Analysis The financial reporting practices of industry titans like Cisco and Microsoft are coming under increased scrutiny. They're big, they're apparently highly profitable, but neither company paid federal income taxes for their most recent financial year. It's all legal, but the accounting approach they're using hovers on the edge of legality and ethical behaviour.
It takes skill. Five areas are gaining increased attention: pooling; related party transactions and cross-ownership; the independence of auditors; stock option schemes; and, in the case of some investors, short-selling. Profit warnings from Intel, Apple, Dell and others resulting from Wall street analysts professing to being disappointed may well prove to be of lesser concern than implications that emerge from murky accounting practices under these headings.
Pooling is an accounting practice that is used by some companies acquiring other companies or merging with them. It can be operated as a smokescreen, but it is at present legal to account for transactions in this way. The US Financial Standards Accounting Board is however endeavouring to ensure that all business combinations are accounted for based on the true cash value of what is given for control - the so-called purchase method. The problem is that with pooling, investors are given less information in the accounts, and it is not possible to tell how much was invested in a transaction, nor to track its success or failure, so preventing meaningful comparisons of corporate performance. Cisco is a major user of pooling, and is actively resisting moves to ban it.
Cross ownership and related back-scratching
Cisco was also criticised in a recent WSJ article about related party transactions and the relationships it has with its customers and suppliers, either directly or through personal holdings by its executives. Lernout & Hauspie's related party transactions are currently being investigated by the Securities and Exchange Commission, but so far Cisco has escaped an SEC enquiry. Cross-ownership implies having influence on the behaviour of a key supplier - or even sometimes a competitor - and can take the form of an equity stake, with or without a seat on the board, or of an executive of a major company serving on the board of a smaller company in which the larger company has a trading or other interest, in order to increase the stature and reward that company.
This is something that Microsoft is increasingly doing. There are several similarities between cross-ownership and Japanese keiretsu.
Fujitsu, Hitachi, NEC and Toshiba - the major keiretsu - developed in Japan after the war, as a continuation of the pre-war Japanese zaibatsu, which were family-controlled corporate giants. Keiretsu are characterised by cross-ownership, which has the effect of decreasing competition between them as a result of the cross-holdings, which to a significant extent are an alternative to wider public ownership. The resulting quasi-cartels may gain some added stability, but too often the consumer suffers as a result of higher prices and reduced competition.
Auditors - poachers, gamekeepers, both?
Auditor independence is critical if there is to be any credibility in the accounts of a company. Last month, Business Week reported how Arthur Levitt, chairman of the SEC, is determined to stop the auditing failures that have cost investors $88 billion in the last seven years as a result of conflicts of interest between the auditing responsibilities of accountants and their consultancy role for the same clients. Even worse, in many cases the consultancy branch of the auditors not infrequently has another business relationship with the audit client and sells its products and services to other clients.
The big five have found that their consultancy businesses already generate more revenue and are growing three times faster than the auditing businesses. The paper walls were too thin for comfort in some cases, it seems, because Ernst & Young has already sold its consultancy practice for $11 billion, PricewaterhouseCoopers is talking to HP about selling its consulting arm for $18 billion, and KPMG says it plans an IPO for a majority of its consultancy business. Arthur Anderson and Deloitte & Touche are adamantly opposed to disposing of their consultancy practices, perhaps banking on Levitt not being confirmed as SEC chairman after the presidential election.
Stock option schemes are widely accepted as a useful way to incentivise employees by giving them a share in the success of a company - and some 10 million people in the US now receive them. Of course, if the share price goes down rather than up - as has been happening at Microsoft - it's not much of an incentive, especially as there is no alternative to take that part of income in cash instead. American companies do not have to set the stock options they grant against their earnings.
It's curious that this came about because in the 1950s the US Accounting Principles Board (the FASB predecessor) couldn't agree on how to value options, so it was arbitrarily decided that the value should be set at zero. This is currently the case in the UK as well, although recently the UK Accounting Standards Board proposed that the estimated present value of the options should be set against earnings. Setting stock options against earnings was proposed by the FASB in 1993, but the protests from Silicon Valley scared off the FASB after a threat that it would be shut down.
Although short selling is an investor practice rather than a corporate accounting practice, it does raise ethical questions. Is it fair - as distinct from legal (in the US at least although not in many other countries) - to make a profit by betting that a company's share price will decline? The counter argument is that if a company deserves to fail, or is acting illegally, let it take the consequences that the market or regulators determine. In extreme circumstances, short sellers of a stock may well be very effective destroyers of investor confidence, and should they release false information or innuendo to the media (or even post it on an Internet bulletin board), this may amount to illegal market manipulation for which the penalty is jail time.
So far as esoteric accounting practices are concerned, much of the detailed criticism of Microsoft's and Cisco's practices - especially the stock option and pooling aspects - has been elaborated by accountant Bill Parish with formidable forensic detail. He particularly addresses practices at the borderline of legality, and although the industry titans he criticises are almost certainly acting legally, he identifies some disturbing financial engineering practices. By no means least of these is the mechanism whereby Cisco and Microsoft manage to avoid paying federal tax because of credits that they get back. ®
Bill Parish's take on Cisco