Start with an investment company, which in turn has controlling shares of four more holding companies. These, in turn, have controlling shares in still other holding companies and ultimately control 240 utility companies. Exempt from most regulatory scrutiny, the holding companies and their subsidiaries manufacture profits by marking up stated values of properties and selling properties from one company to the other and booking those profits — until the stock market plummets, bringing the pyramid scheme crashing down, and ruining thousands of investors.
A nightmare devised after reading one-too-many stories about the fall of Enron Corp.? No. A description of the real-life swelling and collapse of Insull Utility Investments more than 70 years ago and an illustration that greed and fraudulent accounting are nothing new in the business world, according to James Van Horne, the A. P. Giannini Professor of Banking and Finance at Stanford Graduate School of Business.
While regulatory bodies such as the Securities and Exchange Commission were created in the 1930s to put an end to pyramid schemes like Insull, companies continue to evolve accounting tricks that result in income statements that conceal as much as they reveal — particularly during the past 20 years, Van Horne says. "There's been a steady decline in the earnings statement's relevance," he says.
While most of the media and public's attention has been on the allegedly fraudulent accounting and business practices of Enron Corp. — whose collapse Van Horne describes as "the neutron bomb of accounting", — Van Horne says that the problems with income statements go far beyond such egregious examples. "Even without fraud, the financial statement can be misleading."
Van Horne outlines several methods used by corporations to make themselves look more profitable to investors. Pro forma earnings, in which supposedly one-time write-offs and charges are excluded from profit calculations, are intended to give securities analysts and investors a sense of a company's future value but actually can be used to distort it, according to Van Horne. There is no consistent standard used to determine pro forma earnings, and some companies report supposedly one-time write-offs and charges year after year. "Pro forma earnings statements allow companies to determine what they think should matter to investors, not necessarily what investors think is best," he says.
Another dubious accounting practice involves abuses in revenue recognition. To hit sales projections, a company may slash prices and cut deals at the end of the quarter to make the revenue stream look healthier than it actually is. Even dicier is the habit of some companies of off-loading products to dealers, with no underlying retail demand, and then recording those shipments as sales. "Beware of cash-flow illusions," Van Horne says.
Calendar games are also played. A company will ship its product on Dec. 31 and record the sale for the year just ending. The company that receives it after the new year will record the purchase, however, for the following year. Another accounting game is to change the date something is produced to the new year and then record the change as an increase in productivity for that year — something that was done with one phone company's business directory pages, says Van Horne. When the publication date of the business directory pages was moved from January to December, the phone company reported it had increased the number of directories published.
Last, but not least, are the special-purpose corporations, not-quite wholly owned subsidiaries of corporations that were made notorious by Enron. Van Horne points out Enron has plenty of company. "It's not just Enron," he says. " A lot of companies that have never been questioned use them — you essentially hide debt and do not have to show depreciation on assets."
If income statements are suspect, how does an investor analyze a company's financial health? Van Horne suggests being wary of the following: an increasing debt ratio; recurring write-offs; multibusiness companies that aggregate sub-businesses to hide information; and unusual quarterly patterns and expenses.
He also suggests scrutinizing footnotes: "When something is rotten, the odor sometimes wafts through the footnotes," he says.
Nonetheless, he acknowledges that even intense scrutiny of financial statements is of limited use if fraud is being committed. "When a company's management conspires to cheat and its outside auditors are lax, it's hard for outsiders to detect problems," Van Horne says.
Instead of looking to income statements to determine a company's true worth, Van Horne recommends paying careful attention to the balance sheet. "In the final analysis, one must turn to an in-depth evaluation of the flow of funds through the balance sheet."
"This involves the conversion of inventories into revenues, then into receivables, and finally into cash. On the other side of the balance sheet, the conversion of purchase orders into accounts payable, and then into the payment of accounts payable, and, ultimately, debit to cash. The combination of these two conversion cycles gives us the overall operating cash cycle of a company."
Van Horne's remarks were made as part of the Last Lecture Series, a student-sponsored spring event designed to permit students to hear lectures by a group of top professors. Students were able to earn course credit for attending the entire series of lectures.
Book and article recommendations:
Professor Van Horne drew his account of Insull Utility Investments from Frederick Lewis Allen's Lords of Creation, New York, London: Harper & Brothers, 1935.
Professor Van Horne also recommends the following articles:
How to Predict the Next Fiasco in Accounting and Bail Early, Heard on the Street column, The Wall Street Journal, Jan. 24, 2002
Creative Accounting Dot-Com, The Wall Street Journal, July 24, 2000
Deciphering the Black Box,The Wall Street Journal, Jan. 22, 2002.