Archive: Forensic Accounting

DAL: Delta Looks Better When You Don’t Look Too Closely

This article was originally published at RealMoney on September 17, 2007.

When I saw out-of-the-money calls Delta Airlines (DAL) on StockPickr’s stocks with heavy option volume my first thought was that it must have been one of the short squeeze airline plays also mentioned on StockPickr. Nope. So that got me thinking. I typically don’t want to touch airlines with a 10-foot pole, but they do make for the occasional good trade. Is this one of those occasions?

For me, even a speculative trade has to have something underneath it for support. At first glance, it looks like Delta has that. 2008 EPS estimates are at $1.80 and have been marching up steadily, now giving the company a single-digit P/E multiple. Price/Book is also low, but only because they exited bankruptcy with a load of goodwill on the balance sheet. Excluding that, the book value is negative. They have a fair amount of cash, but plenty of near-term liabilities on which to spend it. All in, their total net debt is more than $5 billion, resulting in an enterprise value of $9.7 billion. If they keep generating the cash flow they did during the first half of 2007, the double-digit free cash flow yield could be enticing.

The problem with those valuations, though, is that they rely on the accounting numbers on the face of the financial statements. The last 10Q disclosed that after the June 30 financial statement dates but before July 31, the company issued another $66 million in debt and paid $303 million cash to terminate pension plans and settle some other obligations. Then, on August 28 they were required to issue $650 million in debt to their pilots in exchange for salary concessions they had made. The company has settled $11.4 billion of bankruptcy claims by issuing common stock, but “currently estimate that the total allowed general, unsecured claims in our Chapter 11 proceedings will be approximately $15 billion, including claims with respect to which we have issued or commenced distributions of common stock.” That means that another $3.6 billion are not yet on the books, even assuming their estimate is correct. That brings the enterprise value to $14.3 billion, and the free cash flow yield below 7%. Who knows how many shares will have to be issued to settle the claims, so I won’t even talk about the P/E.

What’s more, airlines are notorious for off-balance sheet and other obligations. Delta has 136 aircraft under operating leases, which make up about a quarter of its fleet but do not appear on the balance sheet. If these were treated as company-owned aircraft, the assets and liabilities would each increase by about $3.5 billion (assuming the leased aircraft are worth about as much, on average, as those that are owned.) Now we’re down to a 5.4% yield on an adjusted enterprise valuation of $18.8 billion.

How quickly we get from something that looks enticing to something that looks like it came out of bankruptcy five months ago. Which, of course, it did. Bottom line, if you want to take a flier on an airline, I’d stick with one of the short squeeze plays. The majors still look like they can cause a major league stomachache.

Topics: Airline, Delta Air Lines (DAL), Forensic Accounting, Fundies, Stock Market, Transportation | 1 Comment

KLAC: KLA-Tencor Case Study in Income Statement Adjustments for Pension Accounting

Pension accounting rules permit certain expense items to be smoothed into income. However, the required disclosures allow investors to adjust the income statement to reflect the true underlying economic cost related to pension plans. The economic cost should equal any change in the plan liability other than benefits paid or employer contributions.

Consider the following pension disclosures from KLA-Tencor’s 10K.

KLAC pension disclosures

The pension obligation increases by 4,175, and benefits paid of $1,519 should be added back to that amount to determine the underlying economic change in obligation. 4,175 + 1,519 = 5,694.

The fair value of assets rose by $1,255. The contributions and benefit payments were a net $789 which should be deducted from this. Notice that in this case the benefits paid figure differs between the asset side and the liability side. It is possible some benefits were paid as a lump sum settlement. At any rate, the net change in assets was 1,255 – 789 = 466.

The net change in the economic liability, then, was 5,694 – 466 = 5,228. Contrast that with the reported pension expense.

klacpensionexpense.jpg

The economic change in the value of the pension was $5,228, but the income statement showed an expense of just $2,280. An investor might want to adjust the income statement by adding $2,948 to pension expense, reducing operating income by the same amount. The effect on net income would be smaller due to the tax effects.

For KLA-Tencor, reported operating income was 589,868 in 2007. After this adjustment it would have been$586,920 – approximately half a percent lower. Earnings per share for the year would have been at least a penny lower. In this case, I wouldn’t consider the difference material.

Topics: Forensic Accounting, Investing 101, KLA-Tencor (KLAC), Stock Market | No Comments

ADBE: Adobe’s Pride in its Headquarters Building Doesn’t Extend to the Balance Sheet

Design software maker Adobe Systems (ADBE) is rightly proud of its headquarters building, which it lauded last December in a press release:

Adobe Systems Incorporated today announced the U.S. Green Building Council (USGBC) has awarded Leadership in Energy and Environmental Design-Existing Building (LEED®) Platinum certifications for Adobe’s East and Almaden headquarters towers in downtown San Jose, distinguishing Adobe as the world’s first commercial enterprise to achieve a total of three Platinum certifications under the LEED program.

However, the pride in its building is more muted when it comes to showing the property and its associated debt on the balance sheet, as disclosed in a recent SEC filing:

On March 26, 2007, Adobe Systems Incorporated (the “Company”) renewed its lease arrangement for one of three buildings the Company occupies as part of its corporate headquarters, known as the Almaden Tower, located in San Jose, California (the “Property”).

Pursuant to a lease agreement (the “Lease”), dated March 26, 2007, between the Company as Lessee and SELCO Service Corporation as Lessor, the Company has leased the Property for a new five year term that extends to March 26, 2012, with an option to extend for an additional five years at the Company’s sole discretion. Rent payments under the Lease are a function of LIBOR; payments for the initial term are currently estimated to be $29.7 million. The Company has the option to purchase the Property at any time during the term of the Lease for approximately $103.6 million. The maximum recourse amount (or residual value guarantee) under this obligation is approximately $89.5 million. The Lease will continue to qualify for operating lease treatment under Statement of Financial Accounting Standards No. 13, “Accounting for Leases,” and as such, the Property and related obligations will not be included on the Company’s consolidated balance sheet.

With a value of $104 million and annual lease payments of approximately $6 million, the payments do not appear all that different from those the company would pay in a mortgage. It’s not like Adobe needs creative financing arrangements, either. With $2.2 billion in cash and short-term investments as of December, they could buy 20 such buildings without taking out a mortgage against any of them. We’re actually more concerned that management is spending time drafting arrangements like this than we are about the arrangement itself. But that’s not the least of it:

As part of the financing of the Lease, the Company purchased a portion of the Lessor’s receivable under the Lease for approximately $80.4 million, which will be recorded as an investment in lease receivable on the Company’s consolidated balance sheet for the quarter ended June 1, 2007. This purchase may be credited against the purchase price if the Company purchases the Property, or may be repaid from the sale proceeds if the Property is sold to a third party.

So rather than carrying the property on the balance sheet and taking a charge for depreciation and interest expense, the company keeps it off the balance sheet and pays rent. With the investment in the lease receivable, it makes us wonder why they even bothered.

Topics: Adobe Systems (ADBE), Forensic Accounting, Fundies, Investing 101, Stock Market | No Comments

XRX: Xerox and the Spirit of Honest Debate

In response to our somewhat heated reaction to Xerox’ (XRX) earnings report, a Xerox employee submitted a comment outlining the Xerox perspective. Since the company appears to be interested in fostering an honest debate, we encourage investors to consider their side of the story as well as our own. Of course, Xerox has presented their side in press releases, conference calls and investor conferences already, but there is certainly no harm in seeing it again here. So we present the comment, along with our response, as this article.

Warning: This is a long article. For those who lack the patience to read it all, our key points are:

  1. Xerox should insist that analysts and First Call base their estimates on Generally Accepted Accounting Principles, rather than adjusting them for “one-time” charges that occur every year.
  2. Whether due to price competition or slower unit sales, we don’t believe the negative constant-currency growth in equipment revenue says good things about the company’s future prospects.
  3. Enough with the light-lens to digital transformation story, already. We’ve been waiting for the growth businesses to offset the declining businesses for four years and are beginning to doubt it will ever happen.
  4. Key financial metrics have been flat to declining for several years.
  5. The company appears to be wasting money on share repurchases, because the share count keeps going up despite $1.5 billion in share buybacks.

Enough of the summary, here’s the beef. More »

Topics: Forensic Accounting, Stock Market, Xerox (XRX) | 3 Comments

Plantronics (PLT) and Oracle (ORCL) Scratch Each Other’s Backs

We’d venture to guess that not too many people follow both small-cap headset maker Plantronics (PLT) and large-cap enterprise software vendor Oracle (ORCL.) We do, which is probably the only reason we noticed this little gem. Both companies recently issued remarkably similar press releases, each extolling the other’s virtues.

Oracle Standardizes on Plantronics Wireless Headset Systems to Optimize VoIP Communications

“We evaluated numerous headset offerings to complement Oracle’s VoIP deployment, and the Plantronics Voyager 510-USB is clearly ahead of the pack for audio performance, ease of use and style and comfort,” said Mark Sunday, Senior Vice President and CIO, Oracle. “We are also very impressed with Voyager’s performance with Oracle Collaboration Suite. Now employees have a single wireless headset for all of their voice and data communications.”

Plantronics Standardizes Global Operations on Oracle(R) … – Yahoo! News (press release)

“We get a great deal of value and cost savings out of the Oracle system,” said Plantronics Vice President of Finance and Worldwide Corporate Controller Susan Fox. “The external auditors we work with have experience using the Oracle E-Business Suite and have developed proven methodologies for testing and verification. That expertise allows us to reap the benefits of economies of scale and avoid the process of educating auditors on the nuances of our system.”

Now, it’s quite likely that this was simply a way to share cost-free favors (talking each other up in a press release) as each business negotiated a standard supply contract. However, it is always something that should draw attention when two parties enter an agreement that may not be arms-length. It would be better to look at it and decide nothing is wrong than to overlook something that could potentially be a warning.

In Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, Second Edition (aff. link) Howard Schilit has this to say about such deals:

On October 5, 1999 Microstrategy (MSTR) announced in a press release that it had signed a deal with NCR Corporation…. Under the agreement, MSTR invested in an NCR partnership and NCR returned the favor and purchased MSTR’s products. We refer to that practice as a “boomerang.” (p. 44)

Later, Schilit elaborates:

A two-way transaction means that you both buy from and sell to the same party. Questions should be raised about the quality of the revenue recorded on such transactions….

If, as a condition of making a sale, the buyer receives something of value from the seller (in addition to the product) the amount of revenue recorded becomes suspect. This may involve a barter exchange, offering the customer stock or stock warrants, or investing in a partnership with the buyer. (p. 80).

In the cases of Plantronics and Oracle, there were no specifics regarding the size of the deals or time frame over which they extend. Neither is a major (10%) customer of the other, so there is some limit as to how much the deal could help one or the other. Questions investors may want to pursue include:

  1. Were the agreements similar in size? Revenue recognized from barter agreement is of lower quality (less likely to recur) than cash revenue.
  2. Given that Oracle’s fiscal quarter ends in November, the arrangement could have allowed them to book last-minute revenue. If their revenue for the quarter misses or only slightly exceeds analyst estimates when they report next Monday, a good conference call questioner could ask how much this agreement contributed (particularly with respect to license revenue.)
  3. Given that Plantronics is much smaller, they could potentially benefit more from the deal than Oracle but they are potentially in a less favorable bargaining position. Their investors might want more information regarding the size of the agreement for that reason.

Or, as we suggested earlier, it could all simply be PR fluffery. But even in that case it is best if investors know all the details.
Disclosure: Author is long Plantronics (PLT) call options and short Plantronics put options.

Topics: Forensic Accounting, Fundies, Microstrategy (MSTR), NCR (NCR), Oracle (ORCL), Plantronics (PLT), Stock Market | 3 Comments

Is DELL Cooking the Books?

As accounting geeks, we are always on the lookout for examples of misleading company financial reports.  In particular, it is a neat find when a company has beaten earnings by a penny or two for several consecutive quarters due to accounting items over which management has discretion. Examples of such discretionary items include the allowance for doubtful accounts and warranty reserves.

Accounting rules require companies to recognize sales and the related expenses in the same period. However, if a product is warrantied for three years after the sale (as DELL products often are) this can be difficult. In such cases, management is required to estimate the future warranty expense and charge the estimated amount when the sale is made. The charge is accounted for as a warranty reserve, and future actual warranty costs act as a reduction to the reserve rather than showing up on the income statement directly. If management’s estimate turns out to be incorrect (intentionally or unintentionally) the amount reserved will be adjusted in the future periods when necessary.
Because management has a good deal of discretion when estimating the costs (especially during quarterly reports – which are not audited as are the annual ones) skeptical investors call reserve accounts “piggy banks.” If management has a good quarter and beats earnings by several cents they could estimate higher than normal warranty expenses, and smooth out the earnings by reporting less in the good time. Then, in a bad quarter they could estimate a lower warranty expense to take some of it back. Which leads us to the following article we found regarding DELL.
Research Firm: Dell Warranty Accounting ‘Troubling’ – Warranty Accruals – CRN

New questions are being raised about the way Dell accounts for its warranty accruals.Friedman, Billings, Ramsey Research (FBR), an Arlington, Va.-based research firm, on Friday said its study of Dell’s books “points to at least three troubling conclusions” in the way that the computer hardware giant has handled warranty accruals in its financial reports.

FBR said in its report that Dell’s accounting for warranty accruals “has caused [earnings per share] overstatement of 2 cents to 8 cents in five of the last 12 quarters for which data is available.” The study comes as Dell faces investigations by the U.S. Securities and Exchange Commission, the U.S. Attorney for the Southern District of New York and the audit committee of its board of directors.

“First, it appears that Dell regularly uses warranty accruals to materially manage margins and earnings, rendering the reported results less useful for gauging actual margin trends,” FBR said in the study. “Second, as of the last quarter for which a 10-Q [report with the SEC] is available, the cost of actual claims as a percentage of products sales was rising steadily — up 30 percent [year over year in Dell's 2006 fiscal year] and costs may be heading higher.

“FBR also said Dell’s way of disclosing how it manages the money it collects from product warranties, the money it sets aside in reserve for warranty expenses and how much it accrues in warranty funds, is unusual, making it difficult to identify the Round Rock, Texas-based company’s warranty accruals based on public financial reports alone. The research firm said Dell could be headed for a restatement of earnings if the SEC probe includes a focus on warranties.

Since that would be pretty serious manipulation, we decided to check things out for ourselves. We come away unconvinced.

We’ll take the last point first. In its reports DELL discloses its warranty costs and reserves using a table very similar to this one:

Accrualreporting.jpg

“Revenue deferred and costs accrued for new warranties” is the line management estimates. The obligations honored represent actual warranty expenses while the amortization of deferred revenue represents amounts DELL has collected for service agreements that it recognizes over the term of the agreement.

As FBR notes, by lumping deferred revenue and warranty estimates into a single line it is difficult to tell which is which. This can be important, as the warranty reserves are recognized as a product-related expense while the deferred revenues are recognized as service revenue. So we looked at several quarters of management estimates as a percentage of both total revenue and service revenue, which we condensed to the following chart:

Warrantyaccrualstosales.jpg

Other than the big spike up in Q306 (the quarter that ended in October 2005) there isn’t too much of a trend in either ratio. As a percentage of total revenue the accruals are rising over time, which actually means that the company is reporting lower profits than they would if the accruals were held constant. As a percentage of service revenue there may be a very mild case that the company is being more aggressive.

Still, there doesn’t have to be a trend in order for the quarterly fluctuations to affect earnings. So we took the average ratio of our nine quarters reported as a “normal” percentage of sales that should be accrued. We see that the fluctuations in accruals were indeed enough to affect EPS. Further, there were more quarters in which the adjustment would have reduced EPS than those in which it would have increased EPS. If the company beat estimates in those quarters by a smaller amount than the warranty accrual, there would be some cause for concern. For example, in the April 06 quarter (Q107) the company reported earnings that met consensus estimates, but normalizing warranty accruals to service revenue they would have missed by $0.02.
epseffect.jpg

However, Friedman’s second point (about the rising actual warranty expenses) seems somewhat frivolous. We noted that the reserve spiked in the October 2005 quarter. Looking at that filing, we learn that:

During the quarter, Dell recognized a product charge of $307 million for estimated warranty costs of servicing or replacing certain OptiPlextm systems that include a vendor part that failed to perform to Dell’s specifications. At October 28, 2005, $274 million of the accrued warranty obligation remains outstanding for servicing or replacing additional OptiPlextm systems.

Having a $307 million expected warranty expense is certainly unfortunate. However, as per the accounting requirements DELL recognized the charge as soon as the problem was discovered, and the higher current expenses at least partly relate to the remaining expenses associated with servicing and replacing those systems as needed. It is hard to argue that this is anything more than the accounting system functioning as it was intended to (matching the expenses to the associated revenues as much as possible.) The charge was taken in October 2005 and disclosed at the time as a way of covering the future expenses. Now, as the expenses are recognized they come out of the reserve rather than the income statement (since they were already charged to the income statement in October.) No big deal. In fact it seems to confirm that management is using the process appropriately. (It would be inappropriate for them to put a big deposit in the piggy bank if they weren’t going to have higher actual expenses.)
Furthermore, since the most recent cases of adjusted earnings falling below reported earnings are due to the timing of recognizing this specific issue, we are less concerned about the adjusted-earnings miss in the April quarter.

Topics: Dell (DELL), Forensic Accounting, Fundies, Investing 101, Stock Market | 9 Comments

What Finisar’s Note Exchange Means to Shareholders

Finisar’s (FNSR) announcement that it was exchanging some of its convertible notes for contingent convertible notes generated some interest in our case study on contingent converts. Given the interest, we figured we would reward it with a study of the specific Finisar transaction. We’ll start with the company’s spin:

Overall, the exchange provides the Company with more flexibility to utilize its cash flow from operations between now and 2010, while also minimizing dilution to shareholders.

If you think this sounds too good to be true, you would be correct. Let’s start by looking a little more closely:

The New Notes contain provisions known as net share settlement which require that, upon conversion of the New Notes, Finisar will pay holders in cash for up to the principal amount of the converted New Notes. Any amounts in excess of this cash amount will be settled in shares of Finisar common stock.

What this means is that the old notes were convertible into stock (270 shares per $1,000 of bond principal) or the company could settle in cash if it preferred. The new notes, by contrast, require the company to settle the first $1,000 of each bond’s ending value in cash rather than shares. This does not provide the company “more flexibility to utilize its cash flow.”  In fact, just the opposite. So we can surmise that some cash flow covenants were restricted “between now and 2010″ to give the company more flexibility in the short term. Specifically:

The New Notes do not contain the put option provisions of the Outstanding Notes which provide the holders of those notes the one-time option to require the Company to repurchase the Outstanding Notes on October 15, 2007.

So instead of being required to repurchase the notes next year, they get a reprieve until the notes expire in 2010.

Now let’s tackle the dilution aspect. The company tells us:

The New Notes also are convertible into 35 more shares of Finisar common stock per $1,000 principal amount than the Outstanding Notes.

Hmm. Instead of 270 shares, the bondholders can get 305 shares worth of value for their bonds. That doesn’t exactly sound like “minimizing dilution to shareholders” to us. What they really mean is that, because the principal will be settled in cash, the reported diluted share count will be lower. This is just accounting sleight-of-hand. The economic reality is that bondholders are getting more value for their money, and this value will come directly out of shareholder’s pockets.

What Finisar has done is this:

  1. They agreed to settle the first $1,000 of each bond’s value in cash in exchange for being able to reduce the reported (not the economic) dilution to shareholders.
  2. They sweetened the notes by making them convertible into 35 additional shares (a $125 value per bond.)
  3. In exchange, bondholders have to wait until 2010 to cash in the bonds instead of having the option to do so next year.

Who do you think got the better end of this deal?

Topics: Ceradyne (CRDN), Finisar (FNSR), Forensic Accounting, Fundies, Investing 101, Stock Market | 2 Comments

Spotting Accounting Chicanery

Motley Fool tells investors to Steer Clear of Accounting Shenanigans. So far, so good. However, we found their advice on how to do so a bit lacking:

So what’s an investor to do? A lot, actually. For starters, look for small caps with conservative accounting practices, positive free cash flow, responsible management, and a history of underestimating and overdelivering on promises to shareholders.

If the average investor was able to discern conservative accounting from aggressive accounting, the advice would be wholly unnecessary. We at least give solid tips and case studies on aggressive accounting practices in our forensic accounting category. You can also check out sites like Financial Education to get some tips on basic accounting practices. “Free cash flow” has so many definitions that looking for it to be “positive” is nearly meaningless.

But the last bit may be the most useless. WorldCom and Enron had long histories of overdelivering on promises to shareholders because they were committing fraud. In fact, one earnings quality study showed that the strongest warning signal is when a company has beaten estimates by exactly one penny for a number of consecutive quarters.

The fact is, monitoring accounting practices is not easy, which is one reason many investors are better off indexing than trying to pick their own stocks. However, it isn’t all that hard either. For investors who are interested in learning more about it and spending some time reading the financial satements it can be a rewarding hobby.

Topics: Forensic Accounting, Investing 101, Stock Market | No Comments

Why Verizon Looks Cheap

We really love accounting arcana, because investment opportunities frequently get buried under the accounting choices that companies make and that are routinely ignored by investors. The differences can become more pronounced when certrain ratios are reported using standardized services such as Yahoo! Finance.

Our friend Doug McIntyre at 24/7 Wall St. is great at spotting industry trends that affect stock prices. He discusses one such trend (broadband strategies at telcos) in his post AT&T: New High Every Week.

AT&T trades at 2.24 times sales. BellSouth trades at 3.64 times. AT&T must have paid a premium. But, Verizon trades at 1.22 times. And, Qwest at 1.2 times. Qwest, being the smallest of the lot does not have the balance sheet or revenue to compete with cable, WiMax, and VoIP as well as the rest. Or, at least that is the conventional wisdom about why it carries no premium….

Verizon says it will spend $20 billion building its fiber system according to the company’s public statments. It also says that the service is now available to six million homes, about 20% of their customers. Of course, that does not mean that the customers are using it.

AT&T and BellSouth have not announced intentions anywhere near as agreesive for upping the ante to get faster wires into their customer’s homes. And, that may be why Verizon trades at a discount.

However, Verizon’s significant discount only applies on the basis of price/sales. On a trailing P/E basis it is actually cheaper, and on the basis of price/book it is just a smidgeon more expensive than AT&T. As it turns out, accounting arcana are largely responsible for the price/sales differential. Specifically, the method each company uses to account for its majority (60% for AT&T and 55% for Verizon) stake in its wireless operations. Let’s have a look.

On page 24 of their 2005 annual report, Verizon says:

Our Domestic Wireless segment provides wireless voice and data services and equipment sales across the United States. This segment primarily represents the operations of the Verizon Wireless joint venture with Vodafone. Verizon owns a 55% interest in the joint venture and Vodafone owns the remaining 45%. All financial results included in the tables below reflect the consolidated results of Verizon Wireless.

The consolidated wireless results (100%) were revenue (in $millions) of $32,301. Of that, Vodafone’s 45% share amounts to $14,535. Were this excluded from Verizon’s total revenue of $75,112 the adjusted revenue for Verizon would have been $60,577. Instead of 1.37x sales (using 2005 revenues and the current share price), Verizon’s market cap would represent 1.70x sales.

Turning to AT&T things get a bit murky. To start with, AT&T (the long distance company) is only included in the merged company’s 2005 results for 45 days. Fortunately they do provide pro-forma data as though it had been included for the full year. A second issue is their method for reporting their wireless operations. We present their comments on their wireless division (p. 28 of their annual report):

We account for our 60% economic interest in Cingular under the equity method of accounting in our consolidated financial statements since we share control equally (i.e., 50/50) with our 40% economic partner BellSouth in the joint venture. We have equal voting rights and representation on the Board of Directors that controls Cingular. This means hat our consolidated results include Cingular’s results in the “Equity in net income of affiliates” line.

In layman’s terms, this means that they don’t record any of Cingular’s sales (but they do record 60% of its net income.) Here’s how this is described in Financial Statement Analysis: A Global Perspective (pp. 561-562):

There are three approaches to accounting for (investments over which the company has significant influence): the equity method, proportionate consolidation, and consolidation.

Each of these three methods yields the same amount of net income for the period. Likewise, each yields the same amount of net assets (or equity) for the period. However, the methods yield different cash flows for the period. Additionally, the details may be different. Consequently, key financial ratios differ under the various methods.

Specifically, under the equity method AT&T doesn’t record any revenue, and records its share of Cingular’s profits as a line (Equity in net income from affiliate) on the income statement. Meanwhile, Verizon records all of Verizon Wireless revenue and profits, and deducts Vodafone’s share as a line (Minority interest) on its income statement.

So what adjustments need to be made for AT&T? First we need to start with the pro-forma income statement, which treats the long-distance business as though it had been included for the full year. This gives us a revenue line of $66,061 rather than the $43,862 reported in 2005. This adjustment alone reduces AT&T’s price/sales (apples to apples for the way we calculated Verizon’s) to 1.86x.

Now we need to add in the proportionate (60%) share of Cingular’s revenue of $34,433, or $20,660. Now our total proportionate revenue for AT&T is $86,721. After this adjustment, AT&T’s price/sales is 1.41x, lower than the apples-to-apples 1.70x for Verizon.
Since both methods result in the same net income and equity, neither the P/E multiple nor price/book multiples are affected by the accounting choice. So we can accept at face value (at least with regard to their accounting for the wireless divisions) the Yahoo! Finance TTM P/E of 18.81x and P/B of 2.22x for AT&T, and the 14.98x P/E and 2.30x P/B for Verizon. Again the multiples end up being fairly close when the accounting treatment is apples to apples. Verizon is more expensive on price/sales and price/book but cheaper on P/E.
This is one of the cases where the market has largely picked up on the accounting difference. This doesn’t mean that investors understand the accounting intricacies, but more reflects the fact that investors more frequently use P/B or P/E rather than P/S. In fact, if Doug is correct in his assessment that Verizon has chosen the wrong strategy, this could be a great investment opportunity since Verizon is trading at about par with its more conservative peer.
So you can see why we like to dig into the numbers – sometimes you dig up a nugget that is pure gold.

Disclosure: Author is long STREETTRACKS GOLD (GLD) at time of publication.

Topics: AT&T (T), Communications Services, Forensic Accounting, Investing 101, Stock Market, Verizon (VZ), Wireless | 2 Comments

Par Pharmaceuticals to Restate Earnings

We saw you rolling your eyes when we wrote about how important it is to monitor the allowance for doubtful accounts. Well, it turns out we sometimes know what we’re talking about.

Watch List company Par Pharmaceuticals will have to restate results due to accounting errors.

Par Pharmaceutical Cos Inc. (PRX.N: Quote, Profile, Research) said on Wednesday it will restate financial results for fiscal 2004 and 2005 and the first quarter of 2006 due to an understatement of accounts receivable reserves.

The understatement resulted from delays in recognizing customer credits and uncollectible customer deductions.

It said it expects the restatement adjustments to reduce revenues by up to $55 million over the applicable periods, prior to any potential recoveries.

We have written about the importance of monitoring accounts receivables reserves here and here. It is also a component of our “Fundies” worksheet, which helps us keep track of a company’s health. This is a real-life example of why we harp on the accounts receivable reserve so often – a stock that is down more than 4 percent in after-hours trading based on this news. More »

Topics: Forensic Accounting, Investing 101, Par Pharmaceutical (PRX), Stock Market | 3 Comments