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Chapter 3

Financial Statements, Cash Flow, and Taxes

Sarbanes-Oxley and Financial Fraud

Investors need to be cautious when they review financial statements. While companies are required to follow GAAP, managers still have quite a lot of discretion in deciding how and when to report certain transactions. Consequently, two firms in exactly the same operating situation may report financial statements that convey different impressions about their financial strength. Some variations may stem from legitimate differences of opinion about the correct way to record transactions. In other cases, managers may choose to report numbers in a way that helps them present either higher earnings or more stable earnings over time. As long as they follow GAAP, such actions are not illegal, but these differences make it harder for investors to compare companies and gauge their true performances. Unfortunately, there have also been cases where managers overstepped the bounds and reported fraudulent statements. Indeed, a number of highprofile executives have faced criminal charges because of their misleading accounting practices. For example, in June 2002 it was discovered that WorldCom (now called MCI) had committed the most massive accounting fraud of all time by recording over $7 billion of ordinary operating costs as capital expenditures, thus overstating net income by the same amount. WorldComs published financial statements fooled most investorsinvestors bid the stock price up to $64.50, and banks and other lenders provided the company with more than $30 billion of loans. Arthur Andersen, the firms auditor, was faulted for not detecting the fraud. WorldComs CFO and CEO were convicted and Arthur Andersen went bankrupt. But that didnt help the investors who relied on the published financial statements. In response to these and other abuses, Congress passed the Sarbanes-Oxley Act of 2002. One of its provisions requires both the CEO and the CFO to sign a statement certifying that the financial statements and disclosures fairly represent, in all material respects, the operations and financial condition of the company. This will make it easier to haul off in handcuffs a CEO or CFO who has been misleading investors. Whether this will prevent future financial fraud remains to be seen.

Recall also that net income fell, but not nearly so dramatically as the decline in EVA. Net income does not reflect the amount of equity capital employed, but EVA does. Because of this omission, net income is not as useful as EVA for setting corporate goals and measuring managerial performance. We will have more to say about both MVA and EVA later in the book, but we can close this section with two observations. First, there is a relationship between MVA and EVA, but it is not a direct one. If a company has a history of negative EVAs, then its MVA will probably be negative, and vice versa if it has a history of positive EVAs. However, the stock price, which is the key ingredient in the MVA calculation, depends more on expected future performance than on historical performance. Therefore, a company with a history of negative EVAs could have a positive MVA, provided investors expect a turnaround in the future. The second observation is that when EVAs or MVAs are used to evaluate managerial performance as part of an incentive compensation program, EVA is the measure that is typically used. The reasons are (1) EVA shows the value added during a given year, whereas MVA reflects performance over the companys entire life, perhaps even including times before the current managers were born, and (2) EVA can be applied to individual divisions or other units of a large corporation, whereas MVA must be applied to the entire corporation.

SELF-TEST

Define Market Value Added (MVA) and Economic Value Added (EVA). How does EVA differ from accounting profit? A firm has $100 million in total net operating capital. Its return on invested capital is 14% and its weighted average cost of capital is 10%. What is its EVA? ($400,000)