Financial Gotchas

When checking on the financial health of a company, be sure to read the fine print. Here's how.

It would be great if technology professionals only had to deal with their first love—technology. Unfortunately, the higher up the ladder you climb, the more strategic (meaning business-oriented) you must become.

Many large computer-systems projects fail not because the technology was flawed, or because the project team wasn't up to the challenge, but because a vital business component was missed early in the planning. When an IT department is taken by surprise at a vital supplier's bankruptcy, or a project partner skips town in the middle of the night leaving critical chunks undone, that's usually a good sign that someone wasn't doing his or her homework.

The Enron/Arthur Andersen debacle has all too painfully demonstrated that it's not always enough to assume that "the financial people" are keeping a close eye on things. As a project leader, you must be able to monitor that aspect of project planning as well. You should be able to read between the lines of a company's financial report to spot potential problems. Find one of these "Gotchas" in a corporate report, and you may catch a troubled partner before you're committed to them.

While annual and quarterly reports provide lots of numbers, it's often in the "small print" where the really interesting information can be found. This month I'll point you to some places to look, define some accounting terms, and suggest items to keep an eye out for when reviewing such reports or when using other resources to check on the financial health of a company. I call these the "Gotchas" of financial reporting.

Gotcha #1: Pro Forma Results
Talk about accounting magic. Pro Forma is designed to show you a "what if" scenario. Suppose Company A closes its purchase of Company B in September. A Pro Forma statement could show all income for both companies assuming they had been operating as a single company for the entire year.

Another Pro Forma trick: Excluding unusual items, such as expenses due to a plant shut down, staff downsizing or foreign currency devaluations (a tricky one for companies operating internationally).

One-time charges, such as McDonald's expenses due to its Monopoly Game scandal, are also triggers for Pro Forma reporting.

Indeed, a Pro Forma statement can reflect just about any condition—or exclusion—a company wants it to (though it must be explained). Pro Forma statements are used to show the company in its best light.

The trouble is, Company A and Company B weren't operating as a single company all year, and that large plant shut down did occur. Don't be fooled. Pro Forma results may be interesting, but only for your curiosity.

Unfortunately, companies are increasingly using Pro Forma results to announce—even glorify—net earnings. Always look for "on a Pro Forma basis" in a company's financial report or press release. It's just part of a company's spin. Don't let it cloud your thinking.

Gotcha #2: Sudden Staff Changes
You've read the news. "Mr. Smith has resigned to pursue other interests." According to a Bloomberg News report, Enron's CEO Jeffrey Skilling resigned for personal reasons. The Wall Street Journal reported Skilling saying he wanted to spend more time with his children. That may be true, but it's hardly the whole story.

A change in personnel tells us there's a problem. Sudden changes at the top, explained away with such euphemisms, are like waving a red flag. If the change occurs at your key supplier, it's critical that you stay abreast of such issues. These statements are designed to protect the employee—and the company—from embarrassment, but they do nothing to help you understand what's going on.

Find out all you can about the person replacing the departing executive:

  • Is it someone on the board of directors?
  • Someone already on staff?
  • Is someone being promoted to fill the position?
  • Or will a lengthy candidate search ensue? Translation: Don't expect a fix to the company's problem(s) anytime soon) while someone (and who is this person?) acts in an interim capacity.

Well-run companies almost always have replacements groomed and waiting in the wings to assume leadership. Unexpected terminations are probably a good indication that something's afoot.

Gotcha #3: Reorganization
Overhauling your organization's structure is a double-edged sword. It can mean the company is responding to new market opportunities, planning for (or reacting to) changing market or economic conditions, or moving to better accommodate future changes.

It may also mean there's a problem and the company is late in reacting.

Look closely to see the impacts and changes, and how such changes may affect your organization. Is the company announcing it will stop selling a key component or modify a service you need?

Gotcha #4: Goodwill
Suppose the assets of Company B are valued at $10 million. If Company A buys Company B, but pays $12 million, that "extra" $2 million is called "goodwill." It represents the premium Company A is paying for Company B.

Though stricter write-off rules have been introduced (companies must write down their goodwill), under Financial Accounting Standards Board (FASB) rules, companies have been allowed to write down goodwill over time (up to 40 years). Rules that the Board introduced this year will now require that overvalued goodwill must be written off immediately.

Surprising as it may seem right now, goodwill may be anything but small potatoes: It's in the tens of billions for companies such as Nortel Networks, JDS Uniphase, AOL Time Warner and Qwest Communications.

Such premiums may be justified, but if you see goodwill on a balance sheet, take a closer look. Did Company A overpay? (If so, perhaps it's because Company A is trying to buy its way out of a problem.) A large goodwill write-off affects the bottom line (it's an expense, after all, thus reducing net income).

Gotcha #5: Notes to Financial Statements
The epitome of the small print, "Notes to Financial Statements," consists of all the small or dry text following financial statements. It's here that analysts often weed out some of the most interesting facts about a company.

You can too. Within these Notes you can find:

  • Hints of a company's new direction
  • Explanations of product failures or successes
  • Unusual market conditions (and forecasts).

The Notes section will explain any special situations, such as those one-time events that may be reflected in (or airbrushed out of) Pro Forma statements.

You can believe that if a company has good news to report, you'll find the information preceding the numbers: in a President's Message, for example. Notes are for the dirty laundry.

Digging Out the Problems
Gotchas are hiding in yearly or quarterly reports, online business sites, or daily or weekly business media. Required corporate reports, such as 8-Ks (Security and Exchange Commission filings by a publicly traded company required when a "material event" merits disclosure), can be found on the Web (www.sec.gov/edgar.shtml).

But even if you find them all, you won't be perfectly safe. The Enron fiasco has taught us that.

There's no way the little guy—that's you and me—could ever dig out all such off-balance-sheet problems. The best we can do is look for—and interpret—the gotchas.