Peeling away financial reporting issues one layer at a time

On Golden’s Con — and Bain Capital’s Travels to Lilliput

There is so much I would like to write about, yet so little time…

I could write about the latest half measure on the accounting for repurchase agreements (ASU 2014-11)— and that Tom Linsmeier’s lone dissent is highly similar to my own views that I posted shortly after Lehman’s Repo 105 manipulation came to light.

Or, I could be talking about former SEC Chair Chrstopher Cox’s rambling, egotistical, anti-IASB (“Today, I have come to bury IFRS, not to praise them”) and anti-lease accounting project speech.  NYT’s Floyd Norris provided his own trenchant observations, here.

Or, I could write at least five posts on why, after 12 years of jerry rigging, there are still more good questions about the new revenue recognition standard than there will every be good answers.

Or, I could write about the recently announced and misguided “short-term” project to “simplify” inventory accounting.  More than any other pronouncement, what is now ASC 330-10 (originally ARB 29, Statement 5 – 1947), has stood the test of time; because it is both principles-based, well-reasoned and eminently reasonable — so much so, that it was scoped out of FAS 157, that unfair fair value standard.

Or, I could continue with the thread of my previous post, which is to share my reactions to Russell Golden’s views on the “foundational issues” he would like to resolve while he is FASB’s chair.  Referring to the title I have adopted for this series, whether Mr. Golden’s true intentions are to “con” us or not, I find his speech to be a convenient vehicle for me to air a whole bunch of pet peeves about the direction that the FASB is going.

In the first post, I discussed measurement.  Next up is presentation.

“…Golden said the board needs to consider whether there needs to be improvement in the performance statement and, particularly, the income statement. ‘Would it be better to classify the income statement between recurring and nonrecurring activities?’ Golden said. ‘Or between operating activities and nonoperating? Or between some form of operating and recurring?’ Disaggregation may give investors a better understanding of the difference between recurring and nonrecurring items … He said some improvements to the statement of cash flows also could be made to conform with changes to the performance statement.

If I were leading a discussion of presentation, these are the four issues that I see as most ripe for improvement:

  1. Intercorporate investments—Providing more information on the face of the financial statements about investments for which the entity has more than a passive interest.
  2. Separating operating revenues and expenses from financial revenues and expenses, to align presentation with modern finance that see financial structure decisions as distinctly different from everything else.  As I have explained previously, capitalization of interest costs is a travesty; yet for some politically influential issuers (e.g., oil and gas), it is a sacred cow.
  3. The basis of presentation of the statement of cash flows.
  4. Disaggregation.

Only the last of the items on my list is on Mr. Golden’s list, and the rest of his are very small potatoes for investors in public companies.  The SEC has long required in MD&A — and closely monitored compliance — that companies disclose these distinctions (nonrecurring, operating v. other things, etc.) as seen “through the eyes of management.”

Is the Direct Method for the Cash Flow Statement Never to be Spoken of Again?

From speaking with analysts whom I respect for their knowledge of financial reporting, and who strive to lead their profession in providing feedback to the FASB, the failure to resolve the longstanding controversy over the direct method for the statement of cash flows remains a frustration; and the recent news that Bain Capital Partners LLC is suing EY for $60 million serves to explain why.

“Bain Capital Partners claims in court that Ernst & Young cost it $60 million by advising it to invest in a children’s clothing company [India-based Lilliput Kidswear] based on falsified financial statements that E&Y certified. …

‘In reality, unbeknownst to Bain, the financial information EY provided was a fiction,’ the complaint states. ‘Lilliput had systematically falsified its revenues, costs, and loans outstanding. In order to artificially inflate revenue, Lilliput added imaginary ‘fake’ sales on top of legitimate ‘actual’ sales.’ …”

Solely for the the sake of argument, let’s stipulate that Bain has a legitimate claim that the financial statements in question were fraudulent.  Moreover, the financial analysts at Bain are the crème de la crème from the elite MBA programs.  “Ambition” for those who thrive at exceeding the expectations their employer has for them doesn’t do justice to the term.  These twenty-somethings compete against each other to show their bosses who works the hardest, who is the most discerning, and who can build the coolest valuation spreadsheets.

Apparently, it did not occur to a single one of Bain’s weapons of mass investment that fraud could be a reasonable differential diagnosis for the financial performance depicted by  Lilliput’s GAAP financial statements.  Surely, these wunderkinds had been admonished by their  former accounting professors not to overlook the red flags of aggressive — if not fraudulent — revenue recognition in receivables and inventory turnover.*  Is it because the halo effect of EY’s imprimatur and its reputation at Bain swamped these basics?

For Bain, that’s a $60 million foundational question. But, for Mr. Golden and the FASB, the question to ask from this case is how Bain’s involvement with Lilliput might have played out if Lilliput’s cash flow statement had been presented under the direct method. Would the added saliency from displaying the trend in cash collections from customers and cash paid to suppliers have overcome Bain’s allegedly misplaced reliance on EY’s unqualified audit opinion?

* * * * * * *

Similarly, as part of the fallout from the Enron debacle, the lack of transparency of the indirect method rightly became a focus of critics for the same types of reasons.  Six months following Enron’s implosion, I attended the annual reunion of alumni from the SEC’s Office of the Chief Accountant. At a presentation to our group, the erstwhile Chief Accountant assured us that the direct method of presentation of cash flows would soon become required.  I was left to understand that there was a clear consensus that reporting cash flows without actually reporting cash flows was nonsense, and had to stop.

That was almost exactly 12 years ago (for some crazy reason, the SEC alumni always met on Father’s Day weekend), and nothing whatsoever has changed.  Instead of a quick fix, the FASB chose to mire itself in a larger and misbegotten convergence project on presentation that has gone absolutely nowhere.

Now that EY is being sued by one of its most prestigious clients for $60 million, for allegedly conspiring to defraud them, I wonder what they think about the direct method?

————–

*I have not obtained Lilliput’s financial statements, so I can’t — and don’t — claim that these signs of alleged fraud were obtainable via conventional financial statement analysis.

1 Comment

  1. Reply Scott June 17, 2014

    Interesting remarks on the direct method statement of cash flows. I am one of the few accountants who has used this method in practice. I have much more to say about it than a web-post comment can accommodate.

    My experience is that most non-accountants find the indirect method non-intuitive, while most practicing accountants find the direct method odd (because it is unfamiliar to them and seems troublesome to prepare).

    I was able to put together a serviceable cash flows from operations section by adjusting the income statement for noncash items (as described at ASC 230-10-55). The direct method certainly makes it easier to explain changes in operating cash flows from period to period, including preparing a coherent “Liquidity and Capital Resources” section of MD&A.

Leave a Comment