Finding The Story Behind The Numbers

Training Journalists to Report on How a Company is Governed and Controlled

Objectives: • Discuss financial statements

– Why they matter to journalists

• Analyze financial statements to uncover stories – Theft of assets

– Fake profits

– Hidden losses

• Apply training to strengthen reporting and analysis of companies’ finances – Simplify the complex

“Spotting irregularities in financial and nonfinancial disclosures made in regulatory filings is a must for investigative business reporting. That often means reading the fine print and doggedly attempting to understand the financial information and technical language.” Guide

Olympus, AIG, Fortis Healthcare... Olympus ─“One of the biggest and longest-running loss-hiding arrangements in Japanese corporate history“ Wall Street Journal

AIG ”suddenly collapsed in September 2008 under the weight of bad bets it made insuring mortgage-backed securities. … [Federal] rescue packages brought the total to $182 billion, making it the biggest federal bailout in United States history.” New York Times

“The Economic Times of India questioned whether Fortis Healthcare India was paying a premium of as much as 20 percent to buy a family owned healthcare business.” Guide

Many Stories To Uncover ─ Why? Pressure Management increasingly driven to generate profits in tough economic times

Unethical business practices • One-in-five surveyed saw financial “manipulation” in their companies • 57% believe bribery and corruption are widespread in their countries

Compliance works, but not well enough Ernst & Young, 2013 fraud survey

“Intentional, deliberate, misstatement or omission of material facts, or accounting data which is misleading and, when considered with all the information made available, would cause the reader to change or alter his or her judgment or decision.” Association of Certified Fraud Examiners

Cooking The Books “An alarming number appear to be comfortable with or aware of unethical conduct. This includes recording revenues early; under-reporting costs or encouraging customers to buy unnecessary stock. This is coupled with the perception that bribery and corruption remain widespread in several markets.” David L. Stulb Ernst and Young

Hiding Losses, Inflating Profits Company Accounting Frauds Losses

Satyam

Manipulated accounts to disguise losses

$1.8 billion

Parmalat

Falsified accounting documents to hide: non-existent cash in bank; fake transactions; debts; use of derivatives

Bankruptcy in 2003 $20 billion

Enron

• Hid huge debts off the balance sheet through complex structures • Inflated revenue and profits

$74 billion Bankruptcy

Olympus

Accounting disguised investment losses

Scandal wiped out 75% stock value ($6 billion)

Perwaja Steel (Malaysia)

Joint venture between government-owned and private steel company used accounting frauds to hide theft of assets, other crimes

Malaysian Ringgit10 billion ($3 billion)

Market Peaks, CEO Spending Habits

• More managers commit

accounting fraud in the two years before economy peaks (Davidson)

• CEOs with excessive spending on yacht, high-end car, and home ─ 10 times more likely to preside over firms engaged in fraud

“Market-wide incentives for managers to manipulate earnings influence the decision to commit accounting fraud.” Spendthrift CEOs “change the composition of the firm’s board [and] compensation structure.” Robert H. Davidson

Developing Sources, Driving Reforms

• Good companies are open to reporters, especially if you understand accounting

– Expertise widens access

– Trust comes from sources’ confidence in reporter’s knowledge, reputation

• Exposing wrongdoing leads to reforms

– Accounting frauds in 2001-02 in United States led to Sarbanes-Oxley

• Insights, analysis benefit many

• Investors, regulators, policymakers, board directors, senior management, stakeholders

“Maintaining our trust with our audience is fundamental to our mission. Reporting truthfully, reporting accurately, correcting errors, obeying our standards are all vital and cannot be compromised.” David Schlesinger Editor-in-Chief Reuters

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Control Environment “Ensuring the integrity of the corporation’s accounting and financial reporting systems, including the independent audit, and that appropriate systems of control are in place, in particular, systems for risk management, financial and operational control, and compliance with the law and relevant standards” OECD Principles of Corporate Governance

k AC/Controls Audit Risk Compliance Disclosure

Dissect Financial Statements • Statement of Financial Position (“balance

sheet”) – Financial health

– “Snapshot"

• Statement of Comprehensive Income (“profits and loss” or “P&L”) – Performance

• Statement of Cash Flows – Changes in financial position

• Notes – Most interesting information to uncover

fraud

– What’s hidden? Why?

Maintain a healthy skepticism toward all financial reports

“They show where a company’s money came from, where it went, and where it is now.“ SEC

“Details create the big picture.“

Balance Sheet Snapshot of a company at close of reporting period: • Assets • Liabilities • Shareholders’ equity

Example

Source: Accounting Coach

Assets (Left Side) • Current: turn to cash or to be depleted within

one year of balance sheet date (e.g., inventory)

• Noncurrent: not likely to convert to cash within one year (may take longer than one year to sell)

• Investments: stocks, bonds, and life insurance policies company owns for top executives

• Property, Plant, and Equipment (“fixed”)

• Intangible: copyrights, patents, goodwill, trade names, trademarks

• Other Assets: bond issue costs amortized to expense over bonds’ life; property readied for sale • Vary greatly year to year

Assets help companies: • weather emergencies • borrow at lowest rates • promote long-term thinking and growth • earn high stock prices

Company’s assets have to “balance”

Apple: Assets

Liabilities (Right Side) • Liabilities: company’s obligations during business

operations (listed by due dates)

• Current liabilities: expect to pay off within the year

• Wages

• Accounts

• Taxes

• Long-term liabilities: obligations due more than one year away

• Long-term bonds/debt (principal and interest)

• Leases

• Pensions, other retirement benefits

• Product warranties

Helps reporter to quickly detect the financial strength and capabilities of the business Rising liabilities may signal problems Value may be reduced

Apple: Liabilities

Shareholder Equity “Net Worth”

= Assets – Liabilities Or

= Capital + Retained Earnings –Treasury Shares • Share capital: portion of company held as

stock

• Retained earnings: profits

• Treasury shares: shares the company sells and then repurchases

Helps reporter quickly detect the financial strength and capabilities of the business

Typical changes in equity result from company profits or losses, dividends, or stock issuances

Apple: Shareholder Equity

Income Statement • Sales (Minus) Cost of Goods =

Gross Profit

• (Minus) Expenses = Net Operating Income

• (Minus) Other Income and Expenses

• (Minus) Extraordinary Items

• (Minus) Income Taxes =

• Net Income (Profits)

• Retained Earnings (if any)

• Amount of revenue a company earned over a specific time period (usually one year)

• Costs and expenses

associated with earning that revenue

• “Bottom line”

reveals company’s net earnings or losses

Apple Income Statement

Cash Flow: Key Terms Cash generated and used during the interval specified:

• Operations: day-to-day business operations

• Investing : asset investments and proceeds from the sale of other businesses, equipment, or other long-term assets

• Financing: cash paid or received from issuing and borrowing of funds (includes dividends paid)

• Net Increase or Decrease in Cash

To survive and succeed, every business depends on its ability to create or otherwise attain cash. Strong cash flow allows a company to increase dividends, develop new products, enter new markets, pay off liabilities, buy back shares, and become an acquisition target.

Cash Flow Statement How much money did the company generate? Where is the cash coming from? Can the company pay its bills? Does it have money to expand?

Apple Cash Flow

Financial Statements ─ Notes • Enhance understanding of financial

statements

• Contain accounting policies, key assumptions and judgments made in preparing the financial statements

• Explain items in greater detail (for example, pension accounting assumptions)

• Provide detail on any uncertainties

• Required by national or listing requirements

• Some companies voluntarily provide additional information

What accounting methods were used for recording and reporting transactions? Assets overvalued? Liabilities undervalued?

Earnings Manipulation • Recording revenue too soon • Booking bogus revenue • Boosting income using one-

time or unsustainable activities

• Shifting current expenses to a later period

• Employing other techniques to hide expenses or losses

• Shifting current income to a later period

• Shifting future expenses to an earlier period

SOURCE: Schilit/Perler, Financial Shenanigans

"I give you the seven-billion-dollar pup, then you give me back the seven-billion-dollar pup, and we’ve each made seven billion dollars.”

Cash Flow Games • Shifting financing cash inflows

to the operating section

• Shifting normal operating cash outflows to the investing section

• Inflating operating cash flow using acquisitions or disposals

• Boosting operating cash flow using unsustainable activities

SOURCE: Schilit/Perler, Financial Shenanigans

“Sorry, sir — we seem to have lost five-million dollars in the fog of accounting.”

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External Audit vs. Internal Audit External audit means business activities involving independent audit of accounting records and financial (accounting) reporting of companies and individual entrepreneurs

Internal audit means an independent, objective assurance and consulting activity designed to add value and improve an organization’s operations. It helps an organization accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control, and governance processes

AC/Controls Audit Risk Compliance Disclosure

“The most common auditor failings were lack of competence and diligence, lack of professional skepticism, and failure to assess and respond to fraud risks,” according to a 2013 study. Reuters May 9, 2013

Unqualified vs. Qualified Opinion Auditor’s report helps attract investors, obtain loans, and improve public appearance

Unqualified/”clean” opinion

Financial statements give a “true and fair” view, comply with:

• Accounting principles

• Relevant statutory requirements, regulations

• Disclosure obligations of all material matters – Changes in accounting principles, methods

Qualified ─ not good

Information incomplete and/or the company has not prepared statements according to sound accounting principles

Auditors may fail to: • gather sufficient evidence to verify management’s information • exercise professional care • be sufficiently skeptical • express the appropriate opinion

Annual Report Contents • Chairman’s Report

• CEO’s Report

• Directors’ Report

• Corporate Governance Statement

• Statement of Directors’ Responsibilities

• Auditors’ Report on Financial Statements

• Financial Statements

• Invitation to the AGM plus proxy form

The annual report provides a summary of exactly how a company has performed in the preceding year, and offers a glimpse of the future.

An Acquisition • Nevaris Enterprises wants to buy another company, Alexey

Holdings, to expand sales worldwide.

• What broad questions would you ask about each company’s financial statement?

• Divide participants into two groups: – Group A develops questions for Nevaris

– Group B develops questions for Alexey

Key Questions

Nevaris Enterprises Alexey Holdings

Red Flags Topics Questions

Changes Size? Reasons? Make sense in light of economy?

Accounting New accountants, auditors? Methods changed in valuing assets, liabilities

Risks Properly assessed and prepared for?

Footnotes Insights into relationships with clients, suppliers?

Debt Increase? By how much? Company’s revenues adequate to repay loans?

Lawsuits From investors, vendors, competitors, government? Why?

Management Discussion and Analysis

Unaudited information – shed light on soundness of business model and management’s style? Growth outlook realistic?

Questions

Action Ideas • I plan to apply the following ideas, skills, and

procedures:

• Obstacles that may prevent me from implementing improvements in my reporting and analysis are:

• Opportunities to acquire skills and resources include:

THANK YOU