Rooting on The Upcoming Financial Crisis

Rooting on The Upcoming Financial Crisis
by S3ra Sutan Rajo Ali
Jakarta, 9 August 2017

1. Sudden fall out in corporate earnings and profits
2. Widespread defaults in servicing debts
3. Panic sell-off to reduce higher financial losses

Surviving Large Losses: Financial Crises, the Middle Class, and the …
By Philip T. Hoffman, Gilles Postel-Vinay, Jean-Laurent Rosenthal

Foreign investors found the doctored accounting and meretricious information spread by rogue corporations particularly shocking. As one German portfolio manager declared, “There is unanimous agreement that the US is not the best place to invest anymore.” Americans had bragged that their accounting standards were superlative, if the rest of the world wanted to enjoy a stock market boom and similar economic growth, they should get on the bandwagon and adopt the same accounting rules. Large companies and foreign investors had bought the argument and flocked to the United States.

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20110727 14 How Companies Fake It (With Cash Flow)
201203 20 Accounting For Half-Truths
20121005 19 Jack Welch Probably Shouldn’t Bring Up Doctored Numbers
20131119 01 The Pentagon’s Doctored Accounting Ledgers Conceal Epic Waste
20140924 21 Have you ever encountered fake receipts for employee reimbursement of phony expense report items?
20150721 07 Toshiba’s CEO resigns over $1.6 billion in doctored accounts
20150721 09 Toshiba CEO Hisao Tanaka resigns over doctored accounts that inflated profits
20151008 11 Brazil’s president Dilma Rousseff loses legal battle and could face impeachment
20160326 06 Too much of a good thing
20160421 17 PCAOB practice alert finds rash of doctored audit files
20160902 16 Ignoring the Pentagon’s Multi-Trillion-Dollar Accounting Error
20161210 02 America’s audit watchdog uncovers serious misconduct at Deloitte Brazil
20161221 08 New Slater & Gordon investigation unsurprising given long history of accounting problems
20170713 18 Albwardy’s Meikles walk -away raises questions
20170803 05 A tale of two markets
20170808 04 Capitalism and the absence of creative disruption
20170809 03 Where might the next crisis come from?
Published: April 6, 1995

A committee representing shareholders of the Leslie Fay Companies sued BDO Seidman yesterday, accusing the accounting firm of failing to uncover a huge accounting fraud at Leslie Fay. The lawsuit was filed in Federal Bankruptcy Court in Manhattan. Leslie Fay filed for Chapter 11 protection from creditors in April 1993 after revealing that company officials had doctored accounting entries to inflate pretax profits by $81 million from 1990 to 1992. BDO Seidman, the auditor for Leslie Fay until May 1993, called the suit “unjustified and hypocritical.” The accounting firm denied allegations of professional negligence and recklessness, saying it had been misled by Leslie Fay employees.
The Spill-Over Effect
Jason Karaian
March 3, 2008 | CFO Europe Magazine

Parmalat survived bankruptcy without losing a day of production. But executives at the dairy group still have a lot more than milk on their minds.

Collecchio is a classic company town. Not far from Parma, in Italy’s Emilia Romagna region, its modest streets and squares sprout from a large dairy factory on its western outskirts. In 2003, on Christmas Eve, this unlikely village gained international fame when Parmalat, the factory’s multinational parent company, declared bankruptcy after its owner’s audacious accounting fraud came to light.

At its height, Parmalat operated in more than 30 countries, employed 36,000 people and reported annual revenue of nearly €8 billion. However, the company had lost money every year since listing in 1990, concealed by aggressive international expansion and heavily doctored accounts. From Parmalat’s nondescript head office on a quiet side street in Collecchio, founder and CEO Calisto Tanzi and CFO Fausto Tonna conspired to hide €14 billion of debt – eight times more than reported on the corporate balance sheet. The two executives, in addition to dozens of other former managers, auditors and bankers, are now the subjects of numerous criminal investigations.

Like Enron, WorldCom and others, Parmalat triggered a host of hasty changes to corporate law, as the shocking scale of the fraud jolted regulators into action. (See “The Silver Lining” at the end of this article.) But there is an important difference between Parmalat and many of the scandal-ridden companies that imploded around the same time, explains Pier Luigi De Angelis, Parmalat’s CFO. “Enron died. WorldCom died. Parmalat is still alive.”

Indeed, not a single day of production was lost during the ordeal. Enrico Bondi, the company’s government-appointed administrator, used the powers granted by new bankruptcy laws to keep creditors at bay. Following divestments, closures and write-downs, in the summer of 2004 he transferred the group’s assets, such as they were, into one of the previous regime’s many dormant shell companies – Cimabue, named after a 13th century Florentine painter – and renamed it Parmalat. The new company with an old name returned to the Milan stock exchange in 2005, less than two years after it became Europe’s largest-ever bankruptcy. Though a shadow of its former self, Parmalat today is not only alive but thriving, in a sense.

Above the Law

While more than 12 billion glasses of Parmalat milk are consumed every year, the reborn company’s fortunes rely only partially on its dairy business. Bondi and Nicola Palmieri, Parmalat’s head of legal affairs, run a lucrative side-business suing the banks, auditors and other advisers that they allege were accessories to the fraud, turning a blind eye to the previous management’s schemes.
After its bankruptcy, Parmalat retained 95 law firms in 32 jurisdictions, drawing on more than six million documents to launch hundreds of cases against former business partners around the world. “We keep the courts here in Italy quite busy,” Palmieri joked in an earnings call last month.

The company has collected €1.2 billion in legal proceeds to date, with banks settling to pay around 10% of the initial claims filed against them. Last year, Parmalat made €755m from these settlements, more than double the €367m in operating profits generated by its dairy business. With around 100 cases still pending, claiming notional damages of €50 billion, bank executives in Milan, Manhattan and other financial capitals continue to live in fear of the sleepy corner of Italian farm country where Bondi, Palmieri, De Angelis and other Parmalat executives unravel the old regime’s web of deceit.

But while investors cheer the firm’s legal victories – the proceeds largely flow to the bottom-line tax free – some are starting to doubt the current management’s ability to run its food business effectively. The euphoria following Parmalat’s triumphant relisting faded fast, and its shares have consistently underperformed others in the sector. (See “Milk Dud” at the end of this article.) On an enterprise value to Ebitda basis, Parmalat is trading at around a 10% discount to food and beverage benchmarks, and 20% more cheaply than competitors such as Nestlé, Danone and Unilever.

Court hearings due this year on Parmalat’s most important remaining cases – suits filed in American courts claiming $10 billion (€6.8 billion) of damages against Bank of America and Citigroup – should provide visibility on the company’s legal endgame. Then what? Many doubt that Bondi, one of Italy’s most respected turnaround specialists, would be satisfied with life at an ordinary, medium-sized food group.

If he goes, the long-time associates he brought to the company, including CFO De Angelis, are likely to follow. Some even suggest that unless current management present a clearer vision for Parmalat’s core business soon, investors may field rival lists of directors when shareholders gather to vote on the board’s renewal next month.

“Today, Parmalat is a semi-finished product,” De Angelis admits. “We need to become a global company, as in the past, but this time balancing business and geographic risk.” Despite the success that Parmalat’s seasoned crisis managers have had fighting legal battles and unwinding a legacy of fraud, getting to grips with the milk business may prove just as much of a challenge.

The Milkman Calls

Before joining Parmalat in April 2006, De Angelis only knew about the company from its products and sponsorship of football teams and Formula 1 drivers. He had little knowledge of the food industry, having moved from Florence to Turin in late 2005 to become CFO of Lavazza, a coffee company, after a long career in finance at various Italian industrial groups.

He received a call from Bondi at Parmalat only a few months after joining Lavazza. “It was a Thursday,” De Angelis recalls. Jumping at the chance to be involved in such a high-profile turnaround story, “I was in Collecchio on the following Monday,” he says.

De Angelis had first worked with Bondi in the 1980s at Fiat, and later followed him to Edison (Montedison at the time). At Parmalat, he replaced Guido Angiolini, another long-time ally of the CEO. Having joined the stricken dairy company at the same time as Bondi, Angiolini reportedly had to be convinced to stay on as CFO beyond the firm’s initial crisis stages.

Naples-born De Angelis describes Parmalat’s bankruptcy as “sad for Italy.” It is maybe for this reason that the company isn’t having trouble recruiting new employees to help restore its reputation, the CFO says. Not that Parmalat has been in hiring mode lately. In 2003, it generated revenues of €4 billion with more than 32,000 employees. Last year, it recorded nearly identical sales with a payroll of around 14,500.

The finance function De Angelis inherited is unrecognisable from the one run by Tonna, the hot-headed former CFO known for smashing holes in desks, shattering glass doors and, famously, wishing reporters “a slow and painful death” on his way into the Parma prosecutors’ office. “For sure, the first, second and third levels were all replaced,” says De Angelis. Financial advisers with ties to the old regime were also cut loose. But De Angelis finds no fault with the remaining clerical and accounting staff who had worked under Tonna.

Parmalat’s legal campaign against nearly every major financial group also complicates the CFO’s relationship with its banks. “I am aware that we are conflicted with some parties,” he says. The rapport that develops between a finance chief and his bankers – which comes in handy when credit conditions are as difficult as they are now – is off the cards at Parmalat. Though he knows all of the major players from relationships built during previous jobs, his dealings with them now are cool at best. “Business is business,” he says. “They don’t put me in difficult situations, and I don’t put them in difficult situations.”

He bats away most questions about Tonna’s legacy in the finance department of Parmalat. “I don’t like to speak about the past. I wasn’t involved,” he says. “We changed the people. We changed the organisation. We changed the systems. We are looking to the future.”

Soul Asylum

As De Angelis sees it, the future is complicated by the fact that the company has three anime, or souls. Tellingly, he hesitates for a moment before deciding in what order to describe them.

First, there is the core business. As a self-described “technician,” most of De Angelis’s contribution to the corporate income statement comes below the operating line. His proudest achievement – the thing he mentions first on conference calls and during meetings with investors – is simplifying the company’s control chain.

This is no small feat, explains Bruno Cova, a partner at law firm Paul Hastings in Milan. He served as Parmalat’s chief legal adviser from January 2004 to April 2005. With little centralised information on how Parmalat was organised, he pieced the puzzle together by fielding calls from far-flung subsidiaries getting in touch with the head office as news about the bankruptcy spread.

“The structure was opaque by design,” Cova says. “That was one of the old management’s objectives.” Bonlat Financing, the Cayman Islands-based company whose forged bank-account statements brought about Parmalat’s downfall, could be traced back to the parent company via a chain of a dozen firms that passed through Malta, the Isle of Man, Luxembourg and the Dutch Antilles. (See “Web of Deceit” at the end of this article.)

When De Angelis arrived at Parmalat, he faced a “constellation” of 225 companies, only 50 of which were operational. He considers it a “miracle” that today the group includes less than 70 companies, 40 of which are operational. Later this year, €40m in dividends will flow to the parent company that would have otherwise been lost in its Byzantine organisation. Marco Baccaglio, an analyst at Cheuvreux in Milan, reckons that Parmalat can save between €15m and €20m of costs, or around €250,000 per legal entity, by rationalising its control chain.

This is not to say that De Angelis is relegated to the back office. He makes the short drive from his office to the Collecchio factory once or twice a week. As he strides across the bridges that snake above the factory floor, pots of yoghurt shuffle along conveyor belts and the smell of strawberries lingers in the air. This business is much easier to understand than some of the others he’s worked in, such as chemical fibres or copper processing, he says.

Over the din of the assembly line outside a conference room, Leonardo Bonanomi, head of Parmalat’s Italian operations, explains the group’s new product strategy under De Angelis’s approving gaze. Last summer, Parmalat launched a range of fruit juices under the Santàl brand. With operating margins more than double those earned on milk, and a market that is growing twice as fast, this guards against the growing commoditisation of the firm’s core product. Offered in five colour-coded flavours – “the colours of health” – the benefits touted on the package represent the company’s other product priority, value-added “functional” products.

“If you have high cholesterol, you don’t care if a yoghurt that’s good for you costs €1.00 or €1.05,” notes De Angelis. A host of health-oriented trademarks – “Cardi Top,” “Rego Plus” – now feature prominently on many of Parmalat’s products. The company is also, for the first time, marketing certain milk, cheeses and yoghurt under single brands – such as Jeunesse (low fat), Zymil (low lactose) and Fibresse (high fibre) – saving on advertising costs, Bonanomi adds, nodding to De Angelis.

Cream of the Crop

The product strategy is connected to the company’s second soul, its evolving M&A strategy. In this area, the CFO plays a leading role, with support from Bondi and COO Carlo Prevedini.

To date, most of the work has been on divestments, unravelling the empire built on dodgy debt by Tanzi and Tonna. The fire sales slowed last year, however, and De Angelis adjusted the company portfolio along more strategic geographic and sector lines. He earned the company €248m in 2007 by offloading its low-margin Spanish operations and Boschi Luigi & Figli, a tomato business.

Today, 80% of both revenues and operating profits are generated in Italy, Canada and Australia, while milk accounts for 60% of sales and 50% of operating profits. With this in mind, De Angelis’s acquisition screen – “from countries to products to companies” – has identified opportunities in several “countries with double-digit growth.”

Parmalat was in advanced talks with a Kenyan company, De Angelis notes, but pulled out recently when the country descended into civil war. He also describes India as a “very important market.” Wherever Parmalat goes, the CFO is quick to add, the company will maintain a group operating margin of between 10% and 11%.

Much of the cash that De Angelis can spend on takeovers comes from the legal settlements that constitute Parmalat’s third soul. To a certain extent, Tanzi, Tonna and their associates are now helping Parmalat, as the accusations they make during investigations bolster the company’s cases against the banks. In past hearings, Tanzi has claimed that bankers forced him into a “drug-like dependency” on loans, constructing “financial alchemies” that neither he nor Tonna fully understood.

In December, Parmalat settled cases against Intesa Sanpaolo for around €400m, its largest single settlement to date. “Our business strategy is obviously boosted by the availability of this money,” De Angelis notes. That said, “when we do the planning, we don’t consider litigation,” he adds. “We only consider investments when we have the money in our pockets. For us, there is only upside.”

The company swung from net debt of €170m at the end of 2006 to net cash worth €857m at the end of last year. “What can I say? Absolutely, we have no shortage of capital,” De Angelis says. He reckons the company’s ideal capital structure would feature roughly equal parts debt and equity, leaving scope to grow its war chest to billions of euros.

Whey Ahead

Analysts tend to value Parmalat’s core business at between €2.20 and €2.40 per share, while the value of future legal settlements would add between €0.50 and €2.00 to the share price. In the first weeks of February, the company’s shares traded around €2.40, a significant discount to most analysts’ price targets. The highly volatile, subjective nature of legal settlements explains this in part, but more fundamentally there are growing doubts that Parmalat’s managers are fully focused on, or capable of, maximising the value of its core business.

De Angelis rejects the suggestion that Parmalat’s managers are distracted by legal matters, noting that “people in operations only hear about it from the newspaper.” A mid-year profit warning, with full-year results only barely meeting the revised guidance, is trickier to explain away.

Last year, the price of Parmalat’s key inputs soared, as did many other commodities. Overall, the company’s raw material costs rose by around 10%, though for inputs in some markets the increase was 100%. Luca Bacoccoli, an analyst at Banca Caboto in Milan, questions executives’ readiness to respond to the price rises, calling their reaction “a little bit disappointing.”

For his part, De Angelis explains the perceived delay in defending margins as being at the mercy of the increasingly powerful retail chains that control distribution. Price negotiations take time, he says, and besides, with €215m of last year’s rise in revenue coming from price and product mix, in addition to €22m in volume gains, the company more than recouped the €150m rise in raw milk costs. Nonetheless, doubts continue to dog Parmalat’s executives.

“Often, the staff a company needs to manage a restructuring doesn’t have the same skills needed to grow the company once it’s up and running,” notes Adriano Bianchi, a Milan-based managing director at turnaround consultancy Alvarez & Marsal. “On the brink of bankruptcy, you need to get a handle on cash flow, minimise working capital and optimise the use of short-term credit lines. This exercise doesn’t necessarily require industry experts.”

This explains the potential for conflict at next month’s vote on Parmalat’s board renewal. The company’s bylaws require an annual payout to shareholders of at least 50% of net profit, estimated at around €550m in 2007. Even though this gives Parmalat’s shares a massive dividend yield of around 7%, analysts peppered executives with questions about a potentially bigger payout following the preliminary results announcement last month. If executives and directors want to stay, wouldn’t an outsize dividend help?

As of mid-February, the company’s largest shareholder – JPMorgan – held only 3% of Parmalat’s stock. However, any investor with more than 1% of shares can submit a list of directors. “If they want to replace us, they can,” De Angelis shrugs. Some of the largest shareholders are the banks whose debts were swapped for equity following the bankruptcy, some of whom the company is still suing. “It seems to me that they are a bit conflicted,” De Angelis adds.

As one of several “Bondi men” at Parmalat, few expect De Angelis to stay if his boss goes. What’s more, “my friends say that I’m not happy if I can’t manage a crisis,” he notes. Still, though he’s served as a finance chief of listed companies for some 20 years, De Angelis admits he has learned a lot from his experience at Parmalat. “I learned to be humble,” he says. “Parmalat is a real public company.” Indeed, early court hearings on the scandal were held in a Parma convention centre, such was the breadth of creditors, shareholders and other interested parties.

And though he accepted Bondi’s offer to turn around another stricken Italian company, his previous stint at a private, family-owned coffee company suggests a potential change in priorities for the 58-year-old. As he drives his estate car through the Emilia-Romagna countryside, as he likes to do with his Maremma sheepdog at his side, his thoughts must turn to what more he can do at Parmalat to make the people of Collecchio, and Italy, proud again.

Jason Karaian is deputy editor at CFO Europe.

The Silver Lining

Parmalat’s spectacular bankruptcy “substantially changed the rules of the game,” says Adriano Bianchi, head of turnaround consultancy Alvarez & Marsal in Italy.

Indeed, all listed companies in Italy now operate under insolvency and capital-markets regimes shaped by Parmalat’s 2003 collapse. The Marzano law, covering bankruptcy, is often compared to the US’s Chapter 11, while another – Law 262 – introduced a number of corporate governance requirements and bolstered the powers of Consob, the Italian stockmarket regulator.

In all, the changes created “a more modern, investor-friendly environment,” says Bruno Cova, a partner at law firm Paul Hastings in Milan and Parmalat’s chief legal adviser in 2004 and 2005. “We are seeing restructurings that would have been difficult to achieve in the past.”

As laws have changed, so have attitudes. Parmalat’s board of directors, for example, boasts nine independent members out of 11. This, and other similar practices, earned the company an accolade from Assogestioni, the Italian association of asset managers, for the most advanced corporate governance in Italy. Parmalat is “rightly proud” of this, notes Cova. “It is an example for others.”

Under founder and former CEO Calisto Tanzi, now indicted, Parmalat’s board once included Tanzi’s brother Giovanni, son Stefano and niece Paola Visconti. CFO Fausto Tonna chaired the audit committee. That anything at Parmalat could now be considered best practice shows how quickly things have changed.

Ex-CFO of Parmalat Blames the Boss
Got Bilked?
Parmalat Investors to Get $.06 on the Dollar from Deloitte
Is There an Enron Sitting In Your Portfolio?
Matthew Argersinger,
Jul 13th 2011 4:30PM

Ask most investors — even financial experts — to explain what happened to Enron and they’ll bring up those bizarrely named fake partnerships the company used to hide massive amounts of its debt.

The faux off-balance-sheet partnerships that Enron employees named after Star Wars characters and themes — the Joint Energy Development Investment (abbreviated as JEDI), Kenobe Inc., Obi-1 Holdings and, of course, Chewco Investments — would be funny if they weren’t merely a sideshow compared with the monumental financial shenanigans taking place at the company.

Granted, silly names aren’t a typical sign that there’s something rotten with the state of a business. However, when a company’s revenues surge from less than $10 billion to $100 billion in five years — as Enron’s did from 1995 to 2000 — it’s time to put down the champagne and start asking questions. After all, consider that the average company that’s attained the $100 billion threshold (and there have only been a handful) took 25 years to hit that mark.

What was behind Enron’s unbelievable growth

How did Enron pull the wool over so many investors’ eyes? In business-speak, the company used some slick sleight-of-hand to change its revenue recognition policy to treat its boring utility business (which sold future delivery of natural gas) as a financial securities business. Using mark-to-market accounting (stay with me here), it treated its service contracts as tradable securities and booked the entire expected revenue from its service contracts immediately, instead of over the life of the contract.

Worse still, there were no actual markets (e.g., no actual customers) for many of the contracts Enron was supposedly selling.

Ultimately, Enron couldn’t keep up with the fancy results it was reporting to investors — later dubbed its “mark-to-make-believe” model — and it ended in disaster for all of the investors that had been seduced by its unprecedented and fraudulent revenue growth.

Oh, but Enron’s Not the Only Bad Apple

Enron may be one of the more infamous, but it’s just one of many examples of financial chicanery in recent corporate history — Computer Associates, MicroStrategy, Satyam, and WorldCom are all once highly respected names that seared legions of investors.

More recently, Bank of America (BAC) agreed to an $8.5 billion settlement for its role in perpetuating mortgage fraud during the housing boom. Its stock price is still down some 80% from its 2007 high. And it doesn’t seem like a week goes by without hearing of yet another U.S.-listed Chinese company being accused of some form of corporate malfeasance.

Examples of financial shenanigans are rich, ripe, and recurring. Learning to spot potential financial black holes — which we’ll help you do in this series — will help you avoid bad investments and purge your portfolio of ticking time bombs.

Is your company monkeying with revenue reporting?

Investors usually don’t think of a company’s revenue as a likely source of financial shenanigans. Maybe that’s why it’s a popular hiding place for ne’er-do-wells to manipulate their results to meet or beat quarterly expectations. After all, investors assume that with revenue, it’s what you see is what you get, right?

Not necessarily. With top-line revenue, it’s all about recognition of that revenue. When demand starts to slow, aggressive management teams accelerate revenue recognition to give the appearance that customer demand is still strong. For example, a company may extend payment terms to customers who agree to make a purchase today instead of at a planned later date. Or it might begin to book revenue from a software license, even though the product hasn’t been delivered to the customer yet.

By pulling revenue forward from future quarters — money that hasn’t yet been made — companies are, in effect, stealing from their future to pretty up the present.

The problem with pushing revenues around is that recognizing them early dramatically increases the risk of an earnings miss down the road. The downward spiral can get ugly: We’ve all had the experience of watching one of our stocks plummet after it misses estimates.

6 signs of accelerated revenue recognition

Here are some red flags to watch for so you don’t get dragged down by a company engaging in accelerated revenue recognition:

Red Flag
What It Tells You
How To Spot It

Receivables growing faster than sales
Accounts receivable measure how much cash a company is owed from customers. If receivables grow faster than sales, the company could be extending generous terms to entice more orders, or it could be having difficulty collecting the money it’s owed.
Using the income statement and balance sheet, watch for trends in revenue and receivables growth. Ideally, you want receivables to grow at the same rate of or below sales.

Increase in days sales outstanding, or DSO
DSO measures the number of days in a quarter that it takes for a company to collect on its bills. Related to our receivables analysis above, a higher DSO is an indication of aggressive revenue recognition, poor cash management, or both.
To calculate DSO, divide a company’s ending receivables with its revenue and multiply the result by the number of days in the period (e.g., 91.25 days for a quarter).

Use of percentage of completion, or POC, accounting
Under POC accounting, a company recognizes revenue on long-term contracts in proportion to the work completed, even though customers may have yet to be billed. Management could overestimate work completed and prematurely boost revenue.
Check a company’s 10-K under revenue recognition policy and see if they are using POC accounting. Also watch for any sharp increases in unbilled receivables relative to revenue.

Big drop in deferred revenue
Software and subscription-based companies often receive cash in advance of delivering a product or service. A sharp drop in deferred revenue boosts revenue in the short term at the expense of future quarters.
Check a company’s balance sheet and watch for any unusually large drops in deferred revenue.

Including inappropriate items in revenue
Proceeds from asset sales, investment gains, and interest on cash usually shouldn’t be counted in revenue and can give a false sense of a company’s operational strength.
Check the latest 10-Q or 10-K to see if any of these line items are being included in revenue. If so, remove them and reevaluate the company’s revenue growth.

A change in revenue recognition policy.
Anytime a company changes the method or timing of its revenue recognition, alarm bells should be going off. What is the motive?
Check the most recent 10-K under revenue recognition policy for any mention of changes to methodology.

Next in this series, we’ll help you spot earnings and cash flow red flags.
4 Signs a Company Is Fudging Its Quarterly Earnings Results
Matthew Argersinger,
Jul 19th 2011 9:00AM

Company illegal activity(Financial shenanigans cost shareholders billions of dollars. This is part of an ongoing series about how to spot Wall Street wrongdoing before it puts your portfolio in jeopardy. See last week’s “Is There an Enron Sitting In Your Portfolio?” for more.)

For many companies, meeting or beating quarterly earnings estimates matters more than anything else. Add stock options to the mix, or big cash bonuses tied to short-term earnings or stock price targets, and executives’ temptation to focus exclusively on quarterly results becomes irresistible. In the worst cases, this tunnel vision can drive companies to creative accounting, or even fraud.

Consider these shameless words from former CEO Joe Nacchio in January 2001, months before his company, Qwest Communications, began a precipitous decline that took its stock from the mid-$30s to a low of less than $2 by August 2002:

The most important thing we do is meet our numbers. It’s more important than any individual product; it’s more important than any individual philosophy; it’s more important than any individual cultural change we’re making. We stop everything else when we don’t make the numbers.

Congratulations, Mr. Nacchio! Qwest may have made its numbers, but it did so via methods that eventually cost shareholders billions.

Qwest ultimately restated its earnings, increasing its losses in 2000 and 2001 by more than $2 billion. Nacchio resigned in June 2002; he was later convicted of insider trading and carted off to jail.

Unfortunately, what happened at Qwest isn’t all that uncommon.

Why Earnings Are So Easy to Manipulate

Bad companies always ultimately lose the expectations game. Accounting trickery can only cloud a company’s struggling operations for so long. Astute investors can look behind the numbers and spot the red flags that clue us in when a company’s earnings results aren’t worth the paper they’re printed on.

Earnings are at the very bottom of the income statement (hence the term “bottom line”). They’re the end result after all expenses — raw material costs, salaries, marketing expenses, research and development, interest, and taxes — are taken out of revenue. Unfortunately, that also makes earnings the figure most susceptible to manipulation.

Shift some expenses around, draw down some reserves, play with your tax rate a bit, and presto! That quarterly earnings per share (EPS) result suddenly goes from a miss to a beat. Hey, what’s a penny or two between friends, if it leads to that fat year-end bonus and a higher stock price?

4 Signs of Earnings Funny Business

Howard Schilit, founder and CEO of the Financial Shenanigans Detection Group, has written extensively on the subject of earnings shenanigans. Here are a few of the major earnings red flags he discusses in his book, Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports. According to Schilit, these signs may indicate that a company is trying to pull a fast one:

1. Smooth and predictable EPS
Wall Street loves steady earnings results, and that’s what many managers strive for. But companies that consistently meet or exceed Wall Street’s consensus earnings estimates are often gaming their company’s earnings to do so. Be especially wary of managers who publicly tout their earnings-guidance track record. At the very least, it illustrates the short-term approach they’re taking with the business.

2. Boosting income or lowering expenses using one-time events
You might be used to seeing management make statements-of-issues releases with words like “adjusted earnings” or “earnings before one-time charges or expenses.” Companies will periodically experience one-time or non-recurring changes to their business: perhaps the sale of a factory, a large gain on an investment, a charge to restructure the business, or a large write-off of obsolete inventory.

Your job is to figure out when management is making appropriate adjustments to the income statement, and when it’s inappropriately shifting line-items around to simply paint a prettier picture of the business. The difference between right and wrong lies in how companies classify these one-time events, and where they show up on the income statement. For example:

Some companies will include one-time gains from asset sales or investments in the operating section of the income statement, as a way to boost operating profits. Obviously, if these activities aren’t normally part of the ongoing operations of the business, they shouldn’t be there.
On the other hand, restructuring charges, which aren’t normally included in operating expenses, should be there if the company keeps reporting regular restructuring expenses. You could call these “recurring nonrecurring” charges.
Finally, a large write-off of bad inventory or uncollectible debt should also be included in operating expenses. Often, it’s not.

3. Inappropriately capitalizing normal operating expenses
One of the classic ways companies boost short-term earnings involves capitalizing certain expenses that should normally be included on the income statement. In essence, a company treats normal operating expenses as an asset, shifting them to the balance sheet to be amortized (depreciated) over many years, instead of in the current quarter.

WorldCom, the famously bankrupt telecommunications giant, reported billions in inappropriate profit by capitalizing a significant portion of its line costs — the fees WorldCom paid to other telecom companies to access their networks, a perfectly normal part of its everyday business.

Watch for big increases in capital expenditures on the cash flow statement, with corresponding reductions in operating expenses on the income statement. That might give you a clue that a company is suddenly shifting normal operating expenses to its balance sheet.

4. Unusual changes in reserve accounts
Computer and car manufacturers normally bundle warranty plans with their products. These plans cover any potential problems you might experience, with the promise to fix or replace any defects over a predetermined number of years.

Manufacturers are required to record an expense and a liability reserve on the balance sheet for expected future warranty costs at the time the product is sold. Similarly, most companies set aside reserves to cover a portion of their accounts receivable — the amount their customers owe them — that they don’t think they’ll collect. And banks, when they have to, set aside certain amounts to cover expected loan defaults.

But management can exercise considerable discretion about how much money to mark for future liabilities. Reserve too little, and profit margins get a nice short-term boost, at the risk of higher expenses — not to mention lower profits — down the road.

In 2007, computer maker Dell (DELL) was required to restate its earnings for several years, because it improperly accounted for warranty liabilities. Investors should monitor changes in reserve items relative to revenue. If reserves decline relative to revenue, it could signal that a company is inflating earnings by not properly accounting for future costs.
Next in this series, we’ll help you spot cash flow red flags.

The Death of the PC
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“Is There an Enron Sitting In Your Portfolio?
How Companies Fake It (With Cash Flow)
Matthew Argersinger,
Jul 27th 2011 3:00PM

Financial shenanigans cost shareholders billions of dollars. This is part of an ongoing series about how to spot Wall Street wrongdoing before it puts your portfolio in jeopardy. See “Is There an Enron Sitting In Your Portfolio?” and “4 Signs a Company Is Fudging Its Quarterly Results” for more.)

Cash is king. And unlike accounting inventions like “earnings per share” and “EBITDA,” cash is tangible, fungible, and, heck, certain currencies are even smoke-able, I’m told.

Focusing on cash flow — instead of the accrual based figures that Wall Street is so fond of — is a good way for investors to measure a company’s financial health and operational strength. That said, measuring a company’s cash flow isn’t as simple as calculating the difference between how many dollars leave a company’s cash register and how many come in.

Just like with revenue and earnings, companies can use a whole range of tricks to manipulate cash flow and hoodwink investors. Savvy managers know that fancy verbiage and accounting sleight of hand can make even the poorest operating cash flow statement look like Warren Buffett’s checking account.

Where’s the Bacon?

The statement of cash flows is divided into three sections: operating, investing, and financing. Cash flows in and out of these sections depending on the type of activity. Here are some examples of typical inflows and outflows.

Cash Inflow (+)
Cash Outflow (-)

Profits, receivables collections
Vendor payments, marketing costs, salaries, taxes

Plant/equipment sales, investment proceeds
Capital expenditures, asset purchases, acquisitions

Bank borrowings, stock issuance
Loan repayments, stock buybacks, dividend payments

Investors and analysts care most about the operating section of the cash flow statement, and for good reason. This is where the company makes its bacon. You want to see cash generated by the company’s operations, not from unsustainable sources such as equipment sales and short-term investments, or from potentially troublesome sources such as borrowing and issuing stock.

Unfortunately, it’s not always 100% clear where a company is generating most of its cash from. Here’s how to tell whether your stock is cash flush or penny poor.

4 Signs a Company’s Pulling a Cash Flow Hustle

1. Capitalizing Normal Operating Expenses: As discussed in the previous article in the series, companies will sometimes treat normal operating expenses as an asset, and shift them to the balance sheet to be amortized (depreciated) over many years. While this boosts profits, it also boosts operating cash flow, because normal expenses (operating cash outflows) get shifted to the investing section as capital expenditures (investing cash outflows).

Red Flag: On the cash flow statement, watch for an unusually large spike in capital expenditures, with a corresponding spike in cash generated from operations. If anything looks fishy, dig further.

2. Misclassifying Inventory Purchases: The costs to acquire or produce inventory that will be sold to customers should almost always be included on the operating section of the cash flow statement. But this isn’t always the case.

Take Netflix (NFLX), which Howard Schilit discusses in his classic work, Financial Shenanigans. For years, Netflix has treated its purchase of DVDs — the essential inventory of its business — as an investing outflow, rather than an operating outflow. This is especially curious, because most of Netflix’s new DVDs are amortized over a period of just one year. Netflix’s accounting treatment provides a big boost for its operating cash flows. At the time it went bankrupt last year, competitor Blockbuster had been classifying its DVD purchases as operating outflows.

Red Flag: It’s up to you to decide whether Netflix’s inventory accounting is proper or not, but the basic takeaway here is that you should always question large investing outflows when they appear to be part of a company’s normal cost of operations.

3. Serial Acquirers: Since 2008, industrial and agricultural conglomerate Trimble Navigation (TRMB) has made no less than 22 acquisitions. You might be surprised to learn that, despite all these acquisitions, and the nasty economic downturn, Trimble reported some of the highest operating cash flow results in its history from 2008 to 2010. How is that possible? Through the magic of acquisition accounting.

When one company acquires another, it uses cash (investing outflow) from its balance sheet, or cash from borrowing (financing inflow) or from issuing shares (financing inflow). The beauty here is that all the costs to make the acquisition come out of the investing and financing sections of the cash flow statement, but all the benefits — increased sales and profits, acquired inventory or receivables that are then sold by the parent company — are reflected in higher cash inflows on the operating section. Companies like Trimble that make regular acquisitions can repeatedly inflate their operating cash flows simply through the magic of acquisition accounting.

Savvy investors have a way of dispelling this. Trimble may have generated operating cash flow of $495 million from 2008 to 2010, but if you subtract Trimble’s capital expenditures and the cash cost of acquisitions — a measure of Trimble’s free cash flow — it’s a much more pedestrian $139 million.

Red Flag: Watch out for companies that make numerous and routine acquisitions. Pay closer attention to free cash flow (operating cash flow less capital expenditures and acquisition costs) to measure the strength of a company’s operations.

4. For the Love of EBITDA: Lots of investors come across the term “EBITDA” without knowing what it means. EBITDA, which stands for earnings before interest, taxes, depreciation, and amortization, is a trendy accounting invention that corporate managers like to use as a proxy for their company’s operating cash flow. By removing interest and taxes (which are non-operational costs) and depreciation and amortization (which are noncash accrual expenses), managers think they’re presenting an appropriate and measurable metric of their company’s operational prowess.

My word for EBITDA: fugetaboutit!

Interest and taxes are real cash expenses that should be accounted for. By excluding interest in particular, serial acquirers like Trimble can run up their debt to dangerous levels to acquire a bunch of bad businesses. Their EBITDA might look beautiful in the short term, but the debt and interest payments could eventually sink them. Most worryingly, EBITDA excludes changes to working capital accounts like accounts receivable and inventory, which have real cash impacts on the business.

Red Flag: Avoid companies that like to use EBITDA as a measure of their company’s performance, especially if it’s tied to management’s compensation incentives. Stick to operating cash flow and free cash flow.

Is There an Enron Sitting In Your Portfolio?
4 Signs a Company Is Fudging Its Quarterly Results
companies will sometimes treat normal operating expenses as an asset
Accounting For Half-Truths
Dipak Mondal, Money Today, March 2012

October 2008: A report by a brokerage on Satyam Computers gives an ‘accumulate’ rating, which means it expects the stock to go up. The rating is based on the company’s high cash/market cap ratio. The information technology company had reported a cash balance of Rs 4,500 crore at the end of the 2007-08 financial year. The report gives a one-year price target of Rs 373 for the stock. The stock closes at Rs 273 the day the report is written.

January 2009: The same brokerage releases a hurriedly-compiled report suspending the previous rating. “Low market cap, high cash status no longer holds,” it says. On 7 January 2009, the founder of Satyam Computers admits to inflating cash and bank balances by Rs 5,040 crore, overstating debtors’ position (money lent) of Rs 2,650 crore as against the actual figure of Rs 490 crore and non-disclosure or understatement of liabilities worth Rs 1,230 crore.

The Satyam accounting scam, one of the biggest in India, left millions of investors in the lurch, as the stock fell from Rs 179 to Rs 23 in one trading session.

The inability of stock analysts to identify the ‘gaps’ in Satyam’s books and ring warning bells proved costly for investors. Had investors known the basics of reading financial statements and techniques used by companies to report false numbers, they would have asked their advisors a few valid questions about Satyam’s finances.

Incentive of committing/abetting a fraud is greater than the disincentive of being caught for companies as well as promoters and other financial service providers.
Arpinder Singh
Partner and National Director, Fraud Investigation & Dispute Services, Ernst & Young India

Some would argue how lay investors could see red flags when experts failed to do so. It’s a valid argument, though we believe that with a little bit of learning you can see what professionals cannot.

We discuss a few common forms of accounting frauds companies indulge in and signs that may alert you to wrongdoing –


A company’s financial health can be gauged through three statements – balance sheet, profit and loss account and cash flow accounts.

A balance sheet records a company’s assets (land, machinery, inventory, cash balance, investments, loans given), liabilities (loans taken, income tax payable, tax liabilities) and owner’s equity. It is generally prepared annually.

A profit and loss statement (or income statement) records a company’s earnings and expenses. Any company whose shares are traded on exchanges is required to release its income statement every quarter.

A cash flow statement tells us where cash is coming from (inflow) and how it is being used (outflow). There are three types of cash flow-operating cash flow (sale of goods, revenue from services, interest/dividend received, payment for purchases, payment for operating expenses), investing cash flow (sale and purchase of assets, sale and purchase of debt/equity, loans advanced to others) and financial cash flow (issue of equity shares, borrowing, repayment of debt).

1. High debt reserves relative to past loan defaults. A debt reserve is money set aside to account for losses that may arise as a result of defaults on future loans.
2. Minimal use of off-balance sheet techniques. It’s a form of financing in which large capital expenditures are kept off a companys balance sheet through various methods
3. Use of accelerated depreciation. It allows one to deduct far more in the first years after purchase. The straight-line method spreads the cost evenly over the life of the asset
4. Showing shorter useful life of assets. Any changes on this front cause higher or lower depreciation writeoffs

Notes to accounts are important as they detail the accounting policies followed, pension and other post-employment benefits and potential liabilities/losses.


There are many items in financial statements for which companies use different policies. These are inventory valuation, investments and fixed assets, conversion of foreign currency and asset depreciation.

Companies often manipulate these to inflate revenue, assets, cash inflow and understate expense, liabilities and cash outflow in financial statements.


1) Lending to customers: Sometimes companies lend money to customers to buy their goods. This way they can report high revenue in the income statement and high receivables (treated as an asset) in the balance sheet.

2) Trade stuffing: Companies use this usually just before the end of a reporting period. They ship goods to customers even though the latter may not need them immediately. This increases sales ahead of the reporting period.

3) Understating provisions: Companies often allow credit sales on generous terms, sometimes even to customers with a poor credit history. Ideally, in such sales, the company should set aside a higher amount for bad debt provisioning. This amount is recorded as a liability. Understating such liabilities is another way of ‘enhancing’ the financial statement.

4) Round-tripping: This means getting into fictitious transactions with related parties to inflate revenue. In round-tripping, a company sells unused assets to a party with the promise of buying back at a later date at the same price.


1) Spreading out expenses: According to accounting norms, if an expense has been made for acquiring an asset whose benefits the company will avail of over a long term, the expense is to be reported in the books in a spread-out manner over that period. The process is called capitalising. Companies often use this to delay recognition of short-term expenses.

2) Cookie jar accounting: Companies put aside money for possible loan defaults. Some companies, during periods of high revenue growth, increase the amount and release the same during periods of poor revenue, offsetting the impact of low sales growth. Among other common forms of financial statement manipulation are revaluation of assets, showing unrealised gains as profits and assigning higher values to fixed assets.

3) Off-balance sheet items: Some assets/liabilities or financing activities are not fully recognised in the balance sheet due to the complexity of transactions involved. These include pension assets and liabilities, assets and liabilities of joint ventures and unconsolidated subsidiaries and lease arrangements. These are recorded in footnotes of financial statements.

Sudden increase in inventory/sales ratio indicates that the company may be fraudulently inflating assets such as inventories.

Many companies resort to off-balance sheet financing by way of entering into joint ventures, research and development partnerships and lease contracts. Floating special purpose entities or subsidiaries to expand business is another off-balance sheet arrangement.

As the liabilities/risk involved in such transactions are not reflected in the balance sheet, one may draw wrong conclusions about a company’s financial health. It is, therefore, necessary to check the footnotes of financial statements.


Some manipulations we mentioned earlier are difficult to detect even for finance professionals. Here are some indicators of rot in a company’s financial books.

Continuous high level of cash, cash equivalents and current assets: Satyam Computers showed high cash balance over the years. Later it turned out it had inflated cash and bank balances by as much as Rs 5,040 crore.

Reported earnings consistently higher than cash flow: If cash flow from operating activities of a company is consistently less than the reported net income, it is a warning sign. The investor must ask why operating earnings are not turning into cash.

Sudden increase in inventory/sales ratio: This indicates the company may be inflating assets such as inventories.

Financial ratios not in line with industry peers could be due to inflated earnings, asset valuation or understating of expenses and liabilities.
Spurt in other income: Revenue sources recorded under other income are non-recurring and may include earnings from asset sales and closure of debt or debt restructuring. However, sources of earnings are seldom disclosed under this head. A sudden spurt should raise eyebrows.

Frequent changes in policies: Earnings and assets can be inflated by alternative accounting policies. If one sees frequent changes in these policies, there may be something fishy about the company’s books.

Financial ratios not in line with industry peers: This could be due to inflated earnings, asset valuation or understating of expenses and liabilities.

Too many off-balance sheet transactions: If a company has been expanding by creating special purpose entities and has entered into many lease contracts, it is possible a lot of liabilities are not reflected in its balance sheet.

We have seen in the past that many respected and renowned companies have been charged with manipulation of account books. Therefore, investors must stop treating financial statements issued by companies as gospel truth and scan them carefully to detect possible foul plays.


Enron, an energy trading company in the US, used various accounting methods for years to show high revenue and profit and understate debt.

How It Cooked Its Books

Inflated revenues: Enron was supposed to report trading and brokerage fees as revenue. However, it chose to report the entire value of transactions as revenue instead of just the fees.

This led to a huge jump in sales figure. In four years between 1996 and 2000, Enrons revenue jumped from $13 billion to $100 billion, a compounded annual growth rate of 65%.

It also started marking its revenue to the market, something unheard of in a non-financial company. This allowed it to record revenue from long-term contracts by estimating the present value of future cash flow even before it actually made any income from the project.

This method, approved by the US market regulator in 1992, helped Enron show inflated income.

1. Are schemes offering high returns safe?
2. How to save yourself from credit card fraud
3. Saving yourself from stock market scams
4. Tips to save yourself from accounting fraud
5. Fraud plagues Indian banking sector: Survey

BT Special on Satyam scam
report gives a one-year price target
The Satyam accounting scam
identify the ‘gaps’ in Satyam’s books
detail the accounting policies
financial statements for which companies
difficult to detect even for finance professionals
Are schemes offering high returns safe?
How to save yourself from credit card fraud
Saving yourself from stock market scams
Tips to save yourself from accounting fraud
Fraud plagues Indian banking sector: Survey
Jack Welch Probably Shouldn’t Bring Up Doctored Numbers
By Eric Randall
Boston Daily, October 5, 2012, 11:48 a.m.

Jack Welch, former CEO of General Electric, Romney supporter, and one of our city’s wealthiest men, caused quite a stir this morning when he tweeted that the Bureau of Labor Statistics unemployment rate, which came in at a surprisingly low 7.8 percent, was doctored on behalf of the Obama re-election campaign:

Unbelievable jobs numbers..these Chicago guys will do anything..can’t debate so change numbers

  • Jack Welch (@jack_welch) October 5, 2012

His accusation quickly went viral. It’s got over 2,000 retweets, and it even caused Secretary of Labor Hilda Solis to address the accusation directly. She called it “ludicrous” on CNBC. The Bureau of Labor Statistics puts together its jobs report each month under conditions of crazy secrecy, but even most Republican experts, including those who argue the numbers are an anomaly, didn’t second Welch’s theory that the BLS twisted the process in order to help the president. George W. Bush administration spokesman Tony Fratto tweeted:

BLS is not manipulating data.Evidence of such would be a scandal of enormous proportions & loss of credibility.

  • Tony Fratto (@TonyFratto) October 5, 2012

Probably the most awkward thing about the accusation is that Welch’s company GE has had its own little number-cooking scandal, as pointed out by former George W. Bush speechwriter David Frum.

BTW Isn’t Jack Welch about the last person on earth who shd talk about organizations manipulating numbers to impress markets? – davidfrum (@davidfrum) October 5, 2012

Indeed, GE agreed to a $50 million fine in 2009 after the Securities and Exchange Commission charged that it had been toying with its accounting numbers for years to make it look as if the company’s performance had met or exceeded analysts’ expectations. Forbes’s Dan Fisher wrote in 2009:

Like a professional baseball player revealed to have been dabbling in steroids, GE prolonged a nearly decade-long record of meeting or exceeding analyst expectations by resorting to tricks including “selling” locomotives to financial institutions in transactions that looked a lot like loans, and fiddling with the accounting for interest-rate hedges.

So maybe that’s why Welch suspects book-cooking where everyone else refuses to see it. He knows it wouldn’t be the first time a major institution has gotten a little tricky with their numbers.

Romney supporter
wealthiest men
surprisingly low 7.8 percent
October 5, 2012
crazy secrecy
October 5, 2012
October 5, 2012
wrote in 2009
The Pentagon’s Doctored Accounting Ledgers Conceal Epic Waste
Scot J. Paltrow, Reuters Nov. 19, 2013, 6:00 AM
(Edited by John Blanton)

LETTERKENNY ARMY DEPOT, Chambersburg, Pennsylvania (Reuters) – Linda Woodford spent the last 15 years of her career inserting phony numbers in the U.S. Department of Defense’s accounts.

Every month until she retired in 2011, she says, the day came when the Navy would start dumping numbers on the Cleveland, Ohio, office of the Defense Finance and Accounting Service, the Pentagon’s main accounting agency.

Using the data they received, Woodford and her fellow DFAS accountants there set about preparing monthly reports to square the Navy’s books with the U.S. Treasury’s – a balancing-the-checkbook maneuver required of all the military services and other Pentagon agencies.

And every month, they encountered the same problem. Numbers were missing. Numbers were clearly wrong. Numbers came with no explanation of how the money had been spent or which congressional appropriation it came from. “A lot of times there were issues of numbers being inaccurate,” Woodford says. “We didn’t have the detail … for a lot of it.”

The data flooded in just two days before deadline. As the clock ticked down, Woodford says, staff were able to resolve a lot of the false entries through hurried calls and emails to Navy personnel, but many mystery numbers remained. For those, Woodford and her colleagues were told by superiors to take “unsubstantiated change actions” – in other words, enter false numbers, commonly called “plugs,” to make the Navy’s totals match the Treasury’s.

Jeff Yokel, who spent 17 years in senior positions in DFAS’s Cleveland office before retiring in 2009, says supervisors were required to approve every “plug” – thousands a month. “If the amounts didn’t balance, Treasury would hit it back to you,” he says.

After the monthly reports were sent to the Treasury, the accountants continued to seek accurate information to correct the entries. In some instances, they succeeded. In others, they didn’t, and the unresolved numbers stood on the books.


At the DFAS offices that handle accounting for the Army, Navy, Air Force and other defense agencies, fudging the accounts with false entries is standard operating procedure, Reuters has found. And plugging isn’t confined to DFAS (pronounced DEE-fass). Former military service officials say record-keeping at the operational level throughout the services is rife with made-up numbers to cover lost or missing information.

A review of multiple reports from oversight agencies in recent years shows that the Pentagon also has systematically ignored warnings about its accounting practices. “These types of adjustments, made without supporting documentation … can mask much larger problems in the original accounting data,” the Government Accountability Office, the investigative arm of Congress, said in a December 2011 report.

Plugs also are symptomatic of one very large problem: the Pentagon’s chronic failure to keep track of its money – how much it has, how much it pays out and how much is wasted or stolen.

This is the second installment in a series in which Reuters delves into the Defense Department’s inability to account for itself. The first article examined how the Pentagon’s record-keeping dysfunction results in widespread pay errors that inflict financial hardship on soldiers and sap morale.

This account is based on interviews with scores of current and former Defense Department officials, as well as Reuters analyses of Pentagon logistics practices, bookkeeping methods, court cases and reports by federal agencies.

As the use of plugs indicates, pay errors are only a small part of the sums that annually disappear into the vast bureaucracy that manages more than half of all annual government outlays approved by Congress. The Defense Department’s 2012 budget totaled $565.8 billion, more than the annual defense budgets of the 10 next largest military spenders combined, including Russia and China. How much of that money is spent as intended is impossible to determine.

In its investigation, Reuters has found that the Pentagon is largely incapable of keeping track of its vast stores of weapons, ammunition and other supplies; thus it continues to spend money on new supplies it doesn’t need and on storing others long out of date.

It has amassed a backlog of more than half a trillion dollars in unaudited contracts with outside vendors; how much of that money paid for actual goods and services delivered isn’t known. And it repeatedly falls prey to fraud and theft that can go undiscovered for years, often eventually detected by external law enforcement agencies.

The consequences aren’t only financial; bad bookkeeping can affect the nation’s defense. In one example of many, the Army lost track of $5.8 billion of supplies between 2003 and 2011 as it shuffled equipment between reserve and regular units. Affected units “may experience equipment shortages that could hinder their ability to train soldiers and respond to emergencies,” the Pentagon inspector general said in a September 2012 report.

Because of its persistent inability to tally its accounts, the Pentagon is the only federal agency that has not complied with a law that requires annual audits of all government departments. That means that the $8.5 trillion in taxpayer money doled out by Congress to the Pentagon since 1996, the first year it was supposed to be audited, has never been accounted for. That sum exceeds the value of China’s economic output last year.

Congress in 2009 passed a law requiring that the Defense Department be audit-ready by 2017. Then-Defense Secretary Leon Panetta in 2011 tightened the screws when ordered that the department make a key part of its books audit-ready in 2014.

Reuters has found that the Pentagon probably won’t meet its deadlines. (See related article [ID:nL2N0J00PX].) The main reason is rooted in the Pentagon’s continuing reliance on a tangle of thousands of disparate, obsolete, largely incompatible accounting and business-management systems. Many of these systems were built in the 1970s and use outmoded computer languages such as COBOL on old mainframes. They use antiquated file systems that make it difficult or impossible to search for data. Much of their data is corrupted and erroneous.

“It’s like if every electrical socket in the Pentagon had a different shape and voltage,” says a former defense official who until recently led efforts to modernize defense accounting.


No one can even agree on how many of these accounting and business systems are in use. The Pentagon itself puts the number at 2,200 spread throughout the military services and other defense agencies. A January 2012 report by a task force of the Defense Business Board, an advisory group of business leaders appointed by the secretary of defense, put the number at around 5,000.

“There are thousands and thousands of systems,” former Deputy Secretary of Defense Gordon England said in an interview. “I’m not sure anybody knows how many systems there are.”

In a May 2011 speech, then-Secretary of Defense Robert Gates described the Pentagon’s business operations as “an amalgam of fiefdoms without centralized mechanisms to allocate resources, track expenditures, and measure results. … My staff and I learned that it was nearly impossible to get accurate information and answers to questions such as ‘How much money did you spend’ and ‘How many people do you have?’ ”

The Pentagon has spent tens of billions of dollars to upgrade to new, more efficient technology in order to become audit-ready. But many of these new systems have failed, either unable to perform all the jobs they were meant to do or scrapped altogether – only adding to the waste they were meant to stop.

Mired in a mess largely of its own making, the Pentagon is left to make do with old technology and plugs – lots of them. In the Cleveland DFAS office where Woodford worked, for example, “unsupported adjustments” to “make balances agree” totaled $1.03 billion in 2010 alone, according to a December 2011 GAO report.

In its annual report of department-wide finances for 2012, the Pentagon reported $9.22 billion in “reconciling amounts” to make its own numbers match the Treasury’s, up from $7.41 billion a year earlier. It said that $585.6 million of the 2012 figure was attributable to missing records.

The remaining $8 billion-plus represented what Pentagon officials say are legitimate discrepancies. However, a source with knowledge of the Pentagon’s accounting processes said that because the report and others like it aren’t audited, they may conceal large amounts of additional plugs and other accounting problems.

The secretary of defense’s office and the heads of the military and DFAS have for years knowingly signed off on false entries. “I don’t think they’re lying and cheating and stealing necessarily, but it’s not the right thing to do,”Pentagon Comptroller Robert Hale said in an interview. “We’ve got to fix the processes so we don’t have to do that.”

Congress has been much more lenient on the Defense Department than on publicly traded corporations. The Sarbanes-Oxley Act of 2002, a response to the Enron Corp and other turn-of-the-century accounting scandals, imposes criminal penalties on corporate managers who certify false financial reports. “The concept of Sarbanes-Oxley is completely foreign” to the Pentagon, says Mike Young, a former Air Force logistics officer who for years has been a consultant on, and written about, Defense Department logistics.

Defense officials point out that most plugs represent pending transactions – like checks waiting to clear with a bank – and other legitimate maneuvers, many of which are eventually resolved. The dollar amounts, too, don’t necessarily represent actual money lost, but multiple accounting entries for money in and money out, often duplicated across several ledgers.

That’s how, for example, a single DFAS office in Columbus, Ohio, made at least $1.59 trillion – yes, trillion – in errors, including $538 billion in plugs, in financial reports for the Air Force in 2009, according to a December 2011 Pentagon inspector general report. Those amounts far exceeded the Air Force’s total budget for that year.

Defense Secretary Chuck Hagel declined to comment for this article. In an August 2013 video message to the entire Defense Department, he said: “The Department of Defense is the only federal agency that has not produced audit-ready financial statements, which are required by law. That’s unacceptable.”

DFAS Director Teresa McKay declined to be interviewed for this article.

In an email response to questions from Reuters, a Treasury spokesman said: “The Department of Defense is continuing to take steps to strengthen its financial reporting. … We’re supportive of those efforts and will continue to work with DOD as they make additional progress.” While the Treasury knowingly accepts false entries, it rejects accounts containing blank spaces for unknown numbers and totals that don’t match its own.

Senators Tom Coburn, an Oklahoma Republican, and Joe Manchin, a West Virginia Democrat, introduced legislation earlier this year that would penalize the Pentagon if it isn’t audit-ready by 2017. Under the proposed Audit the Pentagon Act of 2013, failure to meet the deadline will result in restrictions on funding for new acquisition programs, prohibit purchases of any information-technology systems that would take more than three years to install, and transfer all DFAS functions to the Treasury.

“The Pentagon can’t manage what it can’t measure, and Congress can’t effectively perform its constitutional oversight role if it doesn’t know how the Pentagon is spending taxpayer dollars,” Coburn said in an email response to questions. “Until the Pentagon produces a viable financial audit, it won’t be able to effectively prioritize its spending, and it will continue to violate the Constitution and put our national security at risk.”


The practical impact of the Pentagon’s accounting dysfunction is evident at the Defense Logistics Agency, which buys, stores and ships much of the Defense Department’s supplies – everything from airplane parts to zippers for uniforms.

It has way too much stuff.

“We have about $14 billion of inventory for lots of reasons, and probably half of that is excess to what we need,”Navy Vice Admiral Mark Harnitchek, the director of the DLA, said at an August 7, 2013, meeting with aviation industry executives, as reported on the agency’s web site.

And the DLA keeps buying more of what it already has too much of. A document the Pentagon supplied to Congress shows that as of September 30, 2012, the DLA and the military services had $733 million worth of supplies and equipment on order that was already stocked in excess amounts on warehouse shelves. That figure was up 21% from $609 million a year earlier. The Defense Department defines “excess inventory” as anything more than a three-year supply.

Consider the “vehicular control arm,” part of the front suspension on the military’s ubiquitous High Mobility Multipurpose Vehicles, or Humvees. As of November 2008, the DLA had 15,000 of the parts in stock, equal to a 14-year supply, according to an April 2013 Pentagon inspector general’s report.

And yet, from 2010 through 2012, the agency bought 7,437 more of them – at prices considerably higher than it paid for the thousands sitting on its shelves. The DLA was making the new purchases as demand plunged by nearly half with the winding down of the Iraq and Afghanistan wars. The inspector general’s report said the DLA’s buyers hadn’t checked current inventory when they signed a contract to acquire more.

Just outside Harrisburg, Pennsylvania, the DLA operates its Eastern Distribution Center, the Defense Department’s biggest storage facility. In one of its warehouses, millions of small replacement parts for military equipment and other supplies are stored in hundreds of thousands of breadbox-size bins, stacked floor to ceiling on metal shelves in the 1.7 million-square-foot building.

Sonya Gish, director of the DLA’s process and planning directorate, works at the complex. She says no system tracks whether newly received items are put in the correct bins, and she confirmed that because of the vast quantities of material stored, comprehensive inventories are impossible.

The DLA makes do with intermittent sampling to see if items are missing or stored in the wrong place. Gish also says the distribution center does not attempt to track or estimate losses from employee theft.

The Pentagon in 2004 ordered the entire Defense Department to adopt a modern labeling system that would allow all the military branches to see quickly and accurately what supplies are on hand at the DLA and each of the services. To date, the DLA has ignored the directive to use the system. William Budden, deputy director of distribution, said in an interview that the cost would have exceeded the potential benefits, and that the DLA’s existing systems are adequate.

A “Clean Out the Attic” program to jettison obsolete inventory is making progress, DLA Director Harnitchek said in an interview. But the effort is hindered because the lack of reliable information on what’s in storage makes it hard to figure out what can be thrown out.

The DLA also has run into resistance among warehouse supervisors who for years have been in charge of a handful of warehouse aisles and jealously husband their inventory. “I believe that the biggest challenge is helping item managers identify things we have in our warehouses that they can just let go of,” Budden said in an interview published in an undated in-house DLA magazine.


A few miles away, amid the gently rolling hills of south central Pennsylvania, a series of 14 explosions interrupt the stillness of a spring afternoon, shooting fountains of dirt more than 100 feet into the air. Staff at the Letterkenny Army Depot – one of eight Army Joint Munitions Command depots in the United States – are disposing of 480 pounds of C4 plastic explosive manufactured in 1979 and at risk of becoming dangerously unstable.

If Woody Pike could have his way, the soldiers would be destroying a lot more of the old, unused munitions stored in scores of turf-covered concrete “igloos” ranged across the Letterkenny compound.

There are runway flares from the 1940s, and warheads for Sparrow missiles that the military hasn’t fielded since the 1990s. Most irksome, because they take up a lot of space, are rocket-launch systems that were retired in the 1980s. “It will be years before they’re gone,” says Pike, a logistics management specialist and planner at Letterkenny.

More than one-third of the weapons and munitions the Joint Munitions Command stores at Letterkenny and its other depots are obsolete, according to Stephen Abney, command spokesman. Keeping all those useless bullets, explosives, missiles, rifles, rocket launchers and other munitions costs tens of millions of dollars a year.

The munitions sit, year after year, because in the short term, “it’s cheaper for the military to store it than to get rid of it,” said Keith Byers, Letterkenny’s ammunition manager. “What’s counterproductive is that what you’re looking at is stocks that are going to be destroyed eventually anyway.”

Also, an Army spokesman said, the Pentagon requires the Army to store munitions reserves free of charge for the other military services, which thus have no incentive to pay for destroying useless stock.

To access ammunition and other inventory still in use, depot staff often must move old explosives, much of which is stored in flimsy, thin-slatted crates. “Continuing to store unneeded ammunition creates potential safety, security and environmental concerns,” Brigadier General Gustave Perna said in a 2012 military logistics newsletter, when he was in charge of the Joint Munitions Command. The cost and danger of storing old munitions “frustrates me as a taxpayer,” he said. Perna declined requests for an interview.

Sometimes the danger leads to action, as when the C4 was detonated. And the depot recently received funding to destroy 15,000 recoilless rifles last used during World War II, Pike says.

Yet, on the day of the C4 blasts, piles of Phoenix air-to-air missiles – used on Navy F-14 fighter jets that last flew for the U.S. in 2006 – had just been offloaded from rail cars and were waiting to be put into storage.

In 2010, as part of the Defense Department’s modernization effort , the Joint Munitions Command scrapped a computer system that kept track of inventory and automatically generated required shipping documents. It was replaced with one that Pike says doesn’t do either.

His staff now must guess how much inventory and space Letterkenny has. The Army built at additional cost a second system to create shipping documents and an interface between the two systems. “We’re having problems with the interface,” Pike says.


Media reports of Defense Department waste tend to focus on outrageous line items: $604 toilet seats for the Navy, $7,600 coffee makers for the Air Force. These headline-grabbing outliers amount to little next to the billions the Pentagon has spent on repeated efforts to fix its bookkeeping, with little to show for it.

The Air Force’s Expeditionary Combat Support System was intended to provide for the first time a single system to oversee transportation, supplies, maintenance and acquisitions, replacing scores of costly legacy systems. Work got under way in 2005. Delays and costs mounted. In late 2012, the Air Force conducted a test run. The data that poured out was mostly gibberish. The Air Force killed the project.

The system “has cost $1.03 billion … and has not yielded any significant military capability,” the Air Force said in a November 2012 announcement.

Fixing the system would cost an additional $1.1 billion, it said, and even then, it would do only about a quarter of the tasks originally intended, and not until 2020.

The Air Force blamed the failure on the main contractor, Virginia-based Computer Sciences Corp, saying the company was unable to handle the job.

Computer Sciences spokesman Marcel Goldstein said that the company provided the Air Force with important “capabilities,” and that “the progress we made, jointly with the Air Force, and the software we have delivered could be the foundation for the next effort to develop and deploy a logistics system for the Air Force.”

David Scott Norton, an expert in accounting systems who worked for CSC on the Air Force contract, said the project employed too many people, making coordination and efficiency impossible. “There were probably thousands of people, both Air Force and contractors, on it,” he says. High turnover among both Air Force and contractor staff hurt, too, he says; many of the people who worked on it weren’t the people who had conceived and designed it.

More than $1 billion was wasted when the Pentagon in 2010 ditched the Defense Integrated Military Human Resources System, launched in 2003 as a single, department-wide pay and personnel system that would eliminate pay errors. Interagency squabbles and demands for thousands of changes eventually sank it.

The Air Force’s Defense Enterprise Accounting and Management System was supposed to take over the Air Force’s basic accounting functions in 2010. To date, $466 million has been spent on DEAMS, with a projected total cost of $1.77 billion to build and operate it, an Air Force spokeswoman said. The system lacks “critical functional capabilities,” and its “data lacks validity and reliability,” according to a September 2012 Defense Department inspector general report. It now isn’t expected to be fully operational until 2017.

The Army’s General Fund Enterprise Business System is often held up as an example of rare success. Up and running in 2012, GFEBS is now used in Army posts all over the world to handle basic accounting functions.

Some things it does well, but the inspector general said in March last year that the system didn’t provide department management with required information and may not resolve “longstanding weaknesses” in the Army’s financial management, “despite costing the Army $630.4 million as of October 2011.”

In 2000, the Navy began work on four separate projects to handle finances, supplies, maintenance of equipment and contracting. Instead, the systems took on overlapping duties that each performed in different ways, using different formats for the same data. Five years later, the GAO said: “These efforts were failures. … $1 billion was largely wasted.”

The Navy started again in 2004 with the Navy Enterprise Resources Planning project to handle all Navy accounting – at first. The Navy later decided on a system design that would cover only about half of the service’s budget because a single, service-wide system would be too difficult and time-consuming, according to former Navy personnel who worked on the project. Accounting for property and other physical assets was dropped, too.

Now in use, the Navy ERP relies on data fed to it from 44 old systems it was meant to replace. “Navy officials spent $870 million … and still did not correct” the system’s inability to account for $416 billion in equipment, the Pentagon inspector general said in a July 2013 report.

The Navy declined to comment.

Even an effort to coordinate all these projects ended in failure. In 2006, Deputy Secretary of Defense Gordon England established the Business Transformation Agency to force the military branches and other agencies to upgrade their business operations, adhere to common standards and make the department audit-ready.

Three years later, the Center for Strategic and International Studies said that while the Defense Department was spending “in excess of $10 billion per year on business systems modernization and maintenance, (o)verall the result is close to business as usual.”

Defense Secretary Gates shut it down in 2011 – after the Pentagon had spent $700 million on it. England declined to comment on the episode.

Former BTA officials blamed the failure on their lack of authority to enforce their decisions and resistance from the individual services.


Over the past 10 years, the Defense Department has signed contracts for the provision of more than $3 trillion in goods and services. How much of that money is wasted in overpayments to contractors, or was never spent and never remitted to the Treasury, is a mystery. That’s because of a massive backlog of “closeouts” – audits meant to ensure that a contract was fulfilled and the money ended up in the right place.

The Defense Contract Management Agency handles audits of fixed-price contracts, which are relatively problem-free. It’s the Defense Contract Audit Agency that handles closeouts for department-wide contracts that pay the company or individual for expenses incurred. At the end of fiscal 2011, the agency’s backlog totaled 24,722 contracts worth $573.3 billion, according to DCAA figures. Some of them date as far back as 1996.

The individual military services close out their own contracts, and the backlogs have piled up there, too. The Army’s backlog was 450,000 contracts, the GAO said in a December 2012 report. The Navy and Air Force did not have estimates of their backlogs.

“This backlog represents hundreds of billions of dollars in unsettled costs,” the GAO report said. Timely closeouts also reduce the government’s financial risk by avoiding interest on late payments to contractors.

To trim its backlog, the DCAA last year raised to $250 million from $15 million the threshold value at which a contract is automatically audited. DCAA says that by concentrating its auditors on the biggest contracts, it will recoup the largest sums of money, and that it will conduct selective audits of smaller contracts, based on perceived risk and other factors. Still, hundreds of thousands of contracts that would eventually have been audited now won’t be.

“Having billions of dollars of open, unaudited contracts stretching back to the 1990s is clearly unacceptable, and places taxpayer dollars at risk of misuse and mismanagement,” Senator Thomas Carper, a Delaware Democrat and chairman of the Homeland Security and Governmental Affairs Committee, said in an email response to questions. “We must make sure that the Department of Defense is actively assessing risks and making sure that contractors who fall underneath the threshold remain accountable for their work.”

Spotty monitoring of contracts is one reason Pentagon personnel and contractors are able to siphon off taxpayer dollars through fraud and theft – amounting to billions of dollars in losses, according to numerous GAO reports. In many cases, Reuters found, the perpetrators were caught only after outside law-enforcement agencies stumbled onto them, or outsiders brought them to the attention of prosecutors.

In May this year, Ralph Mariano, who worked as a civilian Navy employee for 38 years, pleaded guilty in federal court in Rhode Island to charges of conspiracy and theft of government funds related to a kickback scheme that cost the Navy $18 million from 1996 to 2011. Mariano was sentenced November 1 to 10 years in prison and fined $18 million.

Mariano admitted that as an engineer at the Naval Undersea Warfare Center in Newport, Rhode Island, he added money to contracts held by Advanced Solutions for Tomorrow. The Georgia-based company then paid kickbacks to Mariano and others, including friends and relatives.

Mariano was charged more than five years after the allegations against him first emerged in a 2006 civil whistleblower lawsuit in federal court in Georgia that had been kept under seal. Court documents suggest one reason why the conspiracy went undetected for so long: The Navy not only gave Mariano authority to award money to contractors; it also put him in charge of confirming that the contractors did the work. The Navy never audited any of the contracts until after Mariano was arrested, a Navy spokeswoman confirmed.

On the opposite side of the country, federal prosecutors in San Diego, California, in 2009 accused Gary Alexander, a Navy civilian employee, of arranging with subcontractors to have them bill the Defense Department for services never performed and then pay him kickbacks from money the subcontractors received. Alexander masterminded the scheme while he was head of the Air Surveillance and Reconnaissance Branch of the Navy’s Space and Naval Warfare Systems Center, based in San Diego.

Alexander in 2010 pleaded guilty to defrauding the Navy and filing false tax returns. He was sentenced to 75 months in prison and was required to pay restitution and forfeitures totaling more than $500,000.

Robert Ciaffa, a federal prosecutor assigned to the case, said the bills were easily padded because DFAS didn’t require detailed invoices. The case came to light, he said, only after “a woman friend” of one of Alexander’s associates went to prosecutors in 2008 with information about the fraud.

A Navy spokeswoman said that Navy Secretary Ray Mabus has taken steps to avert such fraud, including creating a contract review board, requiring closer oversight of employees who manage contracts and establishing antifraud units within Navy contracting services.

Ciaffa said the Alexander case prompted his office in 2009 to set up a toll-free fraud tip line that has so far have yielded at least six cases. One led to guilty pleas in March 2012 by four civilian employees of the North Island Naval Air Station, near San Diego, after they were accused of receiving $1 million in kickbacks from contractors.


In its 2007 audit-readiness plan, the Defense Department called on DFAS to eliminate plugs by June 2008. That hasn’t happened.

In its financial report for 2012, the Army said each month it “adjusts its Fund Balance With Treasury to agree with the U.S. Treasury accounts.” In its 2012 annual report, the Defense Logistics Agency said it does the same. “On a monthly basis, DLA’s (Fund Balance With Treasury) is adjusted to agree with the U.S. Treasury accounts.”

The Navy, in a footnote in its 2012 financial report, “acknowledges that it has a material internal control weakness in that it does not reconcile its” numbers with the Treasury’s. The footnote said the Navy inserts inaccurate numbers in its monthly reports so that they agree with the Treasury’s. It said it is working with DFAS to try to eliminate the problems.

The Treasury says it requires the monthly reports from Pentagon agencies to ensure that it is “providing accurate financial information to Congress and the general public.” The reports verify that the military is using money for its intended purposes; spending money on things other than what it was appropriated for is, with rare exceptions, a violation of the Antideficiency Act, which forbids anyone but Congress to appropriate money. The law carries penalties for individuals involved in violating it.

Because of the lack of accurate accounting, a 2012 GAO report said, “the Department of the Navy is at increased risk of Antideficiency Act violations.”

Without a functioning, unified bookkeeping system, the Pentagon’s accountants have no option but to continue taking that risk.

Woodford, the former accountant in DFAS’s Cleveland office, says that in the frenzy to complete the Navy’s monthly financial reports to the Treasury, much of the blame rested with the “old antiquated systems” the Pentagon used. A common reason for inserting plugs was that “you knew what the numbers were, but you didn’t have the supporting documents.”

The Navy data, pouring in through dozens of jury-rigged pipelines into similarly disparate systems, required many “manual workarounds” – typing data from one system into another, which only added to the potential for errors.

“They do so much manual work, it’s just ridiculous,” says Toni Medley, who retired five years ago after 30 years doing an assortment of jobs at the same DFAS office. It’s tedious work, she says, and the people doing it “make a lot of mistakes.”

The Navy declined to comment.

Yokel, the retired official at the DFAS Cleveland office, worked as a consultant on the Navy Enterprise Resource Planning project, the new accounting system that fell short of expectations. He says that in recent years, the new system has managed to reduce the number of plugs, though they still can add up to a lot in dollar terms. And nearly half the Navy’s budget isn’t covered by the system.
Have you ever encountered fake receipts for employee reimbursement of phony expense report items?
(Manager) | Sep 24, 2014

fake receipts
Did you know that there are fake receipt generators online? I just became aware that there are fake generators, templates, software and services… a cottage industry!

How do you detect expense reports containing fake business receipts and how common do you think this is?

Regis Quirin
(Director of Finance at Gibney Anthony & Flaherty LLP) [advisor] [expert] | Sep 24, 2014

It is very common. It is more than likely that policies are bent and twisted and interpreted differently by people in your organization. Someone told me the following story – A new employee submits an expense report to his boss and it includes the expense of a hat on the report. The boss says, “we don’t pay for hats” and crosses out the expense. The next month the employee submits an expense report with a request for a reimbursement for a hat. The boss says the same thing, “we don’t pay for hats.”

The next month the employee submits an expense report with no request for a hat reimbursement. The boss comments that he is pleased that the employee understands that there is no reimbursement for hats. The employee replies, “oh it is in there…try to find it.”

All you can do is set policy and train your employees on their ethical responsibility. Next, you audit. When you find a breach, you act – advise that policy was not followed and give a warning. If the situation occurs again – terminate.
Toshiba’s CEO resigns over $1.6 billion in doctored accounts
Yuri Kageyama, The Associated Press
Tues., July 21, 2015

While the company was struggling financially, top managers at Toshiba set unrealistic earnings targets under the banner of “challenge,” and subordinates faked results.

Toshiba’s Chief Executive resigned today, a day after an outside investigation said he and other current and former executives were responsible for an accounting scandal in which the Japanese industrial and electronics giant overstates profits by mor(Powered by NewsLook)

TOKYO-Toshiba’s CEO and eight other executives resigned Tuesday to take responsibility for doctored books that inflated profits at the Japanese technology manufacturer by 152 billion yen ($1.6 billion) over several years.

Toshiba Corp. acknowledged a systematic coverup, which began in 2008. Various parts of the Japanese company’s sprawling business including computer chips and personal computers were struggling financially, but top managers set unrealistic earnings targets under the banner of “challenge,” and subordinates faked results.

On top of its struggles in electronics, Tokyo-based Toshiba’s prospects in nuclear power, one of its core businesses, were shaken after the 2011 Fukushima disaster set off public fears about reactor safety, making new nuclear plants unlikely in Japan. All 48 of the nation’s working reactors are now offline.

Bowing deeply before flashing cameras at a news conference, CEO Hisao Tanaka kept his head lowered for nearly half a minute in a gesture meant to convey deep shame and contrition. Tanaka’s predecessors, Norio Sasaki, now a vice chairman, and Atsutoshi Nishida, an adviser, also gave up their posts.

“We have a serious responsibility,” Tanaka told reporters. The company will need to “build a new structure” to reform itself, he said.

The scandal highlights how Japan is still struggling to improve corporate governance despite recent steps to increase independent oversight of companies.

President of Toshiba, Hisao Tanaka (C), chairman Masashi Muromachi (L) and corporate executive vice president Keizo Maeda (R) bow at the beginning of a press conference in Tokyo. (KAZUHIRO NOGI / AFP/GETTY IMAGES)

In 2011, Olympus Corp., which makes medical equipment and cameras, was embroiled in a scandal after its president Michael Woodford, a Briton, blew the whistle on a long-running coverup of losses at the company.

Loizos Heracleous, Professor of Strategy at Warwick Business School in Britain, said corporate Japan is still lacking in areas such as transparency and board independence compared with the global standard.

“The Toshiba scandal will be seen in the context of the Olympus event, with investors wondering whether there is a pattern of account manipulation in corporate behaviour,” he said in a commentary. “Japanese regulatory authorities will need to reassure the markets that they are casting a watchful eye over Japanese corporations.”

Toshiba has repeatedly apologized to shareholders and customers. It has set up an outside investigation group to analyze why the scandal happened and propose what needs to be done to prevent a recurrence.

The inflation of profits to meet targets was carried out not only on one or two projects, but across the board, sometimes because the projects weren’t even breaking even, according to the report of an investigation.

“There was intense pressure to produce results under the challenge initiative,” the report said. “So employees felt cornered into resorting to inappropriate measures.”

Tanaka will be replaced by Masashi Muromachi, chairman of the board.

In the Olympus case, the company eventually acknowledged it hid 117.7 billion yen ($1.2 billion) in investment losses dating back to the 1990s. Woodford, the CEO, won some praise in Japan for his courage in bringing dubious old-guard company practices to light.

Japanese society is conformist and prizes team work so much it tends to frown upon whistleblowers, and their legal protection lags compared to those in the West.

Long-established companies such as Toshiba tend to have a highly hierarchical structure, making it difficult for employees to challenge top-down decrees.

Other systematic cover-ups at big-name companies have surfaced in Japan over the years. Unlike some Western accounting scandals, those in Japan, including Toshiba’s, did not result in any enrichment of individual employees.

Instead, workers collaborated to “save face” for the company, such as hiding defect reports at automaker Mitsubishi Motors Corp., which surfaced in 2000 but had been going on for decades. Another example of questionable accounting was at electronics maker Sanyo Electric Co., which surfaced in 2007.

Toshiba shares were up 6 per cent, recovering recent losses, as investors took the resignations as a sign the company might right itself.
Toshiba CEO Hisao Tanaka resigns over doctored accounts that inflated profits
CBC News, Jul 21, 2015 5:25 AM ET
Last Updated: Jul 21, 2015 10:06 AM ET

Toshiba acknowledges systematic coverup that began in 2008

Toshiba Corp. CEO Hisao Tanaka bows during a press conference to announce his resignation at the company’s headquarters in Tokyo on Tuesday. He stepped down to take responsibility for doctored books that inflated profits at the Japanese technology manufacturer. (Shizuo Kambayashi/Associated Press)

Toshiba’s CEO and eight other executives resigned Tuesday to take responsibility for doctored books that inflated profits at the Japanese technology manufacturer by 152 billion yen ($1.59 billion Cdn) over several years.

Toshiba Corp. acknowledged a systematic coverup, which began in 2008. Various parts of the Japanese company’s sprawling business including computer chips and personal computers were struggling financially, but top managers set unrealistic earnings targets under the banner of “challenge,” and subordinates faked results.

On top of its struggles in electronics, Tokyo-based Toshiba’s prospects in nuclear power, one of its core businesses, were shaken after the 2011 Fukushima disaster set off public fears about reactor safety, making new nuclear plants unlikely in Japan. All 48 of the nation’s working reactors are now offline.

Bowing deeply before flashing cameras at a news conference, CEO Hisao Tanaka kept his head lowered for nearly half a minute in a gesture meant to convey deep shame and contrition. Tanaka’s predecessors, Norio Sasaki, now a vice chairman, and Atsutoshi Nishida, an adviser, also gave up their posts along with six other executives.

“We have a serious responsibility,” Tanaka told reporters. The company will need to “build a new structure” to reform itself, he said.

The company said that the fraud continued through the fiscal year that ended in March, and work on revising the accounts to show the complete and true financial picture is not yet finished. It promised an emergency stockholder meeting for September, where it plans to deliver a genuine financial report.

The scandal highlights how Japan is still struggling to improve corporate governance despite recent steps to increase independent oversight of companies.

In 2011, Olympus Corp., which makes medical equipment and cameras, was embroiled in a scandal after its president Michael Woodford, a Briton, blew the whistle on a long-running coverup of losses at the company.
Lack of transparency

Loizos Heracleous, Professor of Strategy at Warwick Business School in Britain, said corporate Japan is still lacking in areas such as transparency and board independence compared with the global standard.

“The Toshiba scandal will be seen in the context of the Olympus event, with investors wondering whether there is a pattern of account manipulation in corporate behaviour,” he said in a commentary. “Japanese regulatory authorities will need to reassure the markets that they are casting a watchful eye over Japanese corporations.”

Toshiba has repeatedly apologized to shareholders and customers. It has set up an outside investigation group to analyze why the scandal happened and propose what needs to be done to prevent a recurrence.

The inflation of profits to meet targets was carried out not only on one or two projects, but across the board, sometimes because the projects weren’t even breaking even, according to the report of an investigation.

“There was intense pressure to produce results under the challenge initiative,” the report said. “So employees felt cornered into resorting to inappropriate measures.”

Tanaka will be replaced by Masashi Muromachi, chairman of the board.

Toshiba shares were up six per cent, recovering recent losses, as investors took the resignations as a sign the company might right itself.
Brazil’s president Dilma Rousseff loses legal battle and could face impeachment
Reuters in Brasilia
Thursday 8 October 2015 04.20 BST

In a unanimous vote the federal accounts court ruled Rousseff’s government manipulated its accounts in 2014 to disguise a widening fiscal deficit
Brazil’s president, Dilma Rousseff, could face impeachment. Photograph: Eraldo Peres/AP

Brazil’s besieged president, Dilma Rousseff, has lost a major battle after the federal audit court rejected her government’s accounts from 2014, paving the way for her opponents to try to impeach her.

In a unanimous vote the federal accounts court, known as the TCU, ruled Rousseff’s government manipulated its accounts in 2014 to disguise a widening fiscal deficit as she campaigned for re-election.

The ruling, the TCU’s first against a Brazilian president in nearly 80 years, is not legally binding but will be used by opposition lawmakers to argue for impeachment proceedings against the unpopular leftist leader in an increasingly hostile congress.

Opposition leaders hugged and cheered when the ruling was announced in Congress, though it was not clear how quickly they would move or whether they have enough support to impeach the president.

“This establishes that they doctored fiscal accounts, which is an administrative crime and President Rousseff should face an impeachment vote,” said Carlos Sampaio, leader of the opposition PSDB party in the lower house.

“It’s the end for the Rousseff government,” said Rubens Bueno, a congressman from the PPS party. He said the opposition has the votes to start proceedings in the lower house though perhaps not the two-thirds majority needed for an impeachment trial in the senate.

In a last-ditch bid to win time, the government had asked the supreme court to delay Wednesday’s ruling, but it refused.

In a further setback for Rousseff, the TCU rejected a request by attorney general Luís Inacio Adams to remove the judge auditing the 2014 accounts for publicly declaring weeks ago he planned to find them invalid.

Adams said the government would appeal to the supreme court to overthrow the audit decision.

Earlier on Wednesday, Rousseff’s government failed to get enough support in Congress to back her efforts to rebalance Brazil’s public accounts. Rousseff is also reeling from a ruling on Tuesday that cleared the way for a separate investigation on alleged irregularities in her re-election campaign last year.

Congress put off for a fourth time a session on whether to back or overturn her vetoes of two spending bills after her government was unable to obtain a quorum despite a cabinet reshuffle last week meant to bolster her support.

“It’s as if the government has ceased to exist,” said congressman Pauderney Avelino of the opposition Democrats party.

The postponement highlighted Rousseff’s political isolation as she struggles to stave off impeachment efforts amid a widening corruption scandal and Brazil’s deepest recession in 25 years.

The bills Rousseff vetoed would raise public spending by 63bn reals ($16.4bn) over the next four years and include a hefty 78% increase in salaries of judiciary employees and a raise in payments for retirees.

The congressional setback calls into question her ability to raise taxes to plug a widening budget gap that led Standard & Poor’s rating agency to strip Brazil of its investment-grade rating in September.

Backed by a commodities boom, Brazil’s economy posted several years of strong growth that pulled millions of people out of poverty. But the boom ended after Rousseff came to power in 2011, hit by weaker international prices for its products and her government’s interventionist policies. Uncertainty over Rousseff’s ability to survive the political crisis and pull Brazil out of an economic tailspin has driven down its currency, the real, to its weakest ever levels.

The only good news Rousseff has had recently was the confirmation by Swiss authorities that her declared enemy in congress, lower house speaker Eduardo Cunha, holds bank accounts in Switzerland, which he had denied.

Cunha, who holds the key to starting impeachment proceedings in the lower house, already faces charges of corruption in the Petrobras bribery scandal. On Wednesday he said he had no intention of resigning.

Brazilian president Dilma Rousseff cuts her salary by 10% to aid economy
Dilma Rousseff: can Brazil’s fighter survive the turmoil?
Brazil’s Speaker and a former president face corruption charges
Business in America
Too much of a good thing
Mar 26th 2016

Profits are too high. America needs a giant dose of competition

AMERICA’S airlines used to be famous for two things: terrible service and worse finances. Today flyers still endure hidden fees, late flights, bruised knees, clapped-out fittings and sub-par food. The profit bit of the picture, though, has changed a lot. Last year America’s airlines made $24 billion-more than Alphabet, the parent company of Google.

Even as the price of fuel, one of airlines’ main expenses, collapsed alongside the oil price, little of that benefit was passed on to consumers through lower prices, with revenues remaining fairly flat. After a bout of consolidation in the past decade the industry is dominated by four firms with tight financial discipline and many shareholders in common. And the return on capital is similar to that seen in Silicon Valley.

What is true of the airline industry is increasingly true of America’s economy as a whole. Profits have risen in most rich countries over the past ten years but the increase has been biggest for American firms. Coupled with an increasing concentration of ownership, this means the fruits of economic growth are being hoarded.

This is probably part of the reason that two-thirds of Americans, including a majority of Republicans, have come to believe that the economy “unfairly favours powerful interests”, according to polling by Pew, a research outfit. It means that when Hillary Clinton and Bernie Sanders, the Democratic contenders for president, say that the economy is “rigged”, they have a point.

The last year has seen a slight dip in aggregate profits because of the high dollar and the effect of the oil price on energy firms. But profits are at near-record highs relative to GDP (see chart 1) and free cash flow-the money firms generate after capital investment has been subtracted-has grown yet more strikingly. Return on capital is at near-record levels, too (adjusted for goodwill). The past two decades have seen most firms make more money than they used to. And more firms have become very profitable.


An intense burst of consolidation will boost their profits more. Since 2008 American firms have engaged in one of the largest rounds of mergers in their country’s history, worth $10 trillion. Unlike earlier acquisitions aimed at building global empires, these mergers were largely aimed at consolidating in America, allowing the merged companies to increase their market shares and cut their costs. The companies in question usually make no pretence of planning to pass the savings they make this way on to their customers; take their estimates of the synergies involved at face value and profits in America will rise by a further 10% or so.

Profits are an essential part of capitalism. They give investors a return, encourage innovation and signal where resources should be invested. Their accumulation allows investment in bold new ventures. Countries where profits are too low-Japan, for instance-can slip into morbid torpor. Firms that ignore profits, such as China’s state-run enterprises, lurch around like aimless zombies, as likely to destroy value as to create it.

But high profits across a whole economy can be a sign of sickness. They can signal the existence of firms more adept at siphoning wealth off than creating it afresh, such as those that exploit monopolies. If companies capture more profits than they can spend, it can lead to a shortfall of demand.

This has been a pressing problem in America. It is not that firms are underinvesting by historical standards. Relative to assets, sales and GDP, the level of investment is pretty normal. But domestic cash flows are so high that they still have pots of cash left over after investment: about $800 billion a year.

High profits can deepen inequality in various ways. The pool of income to be split among employees could be squeezed. Consumers might pay too much for goods. In a market the size of America’s prices should be lower than in other industrialised economies. By and large, they are not. Though American companies now make a fifth of their profits abroad, their naughty secret is that their return-on-equity is 40% higher at home.

Most explanations of America’s high profits draw on national-accounts data which show that the fall in the share of output going to workers over the past decade is equivalent to about 60% of the rise in domestic pre-tax profits. Scholars typically have three explanations for this: technology, which has allowed firms to replace workers with machines and software; globalisation, which has made it easier to shift production to lower cost countries; and a decline in trade-union membership.

None of these accounts, though, explain the most troubling aspect of America’s profit problem: its persistence. Business theory holds that firms can at best enjoy only temporary periods of “competitive advantage” during which they can rake in cash. After that new companies, inspired by these rich pickings, will pile in to compete away those fat margins, bringing prices down and increasing both employment and investment. It’s the mechanism behind Adam Smith’s invisible hand.

In America that hand seems oddly idle. An American firm that was very profitable in 2003 (one with post-tax returns on capital of 15-25%, excluding goodwill) had an 83% chance of still being very profitable in 2013; the same was true for firms with returns of over 25%, according to McKinsey, a consulting firm. In the previous decade the odds were about 50%. The obvious conclusion is that the American economy is too cosy for incumbents.

In 1998, Joel Klein, who ran the antitrust operation at the Department of Justice (DoJ), declared that “our economy is more competitive today than it has been in a long, long time.” He may well have been right. In the post-war boom American firms grew into mighty conglomerates; in the 1960s J.K. Galbraith, a left-leaning economist, predicted the rise of a symbiotic “industrial state” in which large companies worked closely with the government.

But in the 1980s deregulation opened some industries, such as telecoms and railways, to competition. And a new doctrine of shareholder value led big firms, such as RJR Nabisco, to be broken-up and sprawling conglomerates to become focused. In the 1990s American firms faced a wave of competition from low-cost competitors abroad (and, reciprocally, focused their energy on expanding overseas).

Since then the pendulum seems to have swung back. Huge companies, long the focus of American worries about competition, have not actually got any bigger. In 2014 the top 500 listed firms made about 45% of the global profits of all American firms, as they did in the late 1990s. Instead they, and other companies, have become more focused.

The strategy can be seen as an amalgam of the philosophies of two deeply influential business figures. Jack Welch, the boss of General Electric for two decades at the end of the 20th century, advised companies to get out of markets which they did not dominate. Warren Buffett, the 21st century’s best-known investor, extols firms that have a “moat” around them-a barrier that offers stability and pricing power.

One way American firms have improved their moats in recent times is through creeping consolidation. The Economist has divided the economy into 900-odd sectors covered by America’s five-yearly economic census. Two-thirds of them became more concentrated between 1997 and 2012 (see charts 2 and 3). The weighted average share of the top four firms in each sector has risen from 26% to 32%.

INTERACTIVE: Explore all 893 industries grouped by sector in our interactive scatter chart


These data make it possible to distinguish between sectors of the economy that are fragmented, concentrated or oligopolistic, and to look at how revenues have fared in each case. Revenues in fragmented industries-those in which the biggest four firms together control less than a third of the market-dropped from 72% of the total in 1997 to 58% in 2012.

Concentrated industries, in which the top four firms control between a third and two-thirds of the market, have seen their share of revenues rise from 24% to 33%. And just under a tenth of the activity takes place in industries in which the top four firms control two-thirds or more of sales. This oligopolistic corner of the economy includes niche concerns-dog food, batteries and coffins-but also telecoms, pharmacies and credit cards.

Concentration does not of itself indicate collusion. Other factors at play might include regulations that keep competitors out. Business spending on lobbying doubled over the period as incumbents sought to shape regulations in ways that suited them. The rising importance of intangible assets, particularly patents, has meant that an ability to manage industry regulators and the challenges of litigation is more valuable than ever.

The ability of big firms to influence and navigate an ever-expanding rule book may explain why the rate of small-company creation in America is close to its lowest mark since the 1970s (although an index of startups run by the Kauffman Foundation has shown flickers of life recently). Small firms normally lack both the working capital needed to deal with red tape and long court cases, and the lobbying power that would bend rules to their purposes.

A lack of lobbying clout and legal savvy may also help explain foreign firms’ loss of momentum. In the 1990s adventurers from abroad piled into America, with the share of output from foreign-owned subsidiaries rising steadily. But foreign firms seem to have lost their mojo. Since 2003 their contribution has been flat at about 6% of private business output.

Another factor that may have made profits stickier is the growing clout of giant institutional shareholders such as BlackRock, State Street and Capital Group. Together they own 10-20% of most American companies, including ones that compete with each other. Claims that they rig things seem far-fetched, particularly since many of these funds are index trackers; their decisions as to what to buy and sell are made for them. But they may well set the tone, for example by demanding that chief executives remain disciplined about pricing and restraining investment in new capacity. The overall effect could mute competition.

Quantifying the effect of the corporate America’s defences is tricky. Profits are not the whole picture. In some industries-banking is a case in point-rent-seeking will result in high pay to an employee elite instead. But one can get a crude sense of what is going on by dividing the profits all firms generate into the “bog-standard” and the “exceptional”.

Over the past 50 years return on capital has averaged about 10% (excluding goodwill) and that is what investors tend to demand, so let that represent bog-standard profits. The excess on top of that-which may reflect brilliant innovations, wise historic investments in intangible assets such as brands, or, perhaps, a lack of competition-is the exceptional bit. For S&P 500 firms these exceptional profits are currently running at about $300 billion a year, equivalent to a third of taxed operating profits, or 1.7% of GDP.

I love you, you pay my rent

About a quarter of America’s abnormal profits are spread across a wide range of sectors. Returns on capital, concentration and prices have risen in many pockets of the economy. The cable television industry has become more tightly controlled, and many Americans rely on a monopoly provider; prices have risen at twice the rate of inflation over the past five years.

Consolidation in one of Mr Buffett’s favourite industries, railroads, has seen freight prices rise by 40% in real terms and returns on capital almost double since 2004. The proposed merger of Dow Chemical and DuPont, announced last December, illustrates the trend to concentration. After combining, the companies plan to split into three specialist companies each of which will have a higher share of its market than either original company had before the deal. They say the plan will yield $3 billion in cost savings. Since 2008 American mergers have sought to remove recurring annual costs of about $150 billion from industrial ledgers. Few firms that are not regulated utilities have public plans to pass these gains on to consumers.

Concentration is contagious. As firms become more powerful those elsewhere on associated chains of customers and suppliers bulk up in response. Google now dominates internet searches for flights and hotels. This has led Expedia, the leading internet travel-agent, to beef up by buying two of its main rivals over the past two years. The spectre of very big online travel sites dominating the purchase of hotel rooms has led the hotel firms to consolidate, too, with Marriott agreeing to buy Starwood this month. (A Chinese firm, Anbang, may make a counter-bid).

Roughly another quarter of abnormal profits comes from the health-care industry, where a cohort of pharmaceutical and medical-equipment firms make aggregate returns on capital of 20-50%. The industry is riddled with special interests and is governed by patent rules that allow firms temporary monopolies on innovative new drugs and inventions. Much of health-care purchasing in America is ultimately controlled by insurance firms. Four of the largest, Anthem, Cigna, Aetna and Humana, are planning to merge into two larger firms.

The rest of the abnormal profits are to be found in the technology sector, where firms such as Google and Facebook enjoy market shares of 40% or more. By Silicon Valley’s account such penetration reflects the popularity and inventiveness of the products on offer, some of which are free to consumers. Today’s dominant firms could be tomorrow’s Nokia or Blackberry: Apple now trades on just 11 times earnings, suggesting investors expect it to decline. Firms such as Uber and Airbnb are a rare source of disruption in the economy, competing fiercely with incumbents.

But many of these arguments can be spun the other way. Alphabet, Facebook and Amazon are not being valued by investors as if they are high risk, but as if their market shares are sustainable and their network effects and accumulation of data will eventually allow them to reap monopoly-style profits. (Alphabet is now among the biggest lobbyists of any firm, spending $17m last year.)

A fall from grace in the tech world is not as bad as you might imagine. Microsoft’s operating profits today are twice what they were in 2000, when Mr Klein was prosecuting it in an antitrust trial. And the “sharing economy” startups that are being so highly rated by some investors mostly seek to dominate their markets. The large mountains of cash they are burning today can only be justified if they eventually mature to enjoy very high market shares and margins.

In the past, periods of high and stable profits have ended. Just three years after Mr Galbraith made his 1967 prediction of a cosy, collaborative business world, it was already toast: profits had collapsed by a third relative to GDP as recession struck. Today’s profits, too, may be more vulnerable than they look.

If wages finally pick up it could crimp margins. The earnings-per-share of listed firms have fallen slightly in the past few quarters, though a strong dollar and declining oil revenues explain much of that. Some observers of the stockmarket argue that it is already signalling more decline. The gap between the real yield on equities and that on government bonds suggests that either firms are riskier than ever, bond yields are freakishly low, or that profits face a cyclical downturn.

Even so, it is hard to identify a mechanism by which profits might fall to more normal levels. Investors and managers continue to place extraordinarily high profit multiples on businesses with “moats”. The cable television industry is supposedly under pressure from the likes of Netflix and Amazon Prime.

Yet in 2015 Charter Communications, a cable company, bought Time Warner Cable for $79 billion, or 26 times its free cash flow, which implies that it believes it will be in a position to raise prices. When Heinz (part-controlled by Mr Buffett) bought Kraft Foods in 2015, it paid 31 times the free cash flow and promptly slashed spending to boost margins, suggesting it felt the threat from rival makers of cheese slices was rather small.

Antitrust, but verify

Perhaps antitrust regulators will act, forcing profits down. The relevant responsibilities are mostly divided between the DoJ and the Federal Trade Commission (FTC), although some industries, such as railways and telecoms, also have their own regulators. The DOJ and FTC are busy trying to police the mergers-and-acquisition boom. Rather than contest every deal they select cases that set new precedents and argue them in court: of the 15,000 deals between 2005-14, about 3% have been subject to close scrutiny.

Together the two bodies have roamed far and wide. The DoJ has blocked domestic deals, such as the takeover by AT&T of T-Mobile USA in 2011, and cross-border combinations that would have caused concentration in global industries, such as the merger of two chipmakers, Applied Materials and Tokyo Electron, in 2015.

The FTC spends a big chunk of its time looking at health care. It has blocked hospital mergers and fought “pay-for-delay” deals in which pharmaceutical firms try to stop generic competitors from launching rival products when patents expire. The DoJ is casting a beady eye over the airlines.

Yet the system suffers two limitations. One is constitutional. The two bodies’ job is to police infringements of a well-established and mature body of law through the courts. This leaves them admirably free of overt political interference and lobbying but it also limits their scope. Lots of important subjects are beyond their purview.

They cannot consider whether the length and security of patents is excessive in an age when intellectual property is so important. They may not dwell deeply on whether the business model of large technology platforms such as Google has a long-term dependence on the monopoly rents that could come from its vast and irreproducible stash of data.
They can only touch upon whether outlandishly large institutional shareholders with positions in almost all firms can implicitly guide them not to compete head on; or on why small firms seem to be struggling. Their purpose is to police illegal conduct, not reimagine the world. They lack scope.

The second limitation is intellectual. America’s antitrust apparatus has gone through periods of leniency (1915-35) and stridency (1936-72). By the 1980s the Chicago school of free-market thought was ascendant. Its insistence that the efficiency benefits of big mergers should not be dismissed had a big influence on the courts.

Antitrust guidelines which held that any deal involving a firm with a market share of 35% or more should be considered suspect on principle have been set aside in favour of a more granular approach, with regulators looking ever more closely at the specific effects of a deal. To work out if a deal lowers consumers’ level of choice or lets firms hike prices they will study micro-markets in specific regions.

Who does not prefer the rifle to the blunderbuss, the scalpel to the axe? Such sophistication allows regulators to demand clever remedies, such as the disposal of subsidiaries. But with their heads deep in data and court rulings that set fine precedents, the scientists of antitrust are able to sidestep some troubling questions. If markets are truly competitive, why do so many companies now claim they can retain the cost synergies that big deals create, not pass them on to consumers? Why do investors believe them? Why have returns on capital risen almost everywhere?

These legal and intellectual limitations of the antitrust apparatus raise the question of competition to the political sphere-currently, alas, a realm well supplied with blunderbusses and axes wielded haphazardly and at the wrong targets. Americans’ mistrust of their economic system and the companies that make so much money in it has so far been channelled into calls for protectionism and government intervention. Free trade should be limited. Health-care firms should be more regulated. Foreign firms-particularly Chinese ones-should be discriminated against. Wages should be forced up. Taxes on companies should be raised.

Memories of the future

Nowhere has the alternative approach been articulated. It would aim to unleash a burst of competition to shake up the comfortable incumbents of America Inc. It would involve a serious effort to remove the red tape and occupational-licensing schemes that strangle small businesses and deter new entrants.

It would examine a loosening of the rules that give too much protection to some intellectual-property rights. It would involve more active, albeit cruder, antitrust actions. It would start a more serious conversation about whether it makes sense to have most of the country’s data in the hands of a few very large firms. It would revisit the entire issue of corporate lobbying, which has become a key mechanism by which incumbent firms protect themselves.

Large firms no longer employ all that many people in America: the domestic employee base of the S&P 500 is only around a tenth of total American employment. New firms would invest more, employ more staff, and force incumbents to invest more in order to compete. If this sounds pie in the sky, consider the shale revolution over the past decade.

Although the industry is now suffering from low oil prices, it is a rare example of entrepreneurial spirit taking on a stodgy industry to the benefit of all. A new commitment to competition could be the source of optimism that America is desperately searching for. After all, it is only a healthy dollop of greed and a belief in a better future that prompts people to start from scratch and try to cross the moat that has been dug around corporate America.
PCAOB practice alert finds rash of doctored audit files
Tammy Whitehouse | April 21, 2016

Audit regulators have seen enough altered documentation lately that they felt the need to formally remind auditors that doctoring work papers is a no-no.

The Public Company Accounting Oversight Board published a staff audit practice alert indicating its inspectors have seen cases even at firms affiliated with the global networks where auditors are adding to or altering audit files and passing off the alterations as original documentation. “Evidence identified in connection with certain recent oversight activities has heightened the staff’s concern about such misconduct,” the PCAOB wrote in its alert.

The PCAOB says its inspection rules require audit firms and all their associated individuals to cooperate with the board in regulatory inspections. “This duty to cooperate includes an obligation not to provide improperly altered documents or misleading information in connection with the board’s inspection process,” the alert says. Audit standards on documentation also come into play, the PCAOB points out, and they make no provision for adding to or altering an audit file after the fact.

The board says it has issued enforcement orders in past cases where it found improper documentation or lack of cooperation with inspections. In certain recent cases, the board says it has seen instances where documents were created shortly before or during a PCAOB inspection, then made available to inspectors as if they’d been in the audit file all along. “These recent instances involve both domestic firms and non-U.S. firms, including members of global networks,”

The PCAOB is urging anyone with information about altered documentation to report it either directly to to the board’s inspection or enforcement staff, or to its tip center. The board also says tipsters, “in appropriate circumstances,” can utilize their firm’s internal whistleblower and complaint systems. “Voluntary and timely self-reporting of violative conduct, including violations of the obligation to cooperate with Board inspections or investigations, may be a factor in determining whether to impose sanctions against a firm or person and what sanctions to impose,” the PCAOB wrote.

staff audit practice alert
enforcement orders in past cases
tip center
Ignoring the Pentagon’s Multi-Trillion-Dollar Accounting Error
Dave Lindorff, September 2, 2016

In 2014, the New York Times (10/12/14) ran a major investigative piece by reporter James Risen about several billion dollars gone missing, part of a shipment of pallets of $12 billion-$14 billion in C-notes that had been flown from the Federal Reserve into Iraq over a period of a year and a half in an effort to kickstart the Iraqi economy following the 2003 US invasion. Risen reported that about $1.5 billion of the cash, somehow stolen, had been discovered in a bunker in Lebanon by a special inspector general appointed to investigate corruption in the US occupation of Iraq. The article got front-page play.

Reuters (8/19/16) had one of the few media reports on the Pentagon’s mammoth accounting errors.

Earlier that same year, the Washington Post (4/7/14) ran a story reporting the US State Department inspector general’s finding that during Hillary Clinton’s years as secretary, the State Department had lost records for or misreported some $6 billion in government contracts. (State claimed the money was not lost, just not accounted for.)

These stories are basic Journalism 101, the kind of bread-and-butter reporting on government that one expects from a major news organization. So how to explain that neither of these prestigious and influential newspapers-or practically any of the corporate media in the US, for that matter-bothered to mention it when the Pentagon’s inspector general this year issued a report blasting the US Army for misreporting $6.5 trillion (that’s not a typo; it’s trillion with a T) as its spending total for the 2015 fiscal year.

Now, clearly that number cannot be correct, since the entire Pentagon budget for 2015 was a little over $600 billion, or less than 10 percent of what the Army was saying it had spent.

Even if this were just an outrageous accounting error, it would certainly seem to merit a news article. But the IG’s office did not see it as a laughing matter. The 63-page report, released July 26 at the direction of Principal Deputy Inspector General Glenn A. Fine (the last IG left office in January and hasn’t been replaced), concludes:

The Office of the Assistant Secretary of the Army (Financial Management & Comptroller) (OASA[FM&C]) and the Defense Finance and Accounting Service Indianapolis (DFAS Indianapolis) did not adequately support $6.5 trillion in year-end JV adjustments made to AGF data during FY 2015 financial statement compilation.
The unsupported JV adjustments occurred because OASA(FM&C) and DFAS Indianapolis did not prioritize correcting the system deficiencies that caused errors resulting in JV adjustments, and did not provide sufficient guidance for supporting system-generated adjustments.

In addition, DFAS Indianapolis did not document or support why the Defense Departmental Reporting System-Budgetary (DDRS-B), a budgetary reporting system, removed at least 16,513 of 1.3 million records during third quarter FY 2015. This occurred because DFAS Indianapolis did not have detailed documentation describing the DDRS-B import process or have accurate or complete system reports.

As a result, the data used to prepare the FY 2015 AGF third quarter and year-end financial statements were unreliable and lacked an adequate audit trail. Furthermore, DoD and Army managers could not rely on the data in their accounting systems when making management and resource decisions.

There’s a lot of jargon and a lot of use of DOD acronyms in there, but the key point that makes this story newsworthy is the last sentence (as well as the alarming bit about 16,500 missing records).
If the Army is making up numbers-and that’s exactly what “unsupported adjustments” means to an accountant-then nobody, not a reporter, not a congressional oversight committee, not even an inspector general, can tell what allocated funds are actually being spent on, where the money really went, whether programs are cost-effective, or even whether funds were misused or stolen.
And we’re talking about the single biggest department in the US government, which accounts for more than one-half of all discretionary federal spending each year.

When I called the Pentagon’s public affairs office for a response to the IG’s report, it was a week in coming. Finally Bridget Serchak, chief of public affairs for the DOD Office of Inspector General, emailed me this:

For clarification, these numbers reflect changes made in Fiscal Year 2015…. These adjustments do not adjust the budget amount for the Army. The dollar amounts are possible because adjustments are made to the Army General Fund financial statement data throughout the compilation process for various reasons such as correcting errors, reclassifying amounts and reconciling balances between systems.
The general ledger data that posts to a financial statement line can be adjusted for more than the actual reported value of the line. For example, there was a net unsupported adjustment of $99.8 billion made to the $0.2 billion balance reported for Accounts Receivable.

Remember, this is just a report on the Army’s budget. It turns out that the same kind of indecipherable, fantastical and unauditable accounting is being done by the Navy, the Air Force and the Marines.

One news outfit that did report on this scandal is Reuters. Journalist Scot J. Paltrow first reported on the DOD’s doctored ledgers and inscrutable accounting in 2013 in a series of stories that culminated in an article published on November 18, 2013, headlined “Special Report: The Pentagon’s Doctored Ledgers Conceal Epic Waste.”

Paltrow also wrote a report on the latest IG’s report, published by Reuters on August 19, headlined “US Army Fudged Its Cccounts by Trillions of Dollars, Auditor Finds.”

Where the rest of the media took no notice of the Pentagon IG’s scathing report, preferring to focus instead on the report of another IG over at the State Department who had investigated Democratic presidential candidate and former Secretary of State Hillary Clinton’s improper and illegal use of a private server in her home to handle her official State Department business, Paltrow homed in on the reason this is a big story. He went to a major Defense Department critic to explain:

“Where is the money going? Nobody knows,” said Franklin Spinney, a retired military analyst for the Pentagon and critic of Defense Department planning.

The significance of the accounting problem goes beyond mere concern for balancing books, Spinney said. Both presidential candidates have called for increasing defense spending amid current global tension.

An accurate accounting could reveal deeper problems in how the Defense Department spends its money. Its 2016 budget is $573 billion, more than half of the annual budget appropriated by Congress.

The thing is, the Pentagon has been at this dodgy game for decades. In 1996, Congress passed a law requiring all federal agencies to comply with federal accounting standards, to produce budgets that are auditable and to submit an audit each year. At this point, two decades later, the Pentagon has yet to comply with that law, and therefore cannot be audited.

It is the only federal agency that is not complying or, the IG’s report suggests, even trying to comply.

One would think that would be newsworthy, but apparently for the major newsrooms of the US, not so much.

Edward Herman, noted media critic and co-author with Noam Chomsky of the book Manufacturing Consent, says the media love to report on Pentagon waste-things like the epic cost overruns on the F-35 boondoggle that still can’t fly in combat or a $600 toilet seat. That kind of story, he says “is something the media and public grasp easily.” Such reporting, he argues, “shows the Pentagon makes mistakes but not that it is massively looting the public coffers.” It also “shows that the media is on the alert in protecting the public interest.”

Herman says, “Repeated failure to report on a refusal by the Pentagon to allow an audit represents a major media failure, and one that is almost surely very costly to the general public.” He adds:

The failure to take up this important story reflects, at a deeper level, the power of the Pentagon and the unwillingness of the media or politicians to challenge it. Only power and the derived conflicts of interest can explain this remarkable ability of the Pentagon to avoid a legally required audit.

Requests for comment from the New York Times and the Washington Post about their non-coverage of this $6.5-trillion Pentagon scandal went unanswered as of press time.

Dave Lindorff is the author of Killing Time (Common Courage Press, 2003), an investigative book about the Mumia Abu-Jamal case. He is a founding member of ThisCantBeHappening!, an independent online alternative newspaper.

report blasting the US Army
“Special Report: The Pentagon’s Doctored Ledgers Conceal Epic Waste.”
“US Army Fudged Its Cccounts by Trillions of Dollars, Auditor Finds.”
Bother in Brazil
America’s audit watchdog uncovers serious misconduct at Deloitte Brazil
SÃO PAULO, Dec 10th 2016

The Brazilian unit of the world’s biggest accounting firm doctored paperwork, concealed evidence and withheld information from inspectors

ACCOUNTING scandals are nothing new in Brazil. Its former president, Dilma Rousseff, was impeached in August for cooking her government’s books. The bosses of its biggest building firms have landed behind bars for padding contracts with Petrobras, the state-run oil company. At least, governance gurus joke, all the imbroglios-and a three-year-old law against bribery-have prompted companies to replace what people used to call corruption departments with compliance offices. How ironic, then, that Brazil’s latest affair involves a firm that is meant to ensure that firms stay on the straight and narrow.

On December 5th it emerged that America’s Public Company Accounting Oversight Board (PCAOB) fined the Brazilian arm of Deloitte, the biggest of the “Big Four” accounting networks, $8m, for what Claudius Modesti, the watchdog’s director of enforcement, called “the most serious misconduct we’ve uncovered”.

Deloitte is the first of the Big Four to be accused of failing to co-operate with a probe by the PCAOB, created by the Sarbanes-Oxley act of 2002, itself a response to a massive accounting scandal at Enron, an energy giant. The firm will also have to pay 5.4m reais ($1.6m) to Brazil’s securities regulator.

The bulk of the problems centre on Deloitte’s auditing of Gol, a troubled Brazilian low-cost airline with shares listed in New York. It was in 2012 that the PCAOB examined the firm’s audit papers during a routine review. Its inspectors found that a year before, Deloitte’s senior auditors had signed off on the carrier’s books despite knowing that its staff were still reviewing these for mis-statements, in particular related to reserves set aside to cover aircraft-maintenance costs.

A subsequent probe unearthed systematic attempts by managers and partners to doctor paperwork, conceal evidence and withhold information from inspectors. Similar shenanigans apparently marred Deloitte’s audits of Oi, a Brazilian telecoms firm which filed for bankruptcy protection in June.

Relative to the scale of fines that regulators have been doling out to banks in recent years, Deloitte’s bill looks tiny. But it is a record for the PCAOB. A dozen (now former) partners and auditors have been banned from working at any of the accounting firms the PCAOB oversees, all but one of them for life. As part of its settlement with the agency, Deloitte Brazil also faces the humiliating presence of an independent monitor until at least mid-2017.

Critics of auditors will cite the Deloitte case as further evidence that the world is suffering from an outbreak of accounting fraud. The PCAOB has just fined Deloitte Mexico $750,000 for tampering with documents in an audit there. In August PwC settled a case in which a plaintiff was seeking $5.5bn after Colonial BancGroup, an American lender it audited, went bust. Last year EY, another Big Four firm, failed to flag problems at Toshiba that forced the Japanese firm to restate its accounts by $1.9bn.

Still, the overall trend around the world has been for accounting to get cleaner. In America one good measure of this is the size of the biggest accounting restatement in a given year. It has plummeted over the past decade, from over $6bn to under $1bn. The scale of all restatements was only $2.7bn, or just 0.3% of all corporate profits, in 2015.

Standards outside America have improved, too, partly because Europe and many emerging economies, including those of Latin America, have adopted common international accounting standards. Deloitte’s Brazilian fiasco is depressing, but at least skulduggery is being uncovered and punished.–gordon-investigation-unsurprising-given-long-history-of-accounting-problems-20161221-gtfu0z
New Slater & Gordon investigation unsurprising given long history of accounting problems
by Jonathan Shapiro, Dec 21 2016 at 4:21 PM
Updated Dec 21 2016 at 5:17 PM
ASIC investigating Slater & Gordon

Make no mistake. Wednesday’s revelation that Slater & Gordon is the subject of a fresh investigation into its bookkeeping is about as serious as it gets. As recently as February it was reported that the corporate regulator had concluded its investigation into the law firm’s affairs.

The Australian Securities and Investment Commission has asked for documents that may show whether the law firm’s financial records were “deliberately falsified or manipulated”, or whether its “officers have committed offences.” If they do it is imperative the case is pursued to the fullest extent.

That a large listed company, and a law firm with a fierce reputation for holding corporate Australia to account, could find itself in this position in unfathomable. But it’s not altogether surprising for those that have looked carefully into its accounting practices.

There have been serious question marks about Slater & Gordon’s bookkeeping for some time.

In 2015 there were the accounting errors in its cash flow statement. Before that there was the eye-popping and ultimately disastrous $1.3 billion acquisition of Quindell’s professional services division in the United Kingdom, itself the subject of an accounting probe.
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That controversial deal has deflected much attention away from other problems that seemed to pre-date the acquisition. What ASIC may ultimately uncover raises even more questions about the motives of its UK foray.

So what is Slater & Gordon likely to have done? It is likely that ASIC is looking for evidence that the law firm overstated its “Work In Progress”.

WIP is the accounting term for cases that had been partially completed but for which payment had not been collected.

Since Slater & Gordon does most of its cases on a “no-win, no-fee” basis, its cash is received at the conclusion of a case. In the interim it must account for the future payment based on the amount of work completed, the probability of success and the expected pay-out.

But short sellers, and it seems the regulator, have doubted whether the WIP on its balance sheet was actually worth what the accounts said.

“The WIP calculations are supported by undocumented judgments on estimated fees, probability of success and percentage of completion,” ASIC head of audit Doug Niven wrote in an email to commissioner John Price on September 9, 2015.

“Subject to further discussion with the company, these judgements do not appear fully consistent with our own analysis of historical data and performance.”

The first public suggestion of questionable bookkeeping came in June 2015, when The Australian Financial Review revealed that ASIC was taking a closer look at its accounts.

Slater & Gordon said that it had uncovered errors over three years relating to its cash flow calculation, that summed to tens of millions of dollars.

At the time, the Financial Review argued that the variances, were a convenient mistake at the very best. Even though the overstatement of the cash inflows (receipts) and outflows (payments) netted out, the higher inflows presented a law firm that was collecting more WIP than it actually was.

In February of this year the company agreed to write-downs of WIP and goodwill in the “hundreds of millions” as it announced that ASIC was no longer investigating.

In addition to writing down $876 million of goodwill relating to its Quindell acquisition, Slater & Gordon also wrote off its WIP balance by $149.2 million, of which $117.8 million related to its pre-acquisition balance.

While Slater & Gordon was writing down WIP in its half year 2016 accounts, it was also forced to write up the value of “acquired” WIP – the value of live cases it acquired from smaller law firms.

Its disclosures show the total of acquired WIP was written up from $85.7 million to $103 million – a rise of $17.6 million. What does that mean?

It suggests Slater & Gordon may have undervalued the WIP at its acquisition date so that it could show higher profits at a later date.

In the absence of that write-up in acquired WIP, that $17.6 million difference would have shown up on the income statement at a later stage, to give its profits a lift.

The question is how much of Slater & Gordon’s prior profits were earned in this manner? How much of its WIP, which is presented as an asset, is simply revenue they have failed to collect? And what did they do about it?

We now know from public documents there were some intense behind the scenes negotiations last year where Slater & Gordon prodded ASIC to have the investigation officially wrapped up. ASIC led by its head of audit Doug Niven on the other hand felt they had more work to be done.

It’s now apparent that the investigation into the 2014 full year accounts rolled on into a more serious probe of the 2015 numbers.

We can only speculate at this stage, but the wording of the statement, and the specific date range, suggests ASIC knows exactly where to look.

It’s a targeted request for documents that could provide evidence Slaters numbers were falsified.

The decisions made by management has destroyed the wealth of thousands of investors, left ambitious and good intentioned legal minds facing an uncertain future, and has done little to enhance the credibility of our market.

If ASIC is able to uncover falsification, they would have succeeded where a board of directors, partners at an audit firm and unsuspecting investors failed. So if the numbers aren’t accountable, someone should be.

fresh investigation into its bookkeeping–gordon-ordered-to-give-documents-to-asic-20161220-gtfgw8
concluded its investigation into the law firm’s affairs.–gordon-accounting-20160229-gn6epm.html
controversial deal–gordons-uk-foray-20160229-gn6kmo
wrote in an email to commissioner John Price on September 9, 2015–gordon-accounting-concerns-20160829-gr3s1m
Slater & Gordon said that it had uncovered errors over three years–gordon-confirms-asic-probe-accounting-error-20150628-gi06sb
Financial Review argued that the variances, were a convenient mistake–gordons-books-20150629-gi0slg.html
public documents–gordon-accounting-concerns-20160829-gr3s1m
Albwardy’s Meikles walk -away raises questions
By Dumisani Ndlela, Deputy Editor in Chief
July 13, 2017

Meikles has merged with South Africa’s Pick n Pay to form TM Pick n Pay supermarkets, now Zimbabwe’s largest supermarket chain by outlets.

LAST week, Meikles lifted the cautionary it had issued on the trading of its shares after Albwardy Investments informed the group that it was withdrawing its interest in acquiring a majority stake in the company.

It is not often that a suitor walks away from an asset he covets. Often, prospective buyers get rejected for offering low prices, or because the subject of the take-over is not interested in selling. In some instances, this triggers hostile bids, an inevitable consequence of saying no to a deep-pocketed buyer.

The overture from the buyer may be unwanted, and management’s advice to shareholders to reject an offer may necessarily be on the basis that the offer grossly undervalues the company, which is a big problem facing Zimbabwean firms today: The majority of them have had their sheen taken off by perceived high political and economic risk, and offshore suitors are justifiably seeking to buy them on the cheap.

But what if the price being offered by a suitor is tempting? That is the part minorities may never get to know about the now abandoned acquisition of Meikles by Dubai billionaire, Ali Albwardy, since his company never lodged a formal offer. The first cautionary statement from Meikles in March had indicated that Albwardy wanted to buy out minorities.

That offer was to result in the delisting of the company from the Zimbabwe Stock Exchange. But when the cautionary statement was renewed in April, it noted that the offer had now been made to “all shareholders”. This, inevitably, signalled the United Arab Emirates billionaire’s intention to dismantle the dynasty that has run the company for over a century.

In that announcement, Meikles indicated that the proposed transaction could not be made until the audited financials for the year to March 31, 2017 became public. When the financial results were released, they showed growth for the full year to March 31, 2017, with a reported improvement in operating performance showing a 104 percent growth in earnings before interest, tax, depreciation and amortization to $24,8 million.

This, apparently, was achieved from the excellent performance of supermarkets, hotels and agriculture business. The wholesaling and departmental stores businesses chalked up losses. Income due from the government, last recorded at about $42,6 million, was not included. Turnover increased by 0,9 percent to 457 626 000 during the year under review, from $453 648 000 the previous year.

Operating profit however took a very huge leap, from $1,388 million in the prior year to $13,174 million during the reporting period, an 849 percent jump. This helped turn a $17,815 million loss before tax in the prior year to a profit before tax of $5,344 million during the reporting period.

Materially, the financial statement may only have helped reinforce the view that Meikles was still a business to bargain for, but if the expectation had been that the major shareholders wanted to gain more from the billionaire bidder by using the net asset value (NAV) rather than the share price, the financials did little to pull the figures. That route, however, would have required a delisting first.

The NAV declined by five percent to $100 million during the year to March 31, 2017, from $105 million the previous year. At the close of business on Friday, the Meikles share price was at 25,01 cents per share, giving a market capitalisation of $61,37 million. The company’s price-earnings ratio was at 1,8 times. Considering that the Meikles share is selling at a price below its tangible asset value, it can clearly be said that the Meikles share price is undervalued.

But what may have prompted Albwardy’s walk away? On its website, Meikles describes itself as “a dominant conglomerate with over a 100 years of history and has grown strong household brands in the fast moving consumer goods sector and 5 star-brands in the hospitality sector in South Africa and Zimbabwe.”

Given that this is largely a family-controlled business handed down through generations, members of the Meikles dynasty may have called for a hefty compensation for the intangible value on assets not covered on the company’s balance sheet. But whatever the price, there is no chance this could have been beyond what the billionaire Arab sheikh could pay for.

If efforts to strike a friendly deal had been rebuffed by the Meikles family, Albwardy would have certainly made a hostile bid that may have found favour with minorities. That bid may not necessarily have been an all-share hostile takeover, but an offer to minorities that could have given the company entry into the conglomerate.

According to a table of Meikles’ top shareholders on the company’s website, Gondor Capital Limited, the investment vehicle for the Meikles family, controls 47,42 percent of the listed entity. Old Mutual Life Assurance Company Zimbabwe, with 17 541 113 shares, holds a 6,91 percent shareholding, while Clayway Investments (Pvt) Ltd has 12 812 381 shares accounting for 5,05 percent of the company.

The balance, amounting to 103,084,731 shares or 40,62 percent, is held by minorities.

Albwardy Investments

Eagle eye • 21 days ago
Doctored accounts, arrogance, ill advise and non performance of other units could have played a role. The top man needs good brains around him.

Dopori • a month ago
I think, and I have said it elsewhere, Albwardy could have been pissed off by the long tail and as yet unresolved outstanding debt owed to Meikles by the government amounting to US$42.6 million. This amount, according to John Moxon, would have tipped the scales if it had been paid in full by now, with the net effect that almost, if not all the borrowings, would have been wiped out thereby boosting all the value metrics one can think of. The Arabs must have said to themselves, as newcomers, will we be able to recover this amount from the government if we make an offer and it is accepted by all the shareholders.
One must also understand that in order to go into deal like this, Albwardy must have engaged top notch advisors to give him independent and objective advice but I have a gut feeling that he will come back and and have another bite at the cherry when the time is right and I think it’s a matter of time.
Meikles would be a good investment for him in his scheme of things, and Meikles too including minorities, and especially the long suffering small fish like the writer, would greatly benefit from such an offer especially given that the current economic landscape in Zimbabwe is too politicized, very unpredictable and volatile such that there are always vultures circling around and ready to pounce on the group – wanting to reap where they did not sow.
Talking about dynasties, John Moxon is a steely guy, always swimming against the tide but age is not on his side. At the same time, I don’t think that his children have the same mettle to weather the Zimbabwean storm as him. That’s my take.
The buck drops here
A tale of two markets
Buttonwood, Aug 3rd 2017

The American stockmarket may be hitting new highs, but currency markets have lost faith in the Trump rally

THE Dow Jones Industrial Average closed above 22,000 on August 2nd, something President Trump is almost certain to mention in a tweet soon*. So it might seem as if the “Trump bump”, which began perking American stocks on the night of the election, is continuing smoothly. But the picture is a lot more complex than that as a look at the dollar’s performance against the euro shows (see chart below). The euro fell (and the dollar rose) between election day and the end of 2016. But then came a turning point. The euro has been climbing (and the dollar retreating) for much of 2017.

For dollar-based investors, that means European shares have been a much better bet this year. As of August 2nd, euro-zone shares (as measured by the FTSE Euro 100) were up 19.9% since the start of the year, while the S&P 500 was up 10.7%. Looked at another way, the American market has dropped by 8% in euro terms since February 2nd.

It is a similar story to the British market after Brexit; the FTSE 100 index jumped in sterling terms, but in dollar terms it was down because of the pound’s decline. The two markets interact. A falling currency is good for a country’s exporters and for its multinationals (whose overseas earnings are worth more in domestic-currency terms). That explains some of the resilience of the FTSE 100 and the Dow and some of the recent weakness in European equities; the German Dax is 6% off its June high.

A shift in the markets is also noticeable on a micro level. In the initial aftermath of the election, the big gainers were American stocks with high tax rates or those exposed to infrastructure spending; they were seen as benefiting from a fiscal stimulus. But no detailed plan for stimulus has yet been proposed, in part because the administration devoted its energy to repealing Obamacare.

Those stocks have lost the ground they made. Instead the big winner of the first half was the tech sector, which has not always been a favourite of the new president. Earnings generally have been strong and forecast revisions are the best that has been seen in the last six years, according to Bank of America, with multinationals leading the way.

The failure to pass a stimulus has also weighed on the dollar. The hope was that a strong American economy would prompt Janet Yellen (pictured, right) at the Federal Reserve to push interest rates up quickly. So far, America had a weak first quarter, followed by a better second quarter (but only in line with euro-zone growth).

The IMF cut its growth forecast for America for 2017 and 2018, to 2.1%. That means Ms Yellen may proceed more slowly with monetary tightening and may be replaced by a Trump loyalist next year when her term expires; that means there is less reason to buy the greenback. The euro zone in contrast has enjoyed a pick-up in growth and the European Central Bank will be cutting back on its easing of policy.

The European Union has also seen off the populist threat of Marine Le Pen on France and Angela Merkel looks set for re-election. That creates more reasons to buy the euro. But the year might not have seen its last twist with the possibility for America to escalate its trade dispute with China and its political pressure on North Korea, each of which might lead to risk aversion. That could push the dollar back up and equities down.

*An odd measure of success for Mr Trump to pick. The American stockmarket returned 235% under his immediate predecessor, Barack Obama; that will be hard to top.

recent weakness in European equities; the German Dax is 6% off its June high
lost the ground they made
cut its growth forecast for America for 2017 and 2018
replaced by a Trump loyalist
Wall Street’s high-wire act
Capitalism and the absence of creative disruption
by Buttonwood, Aug 8th 2017

The market is relying on profits to stay high

NINE straight highs for the Dow Jones Industrial Average might suggest that all is well with capitalism. But on the contrary, they could be a sign that things have been going profoundly wrong with the way the system is working.

The main driver for the surge in share prices this year has been the strength of profits; second quarter profits for S&P 500 companies are around 12.6% higher than a year ago, according to Andrew Lapthorne at Société Générale, a French bank. As the chart shows, relative to GDP, profits seem to be regaining their levels of recent years. And those levels are much higher than they have been in much of the post-war era (see chart).

Jim McCaughan of Principal Global Investors says he is not too concerned about this since the nature of capital has changed; no longer is the economy dominated by manufacturing where businesses have to invest in heavy equipment, blast furnaces and the like. But that argument, which has been knocking around since the dotcom boom, strikes me as unsatisfactory.

In essence, the argument boils down to the return on capital having risen. But if that is the case then entrepreneurs round the world should be piling in, creating new businesses and expanding existing firms-especially in the light of low interest rates. The resulting competition should drive profits back down.

That clearly isn’t happening, suggesting something about capitalism has changed. One reason could be that certain sectors are now in the hands of effective monopolies, particularly in technology where network effects favour incumbents (see our coverage of this issue). Creative destruction may not be happening any more. And that may explain why economic growth and productivity improvements have been sluggish in recent years.

It is possible, of course, although three big caveats are needed. There have been several cases in the last 20 years when companies have thought they had an enduring advantage (AOL, Nokia and Blackberry, for example), only for events to overtake them. Secondly, big business was dominated by monopolies in the early 20th century, only for populism to strike back in the form of trust-busting measures.

The same could happen today; barely a day goes by without a tech company facing public controversy. Third, the marginal cost of many tech products tends towards zero which suggests that price competition eventually ought to bite hard. The tech giants may yet be cut down to size.

When it comes to the stockmarket, Jeremy Grantham of GMO has a new note pointing out that investors tend to award high valuations to shares when, like now, profit margins are high and inflation is low and stable. But if one believes that margins are mean-reverting, this shouldn’t happen. When profits are high, investors should fear that they will fall and pay a low multiple of current profits; instead valuations have only been higher in 1929 and the late 1990s.

Mr Grantham thinks that any shift to lower valuations would have to be accompanied by a sustained fall in margins or a rise in inflation (or both). And neither is going to happen soon. He may be right on both counts. But that should worry those who are hoping for a return to healthy economic growth. And all “this time is different” arguments should remind us of when Irving Fisher said, in 1929, that stocks had reached a “permanently high plateau”.

highs for the Dow Jones Industrial Average
our coverage of this issue
a tech company facing public controversy
new note
valuations have only been higher in 1929 and the late 1990s,0
Buttonwood’s notebook
Financial markets

Ten years on
Where might the next crisis come from?
by Buttonwood, Aug 9th 2017

The debt has not gone away; the system has been kept afloat by very low interest rates

TEN years ago, BNP Paribas, a French bank, temporarily suspended dealings in three funds, citing “the complete evaporation of liquidity in certain market segments of the US securitisation market”. Many people treat this as the start of the credit crunch but one can trace it back to the need for Bear Stearns to rescue hedge funds that invested in mortgage-backed securities in June, or the signs of home loan defaults and failing mortgage lenders that emerged in late 2006. The subsequent tightening of credit and loss of confidence in the banking system eventually led to the collapse of Lehman Brothers, when the crisis reached its height in the autumn of 2008 (see picture).

The inevitable question on the occasion of such anniversaries is: could it happen again? Total debt has risen, rather than fallen, over the last decade, reaching $217trn or 327% of GDP, according to the Institute for International Finance. But the debt is differently distributed from 2007; more of it is owed by governments and more of it is owned by central banks. Since these banks have no incentive to hassle countries for repayment, the air of crisis has dissipated. Banks have more capital, making them more secure. And low interest rates have made servicing debt more affordable for both consumers and companies.

Nevertheless, we are nowhere near “normal” conditions; although America’s economy has been recovering for a long while and unemployment is low, the Federal Reserve is proceeding very cautiously with tighter rates. And the ECB, Bank of England and Bank of Japan have not even started on the process.

Given all this, where might the next crisis come from? Clearly, the two obvious possibilities are a sharp rise in defaults (causing lenders to lose confidence) or a signficant increase in interest rates (which would trigger the same process). Defaults can occur without a rate rise if the economy goes into recession.

That could result from war with North Korea (apparently God has authorised President Trump to do this) or a less frightening but still significant trade dispute with China. It could result from internal Chinese debt problems since that is where recent debt growth has been concentrated. Or perhaps it will happen in the corporate bond markets, which are less liquid than they used to be, and could suffer a panic sell-off by investors in bond funds. Other possibilities include student debt or car-loan debt, where consumers may have become overstretched again.

The more likely possibility is a monetary policy mistake. When the Fed started to use quantitative easing, many people cited the “ketchup principle” for the inflation risk (“shake and shake the ketchup bottle, first a little, then a lot’ll”). The inflation never occurred but there is the risk that in the unwinding of policy, all will seem calm until the market suddenly breaks.

Something similar happened in 1994 when the bond market was badly affected by an earlier round of Fed tightening. And the Fed is the most likely culprit, not just because it is first to tighten but because America’s monetary policy has ripple effects through the world, via the dollar and the American economy’s huge weight in global GDP. The next crisis may come from Washington.

temporarily suspended dealings in three funds
Bear Stearns to rescue hedge funds
home loan defaults and failing mortgage lenders that emerged in late 2006
Institute for International Finance
God has authorised
recent debt growth
panic sell-off by investors in bond funds
overstretched again