Notes

Chapter 1 The Adversial Nature of

Financial Reporting

1.        Howard M.

2.        Although this book focuses on for-profit companies, nonprofit companies and governmental entities also produce financial statements. Readers should not presume that those entities invariably eschew reporting trickery. Like their for- profit counterparts, nonprofit organizations seek to raise capital. They have in­centives to portray their financial positions in as favorable a light as possible, when trying to borrow or to demonstrate their financial viability to providers of grants. On the other hand, nonprofits sometimes strive to make themselves ap­pear less flush than they really are, to impress on donors the urgency of their appeal for funds. Governmental units sometimes resort to disingenuous report­ing to avoid political fallout from the consequences of unsound fiscal policies. Anticapitalist ideologues cannot truthfully contend that the profit motive alone leads to devious financial reporting.

3.        Floyd Norris, “Auto Lender’s Finance Chief Disappears; Profits Are Cut,” New York Times, January 30, 1997, pp. D1, D5.

4.        “Mercury Finance Company Announces Discovery of Accounting Irregulari­ties,” PRNewswire, January 29, 1997.

5.        Jeff Bailey, “Mercury Finance’s Controller Denies He Inflated Firm’s Profit Statements,” Wall Street Journal, January 31, 1997, pp.

6.        Norris, “Auto Lender’s Finance Chief,” p. D5.

7.        Arthur Goldgaber, “Life after Mercury,” Financial World, May 20, 1997, pp. 40-44.

8.        Nick Wingfield and Paul Beckett, “MicroStrategy, Results Restated, Is Macro­Loser,” Wall Street Journal, March 21, 2000, pp. B1, B4.

9.        Floyd Norris, “A Hard Fall as Highflier Revises Figures,” New York Times, March 21, 2000, pp. C1, C16.

10.     Floyd Norris, “Failed Audit: The Humiliation of Pricewaterhouse Coopers,” New York Times, March 24, 2000, p. C1.

11.     Alan Abelson, “Up & Down Wall Street: Way to Go,” Barron’s, July 19, 1999, p. 5. The $59 million purchase price that Lernout & Hauspie paid for Brussels Translation Group was neither a revenue nor an expense, but an exchange of one asset (cash) for another (BTG’s stock).

12.     John Carreyrou and Mark Maremont, “Lernout Files for Bankruptcy Protec­tion,” Wall Street Journal, November 30, 2000, pp. A3, A6.

13.     Randall Smith, Steven Lipin, and Amal Kumar Naj, “Managing Profits: How General Electric Damps Fluctuations in Its Annual Earnings,” Wall Street Jour­nal, November 3, 1994, pp. A1, A6.

14.     In financial statements prepared for tax purposes, the corporation minimizes its taxable income by writing off fixed assets over the shortest allowable period.

15.     Senior executives typically own stock in their corporations, so to some extent they penalize their wealth by undercutting quality of earnings. Unless their stock holdings are very large, however, the direct benefits of increased bonuses more than fully offset the impact of reduced valuations on their shares.

16.     Richard Zeckhauser, Jayendu Patel, Francois Degeorge, and John Pratt, “Re­ported and Predicted Earnings: An Empirical Investigation Using Prospect The­ory.” Project for David Dreman Foundation (1994).

17.     Ibtd.

18.     As December 31, 1999, approached, economic pundits warned of massive dis­locations arising from a programming quirk whereby many computer systems would interpret the following date to be January 1, 1900. Many corporations attributed sluggish sales during the latter part of 1999 to customers’ unwilling­ness to make major commitments in advance of impending chaos, fears of which proved to be greatly overstated.

19.     See, for example, Michael C. Jensen and William H. Meckling, “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure,” Journal of Financial Economics (1976:3), pp. 305-60.

Chapter 2 The Balance Sheet

1.        For the record, the accounting profession defines assets as “probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events” (Statement of Financial Accounting Concepts No.

2.        Barry Libert and Barbara Sayre Casey, “Accounting for Value” (letter to editor), Barron’s, December 11, 2000, p. 65.

3.        Jonathan R. Laing, “The New Math: Why an Accounting Guru Wants to Shake Up Some Basic Tenets of His Profession,” Barron’s, November 20, 2000, pp. 31-36.

4.        Barnaby J. Feder, “JDS Uniphase Will Write Down $44.8 Billion in Assets,” New York Times, July 27, 2001, pp. C1-C2.

5.        Advances in Behavioral Finance, Richard H. Thaler, ed. (New York, Russell Sage Foundation, 1993).

Chapter 3 The Income Statement

1.        Strictly speaking, Boston Beer has no direct exposure to interest rate fluctua­tions. Like any other company, the brewer’s earnings are sensitive to swings in the general level of economic activity, which are in turn sensitive to changes in the level of interest rates. As it happens, demand for beer (and for consumer nondurables generally) is less sensitive to variations in the level of economic ac­tivity than demand for many other types of goods.

2.        There are a few exceptions to this generalization. Tax collectors, for example, examine a company’s income statement to determine its tax liability.

3.        Financial Accounting Standards: Original Pronouncements, as of June 1, 1980, Financial Accounting Standards Board, Stamford, Connecticut, pp. 371-373. The APB opinion covering the issue became effective on October 1, 1973.

4.        Floyd Norris, “No Special Accounting Breaks for Recent Corporate Setbacks,” New York Times, October 2, 2001, p. C9.

5.        Source: J. Douglas Hanna, University of Chicago. Cited in Nelson, “P&G” (n. 6).

6.        Emily Nelson, “P&G’s One-Time Charges Make Critics Look Twice at Earn­ings,” Wall Street Journal, April 4, 2001, pp. C1-C2.

7.        Roger Lowenstein, “Sipping the Fizz in Coca-Cola’s Profit,” Wall Street Journal, May 1, 1997, p. C1.

8.size=1 face="Times New Roman">        Patrick McGeehan, “Gabelli Asset Management Earnings Release Accentuates the Positive, Bottom Line Aside,” Wall Street Journal, May 25, 1999, p. C4.

9.        Bill Alpert, “The Numbers Game: Reporting of Pro Forma Earnings Is Rising, and So Is the Debate about It,” Barron’s, September 11, 2000, pp. 22, 24.

10.     Edward Wyatt, “Putting on a Happier Profit Face,” New York Times, May 16, 1999, Sec.3, p.

11.     Elizabeth MacDonald, “Varied Profit Reports by Firms Create Confusion,” Wall Street Journal, August 24, 1999, p. C1.

12.     Randall Smith, with Henry Sender, Gasten Ceron, and Greg Ip, “Bids and Of­fers,” Wall Street Journal, November 2, 2001, p. C13.

13.      McGeehan, “Gabelli Asset Management,” p. C4.

14.     Steve Liesman and Jonathan Weil, “Two Profit Calculations for S&P 500 Dif­fer,” Wall Street Journal, August 24, 2001, pp. A2, A4. As the authors explain, the year-over-year declines were preliminary figures, subject to adjustment dur­ing the third quarter.

15.      Alpert, “The Numbers Game,” p. 24.

16.     Gretchen Morgenson, “In an Effort to Placate Investors, Some Results too Good to Be True,” New York Times, December 21, 1999, p. A1.

17.     Messod D. Beneish, “The Detection of Earnings Manipulation,” Financial An­alysts Journal, September/October 1999, pp. 24-36.

Chapter 4 The Statement of Cash Flows

1.        Exhibit 4.2 and the accompanying narrative simplify the concept of cash flow to introduce it to the reader. Only the two major sources of cash, net income and depreciation, appear here, leaving to subsequent exhibits refinements such as deferred taxes, which arise from timing differences between the recognition and payment of taxes. Similarly, the uses of cash exclude a working capital fac­tor, which is discussed in connection with Exhibit 4.9.

2.        For a detailed rationale for the use of the EBITDA multiple to evaluate a firm, see “Valuation via Restructuring Potential” in Chapter 14. See also “The Ap­plications and Limitations of EBITDA” in Chapter 8.

3.        In large measure, the high failure rate of the late-1990s dot-com public com­panies is attributable to premature IPOs. During less exuberant stock markets, new ventures go through longer gestation periods before going public. A large proportion of them fail while still in the hands of the venture capitalists, rather than under the glare of the financial media.

4.        Amortization of debt discount arises from bonds issued at a discount to face value. Buyers of such a security receive a portion of their interest (all of it, in the case of zero-coupon bonds) through price appreciation over the life of the bond, rather than in the form of semiannual cash payments. The issuer recog­nizes the noncash interest expense in annual installments between issuance and maturity, rather than in a lump sum at maturity.

5.        James Bandler and Mitchell Pacelle, “Polaroid Is Using Chapter 11 to Seek a Buyer,” Wall Street Journal, October 15, 2001, p. B9.

6.        Claudia H. Deutsch, “Market Place: For Polaroid, the Bad News Seems to Be the Only News,” New York Times, October 4, 2001, p. C7.

7.        Michael C. Jensen, “The Free Cash Flow Theory of Takeovers: A Financial Per­spective on Mergers and Acquisitions and the Economy,” in The Merger Boom, Proceedings of a Conference Held in October 1978, edited by Lynn E. Browne and Eric S. Rosengren, Federal Reserve Bank of Boston, pp. 102-37. This arti­cle provides the basis for the synopsis of the free cash flow argument described here, as well as the definition quoted.

8.        Ibid.

Chapter 5 What Is Profit?

1.        John Francis Fowler, Jr., Introduction to Wall Street: A Practical Guide Book for the Investor or Speculator (New York: Harper & Brothers Publishers, 1930), p. 76.

2.        This was probably even truer in 1930 than today, for it was only with the pas­sage of the Securities Act of 1933 that it became a requirement for most United States public companies to have their financial statements audited by indepen­dent public accountants. Even then, financial reporting rules remained fairly loose while the federal government and accounting profession wrestled with the question of how best to establish standards.

3.        Ninotchka: The MGM Library of Film Scripts (New York: Viking Press, 1972), p. 13.

Chapter 6 Revenue Recognition

1.        David Bank, “Informix Reveals More Severe Accounting Errors,” Wall Street Journal, September 23, 1997, p. B10.

2.        Don Clark, “Informix Hurt by Results, Resignation; Accounting, Sales Strategy Play Rose,” Wall Street Journal Europe, May 5, 1997, p. 12.

3.        Mark Boslet, “Revenue Recognition Violations behind Informix Restatement,” Dow Jones News Service, August 7, 1997.

4.        Bank, “Informix Reveals,” p. B10.

5.        Informix Corporation, Form 10-K: Annual Report for the Fiscal Year Ended December 13, 1997, Disclosure, p. 110.

6.        Michael Schroeder, “Informix Settles Allegations by SEC of Accounting Fraud Tied to Deficits,” Wall Street Journal, January 12, 2000, p. B6.

7.        Informix Corporation, Form 10-K: Annual Report for the Fiscal Year Ended December 31, 1999, Disclosure, p. 58.

8.        Tom Steinert-Threlkeld, “KnowledgeWare Stock Decline Imperils Sale to Ster­ling,” The Dallas Morning News, August 2, 1994, p. 1D.

9.        Melinda-Carol Ballou, “Sterling Attempts KnowledgeWare Rescue,” Computer­world, August 8, 1994, p. 32.

10.     Alison Eastwood, “KnowledgeWare Acquisition Could Benefit Canadian User Base; Company to Be Bought by Sterling Software, Inc.,” Computing Canada, August 17, 1994, p. 1.

11.     Mary Welch, “KnowledgeWare Retries: Sterling Reduces Offer for Struggling Software Business,” Advertising Age, September 26, 1994, p. 28.

12.     Bill Husted, “KnowledgeWare Okays Merger with Sterling,” Atlanta Constitu­tion, December 1, 1994, sec. F, p. 3.

13.     Floyd Norris, “SEC Charges 68 Companies and Individuals with Accounting Fraud,” New York Times, September 29, 1999, p. C2.

14.     Liz Skinner, “Former NFL Star Tarkenton among 68 Charged by SEC,” Bloomberg News, September 28, 1999.

15.      Steinert-Threlkeld, “KnowledgeWare Stock Decline,” p. 1D.

16.     The account of Kendall Square’s revenue recognition controversies draws on the following articles: Dorfman, John R., and William M. Bulkeley, “Supercom­puter Maker Kendall Square’s Effort to Crack Business Market Has Some Skep­tics,” Wall Street Journal (October 11, 1993), p. C2; Gallese, Liz Roman, “Kendall Square Fires Founder Burkhardt, Two Demoted Executives,” Bloomberg News (October 26, 1993); “Kendall Square Closes Down 32%,” Bloomberg Business News (October 29, 1993); Zielenziger, David, “Kendall Square Drops 21% after Auditors Withdraw Backing,” Bloomberg News, (No­vember 29, 1993).

17.     Chip Cummins, “Wal-Mart’s Net Income Increases 28%, but Accounting Change Worries Investors,” Wall Street Journal, August 10, 2000, p. A6.

18.     Heather Landy, “Wal-Mart 2nd-Quarter Net to Miss Forecasts,” Bloomberg, August 9, 2000.

19.     Linda Sandler, “Bally Total Fitness’s Accounting Procedures Are Getting Some Skeptical Investors Exercised,” Wall Street Journal, August 26, 1998, p. C2.

20.     Eric Matejevich, “Bally Total Fitness: Flexing Its Muscles; Buy Reiterated,” Merrill Lynch HYLights, September 2, 1999, pp. 18-24.

22.     “BJ’s Wholesale Club, Inc. Says Membership Income Accounting Complies with All Applicable Standards,” Business Wire, September 3, 1998.

23.     Elizabeth MacDonald, Laura Johannes, and Emily Nelson, “Discount-Club Re­tailers Shift Accounting,” Wall Street Journal, October 28, 1998, p. B4.

24.     “MemberWorks Reports Record Fiscal 2000 Fourth Quarter Financial Re­sults,” Business Wire, July 28, 2000.

25.     Elizabeth MacDonald, “Are Those Revenues for Real?” Forbes, May 29, 2000, pp. 108-110. The author credits Bear Stearns & Co. with identifying 120 com­panies that announced they had changed or would change their revenue recog­nition policies in recent months.

26.     “Sequoia, Ex-Officials Settle SEC Charges of Inflating Results,” Wall Street Journal, February 17, 1996, p. B6.

27.     Mark Maremont, “Numbers Game at Bausch & Lomb?” Business Week, De­cember 19, 1994, pp. 108-110.

28.      Maremont, “Numbers Game,” p. 109.

29.     “Bausch & Lomb Responds to Article in Business Week Magazine,” Business Wire, December 9, 1994. Note that the issue of Business Week in which Mark Maremont’s Bausch & Lomb article appeared was published several days be­fore the newsstand date of December 19, 1994.

30.     “Bausch & Lomb Announces Results for 1994 Fourth Quarter and Full Year Earnings Impacted by Charge to Write Off Goodwill in Oral Care Business,” Business Wire, January 25, 1995.

31.     Ben Dobbin, “Bausch & Lomb Posts $3.36 Million Loss, Restates Past Earn­ings,” Associated Press, January 24, 1996.

32.     Louis Hau, “Bausch & Lomb CEO Resignation Blamed on Poor Earnings,” Dow Jones News, December 13, 1995.

33.     “Panel at Bausch & Lomb Releases Results of Probe,” Wall Street Journal, April 24, 1996, p. B5.

34.     Reed Abelson, “Not Quite the Last Word: Gary Lynch, Defender of Com­panies, Has His Critics,” New York Times, September 3, 1996, p. D1.

35.      “Bausch & Lomb Responds.”

36.size=1 face="Times New Roman">     Joseph B. White, “GM Shifts to Reverse on December Data for Cadillac Sales,” Wall Street Journal, May 6, 1999, pp. A3, A6.

37.     Melody Peterson, “S.E.C. Charges Grace and 6 Former Executives with Fraud,” New York Times, December 23, 1998, pp. C1, C6.

38.     Ann Davis, “SEC Claims Profit ‘Management’ by Grace,” Wall Street Journal, April 7, 1999, p. C1, C20.

39.       Davis, “SEC Case,” p. C20.

40.       Ibid.

41.     Peter Ramjug, “W.R. Grace Settles SEC Income Manipulation Case,” Reuters, June 30, 1999.

42.     Michael C. Jensen, “Why Pay People to Lie?” Wall Street Journal, January 8, 2001, p. A32.

43.     Elizabeth MacDonald and Daniel Kruger, “Aiding and Abetting,” Forbes, April 2, 2001, pp. 82-84.

44.       MacDonald and Kruger, “Aiding,” p. 84.

45.       Davis, “SEC Case,” p. C1.

46.     Lipin, Steven, “Citicorp Unit’s Top Officials Are Dismissed.” Wall Street Jour­nal (November 11, 1991), p. A4.

47.     “Cincinnati Milacron Overstated Earnings by $300,000 for Half,” Wall Street Journal (August 4, 1993), p. C9.

48.     “Net of First Financial Management Corp. Restated for 3 Periods,” Wall Street Journal (December 30, 1991), p. B7.

49.     The account of T2 Medical is drawn from the following articles: Krensavage, Mike, “T2 Medical 3rd-Quarter Net Falls 40%; Company Restates 1st Half,” Bloomberg News (August 23, 1993); Pauly, David, “Ways of Wall Street: T2 Med­ical’s Numbers Aren’t Right,” Bloomberg News (August 13, 1993); Quinson, Tim, “T2 Medical Says Management Group May Make Buyout Offer,” Bloomberg News (May 25, 1993); “T2 Medical Net Fell 40% in 3rd Period: Company Re­states Profit for First Half,” New York Times (August 24, 1993), p. B4.

Chapter 7 Expense Recognition

1.        Gary Samuels, “What Profits?” Forbes, October 24, 1994, p. 74.

2."Times New Roman"'>        “Prodigy Management to Unveil Buyout Plan,” Financial Post, May 9, 1996, p. 14. (Originally reported by Bloomberg News.)

3.        Roger Lowenstein, “Did AOL Succeed in Spinning the Street?” Wall Street Jour­nal, November 7, 1996, p. C1.

4.        Floyd Norris, “AOL Pays Fine to Settle a Charge That It Inflated Profits,” New York Times, May 16, 2000, p. C6.

5.        David S. Hilzenrath and Jill Dutt, “Looking for the AOL Numbers That Count,” Washington Post, February 23, 1997, pp. H1, H7.

6.        Linda Sandler, “America Online’s Fancy Accounting Methods Once Again Are Raising Red Flags for Some,” Wall Street Journal, June 3, 1998, p. C4.

7.        Jon G. Auerbach, “IBM’s Accounting Method Faces Scrutiny,” Wall Street Jour­nal, November 24, 1999, pp. C1-C2.

8.        Auerbach, “IBM’s Accounting,” p. C2.

9.        Ibid.

10.     “Wickes PLC Discovers Accounting Problems; '95 Profit Overstated,” Dow Jones and Company, June 25, 1996.

11.     Nigel Cope, “Accounting Problems Ravage Wickes,” The Independent (Lon­don), June 26, 1996, p. 17.

12.     Paul Farrelly, “ ‘Dirty Tricks' at Wickes; Internal Inquiry Looks at Sweetbaum's Management,” The Independent (London), August 4, 1996, p. B3.

13.     Andrew Sawers, “SFO Puts FDS in the Dock over Wickes ‘Pyramid Buying' Scandal,” Financial Director, August 1, 1999, p. 8.

14.     Edward Orlebar, “Wickes Says Profit Overstated by 51 Million Pounds,” Bloomberg, October 16, 2001.

15.     Nigel Cope, “Senior Wickes Management Was Aware of Bogus Profits 6 Months before Disclosure,” The Independent (London), October 17, 1996, p. 22.

16.     “Wickes PLC Discovers Accounting Problems; '95 Profit Overstated,” Dow Jones and Company, June 25, 1996.

17.     Ron Winslow and Scot J. Paltrow, “At Oxford Health, Financial ‘Controls' Were out of Control,” Wall Street Journal, April 29, 1998, pp. A1, A14.

Chapter 8 The Applications and Limitations

of EBITDA

1.        Failures by leveraged buyouts largely accounted for the escalation in the default rate on speculative grade bond issuers, as reported by Moody's Investors Ser­vice, from 3.5% in 1988 to a peak of 10.5% in 1991.

2.        William H. Beaver, “Financial Ratios as Predictors of Failure,” Journal of Ac­counting Research (Supplement 1966), pp. 71-111.

3.        The development of this tradition is more fully explored in Martin S. Fridson, “EBITDA Is Not King,” Journal of Financial Statement Analysis, Spring 1998, pp. 59-62.

4.        Edward I. Altman, “Financial Ratios, Discriminant Analysis, and the Prediction of Corporate Bankruptcy,” Journal of Finance, September 1968, pp. 589-609.

5.        Richard Bernstein, “An Analysis of Low EV/EBiTdA,” Merrill Lynch & Co., September 4, 2001.

6.        Defined as Equity Market Capitalization + Long-Term Debt + Short-Term Debt + Preferred Stock + Minority Interest - (Cash + Cash Equivalents).

Chapter 9 The Reliability of Disclosure and Audits

1.        James Bandler, “Computer Associates Says Error Boosted Annual Earnings,” Wall Street Journal, May 7, 2001, p. B9.

2.        Jacqueline Doherty, “Fuzzy Numbers from Mr. Trump,” Barron’s, November 1, 1999, p. MW16.

3.        “Trump Hotels & Casino Resorts Third Quarter Results,” Business Wire, Oc­tober 25, 1999.

4.        Christina Binkley, “Trump Hotels Failed to Disclose Gain, So Firm Appeared to Beat Estimates,” Wall Street Journal, November 8, 1999, p. B12.

5.        Binkley, “Trump Hotels,” p. B12.

size=1 color=black face=Cambria>6.        Doherty, “Fuzzy Numbers,” p. MW16.

7.        Steve Lohr, “Trump Hotels Settles Case Accusing It of Misleading Investors,” New York Times, January 17, 2002, p. C4.

8.        Adam Steinhauer, “Park Place CEO Goldberg Is out of Hospital,” Bloomberg News, July 7, 2001.

9.        Jeannine DeFoe, “Park Place Taps Hilton Exec to Succeed Goldberg,” Bloom­berg News, October 23, 2000.

10.       Shawn Tully, “The New King of Casinos,” Fortune, September 18, 2000, p. 156.

11.     Judy DeHaven, “What Now for Park Place?” The Star-Ledger, October 20, 2000, p. 53.

12.       John A. Byrne, “Chainsaw,” Business Week, October 18, 1999, pp. 128-149.

13.     John A. Byrne, “How Al Dunlap Self-Destructed,” Business Week, July 6, 1998, pp. 58-65.

14.       Jonathan R. Laing, “SEC vs. Chainsaw Al,” Barron’s, May 21, 2001, p. 13.

15.       “... And Take the Chainsaw with You!” Barron’s, June 22, 1998, p. 13.

16.     Jonathan R. Laing, “Dangerous Games: Did ‘Chainsaw Al' Manufacture Sun­beam’s Earnings Last Year?” Barron’s, June 8, 1998, p. 17.

17.       Laing, “Dangerous Games,” p. 17.

18.     Martha Brannigan, “Sunbeam Slashes Its 1997 Earnings in Restatement,” Wall Street Journal, October 21, 1998, p. B6.

19.       Byrne, “Chainsaw,” p. 142.

20.        Jonathan R. Laing, “High Noon at Sunbeam,” Barron’s, June 16, 1997, p. 29.

21.     Floyd Norris, “They Noticed the Fraud but Figured It Was Not Important,” New York Times, May 18, 2001, p. C1.

22.     Floyd Norris, “An Executive’s Missing Years: Papering Over Past Problems,” New York Times, July 16, 2001, p. A1.

23.     Stephanie Strom, “Woolworth’s Treasurer Blew Whistle,” New York Times, May 20, 1994, p. D4.

24.     Patrick M. Reilly, “Woolworth Executives Faulted in Probe, but Lavin Rein­stated as Chief Executive,” Wall Street Journal, May 19, 1994, pp. A3, A6.

25.     Floyd Norris, “Sometimes, Safeguards Protect Nobody,” New York Times, March 22, 1998, Sec. 3, p. 1.

26.     Elizabeth MacDonald, “Auditors Miss a Fraud and SEC Tries to Put Them out of Business,” Wall Street Journal, November 6, 2000, pp. A1, A8.

27.     Jeanne Patterson and Nell Minow, “Blame Directors for Accounting Practices, Managing Earnings,” Pensions & Investments, May 28, 2001, p. 12.

Chapter 10 Mergers-and-Acquisitions Accounting

1.        Reed Abelson, “Market Place: A Candidate Weighs in on an Accounting Rule Change,” New York Times, October 17, 2000, p. C16.

2.        See Abraham J. Briloff, “Pooling and Fooling: A Critic Draws a Bead on Cisco’s Accounting Policies,” Barron’s, October 23, 2000, pp. 26-29.

3.        Greg Hitt, “Cisco’s Chambers Revs Up Political-Contribution Engine,” Wall Street Journal, June 8, 2000, p. A26.

4.        Jonathan Weil, “FASB Backs Down on Goodwill-Accounting Rules,” Wall Street Journal, December 7, 2000, pp. A1, A6.

5.        Jonathan Weil, “Goodwill Hunting: Accounting Change May Lift Profits, but Stock Prices May Not Follow Suit,” Wall Street Journal, January 25, 2001, pp. C1-C2.

6.        Michael Davis, “Roiling the Waters: Why the Case for Pooling-of-Interests Ac­counting Is All Wet,” Barron’s, October 23, 2000, p. 73.

7.        Bill Alpert, “The Numbers Game,” Barron’s, September 11, 2000, pp. 22, 24.

8.        Floyd Norris, “At Tyco, Accounting ‘Baths’ Begin before the Deals Close,” New York Times, October 29, 1999, p. C1.

9.        Thatcher Thompson, “Navigant: Downgrading NCI Shares,” Merrill Lynch & Co. Research Comment, November 5, 1999.

lang=EN-US style='font-size:8.5pt;line-height:110%'>10.     Barry Henderson, “Number Theory: Navigant’s Growth Rate May Not Be What It Seems,” Barron’s, October 25, 1999, p. 24.

11.       Barry Henderson, “Follow the Money,” Barron’s, November 29, 1999, pp. 15-17.

12.     James P. Miller, “Navigant CEO Resigns, Two Officials Are Fired over Stock­Purchase Deals,” Wall Street Journal, November 23, 1999, p. A4.

13.     A month later, when Navigant announced that it was not for sale, the stock re­ceded to $41.44.

Chapter 11 Profits in Pensions

1.        Gretchen Morgenson noted this contrast between the 1999 IBM and GE annual reports in “What’s Hiding in Big Blue’s Small Print,” New York Times, June 4, 2000, sec. 3, p. 1.

2.        General Electric 1999 Annual Report, p. 42.

3.        Pat McConnell, Janet Pegg, and David Zion, “Retirement Benefits Impact Op­erating Income,” Bear Stearns & Co. September 17, 1999, p. 55.

4.        Vineeta Anand, “SEC Tells Companies to Explain Earnings’ Origin,” Pensions & Investments, December 25, 2000, pp. 4, 43.

Chapter 12 Forecasting Financial Statements

1.        A less restrictive type of covenant merely prohibits incurrence of new debt or payment of dividends that would cause financial measures to deteriorate below a targeted level. No violation o ccurs if, for example, net worth declines as a re­sult of operating losses.

2.        Cabot’s chemical operations sold $20 million of products to the LNG and CMC units during fiscal 1999. In preparing a consolidated statement for Cabot, these intercompany sales were eliminated, in accordance with GAAP. If the accounting rules did not require such elimination, a multidivisional com­pany could create the illusion of dramatic increases in sales and earnings by trading goods back and forth among its various business units. Taking money out of one pocket and putting it into another would not represent a wealth in­crease (income) for the combined enterprise.

3.        Gretchen Morgenson, “Time to Look at Stock Options’ Real Cost,” New York Times, October 21, 2001, Sec. 3, p. 1.

Chapter 13 Credit Analysis

1.        In practice, the United States Bankruptcy Code encourages companies to reor­ganize, rather than simply liquidate, if they become insolvent. Typically, a reor­ganization results in settlement of creditors’ claims via distribution of securities of a firm that has been rehabilitated through forgiveness of a portion of its debt. Determination of the value of securities awarded to each class of creditor is re­lated to asset protection, however, so the analysis that follows applies equally to reorganization and liquidation.

2.        lang=EN-US>The comments on preferred stock in this paragraph also apply generally to pref­erence stock, which is similar to preferred stock in form but junior to it in the capital structure.

3.        In this and subsequent definitions of total capital, minority interest is included. This item should be viewed as equity in leverage calculations because it involves no contractual payment and ranks junior to debt.

4.        Nick Fielding, Richard Thomson, and Larry Black, “Undisclosed Debt Worries Hang over O&Y,” The Independent, May 10, 1992, Business on Sunday Sec­tion, p. 1.

5.        All quotations in the discussion of Viacom, except where otherwise noted, are from Martin S. Fridson, “Crossover Dreams versus Crossover Reality,” This Week in High Yield, published by Merrill Lynch & Co., October 4, 1996, pp. 1-8.

6.        Technically speaking, the effective tax rate is somewhat manageable, even though the statutory rate is not. It is nevertheless useful to calculate the operat­ing margin separately from the pretax margin, to measure management’s oper­ating prowess separately from its financial acumen.

7.        See Edward I. Altman, Robert G. Haldeman, and Paul Narayanan, “Zeta Analysis: A New Model to Identify Bankruptcy Risk of Corporations,” Journal of Banking and Finance, June 1977, pp. 29-54.

8.        See, for example, David T. Hamilton, Greg Gupton, and Alexandra Berthault, Default and Recovery Rates of Corporate Bond Issuers: 2000, Moody’s In­vestors Service, February 2001. The tables in this report relating ratings to mul­tiyear, cumulative default rates show just one small discrepancy. According to the statistics, companies rated AA are more prone to default within one year than companies rated A, an aberration undoubtedly attributable to the tiny

sample of companies that have ever fallen from such high ratings to default within the space of a year.

9.        Altman, Haldeman, and Narayanan set the Zeta model’s cutoff score (the level at which a loan request is rejected on grounds of excessive default risk) with an explicit goal of achieving the optimal tradeoff between the costs of making loans that default and rejecting loans that do not default.

10.     The 2000 Bankruptcy Yearbook & Almanac, Christopher M. McHugh, ed. (Boston: New Generation Research, Inc., 2000), pp. 187-190.

Chapter 14 Equity Analysis

1.        Dividends, unlike interest payments on debt, are payable at the discretion of the board of directors, rather than in fulfillment of a contractual obligation. They are consequently subject to greater variability—through reduction, increase, or suspension—than bond coupons or scheduled principal repayments.

2.        Bethany McLean, “Hocus-Pocus: How IBM Grew 27% a Year,” Fortune, June 26, 2000, p. 165.

3.        The notion that a company can increase its market capitalization by boosting its financial leverage appears to fly in the face of a fundamental tenet of modern finance. Nobel economics laureates Franco Modigliani and Merton Miller demonstrated that under certain critical assumptions, a company’s stock mar­ket value was insensitive to the proportions of debt and equity in its capital structure. Modigliani and Miller followed up on this pioneering work, however, by exploring what happened when the assumptions were relaxed to reflect real- world conditions. In particular, they and subsequent researchers found that the company’s stock market value could in fact rise as a result of boosting financial leverage to take fuller advantage of the tax shield provided by debt. Interest on borrowings is a tax-deductible expense, whereas dividends on stock are not.

4.        Note, however, the uncertainties associated with reserve valuations, discussed in Chapter 2 under the heading “The Value Problem.”