|Dear Friends,Long-Term Contract Accounting Fraud in Asia From Construction to SoftwareA Dreamer and an Accountant is a lethal combination. McDonald’s Ray Kroc had financial wizard Harry Sonneborn to advise him that real estate was the key to a franchise’s financial success. Thomas Edison had his right-hand business partner Samuel Insull who took care of financing, operations, hirings, firings and mergers.
Tanaka Hisashige and Ichisuke Fujioka, the “Thomas Edisons of Japan”, must have wished there is a competent accountant to exercise financial stewardship over their business creation Toshiba (6502 JP, MV $14.6bn). Toshiba was involved in an accounting scandal in inflating profits by over ¥50bn ($419m) for the three year cumulative period through FY13 after calling for an urgent press conference at its headquarters in Minato City, Tokyo, on 15 May 2015 to appoint an independent investigation committee to probe the accounting issues, four years after the Olympus accounting fraud revelation in 2011 that hid $1.7bn in losses in a 13-year cover-up.
Starting from a small workshop rented from the second floor of a temple in Roppongi, Tokyo in 1873, six years after the Meiji Restoration and at the age of 74, Hisashige-san produced the first telegraph equipment in Japan. After meeting Thomas Edison in 1884 while on a tour in the United States, Fujiioka-san pledged to devote himself to establishing a Japanese electric power industry, succeeded in developing an economical, durable light bulb and in constructing an electric railway, taking Japan into the age of electricity. Hisashige’s firm, later renamed Shibaura Engineering Works, merged with Fujiioka’s Tokyo Electric Company to form Tokyo Shibaura Electric, which soon became known as Toshiba.
The in-house investigation into the accounting scandal relates to the underestimation of costs for 9 out of the 250 projects using the percentage-of-completion (POC) accounting method: 4 projects totalling ¥6bn at the power systems company, 4 projects totalling ¥30bn at the social infrastructure systems company and one project totalling ¥14bn at the community solutions company. Toshiba derived around 11% of operating income from its power and social infrastructure business. This is the second accounting investigation in less than two years for Toshiba, which has twice delayed reporting its earnings for the year ended in March because of irregularities. The new panel’s probe will extend to Toshiba’s 593 consolidated subsidiaries, including electrical engineering giant Westinghouse Electric, owned by Toshiba since 2007.
Toshiba and one of its listed subsidiaries, Toshiba Plant Systems & Services (1983 JP, MV $1.2bn), are also members of the JPX-Nikkei Index 400, which was started last year to showcase Japan’s best shares to institutional investors and shame executives of companies that weren’t picked into improving capital efficiency to make the cut. It selects the 400 companies in Japan with the highest return on equity and profit over the past three years. Corporate governance is another factor in choosing the members. The gauge recalculates its constituents every year using data from the last business day of June, and publishes the results in August. Sony Corp was among 31 members that got replaced in 2014. Interestingly, Toshiba has four outside board directors, an apparent sign of good “corporate governance” to keep checks and balances on the managers. Toshiba is now in a race to report its restated earnings before the June 30 deadline. Toshiba risks losing the attention of about ¥650bn tracking the JPX-Nikkei 400 in exchange-traded and mutual funds should it get kicked out of the JPX-Nikkei Index.
We wish to highlight the area of revenue recognition and the accounting for long-term contracts, in particular the percentage-of-completion (POC) accounting method, which has received relatively little inspection from academics and practitioners. There are important implications for value investors given that the POC accounting method is common across industries from construction/infrastructure/property and defence to software.
In essence, long-term contracts present special problems for revenue recognition, which allows for both the POC method and the completed contract method (CCM). Under the CCM, no revenue is recognized until the project is 100% complete; and, the related project costs are held as inventory. The POC method recognizes revenue and costs as measurable important progress milestones on a project (output-based measure) or based on a ratio of costs incurred to date over expected total contract costs (input-based measure 1: cost-to-cost method) or based on comparing measures such as labor hours, labor dollars, machine hours or quantities of material consumed to date to the total quantity estimated forte entire project (input-based measure 2: efforts-expended method). Under the POC method, managers can opportunistically manipulate the percentage of completion to recognize revenue prematurely and conceal contract overruns.
The following can be manipulated to affect revenue recognition:
- Concealing subcontractor, labor and other project costs
- Subjective estimation of costs to complete the projects
- Shifting costs between projects
- Improper allocation of indirect overheads to projects
- Misallocation between project and non-project costs
- Improperly deferring project costs
- Premature expensing of pre-contract costs
- Commingling of project and other costs
- Recognition of unapproved change orders and claims that have no basis for inclusion in contract value
- Setting improper project milestones where cost-to-cost is the more appropriate basis
Note: Should the above red flags be found, value investors should adjust downward the revenue by an amount that is the difference between unbilled receivables (or amount due from customers in contract work) and the work-in-progress (WIP).
Past prominent cases involving POC accounting fraud include:
- Defence contractor Halliburton (HAL US) had increased revenue by $434m during 1998-2001 by booking cost overruns on construction projects before clients agreed to pay for them. In the wake of the recent Toshiba scandal, South Carolina Electric & Gas, a client of Westinghouse and its business partner Chicago Bridge & Iron (CBI US), had filed a petition on the incremental capital costs on a nuclear plant construction that total $698m, of which $539m are associated with delays and other contested costs.
- Data-mining software company MicroStrategy (MSTR US), worth $31.1bn at its peak as compared to its present market cap of $2bn, had recognized over half ($17.5m) of the licensing revenue immediately in a $27.5m multi-year licensing agreement with NCR. The foundation of MicroStrategy’s product had been its corporate data-mining program which combs through terabytes of data looking for interesting relationships; MicroStrategy’s customers McDonald’s, Wal-Mart, NCR could use the program to detect customer buying patterns. According to the NCR order, because MicroStrategy’s software license sales were part of multiple-element transactions that included other services such as product support and development and consulting, the company was required to apply POC accounting. However, for a number of transactions that were subsequently restated due to a misapplication of the accounting standard, MicroStrategy had (1) improperly separated software license sales from their service elements and (2) characterized revenue in multiple element transactions as product or software revenue and recognized it at the time of the transaction. Without this $17.5m addition to third quarter revenue in 1999, MicroStrategy would have reported a revenue decline of 20% from the previous quarter and a loss instead of a profit.
- Similar accounting issues to MicroStrategy arose for…
Recent accounting scandals in Asia who had potentially abused the POC accounting method include water treatment company Sound Global (967 HK, $1.36bn) whose auditors identified audit issues of missing RMB2bn cash shortfall and had reported matters to Singapore’s Ministry of Finance in an announcement on May 4, around three months after allegations of fraud by Emerson Analytics which the company denied with the media supporting the management and blasting the short-seller for the unfair attack. For instance, unbilled receivables (amount due from customer for contract work) at Sound Global soared over five-folds from RMB203m in FY09 to RMB1.1bn in FY13, representing around 15% and 35% of sales respectively, an indication of aggressive revenue recognition before projects are actually completed in the subjective use of the POC accounting method. Managers often opportunistically manipulate the estimates under the POC accounting method to inflate revenue and profits to achieve compliance with existing and future debt covenants and to raise more external financing in debt and equity. Note that the total debt at Sound Global had jumped from RMB227m in FY09 to RMB3.8bn in FY13.
Another example is Japanese vacuum machinery company Ulvac (6728 JP, MV $796m). Around 2010, Ulvac reported that its full year ended Jun 2010 sales were down 1% and operating profit was up 38%. However, the result was due to the switch to POC accounting method and aggressive accounting in revenue recognition much earlier. Interestingly, Ulvac disclosed in the footnotes that had it used the same revenue recognition method as before, its sales would have been down 21% and there would be a loss. Since Jun 2010, Ulvac’s share price is flat, underperforming the 100% rise in the Nikkei index.
Ulvac (TSE: 6728 JP) – Stock Price Performance 2010-2015
When Samuel Insull was not named the president of what is now known as General Electric, he left and went on to build a electricity utilities empire using financial engineering and complex holding companies structure carrying out M&As and became one of the richest man in the world with a personal worth of over $150m (over $1.7bn in today’s dollars). To pay for expansion, Insull had sold low-price bonds and stock. Over a million middle-class Americans bought in – but their investments were made worthless by the Great Depression. Overnight, Insull went from a hero on the cover of Time magazine to the villain who had stolen the people’s money. It was said that before Enron, there was Insull. Charged with fraud, Insull was tried in 1934 and acquitted of the charges. But his reputation was destroyed, and he left the country for good. Four years later, Insull died of a heart attack in the Paris subway in 1938 with 84 cents in his pocket.
When financial and accounting wizards Harry Sonneborn and Samuel Insull left Ray Kroc and Thomas Edison respectively, they were in a “percentage of completion” mode in not being able to build an idea larger than themselves to complete the work. The awkward Dreamer and the suave professional Accountant is the “completed contract”. When separated from the Dreamer and her vision, the Accountant often flounders and loses his Way. Similarly, the technical interpretation and application of the POC accounting method cannot be separated from the wide-moat business model analysis of the company since the long-term nature of the contract with the customer determines the economic substance and viability of the business’ work in progress, of an idea larger than oneself.
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