FINANCIAL STATEMENT ANALYSIS

MGA/MGC-FN-701
MBA 3rd SEMESTER FINANCE

“REPORT ON CASE STUDY ANALYSIS - MICRO-STRATEG

CHANGES ITS MIND”

Submitted to: Dr. Nandan Prabhu

Faculty of financial statement analysis
Finance- MIM

Submitted by:
Swathi (191207002) {Introduction+1 & 2nd questions}
Thriveni (191207003) {3, 4 & 5th questions}
Neha Alosious (191207004) {6, 7 & 8th questions}
Shelton Jain (191207005) {9 & 10th questions}
Liya Jojo (191207010) {11, 12th question + conclusion}

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 INTRODUCTION

Micro Strategy’s announcement on March 20, 2000

The company, in this case, had over reported its revenues. It announced in the year 2000 that
its real revenues of the year 1999 were $150 million dollars, and not the previously reported
$205.3 million dollars. In the wake of this announcement of accounting irregularity, the stock
price of the firm fell drastically. Not that the auditors of this firm had not certified the accounts
of the firm as fair and accurate. After the publication of an article that raised suspicions
regarding the accuracy of accounting profits of Micro Strategy, the auditor of this firm
withdrew their certificates on the company’s financial statements of the past two years also.

Facts of the case:

• Restatement of company’s earnings of the year 1999

• Miscommunication regarding the motivation for understatement of revenues

• Retraction of the statement and the plummeting of share prices

Accounting irregularities were generally seen and what they do is they will over state their
revenue.

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 1. Why do companies engage in income smoothing? What does that mean?

The objective is to show there is a constant increase in their net profits year after year. Reasons
for income smoothing include reducing taxes, attracting investors, and as part of a business
strategy. The main reason is to increase the EPS. The EPS can be found by net income available
to equity shareholders divided by given number of equity shares. When EPS will increase, price
earing multiple will increase which also increases the market price.

Companies change their net income by changing the policy relating to certain discretionary
items such as a writing off goodwill, writing off depreciation, writing off an amount of debtors
by creating provision for bad and doubtful debts and so where there is scope for exercising the
discretion of the accountant it is possible to change the amount of net income.

The companies make adjustments with regard to revenues and expenses of the next quarter t0
shift those revenues and expenses to the current quarter to either increase or decrease the net
profit of the current quarter.

2. What if earnings fall or rise in short of expectations? What do firms do to counter

these surprises?

If there is a possibility of net losses, companies make use of discretionary items and report net
profits. If there are too high net profits, companies don’t want to show it either. Because it
might become difficult for companies to show further increases in the net profits in the
following quarters or years. Therefore, they report smaller profits than the actual ones. This
process is called as income smoothing. When expected rise doesn’t happen EPS will fall down,
therefore to counter these surprises they might create hidden reserves. Hidden reserves are the
profits made through sales may be in the past or previous years and those net profits are not
shown profit and loss account or balance sheet but it’s been shown under separate account.

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So, when in the future, if there’s no expected net profit then they make use of this i.e. they
portray the old profits as new profits? Therefore, to encounter these surprise companies will
make use of either hidden reserves or making use of discretionary items for the purpose of
smoothing the income.

3) What do Blue Chip companies do to smooth their earnings?

A blue-chip company is a nationally recognized, well-established, and financially healthy
company. These are basically the 100 biggest companies listed on the stock exchange. This
category of companies generally sells high-quality and widely accepted products and services
to a large customer base. A blue-chip holds the highest value in the card game of poker.

The Blue-Chip companies may or may not smooth their earnings. Some of the evidences
suggest that most of the companies including Blue Chip companies will smooth their earnings
but some companies don’t because of some own reasons. Study says that in US most of the
blue-chip companies has resorted to one more technique of showing increase in their income,
which is acquisition.

The best of the companies will acquire the smaller companies of their own line. The smaller
companies who are making good sale now will be the part of Blue-Chip Company. Therefore,
even though the Blue Chip Company has not attained any increase in the sales, it will show
increase in sales by purchasing a sufficient number of smaller companies.

There are examples of Blue-Chip Companies acquiring smaller companies around 200-400 in
only 8-10 years. Google has acquired more than 100 small companies in several years. It might
have its own agenda behind the acquisition of these small companies. It could be technical
agenda or financial agenda or some other agenda related to the company. If the sales of the
main company have fallen down, it will show the increased sales of the company which it has
acquired. This is how Blue-Chip Companies increase their earnings or in other words smoothen
their earnings.

4) Why are auditors complicit with corporate accounting?

An auditor is a professional who is qualified to conduct an audit of the company. Such a person
evaluates the validity of the company's financial statements. This is undertaken to report if
the company adheres to the established set of standards or procedures.

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International companies will do the auditing of other big firms and they will be having
professional accountants. They will have an army of charted accountants. Individual auditors
of such international companies will always be intelligent one.

Auditors also become the party to these transactions mainly because of two reasons. One is,
these transactions do not violate accounting standards. And one more is that, if they protest,
big corporates are capable to bring about changes in the accounting standards that are
favourable to them through the law-making process in the parliament.

There is another dubious reason for the complicit that the auditors display. They would know
about these scandals, but the company will not allow them to report about the income
smoothing done by the company. Because these auditing companies also get heavy amount of
audit fees from their client company. And whenever the corporate scandals have happened,
every time it happened with the consent of the auditors. They will lose their clients in case they
raise too many objections. They might give suggestions. They even might try to tighten the belt
of several people who may not, to ensure that they embarrass the cash of the company. But
what these top management decide with regard to income smoothing practices, these big
auditing firms may not raise objections at all.

5) What does incentivize CEO to smooth the earnings?

The main motivation for CEOs to allow the CFOs and charted accountants of their company to
resort in income smoothing practices is to ensure that market price of the equity share of the
company would increase at any cost and there is an antecedent consequence relationship. A
relationship of independent variable and dependent variable between earnings per share and
market price per equity share. So, unless they show increase in earnings per share and thereby
increase in price multiple, the market price per share will not increase. Therefore, income
smoothing is allowed by CEOs to be committed by the charted accountants of their respective
companies.

In simple word we can say that companies will incentivize their CEOs to increase the market
price per share by increasing earnings per share. Therefore, CEOs artificially try to increase
the earnings per share of their respective firm.

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6. Does an accounting change in the schedule of depreciation cause change in corporate
taxes, cash flows, and stock prices?

Accounting policies are specific set of principles and rules followed by an entity to present its
financial statements. A depreciation schedule keeps track of a company’s long-term assets and
how they are depreciated over time. It contains information such as the depreciation method,
the depreciation of the current year, date of purchase, how much it costs, salvage value, life of
assets etc.

The use of a depreciation method allows a company to expense the cost of an asset over time
while also reducing the carrying value of the asset. Depreciation is found on the income
statement, balance sheet, and cash flow statement.

By reducing the value of asset, depreciation reduces the amount of tax a company or a business
entity has to pay through tax deductions. This is because the depreciation expenses reduce the
amount of earnings based on which tax is calculated. Therefore, lager the depreciation expenses
lower will be the taxable income and vice versa. The change of accounting estimate alters the
pace at which depreciation accumulates and thus affects the carrying value of asset (purchase
cost less accumulated depreciation) on the balance sheet over time. Depreciation does not have
a direct impact on cash flow. But as it is included in the calculation of net income, it indirectly
affects cash flow. However, in the cash flow statement it needs to be added back in the
operating activities section simply because depreciation is a non-cash expense. As in the case
of stock prices, when net income increases the stock prices are likely to go up. So, if the
company wants its stock price to go up they might have to charge a lesser depreciation rate for
a better net income.

7. What is the long-run impact of reduced quality of reported earnings?

When MicroStrategy had to announced that it would restate its 1999 revenue it is an example
of bad or reduced quality of reported earnings and because of which the company’s shares
promptly plummeted by $140 to $86.75 a share in 2000. Companies that manipulate their
earnings are said to have poor or low earnings quality. Some companies manipulate earnings
downward to reduce the taxes they owe. Others find ways to artificially inflate earnings to
make them look better to analysts and investors. Such actions and practices will leave a
negative remark for the company which can lead to fall in the value of the company’s shares,

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investors backing out and, in some cases, it can also lead to legal charges. An increase in net
income without a corresponding increase in cash flow from operations is a red flag. The overall
goodwill of the company can fall drastically and such practices might even affect the survival
of the company in the long run. This is why it is always recommended to follow proper
accounting standards, as more closely a company sticks to those standards, the higher its quality
of earnings is likely to be in the long run.

8. Should the executive compensation be linked to EPS or MPS?

Earnings per share (EPS) is calculated as a company's profit divided by the outstanding shares
of its common stock. The resulting number serves as an indicator of a company's profitability.
The higher a company's EPS, the more profitable it is considered to be. Market price per share
(MPS) simply refers to the most recent price of a single share in a publicly-traded stock. This
is not a fixed price—it fluctuates throughout the trading day as various market forces push the
price in different directions. Therefore, EPS is derived from the performance and information
from the income statement and balance sheet of the company while MPS is based on supply
and demand in the market.

Executive compensation should be linked to MPS than EPS based. This is because MPS is the
price potential investors are willing to pay for a share of a company. When more investors are
trying to buy the share market price will go up. This means that in the eyes of the inventor the
company is doing well and they would like to invest in it. The demand and supply will be based
fully on the performance of the company and what the investors think about the firm. This is a
much better method of calculating the compensation of executives as they will focus on
improving the performance of the company. The EPS of the company can be distorted both
intentionally and unintentionally by several factors so compensation based on EPS might not
state the actual performance company just like how in the case of MicroStrategy that had to
restate its 1999 revenue, originally reported as $205.3 million but actually was only $150
million. Therefore, compensations of executives should be MPS based.

9. Why are companies bothered about showing small increases in profits?

If the company faces issues with making proper profits and when they are facing losses
continuously, companies use discretionary items such as depreciation, provision for doubtful

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debts, writing off goodwill etc. to increase the net profit. They also do other things like shifting
the sales of the next quarter to the current quarter by offering more discounts to purchasers,
sometimes when the earnings rises, what company does is, they record a portion of higher sales
of the current quarter or year as the sales of the next quarter or the next year. And they also do
some beautification in the goodwill sector to show it as attractive as possible for the people.
They main reason why they do all these is because to attract more people investing and also
purchasing the product and services of the firm.

10. How do companies manage to show small increases in profits?

Most times when company faces issues like heavy net losses, what they do is they try
showing small profits in sales that they make. They mostly window dress the situation, but
doing this in a high degree can risk their credibility, so they play safe by showing small
profits. But here they cannot use discretionary items to show an increase in profits as it might
be difficult to change the accounting policy on depreciation or shift the sales of next quarter
to the current quarter to patch up the net losses. Companies should be attractive only then
investors invest and public uses the products or services.

11. What is Big Bath hypothesis? What is it resorted to?

A Big Bath is an accounting practice where companies knowingly manipulate their income
statement in order to make losses seem even more heavier than it actually is so that future
results appear better. Big Bath is so named because it is like wiping the slate clean. The Income
statement is manipulated by making changes to the company’s discretionary items. These
include writing of Goodwill, Assets etc. The practice is unethical however it can be done
effectively within the boundaries of current accounting rules and is approved by GAAP. The
ultimate aim of Big Bath is to increase net losses. During the process the stock prices do
decrease however not to the extend that big bath happens. The process of adding losses to the
already incurred losses will not bring down the stock price further.

12. Which is more common? Large increases or large decline in profits?

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Research evidence shows that the presence of large decline in profits are more common than
large increase in profits. By implication, managers do not passively record the combined results
of their own skill and business factors beyond their control, but intervene in the calculation of
earnings by exploiting the latitude in accounting rules. The researchers’ overall impression is
that corporations regard financial re-porting as a technique for propping up stock prices, rather
than a means of disseminating objective information.

CONCLUSION

In March 2000, Micro Strategy restated its revenue which was originally reported as
$205.3 million to $150 million. This resulted the company shares to decrease from $140
to $86.75 per share. Companies use discretionary items such as depreciation to change
reported amounts of net profit. Income smoothing is done to show smooth growth
through higher price earning multiple. Big Bath hypothesis is practised with the aim of
achieving higher profits in the following accounting period.

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