2.9 Mini Case Studies on Managing Financial Statements and Item 7 (MD&A)

The four major financial statements discussed in this chapter are:

·         Consolidated Statement of Income – presents results over a period starting with the top line sales down to the bottom line net income.

·         Consolidated Balance Sheets – presents the financial position at the end of a period.

·         Consolidated Statement of Cash Flows – presents information about cash inflows and outflows summarized by operating, financing and investing activities.

·         Consolidated Statements of Shareholders’ Equity – presents a reconciliation of the beginning and ending balances of accounts appearing in the Shareholders’ equity section of the balance sheet

You should observe that the word consolidated is used in relation to the firm’s financial statements.  The consolidated statements need not be associated with a legal entity; however financial risk is usually assessed relative to these consolidated statements.  This can create a demand for a special purpose entity (SPE), a legal entity designed to isolate the firm from some specific financial risk(s).  SPE’s have been used to let management attain specific goals without putting the entire firm at risk by transferring assets or liabilities to the SPE which lies outside of the consolidated statement net.  SPE’s have legitimate uses but they can also be abused (e.g., Enron exploited SPE’s to re-engineer their Balance sheet).  As a result, US GAAP has made it more difficult post Enron and is covered by an interpretative statement FIN 46R which sets out the treatment of special entities in consolidated statements.

Disclosures about these entities are made in the 10-K but they can appear in different parts.  For example, when special purpose entities are used to re-engineer the consolidated balance sheet there may be no discussion in the “Critical Accounting Policies” section of the MD&A but it may be disclosed in another part of the MD&A.  This was the case for Krispy Kreme discussed in Case 1.  In the second example, there was no disclosure in MD&A and a QSPE (Qualified Special Purpose Entity), a grandfathered SPE under previous accounting standards (FAS 125) was used by Lehman Brothers.  This is discussed in Case II.  These cases are provided to illustrate how accounting principles evolve in the light of abuses in an attempt to close loopholes, in this case FIN 46R.

2.9.1 Case 1:  Krispy Kreme’s Synthetic Leases

In a Forbes Magazine article reporters Seth Lubove and Elizabeth MacDonald asked the following question in 2002:

“What makes Krispy Kreme, a chain of 217 donut shops (of which only 75 are company-owned), worth $2.1 billion on Wall Street? Perhaps investors are impressed by the company's ability to grow rapidly on an eyedropper of capital. For the first nine months of fiscal 2002, capital expenditures fell to $38 million from $59 million in the prior year. Yet Krispy Kreme has expanded along with its customers' waistlines during the same period, with earnings that soared 73% to $18 million on sales that were up 27% to $277 million.”

The answer to this question turned out to be --- it wasn’t worth $2.1b.  Strangely, it took the market nearly 3-years to confirm this answer via market prices.  The accounting practice used was a “synthetic lease.”    In this case the lease was for productive capacity that was generating cash flows for Krispy Kreme, even though it was moved off the consolidated books.  This is a financing structure, which was legal prior to 2003 whereby an asset is acquired by a special purpose entity (SPE) and then leased to Krispy Kreme as an operating lease.  The SPE is given sufficient control to avoid inclusion in the consolidated statements and so no depreciation charges are recorded by Krispy Kreme.  In addition, if the lease payments are combined with balloon payments then cash flows can be further managed via this SPE.  Synthetic leases were popular around this time with a number of companies. 

A close examination of the 2002 10-K for Krispy Kreme which came out subsequent to this Forbes magazine article included the following disclosure in the Item 7.  It is interesting to observe that the synthetic lease referred to in the Forbes article 2/18/2002 was terminated on March 21, 2002 and accounted for in 2003.  On July 29, 2004 the SEC announced an investigation into the accounting practices of Krispy Kreme.  However, it is noted that the disclosure of the accounting practice was not included in the “Critical Accounting Policies” part of Item 7 but instead under the title of Cash Flow from Investing Activities.  As a result, a good analyst should examine carefully the entire MD&A Item 7 when assessing accounting policies.  This disclosure is provided below:

“CASH FLOW FROM INVESTING ACTIVITIES

Net cash used for investing activities was $10.0 million in fiscal 2000, $67.3 million in fiscal 2001 and $52.3 million in fiscal 2002. Investing activities in fiscal 2002 primarily consisted of capital expenditures for property, plant and equipment (shown as purchase of property and equipment on the consolidated statements of cash flows) and the acquisition of associate and area developer markets, net of cash acquired.  Investing activities in fiscal 2001 primarily consisted of capital expenditures and the purchase of approximately $35.4 million of marketable securities with a portion of the proceeds from the initial public offering and cash flow generated from operations. Investing activities in fiscal 2000 primarily consisted of capital expenditures.

In fiscal 2002, our capital expenditures were $37.3 million, an increase of $26.0 million, or 229.2%, compared with fiscal 2000 and an increase of $11.7 million, or 45.4%, compared with fiscal 2001. Capital expenditures in fiscal 2002 included: construction of new factory Company stores, capital expenditures for Company stores, acquisition and upfit of the new equipment manufacturing facility, remodels of Company stores, expenditures for the installation of a coffee roasting operation and construction of doughnut and coffee shops.

Expenditures for some of these projects were not complete at year-end as the projects were still under construction and were not operational as of February 3, 2002. These expenditures were necessary to support our efforts of increasing sales of our products throughout North America and for future expansion internationally. Capital expenditures for property and equipment in fiscal 2003 are expected to be in excess of $43 million; however, this amount could be higher or lower depending on needs and situations that arise during the year. This amount excludes capital expenditures related to the company's new mix manufacturing and distribution facility under construction in Effingham, Illinois. As discussed in Note 21, Synthetic Lease, the Company initially entered into a synthetic lease for this facility under which the lessor, a bank, would fund construction of the facility and lease it to the Company. On March 21, 2002, the Company terminated the synthetic lease and purchased the facility, which is still under construction and expected to be completed in the first half of fiscal 2003, from the bank under a new credit agreement. Capital expenditures related to the Effingham plant in fiscal 2003 are expected to include approximately $35 million related to the purchase, completion and furnishing of this new facility and will be in addition to the $43 million discussed above.”

For the case of Krispy Kreme disclosures were provided.  However, in other cases disclosures were not made as illustrated in the next example.

2.9.2 Case II: The Lehman 105, Structure

Not all critical accounting judgments are processed in the 10-K.  An interesting recent case of this was Lehman Brothers.  It demonstrates how accounting policies can potentially mislead investors and regulators.  Accounting for revenue recognition is difficult and the standards are not currently in agreement.   

Under US GAAP, revenue is recognized when it is earned and the revenue is realized or is realizable.  The latter means that a legally enforceable exchange has taken place, e.g. the buyer has taken possession of the product or benefitted from a service and is obligated to pay.

Under International Accounting Standards (IAS), revenue can be recognized when the seller has transferred to the buyer the significant risks and rewards of ownership.  In some cases, US GAAP also permits this type of revenue recognition criteria.

The following account is taken from the report of the examiner, Anton R. Valukas, to the United States Bankruptcy Court following the collapse of the investment bank.

According to the examiner, “Lehman employed off‐balance sheet devices, known within Lehman as “Repo 105” and “Repo 108” transactions, to temporarily remove securities inventory from its balance sheet, usually for a period of seven to ten days, and to create a materially misleading picture of the firm’s financial condition in late 2007 and 2008…..Lehman regularly increased its use of Repo 105 transactions in the days prior to reporting periods to reduce its publicly reported net leverage and balance sheet. Lehman’s periodic reports did not disclose the cash borrowing from the Repo 105 transaction – i.e., although Lehman had in effect borrowed tens of billions of dollars in these transactions, Lehman did not disclose the known obligation to repay the debt. Lehman used the cash from the Repo 105 transaction to pay down other liabilities, thereby reducing both the total liabilities and the total assets reported on its balance sheet and lowering its leverage ratios.”

To understand the Lehman Repo 105, you need to understand a repurchase agreement. This is a contract that bundles together a sale of an asset or security with an obligation (a forward contract) to buy back the item at a predetermined time and price. The Lehman 105 structure exploited this type of rule immediately before (for the sale) and after (for the obligation to buy back) their quarterly reporting dates. FAS 140 counted repurchase agreements as revenue if the transferor of collateral cedes control of the assets to the lender. According to the FASB, a repurchase collateralization between 98% and 102% of the borrowed amount allows the borrower a chance to buy back the collateral, but collateral greater than 102% is deemed as ceding control. Lehman’s structure was collateralized at 105% so it could be accounted for as a sale under US GAAP. The scale of the activity was quite large; again, from the examiner’s report, “…Lehman undertook $38.6 billion, $49.1 billion, and $50.38 billion of Repo 105 transactions at quarter‐end fourth quarter 2007, first quarter 2008, and second quarter 2008...”

So Lehman used this structure which takes advantage of a rules based accounting system, to eliminate (in their final days) more than $50 billion of liabilities from their quarterly balance sheet for 2nd quarter 2008 in order to reduce their leverage ratios. For example, by reducing Assets and Liabilities by the same amount they can immediately improve their debt to equity ratio because equity remains unchanged.

The transaction was conducted through a QSPE (Qualified Special Purpose Vehicle).  A QSPE must have separate standing from the seller (so the seller cannot control the entity) and so must essentially cede control over the assets (for at least a few days); this allowed the revenue to be recognized as a sale.  QSPE’s were eliminated from FAS 140 shortly after this period.

The above example, illustrates the difficulties associated with setting revenue recognition criteria.  Most large firms provide extensive discussion of their revenue recognition criteria in the Critical Accounting Judgment part in Item 7, the MD&A section of the 10-K report.  It is worth reading this part closely! 

Under the current US GAAP it is more difficult at least to move items off the consolidated financial statements than it was pre the Enron’s and Lehman debacles.  In the following section we turn our attention towards becoming more closely acquainted with the four major real world financial statements including their underlying structure.