Winning Investors Over. Baruch Lev
meager 2001 growth, however, was enabled by a process dubbed internally as “holding disconnects.” This original “growth strategy” was surprisingly simple. Facing an increasing number of customers switching to satellite television and otherwise delinquent or terminating customers, Charter responded by—doing nothing, that is, retaining the deserting customers. This, says the SEC, enabled Charter to pretend that, in 2001, “it was meeting and, at times, exceeding analysts’ expectations for subscriber growth when, in fact, Charter actually experienced flat to negative growth.”22 Whereas the “holding the disconnects” policy took care of the pretense of subscriber growth, Charter also needed to show revenue growth—“show me the money.” This was facilitated by fictitious barter transactions. Charter entered into agreements with set-top box providers adding $20 to the price of a box, and in return the box providers purchased $20 in advertising from Charter, which was duly recorded as revenues to the tune of $17 million in the fourth quarter of 2000. In fact, says the SEC, “no real revenue was generated by these transactions.”23
This scheme highlights yet another aspect of manipulations that makes them unsustainable: manipulating one performance indicator—in this case, subscriber growth—generally requires doctoring other indicators, such as revenue growth.
CMS Energy: Brag-a-Watts
CMS Energy, an integrated energy company, overstated its revenues in 2000 and 2001 by $1.0 billion (10 percent of revenues) and $4.2 billion (36 percent of revenues), respectively.24 This manipulation, however, didn’t affect earnings because it entailed round-trip trades with counterparties, simultaneously purchasing and selling electric power or natural gas in identical volumes and prices, with no deliveries in sight. The purpose of these sham transactions, which were quite popular in the late 1990s and early 2000s in the energy sector, was, according to the SEC, “to elevate MS & T [CMS’s trading division] into the top-20 tier (“top 20”) of the industry publication volume ranking,” expecting that the top-tier status would enhance CMS’s business. As in the Coca-Cola case, the end-of-day contrition was halfhearted. When CMS’s revenues were restated downward on March 29, 2002, to eliminate the effect of the round-trip trades, the explanation CMS gave investors was materially misleading, according to the SEC, because it did not state that the transactions causing the restatement—dubbed in the industry as “brag-a-watts”—lacked economic substance. Nor was the full magnitude of the round-trip transactions—$5.2 billion—properly disclosed.
Both the Charter and CMS cases demonstrate the wide range of manipulated items in addition to earnings and sales, like subscriber growth or oil reserves,25 and the varied target audiences, like customers and suppliers, in addition to investors.
Daisytek International: Driving Miss Daisy to Bankruptcy
Daisytek, a distributor of office products and computer supplies, engaged in an elaborate manipulation of earnings from 2001 to 2003, according to the SEC.26 The company regularly released earnings forecasts it could not meet and made the numbers by a practice euphemistically called “booking to budget.” This, stripped to its essence, meant recording fictitious “budgeted” revenues and expenses instead of the actual numbers. At the end of each quarter, the increasing gaps between real and booked (budgeted) amounts were bridged by income from vendors’ allowances and rebates granted on large inventory purchases Daisy had made.27 The vendor allowances recorded as income were substantial, often exceeding reported earnings, such as in 2002, when Daisytek reported net income of $10.85 million, while vendor allowances were $22 million. Reported earnings were thus significantly inflated by rebates from the acquisition of unnecessary, often obsolete inventory.
Not surprisingly, inventory levels at Daisytek spiraled: $83.6 million, $115.4 million, and $190.7 million at the end of 2001, 2002, and the first nine months of 2003, respectively. Total revenues for the corresponding periods rose only slightly: $1.01 billion, $1.19 billion, and $1.33 billion. Throughout, Daisytek assured investors that “Our purchases of inventory generally are closely tied to sales.” As an aside, since both inventories and sales figures were publicly reported and prominently displayed, one wonders about the gullibility of investors and analysts who failed to realize the increasing misalignment between Daisytek’s inventories and sales. Ultimately, the large inventory purchases, often of hard-to-sell items, had a devastating effect on the company’s liquidity and operations, leading suppliers to place it on a credit hold, until it mercifully filed for Chapter 11 in May 2003.
Daisytek’s schemes, aimed at meeting its own performance forecasts, demonstrate the recklessness and shortsightedness of some managers, willing to mortally hurt the company—purchasing large quantities of unneeded, obsolete inventory—to temporarily mask a deteriorating business, and even paying taxes on fictitious income. Daisytek’s managers apparently believed that they were immune to detection because they manipulated earnings by real actions—excess inventory purchases—rather than by twisting accounting rules. Managing earnings by actions like R & D cuts or deeply discounted sales, some managers believe, is safer than by misapplying accounting techniques, because business decisions are rarely second guessed.28 Earnings manipulation by actions, however, is often more costly than by accounting means, as clearly demonstrated by Daisytek’s bankruptcy.
Made in America?
Finally, lest you think from the previous cases that information manipulation is made in the United States, thirty countries, mostly developed, suffer from more acute cases of manipulitis (see figure 3-1). The researchers producing the graph in the figure, Christian Leuz, Dhananjay Nanda, and Peter Wysocki, developed an earnings manipulation score that reflects various characteristics of managed earnings, such as high volatility relative to cash flows (managed earnings deviate from cash flows more than truthful earnings) and loss avoidance (managed earnings frequently transform small losses to profits).29 By this score, earnings management is, surprisingly, less prevalent in the United States than in other countries, including Switzerland, Denmark, Germany, Japan, and the United Kingdom. Nor are manipulations by large companies restricted to the United States. Royal Dutch Shell (U.K. and the Netherlands); Parmalat (Italy); Nortel (Canada); Nikko Cordial, Sanyo Electric, and Livedoor (Japan); Bawag Bank (Austria); and Ahold (the Netherlands)—a very partial list of sizeable offenders—attest to the globalization of information manipulation. And yet, not being the worst offender is, of course, hardly a consolation for Americans.
FIGURE 3-1
Earnings management around the world
AGGREGATE EARNINGS MANAGEMENT SCORE
Source: Christian Leuz, Dhananjay Nanda, and Peter Wysocki, “Earnings management and investor protection: An international comparison,” working paper, Wharton School of the University of Pennsylvania, 2002.
Why They Do It?
Why do managers manipulate financial information? There are numerous reasons for such a complex, widespread phenomenon. Enhancing managers’ compensation, which is frequently based on reported performance (earnings, sales) as well as on stock price changes—which in turn are affected by corporate performance—is a frequent manipulation motive.30 Others include thwarting proxy contests or activist shareholders by a pretense of improved performance; inflating share prices for larger takes at IPOs and secondary stock issues; avoiding violation of loan covenants; or deflecting regulatory (e.g., antitrust) interventions.31 The wide array of incentives to manipulate financial information as well as the items manipulated arise from the varied uses of this information in contractual arrangements between the company and its employees (to determine bonuses), lenders (loan covenant violations), patent licensees (royalty amounts), and other stakeholders.
But, as the cases show, the major objective of information manipulation is undoubtedly to obscure from investors the deterioration in the company’s operations or in its financial condition, thereby preserving managers’ jobs and reputations. Thus, Gateway embellished its