Mistakes or Mischief Can Plague a Target’s Top Line

The elements used to produce the target’s top line can be an explosive mix that blows up in the face of a buyer who doesn’t probe them Many hard-nosed acquirers may like a target’s cutting-edge technology, strong market share, or impressive product line, but they say they ultimately pay up for its earnings and cash flow. Although buyer executives win kudos from financial analysts and others for being riveted on the bottom line, they may be shelling out for smoke and mirrors by merely glossing over the target’s sales figures. In fact, the top line is an ideal place for making mistakes or purposely fiddling with the numbers to generate false positives deeper in the financial statement, including earnings and cash flow. Nothing should deter an acquirer, especially in the current environment which pressures companies to deliver premium short-term or quarterly profit performances, from conducting a thorough analytical review of the target’s sales and the methods it uses for calculating them, says Trent Gazzaway, National Director of Corporate Governance Advisory Services at Grant Thornton. The ingredients used to produce the target’s top line can be a combustible mixture that blows up in the face of any acquirer who doesn’t check them out during due diligence, he warns. On one level, he says, revenue is the largest item in the income statement, and “by sheer volume, it can lead to errors.” On another, “the accounting criteria for recognizing revenue are some of the most complex out there.” “When you put those two together – the largest number on the income statement and some of the most complex accounting – they lend themselves to both intentional and unintentional mistakes,” he says. Pressure to deliver short-term results exacerbates the problem at the top, Gazzaway adds. “Everyone can’t have a perfect quarter,” he says, “but when you have so much wrapped up in quarterly earnings numbers, I think it puts a lot of pressure on people to sort of push the edge of the envelope. When you push the edge of the envelope once, the next time it gets a little bit easier and you push a little bit harder, and before you know it, you’ve gone too far. It’s a gradual process and it gets built up to the Enrons and the WorldComs and what we’re seeing today.” Watch out, he says, for rapid unexplained revenue growth, especially when there isn’t corresponding earnings growth. Or even when there is rapid earnings growth, he adds, it can be worrisome when there are operating cash flow losses, or cash flow growth just doesn’t correspond to the earnings growth. Additionally, when revenues are increasing but receivables are also up, “something isn’t right because you’re not collecting the cash,” he states. A clue to an intentional misstatement could emerge through analysis of month-to-month bookings throughout the year that may demonstrate efforts to dress up figures. “If there’s a spike in revenues in the third month of a quarter, that could tell you something is happening at the very end of the quarter that is not happening in the other two months, and it might cause you to question it,” Gazzaway notes. Or a more gradual misstatement might show up in a week-to-week revenue analysis. “It might indicate some pushes at the end of the month that deserve a little bit of extra attention.” Some Tip-Offs to Watch For… * Industries, such as software, that have complex revenue recognition rules and where revenue recognition “has to be timed very carefully.” “Any body doing due diligence that recognizes revenues in connection with development of software needs to be careful,” Gazzaway says. * Bill-and hold-techniques, when a customer is billed for deliveries that will be “made at some point in the near future.” “They are often misunderstood and misused,” he notes. * “Percentage of completion” accounting where revenue recognition is phased in based on the progress of work done under long-term contracts, such as construction, installation of IT systems, and even some consulting. “A lot of judgment is involved in that so it’s important to go through the numbers and see how they did it,” he says. Staples, Two Others Drop Poison Pills March was another month in which new shareholder rights plans were installed at the same time others were dropped or cured. Poison pills were eliminated by Staples Inc., First Health Group Inc., and 3D Systems Corp., while Edison International Corp. directors voted not to invoke their pill until it expires in 2006 without shareholder approval. Voting in pills were: 1st Constitution Bancorp, Five Star Quality Care Inc., Orthodontics Centers of America Inc., and Senior Housing Properties Trust. Copyright 2004 Thomson Media Inc. All Rights Reserved. http://www.thomsonmedia.com http://www.majournal.com