 | Definition of 'Cookie Jar Accounting'
A disingenuous accounting practice in which periods of good financial results are used to create reserves that shore up profits in lean years. “Cookie jar accounting” is used by a company to smooth out volatility in its financial results, thus giving investors the misleading impression that it is consistently meeting earnings targets. This reliable earnings performance is generally rewarded by investors, who assign the company a premium valuation. Regulators frown on the practice since it misrepresents a company’s performance, which may be very different in reality from what it purports to be.
The term may be derived from the fact that a company which employs this practice dips into the “cookie jar” of reserves whenever it feels like it. But the company may have to pay a steep price if it is caught with its hand in the proverbial cookie jar. |
 | Investopedia explains 'Cookie Jar Accounting'One-time charges and special items are a couple of areas where a company can manipulate numbers to create cookie jar reserves. Potential investors should therefore scrutinize these numbers carefully before committing investment capital to the stock. One of the best-known cases of cookie jar accounting in recent years was that of computer giant Dell, which in July 2010 agreed to pay a $100 million penalty to the Securities and Exchange Commission (SEC) to settle SEC allegations that it used cookie jar reserves. The SEC maintained that Dell would have missed analysts’ earnings estimates in every quarter between 2002 and 2006 had it not dipped into these reserves to cover shortfalls in its operating results. The cookie jar reserves were created through undisclosed payments that Dell received from chip giant Intel in return for agreeing to use Intel’s CPU chips exclusively in its computers. (Intel made these payments to Dell to lock out rival chipmaker Advanced Micro Devices from Dell computers.) The SEC also said that Dell did not disclose to investors that it was drawing on these reserves. The Intel payments made up a huge chunk of Dell’s profits, accounting for as much as 72% of its quarterly operating income at the peak. Dell’s quarterly profits fell significantly in 2007 after it ended the arrangement with Intel. The SEC alleged that while Dell said the decline in profitability was due to an aggressive product-pricing strategy and higher component prices, the real reason was that it was no longer receiving the payments from Intel. |
Seeking Alpha
Date de fondation : 2004
CGI Group: Cookie Jar Accounting And The Logica Acquisition (Part 1)
Editor's notes: A buysider raises questions about CGI Group's acquisition accounting as part of the short case against the Canadian tech company.
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Disclosure: I am short GIB.
Please read our disclosure at the end of this entry. All figures in CAD unless noted otherwise.
This is the first in a series of entries on CGI Group, Inc. (GIB) in which we will explore CGI's financial disclosures, prospects for growth, and valuation. We are short CGI's stock.
In this entry, we introduce CGI's Logica acquisition and explain a set of accounting techniques that the SEC has referred to as "cookie jar" accounting.
We also suggest investors read a recent article about CGI's accountingwritten by Bethany McLean and published by Vanity Fair. In the article, McLean compares CGI's accounting with techniques that were used at Tyco International Ltd. before Tyco was investigated by the SEC. McLean is a respected financial journalist who became well-known for her reporting on accounting issues at Enron.
CGI and the Logica acquisition
CGI ("CGI" or the Company) is, by market cap, the largest publicly-traded technology company listed in Canada. The Company is an IT and business process services provider that has become famous for its involvement as the lead contractor for the healthcare.gov website. (The Washington Post reported last week that the Obama administration decided to replace CGI because the Company "had not been effective enough in fixing… the federal website.")
Since its founding in 1976, CGI has acquired over 70 companies, including the consulting business of Bell Canada in 1998, AMS in 2004, and Stanley Inc. in 2010. In August of 2012, CGI paid a 60% premium for Logica PLC's common shares, valuing Logica's enterprise at roughly $3.6 billion. Logica had not earned its cost of capital for years prior to the takeover.
The Logica acquisition was a milestone for CGI. We estimate that over 90% of CGI's European revenues come from operations that were part of Logica before the acquisition, and the Company's revenues have more than doubled since the acquisition.
The market has reacted positively to the Logica deal. The enterprise value of CGI has risen over 50% following the close of the acquisition to nearly $15 billion. Bullish sell-side analysts (mostly from Canada) cite the expected transformation of the Logica business as a reason to own the stock. These same bullish analysts model margin expansion in CGI's European businesses.
Deutsche Bank is the only sell-side firm that has a "sell" rating on the Company's stock; it is also the only bulge bracket firm providing research coverage on CGI.
What is cookie jar accounting? How does it relate to acquisition accounting?
Cookie jar accounting is when a company understates profits in one period, so that it can overstate profits in a subsequent period. The understated profits in the first period build a "cookie jar" of losses that can be reversed to increase earnings in the subsequent periods.
Companies can manipulate accruals on the balance sheet (such as receivables, work-in-progress, deferred revenues, and provisions) in order to create the losses that function as earnings cookie jars. For example, if a company creates a provision to accrue for expected future losses in one period, the same company can record a gain in a subsequent period if those expected losses do not materialize. Arthur Levitt, the former Chairman of the SEC, explained the concept in a 1998 speech:
"[An] illusion played by some companies is using unrealistic assumptions to estimate liabilities for such items as sales returns, loan losses or warranty costs. In doing so, they stash accruals in cookie jars during the good times and reach into them when needed in the bad times."
Restructurings can present opportunities for companies to create earnings cookie jars. Walter Schuetze, the SEC's former Chief Accountant of the Division of Enforcement, explained this in a 1999 speech entitled Cookie Jar Reserves :
"The occasion of a merger also spawns the wholesale establishment of restructuring or merger reserves… Write-offs of the carrying amounts of bad receivables. Write-offs of cost of obsolete inventory. Write-downs of plant and equipment costs, which, miraculously at the date of the merger, become nonrecoverable, whereas those same costs were considered recoverable the day before the merger... Recognition of liabilities for moving people. For training people. For training people not yet hired. For retraining people… Or some liabilities that go by the title of "other." It is no wonder that investors and analysts are complaining about the credibility of these numbers."
Acquisitions are interesting moments to engage in cookie jar accounting because losses recorded by the target company before the deal has closed are offset with an increase in the goodwill of the acquiring company. This means that an acquirer can build a cookie jar without ever recording losses in its reported EPS. This is because goodwill acts as a plug on an acquirer's balance sheet between the price paid for a target company and the net book value of the target company.
Are Logica's earnings patterns consistent with cookie jar accounting?
The Logica acquisition was announced in May 2012 and did not close until August 2012. The accounting related to the acquisition was partly summarized in a Business Acquisition Report that was filed on November 11, 2012 in three Schedules (A, B, and C). Schedule B contains Logica's financials for the six months ended June 30, 2012, before those financials were harmonized with CGI's internal accounting policies.
We combined Logica's historical financial statements, Schedule B of the Business Acquisition Report, and CGI filings in order to see how the adjusted operating profit of its businesses changed over time.
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What we find is that the profitability of Logica businesses dropped dramatically in the period immediately preceding the August 2012 acquisition and exceeded the 2010 levels after the acquisition. The financial statements for 1H 2012 show £190 million (or $304 million) of adjusted operating losses. Those financials were unaudited and prepared by CGI - not by Logica - even though they correspond to a period preceding the acquisition.
The 1H 2012 losses are noteworthy because they are inconsistent with the +6.5% margin guidance that was given by Logica just weeks before the end of that period, on May 11, 2012. We quote from a Profit Forecast that was reviewed by Logica's auditors and filed with the UK regulators:
"Our full year revenue and margin guidance remains unchanged despite our expectation of a subdued second quarter given the impact of elections in several countries and a cautious economic outlook for our main markets. Full year revenue growth is expected to be in the range of -2% to +2% and we expect our full year 2012 operating margin to be above 6.5% even in tough market conditions" [Note that 'operating margin' here refers to the adjusted operating margin we have used in our analysis].
The difference between Logica's +6.5% full-year guidance and the -10.2% result reported by CGI is roughly 17 points of adjusted operating margin. Using Logica's reported £1,866 million of revenues for the corresponding period, 17 points of adjusted operating margin is equal to over £300 million or roughly $500 million in adjusted operating profit.
This $500 million figure is equal to nearly 80% of all earnings before income taxes earned by CGI in fiscal 2013.
We leave it to the reader to determine whether this pattern of earnings followed by losses followed by margin expansion is consistent with cookie jar accounting as described by the SEC.
What caused the 1H 2012 Logica losses?
In the November 2012 earnings call, CGI's management provided several explanations for Logica's 1H 2012 losses.
The slowdown in the Company's revenue during this period was attributed to a) general softness in Europe, b) seasonality, and c) "the sideways drift that always occurs or almost always occurs in a targeted company between the announcement date and the closing date." We will not address these three issues here, except to note that a) and b) should have been anticipated in the guidance given by Logica on May 11, and c) would only have affected 30 days of results, between May 31 and June 30.
Logica's losses in this period were also due to certain provisions that are disclosed on note 2 and page 6 of Schedule B of the Business Acquisition Report. We thought that the provisions circled in red below were interesting.
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These provisions were unaudited non-cash charges to Logica's operating income that were applied by CGI's management and totaled roughly £173 million, or $277 million. David Anderson, CGI's CFO, explained the reasons for taking these charges in the November 2012 conference call:
"There was also a provision taken for other claims in the amount of £34 million. Most were project delivery issues having surfaced during this period for which we are actively engaged to rectify. Then there was the £139 million provision taken for expected future losses and write-offs on in-flight contracts. Simply put, we reviewed the cost to complete Logica's fixed price contracts using the same screen that we used for CGI. We then decided it was necessary to recognize forecasted cost overruns and penalties across a number of projects."
Reversing these provisions would allow CGI to record additional operating income without generating additional operating cash flows.
We were surprised to see these provisions because Logica undertook its own independent "thorough review" of its contracts in Q4 2011, which resulted in a one-time charge of roughly £39 million. We would have expected this Q4 2011 review to capture any necessary provisions.
Did CGI reverse any of the 1H 2012 Logica provisions?
We learn on pages 24-25 of CGI's fiscal 2013 MD&A that CGI saw working capital increase $282 million in FY 2013, and that $80 million of that figure is attributable to "the utilization of approximately $80.0 million of the estimated losses on revenue-generating contracts which originated from the acquisition" [emphasis added].
The reversal of $80 million of the contract provisions generated operating income of $80 million for CGI but did not generate any cash flow.
We are curious about what detailed assumptions led CGI first to write down the value of these contracts prior to the acquisition, and write up the value of these contracts after the acquisition. Again, we leave it to the reader to determine whether this pattern of contract valuation is consistent with cookie jar accounting techniques.
How much did other working capital accounts move?
If a company is engaging in cookie jar accounting, we should expect to see large moves in working capital accounts. Changes in working capital are one component of the difference between earnings and cash flow from operations. When working capital grows in a company, the company generates less cash than it otherwise would with the same earnings but no increase in working capital.
Page 10 of CGI's FY 2013 financials shows us that CGI's working capital grew $282 million in fiscal 2013. The size of this increase is meaningful relative to CGI's $456 million of earnings generated over the same period. The $282 million figure is subtracted from the earnings to derive the operating cash flow.
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Note 26 of the same set of CGI FY 2013 financials contains a breakdown of this $282 million increase in working capital. The relevant table from this note is shown below.
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Here, we learn the remarkable fact that the Company's total working capital grew by $282 million even though accounts receivable shrunk by $280 million, and accrued compensation grew by $164 million. Both the shrinking of accounts receivable and the increase in accrued compensation had the effect of reducing CGI's working capital.
Therefore, without the movement in accounts receivable and accrued compensation, the working capital would have increased $726 million instead of $282 million.
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We focus our analysis on the receivables and accrued compensation accounts because we wonder whether CGI can shrink its receivables and grow the accrued compensation further. Receivables and accrued compensation are generally tied to short-term timing differences between accruals and cash flows. Reader should note that:
- Accounts receivable shrunk because CGI received more cash from its customers than it billed, but over time, CGI cannot receive more cash than it bills.
- Accrued compensation increased because CGI recognized charges for compensation in excess of amounts paid out in cash for compensation; in the long term, CGI should make cash payments that match these accruals.
We think it is interesting to consider that if receivables and accrued compensation had not moved over fiscal 2013, the operating cash flow would have been cut by 66% and reduced to $227 million instead of $671 million.
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The $726 million of growth in working capital excluding receivables and accrued compensation is partly due to reversals of valuation adjustments that were made by CGI upon the close of the Logica acquisition. The valuation adjustments (made in accounts such as work in progress and deferred revenue) will be analyzed in a subsequent Seeking Alpha entry. For the moment, we will note that the reversals generated earnings but no cash flows in fiscal 2013.
We will leave it to the reader to determine whether a $726 million increase in working capital excluding receivables and accrued compensation, which creates earnings but no cash flows and is driven by reversals of charges taken in a prior-period acquisition, is consistent with the use of cookie jar accounting.
What has CGI's CFO said about its accounting for the Logica acquisition?
David Anderson, CGI's CFO, has not, to our knowledge, specifically addressed the $80 million reversal of charges at Logica recorded in the 1H 2012 stub period in Schedule B of the Business Acquisition Report.
However, Anderson has made several comments related to other aspects of CGI's accounting for the Logica acquisition. For example, he has addressed the earnings impact of the valuation adjustments made in the Logica purchase price allocation.
Here, we cite two comments made by Anderson in regard to the Company's accounting for the Logica acquisition:
- Q2 2013 earnings call: "When we take a look at all the net adjustments up and down, it wasn't really that significant. If you were to look at note number seven in the financial statements, it did look like there were some other changes that were taking place. A number of those changes were nothing more than just reclassifications, items that were in the short term that have been reclassified to long-term and vice versa. So as we just work our way through the 12 months, we're looking at those assumptions and we just continue to refine those as better information comes forward.To date, there's only been about a 3.8% adjustment to the goodwill, so it hasn't really been significant or material. It hasn't really driven any significant impact to the P&L. Again, just slight refinements within some of the regions and we're trying to make sure that you get visibility to that. We will continue to monitor some of the projects, etc."
- Q3 2013 earnings call: "As you know, under IFRS companies have 12 months from the date of an acquisition to complete the allocation of the purchase price. After nine months, a cumulative impact of all the adjustments to the purchase price allocation on our EPS was negligible representing 0.6%."
In future entries on Seeking Alpha, we will examine issues related to the Logica purchase price allocation onto CGI's balance sheet, and will compare our findings with these and other management statements.
Summary
In this note, we have discussed the following:
- Cookie jar accounting is when a company understates profits in one period, so that it can overstate profits in a subsequent period.
- Logica's business showed years of steady adjusted operating profits until the period just preceding CGI's acquisition of the company; following the acquisition, CGI's European operations saw margin expansion.
- Logica's losses in 1H 2012 were inconsistent with guidance provided by the company in May 2012; the difference between May's guidance and June's results was roughly $500 million in adjusted operating profit.
- The losses in Logica's 1H 2012 were partly due to non-cash provisions taken on contracts.
- $80 million of these provisions were reversed by CGI in fiscal 2013; the reversal of these provisions generated $80 million of operating income but no operating cash flow.
- The total increase in CGI's working capital over fiscal 2013 was $282 million, even though accounts receivable shrunk by $280 million and accrued compensation grew by $164 million.
- Had accounts receivable and accrued compensation remained unchanged over fiscal 2013, CGI's working capital would have increased by roughly $726 million, a figure which is larger than CGI's pre-tax earnings for fiscal 2013. This is important because when working capital grows in a company, it generates less cash flow than it otherwise would with the same earnings and no working capital increase.
- This $726 million figure is partly the result of the reversal of valuation adjustments that were made by CGI for the Logica acquisition. These reversals generated earnings but no cash.
- It is unclear whether and how much CGI will be able to continue shrinking accounts receivable and growing accrued compensation.
In subsequent notes, we will continue discussion of CGI's acquisition accounting and will also look at topics such as organic growth, bookings, government margins, government subsidies, and restructuring charges.
Full Disclaimer:
This article is for informational purposes only and is not investment advice, and does not constitute an agreement, offer, a solicitation of an offer, or a recommendation to purchase or sell any particular security or pursue any investment or trading strategy. This article should not be construed as legal, tax, investment, financial or other advice. This analysis reflects our current opinions regarding CGI Group, Inc. Funds managed by us have an economic interest in the price movement of CGI Group, Inc.'s securities and specifically a decrease in the price of CGI Group Inc.'s shares. Our views and these economic interests are subject to change and we expressly disclaim any obligation to update the data, information or opinions contained in this analysis. We acknowledge that there may be confidential information in the possession of the companies discussed in this presentation that could lead such companies to disagree with our conclusions. Although we may do so, we do not expect to announce subsequent changes in our thinking or economic interests regarding CGI Group, Inc., but it is possible that there will be developments in the future that cause us to change our holdings in CGI Group, Inc.'s securities. We have based this analysis on public sources, including CGI Group, Inc.'s public filings, which can be obtained atsedar.com and sec.gov. While we believe the information presented in this article to be accurate, we make no representation or warranty to that effect, and we cannot guarantee that any projection or opinion expressed in this article will be realized.
Additional disclosure: Please see full disclaimer at the bottom of this article. This article is for informational purposes only and is not investment advice, and does not constitute an agreement, offer, a solicitation of an offer, or a recommendation to purchase or sell any particular security or pursue any investment or trading strategy. Funds managed by us have an economic interest in the price movement of CGI Group, Inc.’s securities and specifically a decrease in the price of CGI Group Inc.’s shares.
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