FOOL ON THE HILL
Corporations Favor Fudge

While Congress and the media have focused on debacles such as Enron and WorldCom, the larger threat to the markets comes from the legal bending of rules. Two companies -- Merck and IBM -- offer up examples of what investors really need to be worried about.

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By Whitney Tilson
July 10, 2002

The following joke email has been circulating the Internet and will soon reach an inbox near you:

New financial definitions:

EBITDA = Earnings Before I Tricked the Dumb Auditor
EBIT = Earnings Before Irregularities and Tampering
CEO = Chief Embezzlement Officer
CFO = Corporate Fraud Officer
EPS = Eventual Prison Sentence
Instead of EBITDA, let's look at EPITDA = Earnings Post-Indictment, Trial, Denunciation, and Arrest

Sure, I laughed, but I flinched a little too. What a sad time in American business history when such an email would circulate -- and have such a basis in reality.

The big story
Congress and the media have focused on debacles such as Enron, WorldCom, Adelphia, and Global Crossing, but I think they're missing the big story. These extreme cases of fraud and deception, often leading to bankruptcy, are rare. Rather, the greatest threat comes from the legal bending of rules. My analysis of countless businesses and conversations with insiders indicate that the above-mentioned mea culpa are only the tip of the iceberg.

The far bigger story is that a large number of mainstream companies -- many of which are good companies run by good people -- are fudging their numbers, within the letter (though certainly not the spirit) of generally accepted accounting principles (GAAP), for the purpose of deceiving investors and inflating their stock prices. Let's look at two examples.

Merck-y waters
Merck
(NYSE: MRK), the eleventh most-admired company in the world, according to the latest Fortune list, has recently become embroiled in an accounting controversy regarding its revenue recognition policies. Specifically, Merck disclosed that from 1999-2001, it recorded as revenue $12.4 billion -- nearly 10% of its overall reported revenue during that period -- of co-payments to pharmacies by patients, even though Merck didn't receive those funds and bore no credit risk for them. (By the way, I'll give you three guesses as to who audited Merck during this period.)

Merck contends that it has legal liabilities for the co-payments under certain narrow circumstances, and correctly notes that its revenue recognition policy has no impact on the bottom line. Nevertheless, I'm troubled. While the company's policy no doubt conforms to GAAP, I think it's aggressive and misleading to investors. So does Lynn Turner, a former chief accountant at the SEC, who is now an accounting professor and director of the Center for Quality Financial Reporting at Colorado State University in Fort Collins:

For a company such as Merck to reflect as revenues in its financial statements billions of dollars of co-payments a customer makes directly to another company, which the pharmacy collects and never remits to Merck, just does not reflect the economics of what is occurring. If that is what the SEC accepts, then investors are in trouble and our financial reporting indeed needs improving.

So why would Merck engage in aggressive accounting? An article in Monday's Wall Street Journal offered one possible motive: "Some competing pharmacy-benefit managers and customers say that large revenues and a lower gross margin are more attractive to potential clients, because they indicate that a company can handle large volumes and that it passes on more of its profits to its customers."

What really bothers me about this situation is not what Merck is doing, but the broader implications. If Merck -- by all accounts a conservative and reputable company -- is engaging in even moderately aggressive accounting, I'm afraid to ask what the rest of corporate America is up to.

Cheating -- and getting away with it
The answer, I regret to say, is probably typified by IBM (NYSE: IBM), a stock I've warned investors about time and time again because I think the company is among the biggest accounting cheats in corporate America. Let me be clear, however: All of the company's financial shenanigans (those that have so far come to light, anyway) have apparently been legal and complied with GAAP. But that doesn't make them right.

I think it's outrageous, for example, that the company has regularly used one-time gains, such as the sale of a business, to reduce reported SG&A (e.g., overhead expenses) and inflate profit margins. Nearly as outrageous is the fact that IBM disclosed what it was doing in its financial filings over the years with the SEC, yet only recently did anyone in the media or analyst community draw attention to it.

Buffett calls end to shenanigans
Warren Buffett has waged a tireless (and until recently, relatively lonely) campaign on this issue. In his 1998 annual letter to Berkshire Hathaway (NYSE: BRK.A) shareholders, he wrote: "In recent years, probity has eroded. Many major corporations still play things straight, but a significant and growing number of otherwise high-grade managers... have come to the view that it's okay to manipulate earnings to satisfy what they believe are Wall Street's desires."

Buffett returned to the topic in his 2000 annual letter, in which he wrote:

Over the years... I have observed many instances in which CEOs engaged in uneconomic operating maneuvers so that they could meet earnings targets they had announced. Worse still, after exhausting all that operating acrobatics would do, they sometimes played a wide variety of accounting games to 'make the numbers.' These accounting shenanigans have a way of snowballing... [which] can turn fudging into fraud.

Why is this happening?
Why are companies engaging in accounting games, given the enormous potential costs? Take Waste Management (NYSE: WMI), which overstated earnings by $1.4 billion in the 1990s. Management's troubles began with a few little white lies, which the company's auditors, Arthur Andersen (surprise!), were apparently willing to overlook because they were not "material." But then, to maintain the fiction, they told bigger and bigger lies, which eventually amounted to massive fraud.

It's easy to see how even good people can get on a slippery slope that leads to destructive behavior. As Terry Hatchett, Arthur Andersen's managing partner for North America, noted two years ago, "The pressures on management to meet expectations are greater than ever in a market where information and capital move instantaneously."

Buffett, in his 1998 letter, wrote about these pressures:

Many CEOs think this kind of manipulation [of earnings] is not only okay, but actually their duty. These managers start with the assumption, all too common, that their job at all times is to encourage the highest stock price possible (a premise with which we adamantly disagree). To pump the price, they strive, admirably, for operational excellence. But when operations don't produce the result hoped for, these CEOs resort to unadmirable accounting stratagems. These either manufacture the desired 'earnings' or set the stage for them in the future.

"Rationalizing this behavior," he continued, "these managers often say that... they are only doing what everybody else does. Once such an everybody's-doing-it attitude takes hold, ethical misgivings vanish. Call this behavior Son of Gresham: Bad accounting drives out good."

Conclusion
I have no doubt that financial manipulations continue to be pervasive in corporate America, and that many investors are being misled to a material degree. As more and more investors have come to share these views, they have lost confidence in our capital markets, and stocks have suffered. Before stocks can rebound, strong measures need to be taken to halt and reverse current trends.

Guest columnist Whitney Tilson is managing partner of Tilson Capital Partners, LLC, a New York City-based money-management firm. He owned shares of Berkshire Hathaway at the time of publication. Whitney appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous columns for The Motley Fool and other writings, visit http://www.tilsonfunds.com/.