Recent accounting scandals have brought to the fore the numerous ways in which a company’s economic performance and true financial condition may differ significantly from what is portrayed in its financial statements. Abuses have ranged from the very mundane – such as the capitalization of operating expenses by WorldCom – to cases involving complex structured financings that exploit arcane accounting rules to circumvent the ordinary reporting of liabilities.
Equity and credit analysts, increasingly, are severely disadvantaged if they do not possess an intimate familiarity with the techniques and devices that may be used, among other objectives, to enhance reported earnings, improve the leverage ratio, or “recharacterize” – and disguise – the financial risks undertaken by companies. In some cases the disclosure has been legal but misleading, while in others it has involved outright fraud; but in all cases, familiarity by analysts with the techniques in question would have prepared them to evaluate the company’s condition with greater accuracy.
This 4-day course is split into two parts: the first half, taught by Andrew Regan, focuses on assessing the quality of corporate earnings and how accounting decisions can distort reported presentations of underlying economic performance; the second part, taught by Oussama Nasr, examines various techniques involving securitizations, structured finance and derivatives that have been used by companies, governments and financial institutions to achieve one or more of the benefits described above. The course concludes by attempting to anticipate future fiascoes for which there are no precedents yet.
Participants will gain improved abilities to anticipate broader market recognition of divergences between reported financial performance and financial condition on the one hand, and true economic realities on the other. Such capacities should improve investment decision-making and credit assessment.
EARNINGS QUALITY ANALYSIS
The first portion of the workshop will focus on the earnings and valuation impacts of accounting decisions. Key issues in assessing the quality of a firm’s earnings will be highlighted, including:
- Revenue recognition policies, including affiliated unit transactions
- Recurring “non-recurring” items
- Pro-forma earnings reporting
- Treatment of customer acquisition costs
- “Gain-on-sale” treatment
- Real cost of options grants
- Venture investments
- In-process R&D
- Revenue allocation among activities
- “Spring-loading” of acquisitions
- “Cookie jar” reserves
- Comparison of reported income to operating cash flow
- Role of barter transactions in revenue
- Accuracy of Volume/Activity Measures (e.g. subscriber counts)
- “Earnings management”/”smoothing”
- Materiality
- Role of unrealized, non-cash gains
- Role of pension fund income and assumed rates of return
- Capitalization vs. expensing of operating costs
RELATIONSHIP BETWEEN THE BALANCE SHEET AND REPORTED REVENUES
The relationship between a firm’s balance sheet and its reported revenues will be examined, with related earnings impacts:
- Accounts receivable policies and levels
- Distinctions between non-operating liabilities and operating liabilities (e.g. magazine subscriptions)
- Inventory accounting and channel “stuffing”/”loading”
- Vendor financing of customer purchases, especially of large ticket items
- Off-balance sheet partnerships and vehicules
- Lease accounting
- Options impacts
- “Estimated Fair Value” determination in mark-to-market reporting
- Rapid purchase and sale of assets
ECONOMIC VS. ACCOUNTING PERFORMANCE: FIVE KEY REPORTING DIMENSIONS
Finally, a short framework for distinguishing between a firm’s periodic accounting income performance and its sustainable, forward-looking economic prospects will be offered:
- Accounts receivable, inventories vs. revenues
- Positive EBITDA vs. negative operating cashflow
- Segmental returns as a barometer of risk and sustainability
- Non-recurring charges
- Related party transactions
- All points will be illustrated with real-world case firm situations.
Securitization, Structured Finance and Exotic Derivatives
The second portion of the workshop will focus on the techniques available to companies, banks and sovereigns to reduce their reported leverage and improve other financial ratios. The first part of this portion focuses on the use of securitization and structured finance techniques, including:
- Securitization and recharacterization of borrowings as asset sales
- Enhancing capital ratios through securitization
- Implicit recourse in asset sales
- Investing in mezzanine tranches of structured financings
- Using prepaid sale contracts involving commodities and other assets to raise funds
- Embedding options in structured notes or borrowings
- Use of senior/subordinated SPV structure to hide currency risk of investments
- Use of unconsolidated partnerships
The second part of this portion will revolve around the potential abuse of derivatives instruments and techniques, especially equity and credit derivatives: Examples of this will include:
- Synthetic share and debt buybacks
- Creative capital instruments and debt-equity hybrids
- Circumventing investment restrictions with derivatives
- Covenant avoidance using derivatives and structured financings
- Using off-market derivatives to defer losses or accelerate gains
- Using off-market derivatives to reduce budget deficit
- Using off-market derivatives to disguise leverage
- Creating phantom capital with credit derivatives
- Self-referenced credit derivatives
- Improving ratios with total return swaps
- Setting derivatives with company’s own shares
- Derivatives that accelerate or knock-out upon company’s downgrade
Again, the course will make extensive use of case studies and authentic transactions.