Eric
22.10.2000, 19:42
OCTOBER 23, 2000
Pooling and Fooling
A critic draws a bead on Cisco's accounting practices
By Abraham J. Briloff
Cisco Systems might well be dubbed Wall Street's New Economy Poster Child. No better illustration of investors' vast esteem is that they've graced the company with a cool $400 billion (it had been as high as $500 billion) market capitalization. However, Cisco might also just as well be designated as the New Economy Creative Accounting Exemplar. It merits that sobriquet thanks to its ability to exploit some of the more questionable, even dubious, accounting concepts -- all of which it should be noted are presently enshrined in the Good Book of GAAP (or, in formal financial parlance, Generally Accepted Accounting Principles).
Indisputably high tech and the leading supplier of networking equipment for the Internet, Cisco Systems describes itself as providing networking solutions that connect computing devices and computer networks, allowing information to be accessed or transferred without regard to differences in time, place or type of computer system. The leading supplier of networking equipment for the Internet, it boasts a truly global reach, selling its products in over 100 countries.
But it is less its vaunted technological prowess than Cisco's inordinate addiction to arguable notions of accounting for business combinations, as well as for stock options, and its occasionally obscure disclosure standards that especially intrigue me, as a critical observer of corporate accounting and accountability.
Cisco's accountings for its fiscal years ended July 1999 and 2000 furnish vivid demonstration of the causes of my concern. Let us start with pooling-of-interest accounting. Just to refresh your memory, under the pooling method of accounting for a business combination, if Company A acquires Company B paying, say, $100 million in stock, it would show as its cost a mere $10 million, assuming that was the amount listed on Company B's books as its shareholders' equity.
In consequence, $90 million of costs actually incurred by A will never pass through A's income statements. Company A thus will be able to realize $90 million of revenues derived from the acquired properties without those revenues being burdened with even $1 of cost. And, a safe bet is, A's earnings will be correspondingly engorged.
Nor does it matter one whit whether that $90 million cost suppression is related to real estate, plant and equipment, inventories, intellectual properties (copyrights, patents or other intangibles) or a pool of Nobel Laureates. The sole aim of the exercise is to add to the glory of A's bottom line.
Pooling, make no mistake about it, is bad stuff. Three decades after Barron's first attacked the practice in an article aptly entitled "Dirty Pooling," the Financial Accounting Standards Board (FASB) promulgated its Business Combinations Exposure Draft, which would effectively outlaw pooling. Alas, egged on by legions of lobbyists, both houses of Congress held extensive hearings this past spring on the pooling controversy and, no surprise, most of the fire was directed against the FASB.
The pro-pooling chorus sang the virtues of the practice. Their theme was that the New Economy vitally depends on pooling accounting and its end would put our unprecedented prosperity in dire jeopardy. Of course, if indeed that absurd claim were true, then our prosperity rests on quicksand.
To see such outlandish twaddle for what it really is, our chosen representatives need look no further than Cisco. In the company's fiscal year ended July 31, 1999, it made three acquisitions, all of which were accounted for as poolings of interest. Of the three, Cisco deemed the historical operations of two not material to the company's consolidated operations on either an individual or aggregate basis, a status that relieved Cisco of the need to restate its prior period results to reflect the revenues and deficit of this "not material" pair.
There's no blinking the fact, though, that for these supposedly insignificant acquisitions, Cisco parted with 16 million shares worth roughly $400 million. For that $400 million, Cisco booked a cost of $45 million, net of a $70 million charge to retained earnings, implying that throughout their pre-merger life the two had accumulated losses of $70 million.
The really big deal in fiscal '99 was the takeover in June of GeoTel Communications. For the latter, Cisco forked over 68 million shares, worth some $2 billion. How much of this $2 billion of cost found its way on to Cisco's books? To find out, one has to burrow into the company's financials, which are not a model of transparency.
The rules require that prior-period statements must be restated to reflect any "material" acquisitions for which pooling was used. By juxtaposing the fiscal '98 balance sheet in that year's annual with the fiscal '98 balance sheet in the fiscal '99 annual, we can come up with a reasonable answer to the question posed above.
In a nutshell, the $2 billion cost of the acquisition surfaced in Cisco's accounts as a mere $41 million! A zero addition to retained earnings clearly implies that GeoTel was bereft of earnings. So, all due thanks to the legerdemain of accounting, Cisco had acquired $2 billion of value capable of being insinuated into its bottom line, with hardly a penny of related cost.
Cisco grew far more audacious in fiscal 2000, ended July, snapping up no fewer than 12 companies in exchange for stock worth a total of $16 billion. Five of the dozen were deemed immaterial; hence, they were not included in the pooling restatement process. Cisco paid $1.2 billion for the "immaterial five," a cost that showed up in Cisco's books as a mere $1 million (of the purchase price, only $75 million went into the company's capital stock account, offset by a $74 million deduction of retained earnings).
Table A lists the seven pooling acquisitions that did require restatement. By my reckoning, the cost of those seven, for which Cisco paid an aggregate of over $14.8 billion, was booked at only $133 million ($207 million was added to the capital stock account, offset by a $74 million deduction from retained earnings, representing the accumulated losses of the seven acquired companies).
Cerent merits a harder look and not only because of the megabucks involved in the takeover. In less than two years it enjoyed a magical transformation from sickly worm into glorious butterfly.
A form S-1 was filed with the SEC in July 1999, as a prelude to a Cerent IPO. The underwriting, however, was aborted with the announcement of the Cisco merger. Happily, though, we have the prospectus, and it furnishes some remarkable insights. Incorporated on January 27, 1997, as Fiberlane Communications, it subsequently changed its name to the more beguiling Cerent. Its business is the development and delivery of a multi-service optical transport platform, designed to reduce network operating costs and boost the efficiency of bandwidth delivery within transport networks.
Sales of its sole product, the Cerent 454, began in December 1998. Targeted markets include emerging interexchange, competitive local exchange and independent carriers, and cable companies.
On page 54 of the prospectus, we learn that Cerent's principal stockholder was venture capitalist Kleiner Perkins Caufield & Byers, with a 30.8% beneficially owned stake. But we also learn that Cisco itself owned 9% of the fledgling. Hence a plausible inference is that the $6.9 billion paid by Cisco was for the remaining 91%, so that Cerent actually was valued at around $7.5 billion.
Before entering the Cisco fold, Cerent had a brief but interesting history. In its first year of operations, it generated no revenues and suffered a loss of $7.9 million. In 1998, it rang up revenues of $220,000, on which it lost $22.5 million. In its last phase as an independent company, the five-plus months ended June 1999, Cerent had revenues of not quite $10 million and a loss of over $29 million.
From mammoth to minuscule
And it was for this company, whose rapid grow
Pooling and Fooling
A critic draws a bead on Cisco's accounting practices
By Abraham J. Briloff
Cisco Systems might well be dubbed Wall Street's New Economy Poster Child. No better illustration of investors' vast esteem is that they've graced the company with a cool $400 billion (it had been as high as $500 billion) market capitalization. However, Cisco might also just as well be designated as the New Economy Creative Accounting Exemplar. It merits that sobriquet thanks to its ability to exploit some of the more questionable, even dubious, accounting concepts -- all of which it should be noted are presently enshrined in the Good Book of GAAP (or, in formal financial parlance, Generally Accepted Accounting Principles).
Indisputably high tech and the leading supplier of networking equipment for the Internet, Cisco Systems describes itself as providing networking solutions that connect computing devices and computer networks, allowing information to be accessed or transferred without regard to differences in time, place or type of computer system. The leading supplier of networking equipment for the Internet, it boasts a truly global reach, selling its products in over 100 countries.
But it is less its vaunted technological prowess than Cisco's inordinate addiction to arguable notions of accounting for business combinations, as well as for stock options, and its occasionally obscure disclosure standards that especially intrigue me, as a critical observer of corporate accounting and accountability.
Cisco's accountings for its fiscal years ended July 1999 and 2000 furnish vivid demonstration of the causes of my concern. Let us start with pooling-of-interest accounting. Just to refresh your memory, under the pooling method of accounting for a business combination, if Company A acquires Company B paying, say, $100 million in stock, it would show as its cost a mere $10 million, assuming that was the amount listed on Company B's books as its shareholders' equity.
In consequence, $90 million of costs actually incurred by A will never pass through A's income statements. Company A thus will be able to realize $90 million of revenues derived from the acquired properties without those revenues being burdened with even $1 of cost. And, a safe bet is, A's earnings will be correspondingly engorged.
Nor does it matter one whit whether that $90 million cost suppression is related to real estate, plant and equipment, inventories, intellectual properties (copyrights, patents or other intangibles) or a pool of Nobel Laureates. The sole aim of the exercise is to add to the glory of A's bottom line.
Pooling, make no mistake about it, is bad stuff. Three decades after Barron's first attacked the practice in an article aptly entitled "Dirty Pooling," the Financial Accounting Standards Board (FASB) promulgated its Business Combinations Exposure Draft, which would effectively outlaw pooling. Alas, egged on by legions of lobbyists, both houses of Congress held extensive hearings this past spring on the pooling controversy and, no surprise, most of the fire was directed against the FASB.
The pro-pooling chorus sang the virtues of the practice. Their theme was that the New Economy vitally depends on pooling accounting and its end would put our unprecedented prosperity in dire jeopardy. Of course, if indeed that absurd claim were true, then our prosperity rests on quicksand.
To see such outlandish twaddle for what it really is, our chosen representatives need look no further than Cisco. In the company's fiscal year ended July 31, 1999, it made three acquisitions, all of which were accounted for as poolings of interest. Of the three, Cisco deemed the historical operations of two not material to the company's consolidated operations on either an individual or aggregate basis, a status that relieved Cisco of the need to restate its prior period results to reflect the revenues and deficit of this "not material" pair.
There's no blinking the fact, though, that for these supposedly insignificant acquisitions, Cisco parted with 16 million shares worth roughly $400 million. For that $400 million, Cisco booked a cost of $45 million, net of a $70 million charge to retained earnings, implying that throughout their pre-merger life the two had accumulated losses of $70 million.
The really big deal in fiscal '99 was the takeover in June of GeoTel Communications. For the latter, Cisco forked over 68 million shares, worth some $2 billion. How much of this $2 billion of cost found its way on to Cisco's books? To find out, one has to burrow into the company's financials, which are not a model of transparency.
The rules require that prior-period statements must be restated to reflect any "material" acquisitions for which pooling was used. By juxtaposing the fiscal '98 balance sheet in that year's annual with the fiscal '98 balance sheet in the fiscal '99 annual, we can come up with a reasonable answer to the question posed above.
In a nutshell, the $2 billion cost of the acquisition surfaced in Cisco's accounts as a mere $41 million! A zero addition to retained earnings clearly implies that GeoTel was bereft of earnings. So, all due thanks to the legerdemain of accounting, Cisco had acquired $2 billion of value capable of being insinuated into its bottom line, with hardly a penny of related cost.
Cisco grew far more audacious in fiscal 2000, ended July, snapping up no fewer than 12 companies in exchange for stock worth a total of $16 billion. Five of the dozen were deemed immaterial; hence, they were not included in the pooling restatement process. Cisco paid $1.2 billion for the "immaterial five," a cost that showed up in Cisco's books as a mere $1 million (of the purchase price, only $75 million went into the company's capital stock account, offset by a $74 million deduction of retained earnings).
Table A lists the seven pooling acquisitions that did require restatement. By my reckoning, the cost of those seven, for which Cisco paid an aggregate of over $14.8 billion, was booked at only $133 million ($207 million was added to the capital stock account, offset by a $74 million deduction from retained earnings, representing the accumulated losses of the seven acquired companies).
Cerent merits a harder look and not only because of the megabucks involved in the takeover. In less than two years it enjoyed a magical transformation from sickly worm into glorious butterfly.
A form S-1 was filed with the SEC in July 1999, as a prelude to a Cerent IPO. The underwriting, however, was aborted with the announcement of the Cisco merger. Happily, though, we have the prospectus, and it furnishes some remarkable insights. Incorporated on January 27, 1997, as Fiberlane Communications, it subsequently changed its name to the more beguiling Cerent. Its business is the development and delivery of a multi-service optical transport platform, designed to reduce network operating costs and boost the efficiency of bandwidth delivery within transport networks.
Sales of its sole product, the Cerent 454, began in December 1998. Targeted markets include emerging interexchange, competitive local exchange and independent carriers, and cable companies.
On page 54 of the prospectus, we learn that Cerent's principal stockholder was venture capitalist Kleiner Perkins Caufield & Byers, with a 30.8% beneficially owned stake. But we also learn that Cisco itself owned 9% of the fledgling. Hence a plausible inference is that the $6.9 billion paid by Cisco was for the remaining 91%, so that Cerent actually was valued at around $7.5 billion.
Before entering the Cisco fold, Cerent had a brief but interesting history. In its first year of operations, it generated no revenues and suffered a loss of $7.9 million. In 1998, it rang up revenues of $220,000, on which it lost $22.5 million. In its last phase as an independent company, the five-plus months ended June 1999, Cerent had revenues of not quite $10 million and a loss of over $29 million.
From mammoth to minuscule
And it was for this company, whose rapid grow