Financial Reporting and Capital Markets

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Financial Reporting and Capital Markets:

Explain the accounting for AT&T’s acquisition of NCR and Coca-Cola’s “channel stuffing. Discuss and compare the motivations of those who made the accounting choice, explaining what consequences the academic literature would predict to follow from the choice.

Creative accounting is a means by which companies manipulate standard accounting practices, in an attempt to influence the way certain parties interpret financial performance. A multitude of devices exist within creative accounting, two examples of which will be discussed in this essay: firstly, the pooling method of accounting used in AT&T’s 1991 acquisition of NCR; and secondly, Coca-Cola’s 1997-99 “channel stuffing”. The motivations of such accounting choices will be discussed and compared, explaining the relevant consequences academic literature would expect to follow. Discussion relies on the assumption, held and tested by many academics[1], that market efficiency is of the semi-strong form.

AT&T monopolised the long-distance telephone industry for almost a century, until the Department of Justice filed an antitrust action in 1974. A consent decree was signed in 1982 – a widely criticised decision – stating AT&T must divest 75% of their assets (Lys, 1995), yet could enter the unregulated computer-orientated industry. 1988-appointed CEO in 1988,, Robert Allen’s analysis suggested AT&T’s continuing computer losses could be solved significant investment or divestment. Moving forward with the former option – arguably to “save face” after signing the decree – presented NCR as a potential acquisition. AT&T was determined to acquire NCR, debatably in an attempt to reposition itself as a market competitor, despite weak history regarding computer mergers, NCR’s financial setbacks and the general consensus of NCR’s “lemon”-like status.

Acquisitions can either use the pooling-of-interests or purchase method of accounting – neither of which impact future cash flow. The former sees assets acquired at book value, and the latter requires acquisition at fair market value, with the inclusion of amortisable goodwill. Several barriers existed to prevent the Securities and Exchange Commission (SEC) from granting permission to pool (Lys, 1995) some of which were purposefully introduced by NCR as a defence mechanism. Significant costs were incurred to sidestep the barriers; including reportedly lobbying the SEC. AT&T arranged 6.3 million NCR shares (at $102.75) to be placed with Californian money manager, Capital Group Inc., which were exchanged for 6.3 million AT&T shares (at $110.74). This cost AT&T $50.3 million – profit recognised by Capital Group – with an additional $10 per share offered for NCR’s managerial cooperation.

AT&T’s motives to pool rather than purchase – costing them a confirmed $50 million premium, with the willingness to pay an additional $450 million – were related to the belief that earnings per share (EPS) would increase. The believed increase related to AT&T’s perception of the market efficiency, who predicted that, with the purchase method, shareholders and financial analysts would incorrectly interpret decreasing earnings due to goodwill amortisation as decreasing cash flow, resulting in a 20% share price decrease (with 100% stock, pooling EPS = $2.42, purchase EPS = $1.97).

AT&T investors, during the six-month negotiation period, had adverse reactions to all news that increased likelihood of acquisition. Indeed, throughout the 9-month, $7.5 billion acquisition, AT&T shareholders’ wealth decreased $6.5 billion (NCR’s increased $3.5 billion).

AT&T’s assumption relating to market inefficiency was that analysts and investors would not recognise the difference between the purchase and pooling effects on earnings. However, research into the correlation between purchase accounting and stock prices reveals no market inefficiencies (Hong 1978). The lack of evidence supporting this assumption perhaps suggests that NCR supplied inside information to AT&T. The disregard to the market’s negative response to the deal is illustrative of AT&T’s belief of market inefficiency with regard to acquisitions. Lys suggests that psychological motives exist, such as the pressure on a decision-maker to “become bound” to decisions that are taken freely, not easily reversed and have personal ramifications. Such theory coheres with the earlier notion of AT&T trying to redeem itself after the 1982 decree, within the computer industry.

Coca-Cola Enterprise (CCE) – the world’s biggest manufacturer and distributer of non-alcoholic concentrates and syrups – surpassed expected earnings from 1990-1996, with its share price increasing over twice as fast as the S&P500. In 1996, Coca-Cola began to face competition in a tough economic environment yet it publically maintained its growth through hidden “channel stuffing”, an example of real earnings management.

Demand is only truly seen internally, and as such when anticipated demand is low tangible products can be “stuffed” downstream to customers – known as the carryover effect (Lai, 2010) – allowing higher sales revenues to be reported, with investors thereby incorrectly overvaluing the company.

CCE persuaded bottlers to purchase additional concentrate, that they wouldn’t have required until the next period, offering incentives such as: extended payment terms (Terhune, 2004), indications of increasing price, discounted prices for extra purchase quantities (United States District Court, 2005), etc. Increasing bottler concentrate inventory levels suggested increasing sales, yet their sales rose only 11% from 1997-1999, whereas concentrate levels produced and delivered by CCE increased over 60%.

The inflation of product sales – increasing revenue by $600 million – falsely implied a healthy future for CCE. Channel stuffing was not disclosed to shareholders, and relied on semi-strong market efficiency assuming, correctly for a period of time, that shareholders would not notice the creative accounting device.

CCE released higher sales figures, in line with past growth, which created a short-term profit boost; this was not sustainable. Bringing future inventory forward created a deficit for the next period, which required another, larger channel stuff, forcing a vicious spiral of declining sales, inventory deficits and gallon pushes. Ultimately, bottlers were holding significantly more inventory than the forecasted decreasing demand required. In 1999 inventory levels were too high, thus channel stuffing ended, leading to a large decrease in revenue. Gunny (2005) refers to channel stuffing as a manager’s “willing[ness] to sacrifice future cash flows” in the short-term, with research showing that operating performance will be reduced in the long-term.

CCE violated Sections 17(a)(2)/17(a)(3) of the Securities Act by not disclosing their channel stuffing to investors. Additionally, CCE produced false statements announcing a “several-month long optimum inventory study” conducted alongside retailers (SEC 2005). Additionally, CCE violated Section 13(a) of the Exchange Act, which stated that any trends known by a company that are expected to negatively impact revenue must be disclosed. In 2000, the investors who bought CCE stock, after being misled, filed a lawsuit claiming that channel stuffing led to inflated and dishonest revenues. CCE agreed to settle in order to elude unwanted litigation, yet did not admit any misconduct. They agreed to abstain from future securities violations, paying close attention to sales levels to bottlers.

CCE’s motives for channel stuffing are arguably twofold: the decline in demand for products, explained by CCE as due to bad weather and unexpected expenses, meant that financial analysts’ sales forecasts would be missed and hence share prices would decrease (Chan, 2005). Secondly, (Chan 2005); and plaintiffs alleged that the performance-based bonuses contributed to the creative accounting. Such theory corroborates the discovery that several officers later suspiciously shorted millions of dollars of inflated CCE stock days before corrective disclosures of CCE’s financial position (United States District Court, 2005).

Similarly, Lys discuses the possibility of incentive-based compensation in AT&T’s pooling decisions. Details of calculations and estimates can be found in Lys (1995), though an overview explains that the $0.45 EPS decrease from the purchasing method would have reduced Allen’s bonus by $427,245 (over the ten-year goodwill amortisation period) and by $3.4 million for the officer group, compared to smaller bonus reductions of $140,445 and $811,468 respectively after pooling treatment. This resulted in a £2,909,862 net pooling benefit, though this is relatively small compared to the wealth of the officer group.

It can be reasoned that AT&T either had motives not aligned to maximizing value to the shareholders or possessed inside information. The former relates to the principal-agent problem; arguably AT&T had psychological and, as well as CCE, compensation scheme motives. The latter relates to the market efficiency, in particular the asymmetry of information. CCE’s channel stuffing was based on the premise that they knew something the market and distributors did not about the demand trends. Similarly, NCR appeared to the market as a lemon, with all events associated with acquisition reducing AT&T’s stock price. Their persistence regarding the deal suggested they saw value that the market did not. Contrary to this, Lys (1995) described the deal as value destruction, and 6 years after the hostile takeover NCR re-established itself as a separate company after a “disastrous relationship” with AT&T (Andrews, 1996), confirming the market’s lemon opinion.

Considering the motives to pool and not purchase, one must ask if AT&T’s management’s belief that EPS would decrease with purchase was justification for a $50 million premium. Hong’s (1978) research into the correlation between purchase accounting and stock prices questions AT&T’s pooling rationale, revealing no inefficiencies, rendering the premium to pool shares redundant. Yet, Ayers (2002) indicates that CFOs commonly fear purchase accounting negatively affects stock values justifying the large premium, researching that on average a firm will pay over $60 million for pooling treatment. Hopkins’ (2000) research, contradicting Hong’s, within experimental settings shows that analysts frequently do not appropriately take into account purchase or pooling methods when adjusting stock prices. Additionally, it could be argued AT&T’s concerns over investor misinterpretation could have been reduced with voluntary disclosures, reducing the information gap between managers and investors (Healy, 2001).

A decline in demand and failure to meet analyst forecasts and expectations would indefinitely result in a decreasing stock price. CCE, rightly, believed the market would not recognize the downward trend due to their lack of access to the soft drink industry’s data. Additionally, their understanding of market efficiency led them to assume investors would not immediately recognize their channel stuffing activities.

Though financial reporting and disclosure are crucial for outside investors to understand performance, it can be argued that the device used by AT&T was transparent – an informed investor could have inferred motives from publically available information – and by CCE was opaque. Keller (1991a) references that Donaldson, Lufkin & Jenrette analyst Gross recognized and agreed with AT&T’s insistence on pooling treatment, foreseeing the negative share price implications if SEC denied the pooling request. Though in CCE’s case it was not recognized, Lai (2010) notes certain activity – for example large increases in accounts receivable or excess inventory at customers’ (Hendricks 2008) – can hint at, though not identify, channel stuffing. Ulterior motives to use the aforementioned accounting devices, such as psychological or bonus schemes could not be deciphered without inside information.

Though AT&T did not use an illegal device, and CCE admitted no wrongdoing, both performed questionable accounting practices. Thus, decreasing shareholder trust would be a certain consequence, especially for CCE. Indeed, Akerlof (1970) stated “dishonest dealings tend to drive honest dealings out of the market”, suggesting future and potential investors would distrust AT&T, who acted despite the market’s concerns, and CCE, who used information asymmetry to mislead the market. The SEC proved that channel stuffing occurred and CCE put certain bodies and practices in place to ensure openness with regard to financial, ethical and compliance matters. This would not repair the broken trust between the two companies and the market and thus stock prices, in the long-term, would be predicted to decrease due to the dishonesty.

CCE knowingly misled investors into believing their sales were continuously growing, in order to meet and exceed forecasted earnings, taking advantage of the asymmetric nature of the market’s information. Whereas, AT&T paid a $50 million premium, with the potential to increase this to $500 million, in order to protect themselves from misinterpretation due to their perceived market efficiency, which was arguably weaker than semi-strong. An alternative hypothesis is that the principal-agent theory was in play, with AT&T managers acquiring the lemon-like company for reasons other than maximising shareholder value. Both AT&T and CCE office members received financial benefits from the acquisition and channel stuffing respectively, although neither the significance nor the malicious attempts to secure such bonuses has been proven.

Academics, in particular Hong, suggests that the semi-strong market form would not let either pooling or purchase methods of accounting affect AT&T’s stock price, contradictory to Gross’s and Hopkins’s analyses. Lai and Hendrick both suggest that certain activities can indicate channel stuffing and though the CCE device was not immediately detected the incident has helped reinforce and improve regulations put in place to prevent future channel stuffing. Akerlof’s Lemon model implies that the two companies’ dishonest behaviour would not bode well in the long-term with investors or shareholders.

In conclusion, the assumption, held throughout this essay, of semi-strong market efficiency is crucial when deciphering the true motives and consequences of the two cases. The motives, which are still unclear, of AT&T’s pooling treatment and CCE’s channel stuffing stemmed from the seemingly innocent desire to increase shareholder value and avoidance of misinterpretation, to the controversy of performance-related bonuses, malicious information asymmetry and psychological pressures. AT&T’s perception of lower than semi-strong form, and corroborating analyses from Gross and Hopkins, suggested uninformed investors would misinterpret their financial performance, despite Hong’s conflicting research. CCE believed the semi-strong form left room to mislead the uninformed investors into thinking financial performance was significantly greater than it actually was, leading to poor performance and distrust in the long-term. The creative accounting devices discussed would have led to decreasing stock price as a consequence of their dishonest nature. In the words of Akerlof (1970), the “cost of dishonesty” ultimately “[drives] legitimate business out of existence”.

Bibliography

Akerlof, G 1970, 'The Market for "Lemons": Quality Uncertainty and the Market Mechanism', The Quarterly Journal of Economics, vol 84, no. 3, pp. 488-500.

Ambreen A. Delawalla, JAJJ,TRDA&BLA 2007, 'In re Coca-Cola Enterprises Inc Securities Litigation', Case: 1:06-CV-0275-TWT, United States District Court, Georgia.

Andrews, E 1996, 'AT&T Acquisition, Soon to Be Spun Off, Regains NCR Name', The New York Times, 11 January 1996.

Ayers, B 2002, 'Do firms purchase the pooling method?', in Review of Accounting Studies, Kluwer Academic Publishers, Netherlands.

Chan, F 2005, 'The JIT revolution: What actually happened in the inventories of American companies between 1981 and 2000?', Forthcoming in Management Science.

Fama, EF 1970, 'Efficient Capital Markets: A Review of Theory and Empirical Work', The Journal of Finance, Blackwell Publishing for the American Finance Association, New York.

Gunny, K 2005, 'What are the Consequences of Real Earnings Mangement?', Haas School of Business, University of California, Berkeley.

Guoming Lai, LDLN 2010, 'Manager Incentives for Channel Stu±ng with Market-based Compensation ', Chicago Booth School of Business , University of Chicago , Chicago.

Hai Hong, RSKGM 1978, 'Pooling vs Purchase: the effects of accounting for mergers on stock prices', The Accounting Review, no. 53, pp. 31-42.

Hendricks, KB,VRS 2008, 'Demand-supply mismatch and stock market reaction: Evidence from 28 excess inventory announcements', M&SOM.

Hopkins, PE,RWHAMFP 2000, 'Valuation of the components of purchased goodwill', Journal of Accounting Research.

Lys, T 1995, 'An analysis of value destruction in AT&T's acquisition of NCR', Graduate School of Business, J.L. Kellogg Graduate School of Manchester, Northwestern University, University of Chicago, Chicago.

Merton, RC 1987, 'A simple model of capital market equilibrium with incomplete information.', The Journal of Finance , pp. 42, 483–510.

Paul M Healy, KGP 2001, 'Information asymmetry, corporate disclosure, and the capital markets: A review of the empirical disclosure literature', Graduate School of Business, Harvard University, Journal of Accounting and Economics, Boston.

Perler, HMSJ 2010, Financial Shenanigans, 3rd Edition, McGraw Hill, New York.

SEC 2005, US Securities and Exchange Commission, viewed 20 February 2014, <http://www.sec.gov/news/press/2005-58.htm., April 18, 2005>.

Terhune, C 2004, 'Probe of Coke's Sales Leads to Japan', The Wall Street Journal.

Tobin, J, 'On the Efficiency of the Financial System', Lloyds Bank Review, 153: 1-15.

United States District Court 2005, 'Civil Action, file note 1:06-CV-0275'.

Vishny, ASARW 2011, Stock Market Driven Acquisitions , Harvard University, Boston.

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Financial Reporting and Capital Markets, Essay 1, 7167N


[1] Notably, (Vishny, 2011),) (Tobin, n.d.) (Fama, 1970)

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