Fun with Accounting Games

I've had a very busy and exciting couple of weeks. Two weeks ago was probably the most diverse week of activities I've had in a while, filled with a handful of world-renowned speakers. I hope to get through my backlog of blog posts as soon as I can (I don't remember the last time I had a backlog -- usually I'm struggling with some writer's block).This post covers some accounting-related lessons I learned in my finance and entertainment classes (strangely enough). The outlook is somewhat pessimistic but boils down to ethical principles of honesty in company accounting and valuation.

1. Channel stuffing: This refers to a practice of giving inventory to distributors/retailers and counting the transfer as "sales" even though the inventory has not yet been sold to end-consumers and not paid for by the retailers. It can inflate a company's sales by making them seem to come earlier and more regularly, but it does not present an accurate picture of a company's financial condition.
   
   There are a number of reasons that a company would do this, intentionally/fraudulently and unintentionally. An "unintentional"/ethically-sound reason would be if they had no way to accurately track sales in the field. However, in the modern era with many sophisticated inventory-tracking systems, I see no excuse for companies not to track sales carefully and exactly.
   
   
2. Window dressing: This refers to a practice of displaying financials that make the company look good but which mask underlying problems. The issue stems from the fact that balance sheets are just a snapshot of one day in time, so a company can just make that one day's ending balances look like it wants and proceed to have a completely different looking balance sheet the rest of the month/quarter/year that no one's looking. Banks and regulated institutions have been known to do this when they face  specific requirements that are discretely timed rather than continuous  in nature (such as having quarter-end balances of cash be some specific minimum, etc.). This is why it's important to inquire about average daily balances and look into overall activity to better ascertain a company's true financial condition. The only real way to regulate this correctly would be to have all requirements be continuous in nature and for all bank and brokerage accounts to be directly monitored by the SEC rather than self-reported and audited.
   
   
3. The Five Main Accounting Games: Because there is no concrete law about how accounting should be done and only IRS and GAAP rules that are often vague, there are many common games people play. My entertainment law/finance professor taught us the five most popular games that studios use to trick film investors out of all their "net profits," but the lessons apply to all other types of companies as well; it was eye opening to learn these tricks and understand how to spot them and protect against them. The reason people play these games in public companies is to appeal to what analysts look for: short term profits and a debt ratio. It is sad that longer-term profits are not the focus and are often destroyed through some of these games and resulting transactions.
   
   A. Acceleration: This refers to booking the present value of future earnings now, even if they will be earned over time in the future (and even if they are uncertain). For example, selling property for a note to pay it later (which is never paid) or loaning out money which is immediately repaid (as cash from operations). This will increase gross income, even if at a long-term loss, which makes analysts happy. The film industry even has specific accounting rules and accommodations that make accelerating future licensing payments to present value as if earned "now" completely acceptable. This is really concerning.
   
   B. Capitalization: This refers to spreading out an expense over time (as a capital asset) in order to increase current income and increase the assets on the balance sheet (and lower the debt ratio). Because companies can keep totally separate books for tax purposes, they can capitalize expenses to show high income and expense the same items to lower their tax liabilities. This strikes me as so unfair and manipulative but apparently is completely kosher.
   
   C. Deferring write-downs on assets: Film companies and banks hate to mark to market bad loans or bad films, so why do it at all? If they just keep them at cost on the balance sheet, they can keep their assets and income high.
   
   D. Extraordinary loss: If they're forced to write down losses, they can just do it as extraordinary losses that don't hit the income statement and just affect the balance sheet. Though there may be legitimate reasons to use extraordinary losses, this category can clearly be manipulated and overused.
   
   E. Consolidation: Companies can consolidate into their financials the financials of subsidiaries they own, but they can do this selectively based on which subsidiaries have the performance they're looking for. Because the rules behind consolidation are loose and involve having control of a subsidiary, the parent company can quickly change the subsidiary's control and ownership structure to achieve the consolidation it wants based on the subsidiary's performance.
   
   
4. Problems with the current system of auditors: Because of the above problems with accounting statements, it would seem like the solution would be to have auditors find and publicize these manipulations. However, companies currently choose and pay for their own auditors, which clearly presents deep conflicts of interest and problems of adverse selection. Though I have heard from auditors that "shopping for opinions" is rare, I have learned that it does happen, and because auditors want to keep their clients happy, they are likely to accommodate their clients, especially in the gray areas of accounting. I'm not even mentioning the problems inherent with owning your own accounting and auditing firm, like Madoff did.
   
   My professor suggested that a solution to this would be mandatory, regular, random cycling of auditors that is regulated and managed by the SEC so that companies cannot choose or sway their auditors. This seems like an ideal solution to me but one that would be hard to implement as it would need SEC, company, and auditor buy-in, two of which would likely be heavily against it.
   
   
5. Valuing at dividends: Because of the problems inherent with financial statements and the myopic view of Wall Street analysts, how can investors value companies? One of my professors explained that in the "olden days," people would do this purely on what they could see and feel with their own senses, meaning cash dividends. If we valued companies purely on the dividends they actually paid (instead of "expected" to pay), we could quickly derive some minimal value for the firm. Though discounted cash flow analysis is the standard method used to value a company, it is flawed because it depends on using a company's financial statements and modeling what dividends it may one day pay in the future. The valuation of only dividends may cause companies that never pay dividends (such as some growing tech companies) to be considered worthless (which may fundamentally be the case, since the only reason to invest in them is the "greater fool theory" of buying the stock cheap and selling it later more expensively). This may appear problematic, but there is something inherently appealing to me of a simple, direct, no-nonsense and skeptical method of valuing a company by its paid dividends.