Financial Reporting – Al (Aloke) Ghosh

Category: Financial Reporting

Bavarian Book-Keeping: Cash-in-out

Wirecard, a high flying publicly traded fintech company from Munich, Germany, has attracted major investors around the globe including SoftBank. In about a year, the stock price of the company rocketed from €41 in 2017 to €192 in 2018.

Recently, Wirecard has admitted to book-keeping or accounting fraud. The company declared that the $2.1 billion cash on its balance sheet is “missing” (a quarter of its Balance Sheet value). It is not that the company received cash (cash-in) and then the cash was stolen (cash-out). The company never acquired that cash! By recording fictitious revenues/profits, the company accumulated a mammoth “paper” cash balance of $2.1 billion. Welcome to Alchemy Accounting.

Regrettably, the investors are left with the hefty bill—the stock is trading today around one euro!  

WireCard Business

Wirecard specializes in digital payments. The company offers its customers electronic payment transaction services, risk management, and physical cards. Initially known for processing payments in controversial markets, the company evolved into a full-service global financial payments player from 2006 following the acquisition of a bank. The company became publicly traded from 2005 following a “reverse merger” with InfoGenie, a Berlin-based company.

Over the past decade Wirecard fueled its expansion through aggressive acquisition of smaller payment processing businesses including a major acquisition of 20,000 merchant clients of CitiBank in Asia-Pacific region.

What is Fintech

Fintech encompasses any kind of technology in financial services industry linking businesses with consumers through software or other technology/apps (from payment apps to cryptocurrency). Fintech has been used for many of the newest technological developments – from payment apps like PayPal, Venmo, and cryptocurrency.

Cooking the Books

As part of investigations of potential financial fraud, Financial Times (FT) concluded that there were reasons to suspect that Wirecard’s units in Singapore and other Asian countries may have engaged in accounting fraud. According to FT, one of Wirecard’s “third-party acquirer” (licensed by Visa and Mastercard to help retailers accept credit card transactions), a Dubai-based intermediary called Al Alam Solutions, contributed half of the German company’s worldwide profits in 2016. This third party acquirer had only six-seven staff members despite processing vast sums of transactions for 34 of Wirecard’s most important clients in the US, Europe, Middle East, Russia and Japan (around E350 million between 2016 and 2017). Neither Visa nor Mastercard have any record of a relationship with Al Alam.

Investigations raise doubts whether the sales and profits recorded by Al Alam were invented. For instance, Wirecard says the US payments processor CCBill was a multimillion-dollar-client of its partner company Al Alam Solutions but CCBill says it had no business with Al Alam. Similar cases of fraud may have been perpetrated by Wirecard Dublin office.

Wisecard and Big 4: E&Y is the external auditor

As the audit firm of Wisecard for nearly a decade, E&Y GmbH, the German affiliate of E&Y Global Limited (global umbrella organization for E&Y firms) issued unqualified opinions every year until 2018 despite increasing questions from journalists and short sellers over the company’s accounting practices. 

In 2019, Wirecard hired KPMG to investigate allegations raised by some in the media and sophisticated investors that a large share of Wirecard’s reported revenue-profits between 2016 and 2018 originated from a trio of third-party partners. In April, KPMG released a 74-page report saying it couldn’t verify the arrangements with the third parties because of lack of cooperation.

During its 2019 audit, E&Y concluded that it could not verify the cash balance of $2.1 billion held by trustee-controlled bank accounts in Philippines. Why would a German company hold cash in Asia that too in a trustee-controlled account? Wisecard’s explanation for such an unusual arrangement was that they were following risk management strategies and were reserving cash to process refunds and chargeback. Ironically, Germany’s central bank could not confirm that the money had entered its financial system.  

On Friday, a German shareholder association filed a criminal complaint to the prosecutors’ office in Munich accusing E&Y auditors of missing the alleged fraud.

Political Fallouts

In Germany, Financial Reporting Enforcement Panel (FREP), a quasi-private entity, supervises the financial statements of companies traded on the German stock exchange. Germany’s lead financial regulator BaFin often relies on the investigations initiated by FREP to supervise companies. Following the Wisecard accounting scandal, Justice and Finance Ministries decided to sever ties with FREP.

BaFin President Felix Hufeld is scheduled to testify behind closed doors to German parliament members.

Expect even more fallout!
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Centurion Auditor: Good or Bad?

General Electric (GE) has been courting negative publicity because of its questionable accounting practices. The maker of jet engines, light bulbs and MRI machines is being bombarded with lingering questions about its reporting practices.

In 2009, the SEC charged GE with accounting fraud and overly aggressive accounting practices, which lead to false and misleading statements to investors. GE paid $50 million to settle those charges without admitting to or denying wrongdoing.

Last year, the SEC started an investigation into the company’s accounting practices related to revenue recognition. The SEC investigation was expanded in scope following the reporting of $6.2 billion loss on its portfolio of long-term care insurance policies.

Who GE’s Auditor?

A centurion, KPMG is the external auditor of GE and they have been so for the past 109 years.

Regulators and media often hold the viewpoint that long-tenured auditors can become too close to a client, which erodes audit quality, while a new auditor can be more efficient in uncovering problems previously unidentified, which leads to enhanced audit quality. Many commentators and analysts believe that, in the case of GE, the auditor’s extensive tenure has jeopardized KPMG’s independence which ultimately questions the audit quality rendered by the firm. 

KPMG is part of an exclusive audit club, also known as the “Big 4” (others are E&Y, Deloitte, and PWC) revered for their professional expertise and commitment to independence. Yet, that pristine reputation has been lacking lately for KPMG—the firm has been chasing its own demons.

  • In the USA, six accountants, including former employees of PCAOB, were charged with leaking confidential data to KPMG. The SEC said the sensitive information helped KPMG clear regulatory inspections at a time when the firm was under pressure to clean up its audit record (akin to dishonesty in an exam).
  • In South Africa, KPMG’s South Africa division found the accounting firm had missed red flags in its auditing of companies owned by the Gupta family in that country. South Africa is arguably KPMG’s most important market in Africa, as it boasts the continent’s most industrialised economy, its biggest companies and its largest stock market (lacking independence).
  • In Canada, KPMG’S Canadian division is the subject of two complaints from one of the country’s largest financial worker’s unions. KPMG is charged with setting up offshore tax structures in the Isle of Man to help wealthy Canadians avoid paying taxes, which is against the profession’s code of conduct” (violation of professional code of ethics).

Shareholder Watchdogs

Shareholder watchdog groups worry that GE and KPMG may have become “too cozy” during their 109-year-old relationship. Both Glass-Lewis and Institutional Shareholder Services are urging shareholders not to ratify KPMG as GE’s auditor at the company’s annual shareholder meeting on Wednesday.

Ultimate Outcome

KPMG is most likely to continue to serve as the external auditor of GE despite widespread shareholder dissatisfaction with KPMG. The negative proxy votes not to ratify KPMG as the auditor satisfaction in annual shareholder meetings are unlikely to topple the audit firm. Why?

Under the current US regulations, only GE’s Audit Committee (a subcommittee of GE’s board consisting of independent members) has the ultimate authority to retain or dismiss auditors. The audit committee is also free to ignore how shareholders may feel about the auditor.

This is what we call “hullaballoo!”

May 8, 2018Facebooktwitterredditlinkedinmailby feather

Harvard’s Big Bath

We are all familiar with the notion of a bath in our communal lives, but the term “big bath” is equally common in the corporate world. Big Bath is an earnings management technique whereby a one-time charge is taken against income in order to reduce the value of an  assets.  This technique is often employed in a bad year, e.g., when sales are down, or when a company reports losses, to account for overvalued assets on the balance sheet.

Although the process is discouraged by auditors, it is frequently used by public companies. A notable feature surrounding big baths is that this accounting treatment tends to coincide with new management team because the new management team can then blame the one-time charges on the prior management team while simultaneously calibrating current reported income to unusually low levels thereby making it easier to meet or beat income in future periods.   

Big Bath in Non-profit Sector

Does Big Bath happen in the non-profit sector? Bien sûr!

 Harvard University has the largest endowment fund in the world with assets around $37 billion. The new chief of Harvard University’s endowment, Narv Narvekar, actively pushed to slash the value of some of its investments in natural resources portfolio of forests, farms and vineyards given his bearish outlook on some of the assets. Although Harvard University has the largest endowment, it was the only Ivy League endowment which generated less than 10% in the most recent year, which is why there was a “change of guards” at fund management level.

New endowment chiefs often have an incentive to write down investments they inherit because it is easier to blame the losses to the prior investment chief. It also helps remove potentially overvalued assets. Mr. Narvekar described Harvard Management Co. as having “deep structural problems” that would take five years to restructure. “An honest, reflective, and clear-sighted recognition of these problems is the first critical step towards generating solutions,” he wrote in his first annual letter in September, 2017.

Under Mr. Narvekar, Harvard reduced the value of its natural-resources investments by more than 25%, which is an unprecedented amount of a write-down (Harvard had valued the portfolio at roughly $4 billion at the end of the prior fiscal year).

Big Subjective Decisions

Many asset managers and appraisers say valuing assets that trade infrequently or aren’t generating cash—trees, for example, take years to grow before they can be sold for timber—is difficult. However, the new chief investment officer indicated that some natural-resources investments carried more risk than previously calculated. Therefore, he raise the discount rate (because the risk was high), which caused some investments to lose value.

Valuations for the endowment’s private assets were approved by the board, reviewed by Harvard and “the valuation process was independently verified by external auditors,” board Chairman said in a statement.

Big Pay Day

Harvard has guaranteed Mr. Narvekar at least $6 million a year for his first three years on the job. Additionally, the Chief is expected to earn additional performance-based compensation which is expected to be closely tied to the endowment’s performance in the long term.

When a non-profit sector mimics the pay of the for-profit sector in order to generate high future returns on the largest endowment fund!

January 25, 2018Facebooktwitterredditlinkedinmailby feather

(Un)Accountable Shell Games

A shell corporation often has no active business operations or hold any productive assets. Structured as an efficient financial vehicle, a shell corporation can serve as a convenient mechanism to raise funds, to complete a hostile acquisition or to take a company public. Nevertheless, these corporate structures can also be used for nefarious purposes some of which include disguising ownership from law enforcement or the public, or to evade taxes.

For instance, the “Panama Papers” leaks revealed that banks, political leaders and wealthy individuals had allegedly hidden billions of dollars in shell companies through a Panama law firm. The scheme allowed clients to evade taxes. Reportedly 214,000 shell companies were created to facilitate illegal activities.

Shell Games

Not all shell companies are creating to siphon off funds or to evade taxes. There can be merits to creating a shell company.

  • Fortunes
  1. A startup can use a shell corporation to safeguard its assets before officially launching its business.
  2. A company preparing for a merger or an acquisition can hold its assets in a shell company for legal reasons and keep those assets separately from the acquiring entity.
  3. Foreign companies can create shell companies in tax havens like Panama (Swiss private banking, Hong Kong, Belize are some of the other dubious and prominent tax havens) and lower their taxes at home. How so one may ask? Most tax haven countries do not mandate tax information for the funds being funneled into the tax haven countries via shell companies. Further, some tax havens do not report the existence of these shell companies to the government of the owners operating the shell companies thereby creating a “black hole.”
  • Misfortunes
  1. Shell companies are often set up to mask the identity of the individual owning assets in the company or to evade taxes.
  2. Occasionally, companies take advantage of the secretive nature of shell companies and engage illegal activities like money laundering.

Limited Games in the Land of the Free 

In the U.S., we are fortunate to have monitoring agents like the Securities and Exchange Commission, the Justice Department, and the Public Company Accounting Oversight Board (PCAOB) guarding the corridors of capital markets to ensure that public companies are not actively engaged in “shell games” to defraud minority shareholders.

In sharp contrast, and most inappropriately, in emerging markets and particularly in the BRICS countries, minority shareholders may not be as fortunate where the use of shell companies to hide business ownership or to evade taxes is rampant.

What is the auditors’ role in policing dubious shell companies which are actively created by publicly listed companies to siphon off funds and to dupe minority shareholders? 

Let the Games Begin in BRICS Countries

The Securities and Exchange Board of India (the counterpart of US SEC) is scrutinizing the functioning of auditors in various public companies in India, especially if the auditor has had a long-standing relationship with the client. Under the Companies Act of 2013, auditors, have greater responsibilities to ensure that financial statements of an Indian company are not materially misstated and that auditors red flag “dubious” transactions.

The Finance Ministry in collaboration with SEBI is taking actions against 331 listed suspected shell companies. More than 100,000 directors (holy cow!) may be disqualified for their association with shell companies. Investigations are in progress to identify professionals, chartered accountants, company secretaries and cost accountants associated with the defaulting companies.

The auditors are not exempt from these inspections. Authorities are looking at the possibility of having stricter scrutiny of global auditing firms (e.g., the Big 4 audit firms) and to make them more accountable when their auditors certify companies with a clean opinion even when clients are actively engaged in corporate misconduct.

Commentary on BRICS

Similar to the initiatives in India, China, where the problems of shell games are even more pervasive, under President Xi Jinping, has been actively confronting these problems. While these are modest steps, India and China can do more to bring the unaccountable or black money back into the mainstream economy for the betterment of their citizens.  

While India and China are at least attempting to tackle this social ailment, sadly not much can be said about the other 3 countries within the BRICS which include Brazil, Russia and South Africa where their top leaders appear to be the cause and not the solution to this social ailment. feather

Italian Job

BT shares, which trade in the US as ADRs (BT Group plc), have declined by more than 45% in less than a year. Around half of that descent was confined to a single day last month (Jan 23) when the company announced accounting improprieties associated with its Italy-based operations. The company also noted that some senior management personnel may have embezzled funds. UK’s parent BT shares have shed more than 8 billion pounds because of this accounting scandal.

Italian prosecutors have initiated their own investigation into BT Italia’s accounting fraud. BT Group Plc has been hit by at least two shareholder lawsuits in the U.S. A number of other US law firms specializing in shareholder class action suits are considering filing lawsuits against the company and senior management.

British Telecommunications (BT)

BT Group plc is a holding company which owns British Telecommunications plc, a British multinational telecommunications services company with head offices in London. The company has operations in around 180 countries. The company’s shares are among the most widely owned stocks in the UK. The ownership of BT shares is widely dispersed ̶ about 700,000 of its 827,000 shareholders own 1,600 or fewer shares of the company.


American depositary receipts (ADRs) were introduced in 1927 as an easier way for U.S. investors to purchase stock in foreign companies. Non-U.S. companies also benefit from ADRs as it makes it easier to attract American investors. ADRs are negotiable certificates issued by a U.S. bank representing a specified number of shares (or one share) in a foreign stock traded on a U.S. exchange.

ADRs are denominated in U.S. dollars, with the underlying security held by a U.S. financial institution overseas, and holders of ADRs realize any dividends and capital gains in U.S. dollars, but dividend payments in euros are converted to U.S. dollars, net of conversion expenses and foreign taxes. ADRs are listed on either the NYSE, AMEX or Nasdaq but they are also sold OTC.

Italian Job

The fraudulent transactions related to BT-Italy emerged sometime during the summer of 2016 following an internal probe into its Italian business after a “whistleblower” flagged concerns. A whistleblower is an employee who discloses information about illegal acts, mismanagement, abuse of power, or general wrongdoing occurring in the company. If the company is publicly traded and subject to the filing requirements of the Securities and Exchange Commission, whistleblowers are protected by law from retaliation in the US. Some of the major US companies perpetrating accounting fraud were caught and brought to justice by their own employees (e.g., Enron, Freddie Mac, Madoff).

Upon investigation, BT discovered “inappropriate management behavior” within the Italian division. The expected cost of the rent extraction initiated by the Italian subsidiary was estimated to be around £145 million. Sometime in January this year, just days prior to the announcement of the third-quarter results, the company released a statement declaring that, according to an independent investigation by the Big 4 accounting firm KPMG, the losses to BT from the accounting irregularities related to Italian operations were being reassessed at £530m, which is almost 4 times larger than the previously estimated number.

The company suspended several BT Italy’s senior management team. BT has also appointed a new chief executive of BT Italy who took charge of Italy’s operations from Feb. 1.

Telecom Blues

What remains troubling is why wasn’t the accounting irregularity detected by UK’s parent company much earlier. Nick Rose, the chairman of the BT’s audit committee, flagged internal-control issues in Italy in every annual report since May 2013. Yet, the persistent accounting fraud was not detected until 3 years later. By blaming BT-Italy for all the current problems, the CEO of BT may be attempting to distance the parent company, and himself, from the Italian operations by censuring a few perpetrators.

What is even more worrisome is why didn’t the auditors detect this size of an accounting fraud earlier? Independent auditors are expected to provide an assurance that the financial statement are free of material misstatements. One would agree a misstatement exceeding $600 million is material.

Who was BT’s independent auditor? The answer is PwC, which a Big 4 global accounting giant. PwC has been BT’s auditor for the last 30-year since 1984. It is unclear whether BT intends to end its business relationship with PwC. The big accounting firms are renowned for rendering high audit quality so this type of an accounting fraud is likely to a huge set-back for PwC.

Moody’s has warned it may cut BT’s credit ratings. Analysts are skeptical whether the company can afford to maintain a 10 percent growth in its dividend.

Randoph, February 2, 2017


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Mardi Gras Float in Trouble: First NBC

mardigrasIn the absence of major national banks in New Orleans, regional banks have floated the NOLA (New Orleans, Louisiana) economy. Through its wholly-owned subsidiary First NBC Bank, First NBC Bank Holding Company provides a wide range of financial services in New Orleans, Florida, and Mississippi Gulf Coast with 39 banking offices.

Following Hurricane Katrina, First NBC invested heavily in New Orleans construction projects that included generous tax credits established by federal and state governments. These investments collectively helped propel First NBC to become the city’s largest bank based on assets under the leadership of CEO Ashton Ryan.

Halloween Scare: Stress Test

The Federal Reserve Bank of Atlanta and the Louisiana Office of Financial Institutions informed First NBC on Oct 11 that the bank is under “troubled condition.”  As troubled bank, it must seek regulatory approval before adding any new directors or senior executives or changing the responsibilities. The bank is also prohibited from increasing its debt, distributing interest on subordinated debt or paying dividends on its stock.

To add to the stress, the Federal Deposit Insurance Corp. (FDIC) recently declared that First NBC is no longer “well capitalized,” restricting its ability to take on certain deposits and pay interest. First NBC was recently downgraded to junk status by Kroll Bond Rating Agency Inc., which specializes in rating smaller lenders. HoldCo Asset Management, which owns the banks’s debt has shorted the bank’s stock and as a way to hedge its risk against a bank default has also publicly questioned the bank’s accounting policies.

Uncle Sam’s Subsidies: Tax Credits

First NBC invested heavily in New Orleans in construction projects following Katrina and thereby benefited from the generous tax credits from federal and state governments. Because the tax credits received by First NBC were more than the taxes being paid, the bank was able to use the unused portion of the tax credits to reduce future tax payments by offsetting future taxes against the unused portion. For instance, if the government gives a $1,000 tax credit to a single parent for raising a child alone, and the parent must pay $800 as federal income taxes based on his/her income, the parent does not pay any taxes for the current period because the tax credit fully offsets the $800 taxes payable for the current year. More importantly, even after the tax offset, the remaining $200 tax credit balance can be used to reduce future taxes.

Accounting rules allow this $200 future tax benefit to be capitalized (i.e., treated as an asset) and booked as a deferred tax benefit. As of the first quarter of 2015, the bank’s deferred tax assets—the benefits from reduction of future taxes—are $247 million, up from $95.8 million a year earlier.

In 2014, the company reported $28.6 million as income before taxes yet it reported a net income of $55.6 million because it had an income tax benefit of $27 million (instead of having an income tax expense which normally reduces net income).

Mardi Gras Float in Trouble: Recanting Previously Issued Statements

First NBC announced in August 2016 that it expects a delay in filing its 2015 Form 10-K (annual report filing with the SEC) because of restatement of previously issued financial results! The prior results included errors because of the following reasons:

  • Use of an inappropriate amortization method in accounting for investments in tax credit (Halloween Hullaballoo)
  • Consolidation of certain investments in Federal Low-Income Housing Tax Credit entities because such entities were determined to be variable interest entities in which the Company was the primary beneficiary (Enron Phantom).
  • The result of the consolidation has adverse effect on the financials (Hurricane)

Following the error corrections, the 2014 net income was now being restated (or reduced) by 20% ($55.6 million being revised to $44.7 million). Similarly, the 2013 net income was being restated (or reduced) by 18% ($40.9 million being reduced to $33.6 million). Accumulated earnings for 2012 and prior periods was being reduced by 16% from $59.8 million to $50.3 million. The company in its 2015 10-K stated “We determined that we had insufficient qualified personnel at both the executive management and staff levels with appropriate knowledge, experience and training on accounting and reporting matters, which contributed to the material weaknesses that resulted in the restatement, as well as the inability to timely file this report.”

To make matters worse, the bank was in violation of NASDAQ listing rules because it had not filed its 2016 quarterly statements. To avoid delisting from NASDAQ, First NBC submitted a plan to regain compliance with Nasdaq’s listing rules.

In a time-span of less than a year, the stock price of First NBC declined from a high of about $40 to around about $5.30, which is a cyclonic decline of around 86%. More than $600 million in shareholder wealth was destroyed because of the accounting related aggression.  

Grateful Dead Sings Aiko Aiko Ande

Ernst & Young (E&Y), a Big 4 auditor with international reputation and stature, has been the independent auditor of First NBC leading up to the 2015 financial statements. First NBC’s restatement is likely to bring considerable negative publicity, media scrutiny and regulatory intervention for E&Y. It will not be surprising to see class action lawsuits initiated by shareholders to recover losses.

In September 2, 2016, Ernst & Young declined to stand for reappointment as the company’s independent auditor for 2016. Is it a case of too little too late? A restatement is considered an audit failure.

Did E&Y fail the shareholders of First NBC? Only courts and the SEC can render a verdict on this matter. Until then, the accounting profession sings “Aiko Aiko Ande” in Cajun style.

 My spy boy saw you spy boy sittin by the bi-yo

My spy boy told your spy boy, Im gonna set you flag on fi-yo.

I said, hey now, hey now, Aiko aiko all day, jockomo feeno na na nay, jockomo feena nay.

My grandma and your grandma were sitting by the fire

Said my grandma to your grandma, gonna get your tail on fire.

Chatham- Helsinki; October 30, 2016



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Accounting’s Got Talent

accountingtoday-top-100Financial economics, as the title of the discipline suggests, is an embedded field within mainstream economic sciences. Therefore, it should not come as a surprise that quite a few Nobel Laureates in economics are finance professors who have done pioneering work in financial economics.

Closely linked with economics and finance, mainstream accounting research is derived from economics and financial economics. While there are a few strong delineators between finance, economics and accounting, the three fields intermingle and influence one another which is why it is difficult to have a strong grasp of one without at least a basic understanding of the other two.

Yet, accounting has never been considered part of mainstream economic sciences which is why no accounting researcher has won the Nobel Prize. Not to be outdone, the accounting profession has created a list of 100 most influential individuals, thought leaders, and visionaries who are responsible for shaping the accounting profession.

Requirements For Top 100

Gaining entry into the coveted top 100 Most Influential Person in Accounting is a daunting task. The Accounting Today complied the Top 100 list using the following criteria.

  • Innovator and creator. The individual must have created new ways to market the accounting/auditing professional services.
  • Educator. The individual must have taught the profession something the profession didn’t know already.
  • Regulator. The individual must have been involved in enforcing rules which had a game changing influence on the profession.
  • Elevator. Individuals who help achieve the ideals of the profession, or and those who are actively planning the future of the profession, are deemed the most influential of all.

What is the gender composition? Among the top 100 most influential accounting professionals, 70% are males and the remaining 30% are females.

Top 5

The top 100 most influential accounting professionals then voted to pick the Top 5 thinkers within the profession. The Superstars in Accounting are:

  1. Barry Melancon: President and CEO of AICPA
  2. Tom Hood: CEO and Executive Director of MACPA
  3. Mary Jo White: Chair, SEC
  4. Russell Golden: Chairman of FASB
  5. Ron Baker: Founder of VeraSage Institute


Surprisingly, no academic made it to the Top 100 list. Although academics meet the threshold requirement as an educator, presumably, Accounting Today does not consider academics to be influential enough to teach something to the profession that the profession didn’t know already. Academics are merely disseminating accounting/auditing knowledge that is already codified by the profession so academics are not deemed as innovators in the field.

We salute the Top 100 Most Influential Accounting Professionals!

Chatham; September 10, 2016

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Equestrian Polo Designer Fails to Score

198_Polo_Ralph_Lauren_logo_profileThe stock price of Ralph Lauren, an upscale apparel company renowned for its Polo brand, has taken a thrashing lately. The stock has declined by about 50% over the past one year because of sluggish demand in the US and a decline in the value of its overseas sales from a strong dollar. In the third quarter of this year, the company reported a colossal 39% drop in  earnings.  The company also lowered its fiscal 2017 guidance numbers. Investors fear that the company may be at the vortex of a long-term slump.

End of an Era

To energize the polo pony, Mr. Ralph Lauren, the iconic designer-founder of Ralph Lauren and its sole Chief Executive Officer (CEO) and Chief Creative Officer, finally decided to step down as the CEO after being at the helm for almost 50 years. Mr. Lauren is hoping to inject some youthfulness into the septuagenarian polo team. Stefan Larsson, who is a former H&M executive and president of Old Navy, was hand-picked by Mr. Lauren to take charge of a company that is under attack.

Mr. Larsson will report to Mr. Lauren, although Mr. Lauren characterized their relationship as a “partnership” which is understandable considering that Mr. Lauren is the largest individual shareholder in his company and is expected to play a role in major decisions. Essentially, the company is separating the roles of the professional manager from that of the creative manager. The separation of the two roles will help assure Wall Street that the creative aspirations do not bleed the financial foundations of company.

Brutal Cost Cutting

Under the new strategy labelled as “New Plan Forward,” the incoming CEO intends to slash costs to fashion a reversal in downward profits. The company intends to close 50 stores, lay-off about 1,000 employees (or 7% of its workforce), and remove three of the nine layers of management that stand between the CEO and sales team.

The clothing production lead times will be amended from 15 to 9 months. Certain clothing lines will be on a hyper fast production time whereby it will be moved from the development stage to the shop floor within eight weeks.

The cost cutting strategy is bold and brutal, the Swedish CEO intends to slash costs by about $180 million to $220 million per year which is in addition to the $125 million in cost cutting completed last year.

Restructuring Costs

According to the plans, the company is projecting $400 million in restructuring charges and additionally the company intends to write off as much as $150 million in inventory that is scheduled to be liquidated. Evidently, near term earnings numbers are going to take a big hit before increasing.

Uncertain Prospects

The reasons for Mr. Lauren giving up some operational and financial control of the company after 50 years are notable and praiseworthy. Once a founder-owner company becomes sufficiently complex, the natural economic progression for the company is to retain a high quality professional manager who is responsible for supervising day-to-day operations, mange investments, and make optimal financing decisions with the objective of maximizing firm value. The advent of a professional managers also assures investors that the financial aspects of the company are not being compromised as creative side blossoms.

However, some of the restructuring plans are hard to assess. Some immediate concerns include,

  1. Why hire a CEO from outside the company? Why not hire an insider who understands the value of the brand?
  2. Can young CEO render value while being under the influence of a powerful founder-owner?
  3. Why pick a CEO from a low-priced apparel designer company that is not a direct competitor?
  4. Why are the business models that helped revive the fortunes at Old Navy and H&M likely to be useful for Ralph Lauren?
  5. Cost cutting strategies can only render value up to a point, eventually the principal driver of earnings is revenue growth.
  6. Too much cost cutting can also harm the brand value because of a loss in human capital.

Considering all these questions, the future of Ralph Lauren remains highly uncertain.

Helsinki, June 21, 12.48P.Facebooktwitterredditlinkedinmailby feather

How Mobil(e) is ExxonMobil?

Losing Triple A Credit Rating

Losing Triple A Credit Rating

ExxonMobil Corp. had the honor and distinction of having a gold-plated AAA credit rating since the post WWII period. However, fortunes can change abruptly when one is trading products of mother nature. Last week, Standard & Poor’s (S&P) downgraded Exxon Mobil’s credit rating for the first time in almost 70 years from the coveted “AAA” rating to a “AA+” rating citing expectations of continuing low oil prices. ExxonMobil joins two other US companies with S&P AA+ credit ratings; General Electric Co. and Apple Inc. The two remaining US companies with the highest possible corporate AAA debt ratings are Johnson & Johnson and Microsoft Corp.

Exxon Mobil History

ExxonMobil is an American multinational oil and gas company based in Texas. It is the largest direct descendant of John D. Rockefeller’s Standard Oil Company. Exxon Mobil was formed in 1999 by the merger of Exxon (formerly Standard Oil Company of New Jersey) and Mobil (formerly the Standard Oil Company of New York). ExxonMobil is also the Fifth largest publicly traded company by market capitalization. ExxonMobil was the second most profitable company in 2014.

Downgrade Reasons

S&P stated that the “company’s debt level has more than doubled in the recent years, reflecting high capital spending on major projects in a high commodity price environment and dividends and share repurchases that substantially exceeded internally generated cash flow.”

S&P also said that while Exxon made efforts to reduce capital spending, the maintenance of production and replacing reserves will ultimately require the company to spend more. Because the company is returning cash to shareholders, instead of building cash or reducing its debt, the company faces limits on credit improvements even when oil prices recover.

S&P cautioned that it could further lower its rating on Exxon if the company is unable to sufficiently adapt to a prolonged period of low commodity prices. The downgrade is not a complete surprise. In February, S&P downgraded rival Chevron Corp and warned that such a move was also possible for Exxon.

Shareholder Payments

ExxonMobil paid out $325 billion as dividend and share repurchases over the last 11 years which exceeded its outlays for new property, plant and equipment of $272 billion over the same period. During the fourth quarter of 2015, the company paid out $3.6 billion in dividends and share repurchases, which is more than it earned in that quarter.

In February, Exxon Mobil changed its strategy and declared that it would only repurchase shares to offset dilution, and not pay back cash as dividend.  

Why Repurchase Over Dividend

Many companies prefer stock repurchase over dividends. One explanation is accounting based therefore cosmetic and the second explanation is more economic.

Investors tend to focus on accounting earnings, mostly earnings per share (EPS), which is computed as net income divided by number of shares outstanding. When a company buys back (repurchases) its own stock, it reduces the shares outstanding and thereby increases its EPS. This type of an increase in reported EPS is cosmetic (nip and tuck). Shareholders care about the pie (earnings) and not how the pie is being shared (EPS). So stock buyback initiated to increase EPS is a akin to a magician’s show intended to circumvent reality.

The advantage of stock buyback is that it is a one-time cash payout unless the company elects to announce future buybacks. Dividends, on the other hand, are more permanent in nature and investors expect continuation of dividend payments when one is announced. Therefore, companies wanting to preserve future cash prefer stock buyback over dividend.

ExxonMobil wants to buyback stock to offset the stock price decline from declining oil prices. Given the low oil prices, it has cut back on its planned investments or production capacity. However, when oil prices bound back, it wants to preserve cash to fund its future growth which is why it prefers stock buyback over dividend.

Stock Price

ExxonMobil’s stock price went down from a high of around $103 in 2014 to a low of $72 in 2015. The stock is back at around $90. With oil prices trending up, we can only expect ExxonMobil’s stock price to continue its upward trajectory.

Chatham; June 11, 2.11P feather

The Mexican Wall (Mart) Spectacle

walmartWal-Mart Stores, the leading private employer in the world, operates in 25 countries with a strong presence in Mexico. Roughly about 20% of Wal-Mart’s 11,500 locations are based in Mexico. Over the last three years, the Justice Department has been investigating allegations that Wal-Mart paid bribes in Mexico to obtain permits. 

A group of beneficial Wal-Mart owners filed a complaint with the Securities and Exchange Commission (SEC) and the Public Company Accounting Oversight Board (PCAOB) that Wal-Mart’s auditor, Ernst & Young (E&Y) was aware of the bribery long before the company disclosed this irregularity to U.S. authorities in 2011. According to the complaint letter, E&Y as the independent auditor should have reported the suspected bribery to the SEC as soon as it became aware of such improprieties in 2006.

Bribery Act

The Foreign Corrupt Practices Act of 1977 (FCPA) makes it unlawful for persons and entities to make payments to foreign government officials to assist in obtaining or retaining business. The Act was amended in 1998. The anti-bribery provisions of the FCPA now applies to foreign firms and makes it illegal for foreign companies to pay bribes in the U.S.

The Act levies criminal and civil liability for paying bribes to foreign government officials. The Justice Department has jurisdiction over the FCPA.


The Justice Department launched an investigation following a 2012 New York Times article about the alleged Mexican bribes. According to the article, Wal-Mart Mexico unit paid middlemen to obtain permits and that Wal-Mart executives chose not to pursue an internal inquiry into the suspicious payments.

Although the three-year investigation remains incomplete, according to Wall Street Journal, the case could be resolved with a fine and no criminal charges against Wal-Mart executives because the charges may not be as severe as previously anticipated.

Auditor’s Obligations

According to the auditing standards (AU section 317), auditors have a responsibility to design procedures that provide reasonable assurance of detecting illegal acts. In cases of bribery, the auditor is also implicated because bribing a foreign government official is illegal in the US and also because any bribery is likely to have a material effect on a company’s financial statements.

Companies that pay bribes generally record the underlying transactions in their accounting books as legitimate operating expenses to avoid detection. Since bribes often involve disbursements of cash, recording a bribe as a legitimate operating expense results in false reporting of expenses on the income statement.

What are the duties of the external auditor when it becomes aware that its client is suspected of violating FCPA provisions?

The answer may surprise you.

  • If an outside auditor discovers an illegal act, it is required to notify responsible authorities within the company including the company’s board and audit committee.
  • The external auditor is not required to notify the government.
  • Only when the company refuses to take corrective actions or the company’s books are compromised is the auditor obligated to notify the government.

Essentially, the rules and obligations are suggesting that the company has the obligation to correct improper acts and also inform appropriate government authorities.

Top Gun: Tom (Cruise) Ray

According to Chief Tom Ray, past Chief Auditor of PCAOB and my colleague at Baruch College,  external auditors are not legally obliged to inform outside regulators about potential scandals except in limited circumstances. Auditors are required to report those acts to management and the board’s audit committee, which is responsible for monitoring financial reporting and disclosure practices. The accounting firm also needs to evaluate whether the bribers would have a material impact on financial statements.

Top gun in auditing, Tom states that only when the company doesn’t take appropriate actions, an outside accounting firm may be legally required to report the problem to a federal agency,


Needless to say, Wal-Mart will become target of lawsuits. E&Y, with its deep pockets, is also likely to become a prime target. However, if the norm is to pay bribes to secure contracts, especially in developing and emerging countries, U.S. companies are at a disadvantage relative to almost all other countries that do not have anti-bribery provisions.  

Maybe it is time to have an anti-bribery world statute.

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