SEC Settles Microsoft Accounting Investigation

guttentag writes "The Securities and Exchange Commission has wrapped up its two-year investigation into Microsoft's accounting practices. The investigation focused on "cookie jar" accounting practices in which a company reports that it earned less money than it actually did, secretly storing the unreported money to artificially boost earnings in the future. The SEC called off its investigation in exchange for Microsoft's promise that it will not break the rules in the future, though the company is not admitting that it broke rules in the past. Microsoft publicly states that it has $40 Billion on hand." Gates realized a long time ago that regardless of actual performance, if you "beat estimates" people will buy your stock. So, he's arranging it so that no matter what the actual performance is, Microsoft always "beats estimates". If your analyst estimate is low 61 out of 63 times, either A) you need a new analyst or B) someone is feeding the analyst bad numbers. In this case, probably both.

Comments

Analysts are the ultimate sheep!

[JohnA]

Sorry to go off on a rant here, but analysts are the biggest farce in the financial industry. Don't take my word for it... see for yourself. Analysts consistenly raise or lower their rating of a company AFTER a major rise or fall.

Anyone who uses an analyst's recommendations as anything other than a source of humor needs to seriously reconsider their actions. Here's another great example of how "accurate" analysts are. Merrill Lynch is one of the worst.

Just my $0.02.

Re:Analysts are the ultimate sheep!

[kmellis]

I have a friend who's a senior analyst at one of the big banks. He told something that I already knew, but that many people don't.

The "buy/sell" ratings are unimportant. If you're an investor basing your decisions on ratings, then you're an idiot. It simply isn't true that an analyst's job (even in theory) is to study a company and then come up with a simplistic investment recommendation that's universally applicable. That's not the analysts's chief concern.

Their chief concern is understanding what's happening with the company. They try to present that understanding in detailed reports and those are what you should pay attention to. The real investors are looking at that, not the rating; and, in fact, they're not really even looking at the report so much as they calling up the analyst and talking about the stock in person.

If I were in my friend's shoes, which I'm certainly not, because I'm pretty outspoken and a risk-taker, I'd go right to the top of the company and say, "Let's position ourselves as the one that investors trust. Let's stop making buy/sell ratings, and insist that investors and their advisors make decisions based upon our lengthy analysis of a stock, and the personal situation of the investor." I'd either lose the job, or have contributed to a real smart strategic move.

I'm not defending analysts as much as it may appear. Theoretically, they were supposed to have integrity, and their integrity was compromised at many firms during the boom. Reading Blodgett's emails is enlightening. But day-traders and other retail investors deserve a huge chunk of the blame for jumping into the market as if they were running to the craps table because they thought they were on a hot streak.

Welcome to the world of Income Smoothing

[Silver222]

And before we crucify MS, every single public company does it. Investors and analysts don't like crazy up and down profits. They like the earnings line chart to climb up like a ramp if possible, and since that is what they like, companies will try to give it to them.

The real bad guys here are probably the auditors, since they are supposed to find stuff like this and make sure it doesn't happen. People in the know are aware that audited financial statements are just bullshit backed up by a promise that means just about nothing. There is still good info in there, you just need to really read between the lines and pay attention to what the company does not have on the balance sheet.

Re:Welcome to the world of Income Smoothing

[jayed_99]

You're exactly right.

Investors do not like to see large variations over a short period of time. Large fluctuations -- either up or down -- skew the statistics they use to make future projections.

Investors want to be able to make accurate projections. Analysts want to be able to make accurate projections so they can get paid by investors. Companies want to be able to provide the information to make accurate projections so they can get paid by investors. Accountants want their numbers to be conducive to making accurate projections so they have a company to work for. Auditors want their reports to say that accurate projections are possible so they can get paid by companies.

It's an incestuous system whose sole purpose is making people think that investing is more like monopoly than blackjack.

Re:Welcome to the world of Income Smoothing

[Multics]

Income smoothing has been turned into a (questionably) legal art form by General Electric and its former leader Jack Welch.

This started long before George 'W' and represents a larger than Enron class failure of auditing and business ethics. The point of accounting is to report the accurate state of affairs of the organization, not some CEO/CFO's wishful thinking.

Generally Accepted Accounting Principles (GAAP) are created and maintained by the Financial Accounting Standards Board (which interestingly doesn't come up with a Google search -- at least when I looked for it). Much of the current round of problems can be laid clearly in their lap.

The consensus in the auditing community is that the lesson was not learned with Enron and hence an even larger disaster will have to happen before this increasingly corrupt set of practices, auditors, and corporations is revised.

I'll also note that I am about as pro-business as it is possible to be, but when all of business stands on quicksand because of bogus financials there is the opportunity for just a little shaking causing the whole thing to liquify and slide into the morass.

-- Multics

Ilegal but

[asv108]

Most corporations usually don't have the luxury of beating estimates with large unreported cash reserves. In a twisted way this showcases the strength of Microsoft's business model giving them the ability to ride out the hard times. If I was a shareholder, I would approve so therefore Microsoft is doing what any good corporation should do, increase shareholder value. Obviously the risks of legal action do not outweigh the benefits for the company so in a sense this is just a good business strategy.

Re:Ilegal but

[mjh]

If I was a shareholder, I would approve so therefore Microsoft is doing what any good corporation should do, increase shareholder value.

Yes, but the assumption that is made when a company increases shareholder value is that the company is actually doing something that increases the gdp of the entire country. Otherwise you end up with a zero-sum gain.

So for example, if I am a company that produces widgets, and I develop a way to produce more widgets for the same price, I've increased the value of the company, in that I'll be able to lower the price of my widgets while still increasing the profits of my business. Society benefits by getting cheaper widgets and shareholders should reward that kind of thing.

However, if I don't actually do anything but make it look like I'm perpetually increasing the profits of my company, I'm duping society. You end up with one person getting rich by selling high valued stock, while another person (who buys that stock) gets poor. Nothing is produced. Money is simply changed from one hand to another: the zero sum gain.

In the first example, all of society is richer because of the innovative prodution method that allows them to reap profits which is further rewarded in the stock price. In the latter example, nothing actually improves, money just moves from one person to another, without anyone having had to do any actual work.

Which is fine, I suppose. But I would suggest that we as a society demand that people play by the rules. Specifically that companies get to reap the rewards of being profitable when they produce something that benefits society (as determined by the market). If they don't produce anything new, then they shouldn't be rewarded. If they're using accounting practices that allow a company to reap the rewards of producing something new without actually producing something new, I think we should decide to call that fraud or theft, and treat it accordingly.

$.02.

Re:Ilegal but

[kmellis]

"Capitalism 'works' (to what extent is arguable), because it expects people to act selfishly. And there's just no stopping that."

Exactly. And that's why a functional market requires a mininum level of regulation to assure that a selfish agent is unable to subvert the market.

Capitalism does not glorify "selfishness"; and an understanding of macroeconomics and the benefits of free markets does not require that selfishness be elevated to a virtue.

Rather, capitalism elevates rational self-interest as a fundamental principle. Rational self-interest allows--requires--some level of enforcement of the rule of law such that less rational people are prevented from literally and metaphorically hitting other people over the head with a rock and stealing their sheep. Rational self-interested agents support the rule of law because they recognize the fundamental benefit of markets: the principle of comparative advantage. Stealing is zero-sum, comparative advantage is not.

You might ought to learn a bit more about macroeconomics. Let's take the counter-example you offered. It had to do with one company taking market share from another, and your contention was that this doesn't represent an increase in productivity. No? Well, you're wrong.

Theoretically, there is an increase in productivity because the consumers--presumed to be rational self-interested agents--evaluated one vendor as being superior to the other. The only reason the market works at all is because, collectively, these judgments are usually correct. If company A is making a superior product to company B, then switching resources to the production of company A's widget necessarily represents a gain in productivity. Whatever that extra value is that the consumer recognized is present when it otherwise would not have been present.

We have markets for all sorts of things, and this is because they tend to work significantly better than any designed process. This is true in capital--thus, the securities markets--in international capital flows--the currencies markets (although there's good reason to believe that the currency markets are flawed at present)--and others. In the case of capital, theoretically, your capital investment will only show a return if that investment has generated wealth. In reality, there are speculative bubbles and whatnot that mean that people can, and do, generate large returns on investment where there was no actual wealth generated. But that doesn't mean that it is rational for an investor to make investment decisions independent of real corporate value--because, on average, it's necessarily the case that the market punishes faux wealth creation and rewards genuine wealth creation. Otherwise, we'd all be broke by now.

If you're an investor and you believe that you can predict the short-term false and longer-term-but-false valuation changes, then, hey, go for it. But not only are you less likely to be right than wrong, even if you're right your trading strategy would only be effective until the market incorporated it and cancels it out. So, if you're a gambler--and a certain kind of investor is a gambler--then you'll think that it makes sense to invest outside the context of fundamentals (which ultimately represents wealth creation or destruction). In contrast, if you have any sense, you'll ultimately look for actual wealth creation or destruction to evaluate your investment decisions. Just like you would if you were investing in your brother's bakery.

Market economics is a good thing because it works. It creates wealth where there was no wealth before, and as a general rule everyone benefits from this. (Certainly that's true in contrast to mere wealth redistribution.) That's why it's revered and promoted. Not because it makes sense to elevate simple selfishness to some grand moral principle. That way of thinking is that of the Market Cultists, and they're down the hall, in the padded room with the Objectivists.

what?

[AdamBa]

Although you could argue that the shareholders own the $40 billion (and Bill Gates works for them too), it's not like they can get their hands on it. If people sell the stock, they won't be selling it back to Microsoft, they will be selling it to other saps in the stock market.

In fact the $40 billion in cash puts a floor on how low the stock can go, since the stock shouldn't drop much below the breakup value of the company (what you would get if you bought the whole company, sold off the buildings, etc and took the $40 billion for yourself). Of course with a market cap of $275 billion the breakup value is a long way down.

- adam

Re:The $40 billion fallacy

[ProfMoriarty]

The magic of accounting 101 ...

The $40B in the bank is NOT owned by the shareholders. Period. It IS owned by Microsoft, a government recognized entity.

Your argument is that since Microsoft is public, the shareholders "own" whatever Microsoft owns ... this is fallacious reasoning, since if YOU owned ... let's say $89 worth of Microsoft, you don't get a copy of Windows for free, in exchange for your shares.

What is owned by Microsoft, cannot ever, be "magically transferred" to the shareholders, just by holding stock.

Now ... lets say that Microsoft decides to throw in the towel, and close operations. The stocks would plummet, and the assets would be sold off to cover the debt. ASSUMING that there was money left over, the rest THEN would go to the shareholders, based on the amount of you have/total shares ...

Usually companies in Microsofts position pay dividends, Microsoft decided not to ... it has that right, and keep the $40B in the bank for a "rainy day" ...

BTW, the $40B doesn't "evaporate" if MS's stock goes down ... ever ... since its shielded from the stock market in banks. Kind of like money laundering. :)