By the look of things, business couldn't be better at Heilig-Meyers Co. After four years of acquisitions, the furniture and home-accessory retail chain has grown 46%, to 589 outlets. Last year, profits swelled 45%, to $55 million, as sales rose 31%, to $864 million.
Sound just a little too rosy? Howard M. Schilit certainly thinks so. After the American University accounting professor looked at Heilig's books recently, he was decidedly less upbeat. For starters, the company includes installment purchases in revenues before sales are final, says an Aug. 15 report Schilit wrote. More significant, its three years of steadily rising net income obscured rapidly growing cash-flow deficits. Last year, Heilig's negative cash flow totaled $75 million. While emphasizing that Heilig's financial-reporting practices are perfectly legal, Schilit says "these aggressive accounting policies may distort the true financial condition" of the company.
Whether ferreting out instances of allegedly overstated revenues, as in Heilig's case, or showing how some companies can artificially depress current earnings to assure a big gain in subsequent years, Schilit is quickly earning a reputation as one of the top forensic accounting analysts in the country. He's one of a handful of front-line sleuths who are picking apart corporate earnings reports in the wake of criticism that traditional outside auditors are falling down on the job of stopping misleading--or downright fraudulent--accounting practices.
As head of his own part-time consulting firm, the Center for Financial Research & Analysis, Schilit boasts a client list that includes some of the biggest money managers in the country, such as Fidelity Investments, Teachers Insurance & Annuity Assn.-College Retirement Equities Fund and The Portfolio Group of Chemical Bank, as well as the Council of Institutional Investors.
OVERZEALOUS? Equally long is the list of Schilit critics who lambaste the mild-mannered professor for what they see as his overzealousness or misinterpretation of accounting rules. "The whole report is completely erroneous and full of inaccuracies," fumes Heilig Treasurer Roy B. Goodman. He argues that accounting rules support the company's interpretation of when to book installment revenues. As for the negative cash flow, Goodman says "it simply reflects the rapid expansion of a high-growth company." Irwin S. Cohen of Deloitte & Touche, Heilig's outside auditors, dismisses Schilit's analysis as "off-base."
Heilig's managers aren't the only ones angry at Schilit. He has studied the financials of 39 companies over the past year. The result: 24 companies on which he wrote negative reports have seen their stock dragged down by an average of 31%. Critics charge that even an off-base analysis can send stock prices plummeting, spark investigations, and trigger costly lawsuits.
Schilit's specialty is flagging the frequent--and perfectly legal--gambit of "window dressing," which puffs up profits and revenues. He is not alleging fraud; indeed, the accounting techniques he highlights are allowed under generally accepted accounting principles (GAAP). But GAAP rules are subject to wide interpretation--and companies have great leeway in choosing how conservatively or aggressively they account for financial transactions. Schilit's aim is to make sure investors know how solid the numbers in company accounts really are.
Schilit became well known when he figured in the stunning fall of supercomputer maker Kendall Square Research Corp. After going public in early 1992, Kendall's shares more than doubled, to $22, within a year, as revenues soared from $904,000 to $20.7 million. Suspicious of that growth, Fidelity hired Schilit to look at the company. In a September, 1993, report, Schilit argued that Kendall was booking sales for which no cash was coming in. Kendall's auditor, Price Waterhouse, subsequently discovered that Kendall was claiming revenue from computer sales to universities that had not paid for the equipment. Price Waterhouse revised 1992 revenues downward to $10 million, and said that a loss of $12.7 million should have been $21.6 million. For 1993, Kendall reported a net loss of $67 million on revenues of $18 million, and its stock was delisted by NASDAQ after falling to 21/8 in April.
By uncovering such cases, their supporters say, Schilit and other forensic accountants are a needed counterweight to the securities analysts, auditors, and short-sellers who may have financial conflicts of interest that influence their reports. "His value to me is fleshing out the mismatch between reality and accounting," says Schilit client Abraham Bronchtein, research director at Chemical Bank's portfolio management unit.
FINANCIAL FERRETS. Some experts fear the financial fudging will increase, as shaky companies that went public during the recent stock market boom try to prop up high share prices. They may be tempted "to contrive transactions to increase income or take out expenses," says Abraham J. Briloff, an accounting professor at City University of New York's Bernard M. Baruch College.
Briloff and other critics of the accounting profession say investors can't always depend on independent auditors to ferret out such practices. With the Big Six depending more on management consulting services for income, some experts fear that the firms are unwilling to sacrifice the consulting business to go to the mat over accounting issues.
Often, securities analysts aren't much help either. Dallas-based David Tice, who publishes the newsletter Behind the Numbers, notes that it's rare to get downbeat analyses or "sell" recommendations from equity analysts. "The purpose of most Wall Street research is supporting the firm's underwriting business," says Michael Murphy, publisher of the Overpriced Stock Service, a newsletter for short-sellers.
Of course, investors have to be equally wary of short-sellers' incentives for trashing a stock. It's just that battle of conflicting agendas that has left a lucrative niche for independent gumshoes such as the 42-year-old Schilit, who doesn't invest in or make recommendations on the stocks he writes up.
RED FLAGS. Schilit's method for targeting companies is less than scientific. He scours published lists of hot-growth companies, looking for companies whose stock prices have tripled in 18 months. Last winter, Pyxis Corp., a San Diego outfit that makes and leases automated systems for distributing medications, piqued his interest after its stock soared from $10 to $37 in less than two years. His Mar. 3 report concluded that the sharp rise in revenues--from $13.4 million to $100 million--that Pyxis had reported over the past three years was "misleading" and "unsustainable." Just before going public in 1992, Pyxis started booking revenues from equipment leases as if they were outright sales, rather than spreading them over the life of the lease, Schilit says. Although permitted by accounting rules, he says the practice "exaggerates the growth in sales and earnings."
Reaction was swift. Pyxis' stock price fell to $20 by late April. Four shareholder lawsuits were filed, although they were eventually dropped when no evidence of fraud was found. "The report was not responsible; it contains several factual errors," says Nadine Padillo, investor relations officer for Pyxis. A letter from auditor Ernst & Young defending the practice was printed as an ad in Investor's Daily. "There is no acceptable alternative," the firm declared.
Schilit also looks for financial-statement chicanery at companies where there are management red flags: boards packed with people who have ties to the company, questionable compensation arrangements, and insider stock sales before bad news. One example of a company whose management practices gave Schilit cause for concern: Checkers Drive-In Restaurants Inc. in Clearwater, Fla. His Feb. 14 report noted that Chairman Herbert G. Brown named two sons, both in their 20s, as executive vice-presidents, and it claimed that the board has no truly independent outsiders.
In looking at Checkers' books, Schilit found examples of aggressive accounting in 1993 that he alleges hid the company's deteriorating condition. Checkers' rapid earnings growth came to a halt in 1994's first half, as the company posted a $500,000 loss, compared with $7.8 million in profit for the first half of 1993.
POOL HAULS. Schilit points out that when Checkers sells its modular restaurant kits to franchisees, it books the full sale price as revenue during construction, before the sale is completed. He also criticizes Checkers for making frequent acquisitions with stock and accounting for them by a favorable method known as "interest pooling." The result, he says, is that Checkers' own earnings could have received a deceptively large boost from consolidating earnings from acquired restaurants.
Checkers officials reject the criticism. "Our accounting methods are dictated by generally accepted accounting practices and have been approved by the SEC and our outside accountants," says one. KPMG Peat Marwick, Checkers' auditors, declined comment. The company's stock, at 51/16, is down 57% since December 1993, following Schilit's report and a shareholder suit alleging securities fraud.
Schilit's reports don't always precipitate a stock drop. The share price of Seitel Inc. has increased 11%, to 313/4, since it was the target of a critical report in May. The Houston seismic-data company got a boost from good drilling news in its recently started oil-and-gas-exploration business. But that hasn't changed Schilit's opinion. He complains in his July report that Seitel books all the costs of gathering its seismic data as assets rather than charging some as expenses. That could overstate earnings and net worth. He also thinks revenues could suffer because Seitel understates the risk of nonpaying accounts. "Time will tell if I'm right," he says.
Seitel replies that Schilit's complaints smack of overzealousness. Debra D. Valice, Seitel's chief financial officer, says that "capitalizing exploration costs is an acceptable practice in the oil-and-gas industry." The company's accounting methods have won approval from Arthur Andersen & Co., its outside accountants, as well as the IRS and the SEC. Moreover, Valice says Seitel has no need to increase provisions for bad debts, because the company suffers only minor write-offs. "It's unfair to criticize companies for using accounting methods that are allowed by the rules," says Philip D. Wedemeyer of Arthur Andersen.
Still, major energy companies don't typically capitalize 100% of exploration costs. The dispute highlights how unscientific accounting can be. In an effort to make reporting more precise, an advisory committee to the American Institute of Certified Public Accountants has recommended instituting stiffer disclosure requirements by yearend 1995. But the move is strongly opposed by the Business Roundtable and the Conference Board. Whatever the rules, many accountants say there are limits on what they can do. As long as companies can find accounting loopholes to exploit, sleuths like Schilit will have a field day.
QUESTIONING THE NUMBERS Company CHECKERS Business Franchises and operates fast-food restaurants Revenues $189.5 million, up 80% Earnings $15 million, up 21% Stock price 5 1/16 , down 57% since Schilit's Feb. 14 report Schilit's When selling restaurants to franchisees, Checkers books sale analysis price as revenue immediately, before the sale is completed. High ly favorable accounting for acquisitions allows overly rapid con solidation of earnings. Company Company follows generally accepted accounting practices in all response transactions. Company HEILIG-MEYERS Business Furniture and home-accessory chain Revenues $864 million, up 31%* Earnings $55 million, up 45% Stock price 24 7/8, down 5% since Schilit's Aug. 11 report Schilit's Company books installment purchases as revenues before sales are analysis final. Despite rising net income, Heilig has negative cash flow that totaled $75 million last year. Company Company says accounting standards support its interpretation of response when sales are final. It also says that negative cash flow reflects aggressive expansion and cost of building new stores. Company SEITEL Business Seismic-data provider, oil and gas explorer Revenues $47 million, up 50% Earnings $5.7 million, up 26% Stock price 31 3/4, up 11% since Schilit's May 24 report Schilit's Company books cost of all exploration analysis activities as an asset. Has not established sufficient allowance for doubtful accounts. Company If customers don't pay bills, earnings and revenues will have response been overstated. Capitalizing all exploration costs is an accept able accounting method for oil companies and is approved by the SEC and the IRS. Company has no need for larger provisions as bad debts have been minor. *Fiscal year ended Feb. 28