SUV market for the first time in 2002. Global sales of premium SUVs rose from less than 400,000 in 2000 to 1.2 million last year (about 10% growth rate). However, very few brands compete in this high-end SUV market where the prices of SUVs range between $70K-$100K (e.g., Porsche, Land Rover, Mercedes Benz, BMW). Lamborgini is now tapping into this profitable sector but, by pricing its Urus over $200k, it is essentially entering a segment of the SUV market where it has absolutely no competitor.

Why this shift in business strategy? I believe the answer is tied to changes in the company’s organization structure and the race to find attractive profitable opportunities. Lamborghini as a family owned company was more conservative and content with its production of limited edition cars. However, once it became owned by a bigger public corporation, the conservative business model was bound to change. Automobili Lamborghini is owned by Audi, which is a unit of Volkswagon AG, which in turn is majority owned by Porsche!

http://www.economist.com/blogs/economist-explains/2015/06/economist-explains-2

Musings of a Colleague From Sweden

August 1, 2015 / [email protected] / 0 Comments

A professor in Business Administration from a University in Sweden wrote this email regarding one of Professor Ghosh’s recent article in the Journal of Accounting and Economics. This email is being reproduced after obtaining permission from its author.

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Subject: OK, you found this, but what about…

Hello
Normally I do not send comments to authors of articles I read. But today, sitting in the south of Sweden (Kristianstad), going through many articles, since I have to revise a paper and therefor have to inspect what has happened the last year, I got my hand on your paper from Journal of Accounting and Economics 2015. And I have to send you a report of my impression and experience of your article.
Normally, when I read, I go: OK, you find this, but what about… And then, at the end of the reading, I have several ‘But what about..’ left unanswered.
With your paper, within the range of the first two pages I said:
OK, you found this, but what about…
But then you report on that, so then I say:
OK, you controlled for that, but what about…
But then you report on that, so then I say:
OK, you controlled for that, but what about…
But then you report on that, so then I say:
OK, you controlled for that, but ….eh…
And then I run out of ‘OK, but what about…?’
Normally I do not smile when I read articles, but when reading your article I smiled a lot, because I had no ‘OK, but what about…?’ left when the article ended.
So, congratulations to an excellent article. Of course I am very irritated that I will never be able to do such a strong article, but I am happy that others can do it (since then I do not have to do them).
Thanks for an amusing morning.
Sven-Olof

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Sven-Olof Yrjö Collin

Professor in Business Administration
The Corporate Governance Research Group at Linnæus University
School of Business and Economics, Linnæus University
Sweden

Mary Barra’s Bullish Bet on India

July 31, 2015 / [email protected] / 0 Comments

General Motors, the world’s third-largest car maker, plans to make India an “export hub.” It announced an investment of $1 billion aimed at expanding its production capacity in India. GM’s intention is to increase the production capacity at the Talegaon factory (in Maharashtra) which is relatively close to its research center at Bangalore. Mary Barra, CEO of GM, also added that the plan is to make India “…its hub for exports. Our aim is that 30% of its production will be exported.”

Given that GM’s Indian market share is less than 2%, and that it has accumulated losses of about $420 million from its India operations, this might appear as a risky investment decision. Yet, Mary Barra remains highly optimistic about India because, according to some analysts, India is expected to become the world’s third-largest passenger vehicle market after China and the United States.

This investment decision might also indicate GM’s faith in the Modi-Government and a more favorable Indian labor market. It remains unclear, however, whether this is an isolated investment decision or whether this is a harbinger of other investments in India as U.S. companies seek cost effective production hubs away from China which is no longer as cost effective because of rising wages.

http://www.hindustantimes.com/htauto-topstories/gm-in-a-1-bn-make-in-india-push/article1-1373893.aspx

When Accounting Becomes a Business Language

July 29, 2015 / [email protected] / 0 Comments

Compiling information for an annual report is a major business operation for a public company. At General Electric Co. (GE), its finance department works for about two months with input from about 200 people before it complies its 10-K (SEC required annual report). GE’s 2013 10-K had 246-pages containing 109,894 words. However, this information treasure chest was downloaded only 800 times from GE’s website. Given that GE has about 5 million individual shareholders, less than 0.01% of its individual shareholders chose to download the 10-K!

In 2014, GE decided to simplify its 10-K which contained 103,484 words (the footnotes alone contained 42,000 words). GE’s 2014 10-K was downloaded 3,400 times.

Do you read the 10-K before you invest in a public company?

http://blogs.wsj.com/cfo/2015/06/02/the-109894-word-annual-report/

Big U.S. Banks Must Pay a Surcharge to Remain Big: Should You Care?

July 25, 2015 / [email protected] / 0 Comments

Under Fed’s new proposal, big U.S. banks posing systematic threat to the financial system will be required to implement a risk-based capital surcharge unless they decide to shrink their size to a particular level. The eight largest U.S. banks would need to have an additional capital buffer (between 1% and 4.5% of their risk-weighted assets) depending on the relative threat a bank poses to the financial system.
Under current Basel III rules, banks have to increase their core tier-one capital ratio to 4.5% and carry an added capital conservation buffer of 2.5%, which raises the total common equity requirements to 7%. Any bank that fails to meet the requirements would be barred from paying dividends to shareholders. Similar to the Basel approach, the Fed’s proposal adds an additional “surcharge” to that 7 percent requirement based on a bank’s size and the nature of its activities. The biggest impact will be felt by J.P. Morgan Chase & Co., the nation’s largest bank by assets, which is $21 billion short of the requirement, according to Fed officials. Fed officials did not provide any further information on what surcharge other large banks might have to pay.

What does this mean for consumers? If the large banks absorb the higher regulatory costs, investors will be unhappy because of lower expected profits. More likely outcome is that these banks would pass on some of the added costs to their customers, which means consumers might be partially financing large banks to remain large. One solution is to consider smaller regional banks which are able to avoid these surcharges.

Toshiba: Accounting and Accountability

July 23, 2015 / [email protected] / 0 Comments

Toshiba Corp. overstated nearly $1.2 billion (152 billion yen) of profits (accounting earnings) over the last six years. It expects to take a charge of nearly $3 billion for improper accounting and restate its prior period financial statements. Not surprisingly, since May 8, when it withdrew its earnings forecasts, canceled the year-end dividend and widened an accounting probe, the company has lost $3.8 billion in market capitalization. The stock has declined 26% this year making it the second-worst performer on the Nikkei 225 Stock Average, which has climbed 18% (Toshiba is not listed in the US).

The company initially uncovered irregularities related to percentage of completion estimates and then appointed a third-party committee to expand the investigation. The Chair of the audit committee, the CEO, and a string of other senior officials also resigned. At least eight analysts have suspended their ratings on the company’s shares.

Who was the auditor of Toshiba during the period of accounting irregularities? It was E&Y’s Japanese affiliate E&Y ShinNihon. Why did the auditors, a Big 4 affiliate, fail to uncover this accounting “fraud”?
http://www.bloomberg.com/news/articles/2015-07-20/toshiba-to-restate-152-billion-yen-of-past’-profits-after-probe

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Aloke Ghosh

Professor of Accountancy Baruch College, CUNY

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