Lie detectors. That is what Putnam Investments of Boston has brought in to combat fraudulent corporate activity after Enron, WorldCom and all the rest of the accounting scandals. Human lie detectors.
"Outright accounting fraud is inherently tough to catch," Putnam maintains in a capital markets outlook, special report. "We have, however, recently retained consultants from government intelligence agencies to enhance our analysts' interviewing techniques, so that they can more readily identify if a company's managers are not being fully truthful."
Post-Enron Accounting At Fund Complexes
Putnam would not comment further on these new special-agent "consultants," including exactly which government intelligence agencies they're coming from. But, clearly, Putnam is doing more than simply "returning to fundamentals," something many fund companies maintain is necessary right now.
While Putnam's new consultants may be an extreme course of action, several other firms have made strict adjustments to how their portfolio managers and analysts are examining potential investments.
"We've developed a supplement to our financial models to highlight certain data, which will help us uncover anything suspicious and detect fraud," said Peg Thompson, assistant director of research at Janus of Denver. "The supplement contains balance sheet and cash flow-related data as well as information typically buried in the footnotes of its financial statement."
Janus also recently hired a former chief accountant with the SEC as well as an accounting professor from Wake Forest University. Further, the mutual fund giant is relying on its own internal auditors to provide insight into new accounting rules and the convoluted accounting techniques that some companies have misused in order to manipulate earnings, said Janus star portfolio manager Laurence Chang in an interview.
"We're more cynical about a company's management," Chang said. "We're broadening our list of outside contacts to verify the legitimacy of management and the story they're telling us."
Whither the Green Eyeshades?
Janus has good reason to be cynical. The fund family was one of the most heavily hit by the Enron debacle. At one point, Janus owned about 40.9 million shares of Enron, more than 5% of the firm's stock. Implementing stricter accounting analytical procedures and scrutinizing company balance sheets will not automatically prevent making a mistake about a company engaged in outright fraud, according to Janus Director of Research Jim Goff.
Still, holding Enron is a slip-up the firm admits to readily, and one it is aggressively trying to avoid repeating.
"We should have probed more deeply into the reasons behind [former Enron] CEO Jeff Skilling's unexpected departure," Janus confessed in a recent report. "Our biggest mistake, however, was in not pressing management harder about Enron's complex and obscure accounting methods."
The major change that industry analysts say fund companies have made is that when analyzing companies, they are paying much more attention to cash flows and less to reported earnings. Both Putnam and Janus have made it a point to communicate to shareholders that they are examining cash flow-related data as a way of scrutinizing companies.
Adam Bold, founder and chief investment officer at The Mutual Fund Store, an Overland Park, Kan.-based independent investment management and advisory firm that puts together portfolios of mutual funds for clients, said that he is now much more vigilant of companies' cash flows and debt.
"Some of the accounting techniques corporations use are extremely complex and difficult to decipher," Bold said. "In light of corporate fraud, you have to really look at what's inside the funds. We've made a substantial effort to upgrade the quality of the stocks we own. You have to use different measures of assessing firms than just earnings."
Some analysts, however, are wary of firms concentrating too much on cash flows. While being cognizant of cash flow is important, analysts have to remember that cash flow numbers can be manipulated too, according to Thomas Schindler, a analyst with Diamond Hill Capital Management of Columbus, Ohio, which manages four equity funds.
"We have heard some commentators express, to some extent quite rightly, that earnings are an opinion, while cash is a fact," Schindler said. "Unfortunately, some have taken this as an instruction to focus solely on cash flow from operations, ignoring that cash can bleed out of a company through investing and financing activities as well," Schindler said.
"In reality, an analysis of both the balance sheet and income statement are necessary to evaluate corporate profitability in any given period," he said.
Concentrating strictly on cash flow can be tricky because those numbers are highly dependent on what firms decide to capitalize and what they choose to expense, said Tim Mulligan, founder and president of Forensic Advisors of Rockville, Md., an independent financial research firm and self-described "accounting watchdog."
For example, if a firm decides to expense something, it will lessen the firm's listed cash flow from operations. If the firm should capitalize the item, however, it might be deducted from the cash flow of the investing activity, thereby not touching cash flow from operations. Because firms have this sort of discretion as to where to expense or value their activities, both a closer and more comprehensive approach is necessary to ascertain exactly what the firm's stated cash flow means.
Sometimes firms will include the tax benefit from stock options in their cash flow from operations, which is allowed under GAAP [generally accepted ac-counting principles]. When firms do that, Mulligan deducts that from the total cash flow number, something he said some analysts probably do, but many do not.
"Tax benefits from stock options are more a function of how the stock is doing than how the company is doing," Mulligan said. "It requires employees with money exercising the options. I remove that from the cash flow."
One of the problems is that the accounting rules and procedures currently in use are outdated, according to Mike Shanahan, chairman of Capital Research and Management Co. of Los Angeles, investment advisor to American Funds. As a result, American Funds tries to estimate how a company's financial situation has changed, not how it has been accounted for, he said.
"Accounting rules have not kept up with the development of new businesses and financing techniques," Shanahan said. "Over the years, American business has shifted from manufacturing to service and software. Business operations have become more complex. Since the world has changed, the accounting profession has had difficulty reporting in a consistent way the financial position of companies. The rules need to be modernized."
The Securities and Exchange Commission is currently working on updating those rules. Late last month, it adopted rules forcing companies to file financial reports quicker and for corporate executives to certify the reports. The SEC also recently completed processing the sworn statements filed by the CEOs and CFOs of the largest U.S.-based companies, which the commission ordered in June.
"The certification requirements are one piece of the package of far-reaching reforms that we have been putting in place," said SEC Chairman Harvey Pitt. "Together with effective actions by the Administration, Congress and the self-regulatory bodies governing the securities industry, they represent important progress in our ongoing efforts to restore investor and market confidence in the integrity of public company disclosure."
Naturally, many firms maintain that their analysis has always been sound and that they have found no reason to change how they look at earnings statements. Diamond Hill believes in focusing on the "timeless principles of investing rather than looking for any new tactic' or method of analysis in the wake of various corporate scandals," according to Schindler.
Christopher Davis, the famed value manager who runs the portfolios at Davis Advisors of Boston, bragged in a recent shareholder letter that as long as two years ago, he had already espied corporations "torturing accounting policies" to meet "Wall Street's premium on consistent results." As a result, he said, he stayed away from Enron, WorldCom and Qwest long before they made the headlines with their goosed earnings "and other financial gimmicks."
Alarms go off, Davis said, when he notices "non-recurring items, such as expense reductions from previously incurred restructuring charges, and other accounting tricks such as pro forma earnings' or EBITDA [earnings before interest, taxes, depreciation and amortization]". Davis even lent some humor to the issue, noting that some pundits call EBITDA "earnings before I tricked the dumb auditors."
EBITDA =Cash Flow
A common mistake among analysts and executives alike is that they view EBITDA and cash flow as the same thing, Mulligan added. If a firm uses accrual accounting methods, instead of cash accounting methods, it's possible for the firm to show increased EBITDA, even though the firm's cash flow actually dropped, he said.
Looking for those nuances that affect companies' bottom lines will help determine the validity behind the numbers firms report, but there will always be the possibility that firms are trying to deceive analysts.
We certainly can and will be more alert to inconsistencies in financial reporting, but there still are no guarantees. That's a good thing, though, because it helps us stay on our toes," said Thompson of Janus.
Perhaps Janus should follow Putnam's lead: Hire some lie detectors of their own and force the corporate executives to stay on their toes.