|
Is There an Opposite
of Enron and WorldCom? ………. Yes, Privately-Held Companies
Are Sometimes Stronger Than They Appear
In our last newsletter, we examined the weaknesses inherent
in audited financial statements. The context was Enron and
the vast overstatement of earnings that preceded that company's
downfall last year. In light of Enron and now WorldCom, another
example of public company financial fraud that has recently
been in the news, we thought it would be interesting to look
at situations that involve the exact opposite of those companies,
i.e. where financial statements understate the true earnings
of a business. In the article that follows, we will discuss
this subject in more detail.
- Who is the audience for a company's financial statements?
The first question to ask when reviewing financial statements
is this: Who is the audience for the statements? Publicly-held
companies such as Enron and WorldCom prepare financial statements
primarily for the investing public. As public companies,
they have as their overriding objective a desire to increase
the price of their stock. This is not to say that financials
of public companies are always prepared with the aim of
increasing the price of a company's stock. Financials of
public companies should and very often are prepared with
the objective of simply describing the financial performance
of the business, a relatively straightforward factual presentation.
However, as we discussed in our last newsletter, the large
amount of gray area in accounting rules gives companies
a measure of flexibility that is sometimes used, as it was
at Enron, to overstate the performance of a business. This
is why you almost never hear of a public company vastly
understating its earnings.
When a privately-held company prepares its financials, who
is the audience? Very often a privately-held company prepares
its financials with an eye on the IRS. And because of this,
those gray areas of the accounting world that can be used
by public companies to inflate their earnings can also be
used by privately-held companies to deflate their earnings,
leaving as little as possible for the tax man.
- When a privately-held company is for sale, it will
face a new audience for its financial statements.
When a privately-held company decides to consider a divestiture,
it will face a new audience for its financial statements
-- the prospective buyer. All those years of financial statements
that were prepared with an eye on keeping taxes to a minimum
are no longer relevant, and in fact are counterproductive
since the owner's desire is to maximize the value of the
company on a sale. The situation is a very common one, and
those in the business of acquisitions and divestitures are
used to seeing or preparing "recast" financials of privately-held
companies for sale. A privately-held company that is considering
a sale must take a close look at its historical financials
and restate or "recast" them in a way to show the true earnings
of the business.
- Examples
- Owners' Compensation -- The salary and bonus taken
by an owner or owners of a privately-held business can often
be significantly higher than the compensation that would
be paid if that person were the employee of a prospective
buyer or if the buyer replaces the owner with a new employee.
It is therefore very common to restate the compensation
expense of a selling company to reflect this lower level
of compensation.
- Compensation to Family Members -- Another area
that is often subject to restatement is the compensation
paid to family members of the owner or owners. Here again,
these expenses are often reduced in a restatement to reflect
what the potential buyer will likely incur if it acquired
the business.
- Perqs/Benefits -- There are many types of perqs
and benefits that a privately-held company provides that
are often subject to restatement because a buyer of the
business will probably not continue with them. Company cars,
generous pension, medical and life insurance plans, season
tickets to local sporting or cultural events, etc. are just
a few of the many kinds of these expenses that are often
not relevant to a potential buyer and therefore are eliminated
when presenting a seller's financials.
- Capital Spending or Operating Expense? -- One of
the major elements of fraud at WorldCom involved the improper
classification of operating expenses as capital spending.
As a public company trying to inflate its earnings, this
has the desired effect in the short term. With privately
held companies you often see the opposite, i.e. spending
that is classified as an operating cost rather than a capital
cost in order to minimize earnings subject to tax. While
it appears that WorldCom went far beyond the gray area that
is allowed here, you can expect the privately-held company
to use as much of the gray area as possible to minimize
earnings, and so sometimes a restatement is in order to
more accurately portray the operation of the business (although
this is not relevant if you evaluate a company strictly
on a cash basis).
- Inventory Valuation -- Accounting rules give a
certain amount of flexibility when valuing inventory. A
lower ending inventory valuation will increase a business'
cost of goods sold and therefore decrease its taxable income.
This may sometimes be used by a privately-held company as
a means to limit taxable income, but the problem an owner
faces is that this year's lower inventory figure becomes
next years' beginning inventory figure, thus having the
opposite effect on income in this subsequent year.
In the context of an acquisition or divestiture of a business,
the financial statements of a selling entity can be vastly
different from one deal to the next, depending on whether
the entity being sold is a public company or a privately-held
company. In all cases, care must be taken to understand who
the audience is for the financials of the seller, and any
evaluation of such statements must be guided accordingly.
|
