THE PURPOSE OF FINANCIAL REPORTING

Analysts who believe in the inherent reliability of GAAP numbers and the good faith of corporate managers misunderstand the essential nature of fi­nancial reporting.

The primary goal in financial reporting is the dissemination of financial statements that accurately measure the profitability and financial condi­tion of a company.¹

Missing from this formulation is an indication of whose primary goal is accurate measurement. Schilit’s words are music to the ears of the financial statements users listed in this chapter’s first paragraph, but they are not the ones doing the financial reporting. Rather, the issuers are for-profit com­panies, generally organized as corporations.²

A corporation exists for the benefit of its shareholders. Its objective is not to educate the public about its financial condition, but to maximize its shareholders’ wealth. If it so happens that management can advance that objective through “dissemination of financial statements that accurately measure the profitability and financial condition of the company,” then in principle, management should do so. At most, however, reporting financial results in a transparent and straightforward fashion is a means unto an end.

Management may determine that a more direct method of maximizing shareholder wealth is to reduce the corporation’s cost of capital.

The purpose of financial reporting is to obtain cheap capital.

Attentive readers will raise two immediate objections. First, they will say, it is fraudulent to obtain capital at less than a fair rate by presenting an unrealistically bright financial picture. Second, some readers will argue that misleading the users of financial statements is not a sustainable strategy over the long run. Stock market investors who rely on overstated historical profits to project a corporation’s future earnings will find that results fail to meet their expectations. Thereafter, they will adjust for the upward bias in the financial statements by projecting lower earnings than the historical re­sults would otherwise justify. The outcome will be a stock valuation no higher than accurate reporting would have produced. Recognizing that the practice would be self-defeating, corporations will logically refrain from overstating their financial performance.

The inconvenient fact that confounds these arguments is that financial statements do not invariably reflect their issuers’ performance faithfully. In lieu of easily understandable and accurate data, users of financial state­ments often find numbers that conform to GAAP yet convey a misleading impression of profits. Worse yet, outright violations of the accounting rules come to light with distressing frequency. Not even the analyst’s second line of defense, an affirmation by independent auditors that the statements have been prepared in accordance with GAAP, assures that the numbers are reli­able. A few examples from recent years indicate how severely an overly trusting user of financial statements can be misled.

Mercury Plunges

In January 1997, Mercury Finance’s controller was reported to have disap­peared³ after the company reduced its 1996 earnings to $56.7 million from an originally reported $120.7 million. The used-car loan company’s co­founder and chief executive officer, John Brincat, contended that the irregu­larities necessitating the restatements were apparently “the result of unauthorized entries being made to the accounting records of the company by the principal accounting officer,” the missing James A. Doyle.⁴ On Janu­ary 28, the day before the earnings revision, Mercury’s stock closed at $14.875 a share. When trading in the shares reopened on January 31, the price plunged to $2.125.

As the story developed, controller Doyle’s attorney denied that his client had disappeared. Rather, “He decided with the advice of counsel to no longer participate in the charade taking place at Mercury Finance.”⁵ Speak­ing through his lawyer, Doyle added that he was cooperating with a federal investigation of the company.

Thickening the plot was the provision in CEO Brincat’s management contract whereby he was not entitled to any bonus in any year in which earnings per share rose by less than 20%.

Also in February 1998, Mercury announced that it would file for bank­ruptcy. By then, the company had revised its originally reported 1996 profit of $120.7 million to a net loss. In hindsight, the financial statements had in­corporated unrealistic assumptions about the percentage of Mercury’s low- income borrowers who would fail to keep up their loan payments. The auditors had certified the results, despite the telltale warning sign that the statements showed Mercury earning more than double the historical aver­age return on equity (see Chapter 13) of other companies in its business.

Securities analyst Charles Mills of Anderson & Strudwick likened such im­probably superior performance to a human running a two-minute mile.⁷

MicroStrategy Changes Its Mind

On March 20, 2000, MicroStrategy announced that it would restate its 1999 revenue, originally reported as $205.3 million, to around $150 mil­lion. The company’s shares promptly plummeted by $140 to $86.75 a share, slashing chief executive officer Michael Saylor’s paper wealth by over $6 billion. The company explained that the revision had to do with recog­nizing revenue on the software company’s large, complex projects.⁸ Micro­Strategy and its auditors initially suggested that the company had been obliged to restate its results in response to a recent (December 1999) Secu­rities and Exchange Commission (SEC) advisory on rules for booking soft­ware revenues.

Until MicroStrategy dropped its bombshell, the company’s auditors had put their seal of approval on the company’s revenue recognition policies. That was despite questions raised about MicroStrategy’s financials by ac­counting expert Howard Schilit six months earlier and by reporter David Raymond in an issue of Forbes ASAP distributed on February 21.⁹ It was re­portedly only after reading Raymond’s article that an accountant in the au­ditor’s national office contacted the local office that had handled the audit, ultimately causing the firm to retract its previous certification of the 1998 and 1999 financials.¹⁰

No Straight Talk from Lernout & Hauspie

On November 16, 2000, the auditor for Lernout & Hauspie Speech Prod­ucts (L&H) withdrew its clean opinion of the company’s 1998 and 1999 fi­nancials. The action followed a November 9 announcement by the Belgian producer of speech-recognition and translation software that an internal in­vestigation had uncovered accounting errors and irregularities that would require restatement of results for those two years and the first half of 2000. Two weeks later, the company filed for bankruptcy.

Prior to November 16, 2000, while investors were relying on the audi­tor’s opinion that Lernout & Hauspie’s financial statements were consis­tent with generally accepted accounting principles, several events cast doubt on that opinion. In July 1999, short-seller David Rocker criticized transactions such as L&H’s arrangement with Brussels Translation Group (BTG). Over a two-year period, BTG paid L&H $35 million to develop translation software. L&H then bought BTG and the translation product along with it. The net effect was that instead of booking a $35 million re­search and development expense, L&H recognized $35 million of rev- enue.¹1 In August 2000, certain Korean companies that L&H claimed as customers said that they in fact did no business with the corporation. In September, the Securities and Exchange Commission and Europe’s Easdaq stock market began to investigate L&H’s accounting practices.¹² Along the way, Lernout & Hauspie’s stock fell from a high of $72.50 in March 2000 to $7 before being suspended from trading in November. In retrospect, un­critical reliance on the company’s financials, based on the auditor’s opinion and a presumption that management wanted to help analysts get the true picture, was a bad policy.