Question - TYCO International

TYCO International was featured in a November 1999, article in Business Week for its accounting methods related to acquisitions. In mid-October 1999, Tyco's market value declined by 23% amid allegations by an analyst that the company was inflating its growth picture using accounting gimmicks along with rumors that Tyco's auditors would resign. Tyco has spent $30 billion on deals in the past three years alone-$23 billion paid with stock. It has focused on mundane technologies-including security systems, electronic connectors, industrial valves, and health care products. Tyco reported that its fiscal 1999 net income before special charges more than doubled to $2.6 billion, and sales jumped 83%, to $22.5 billion. Before the allegations, Tyco's market value was over $80 billion, up from just $1.7 billion in 1992.

Some analysts allege Tyco aggressively managed its earnings using acquisitions to produce eye-popping numbers. Wall Street's short-sellers have long whispered about Tyco's accounting. Tyco is known as a "rollup" company-one that uses its lofty stock price to snap up companies with lower PE multiples-whose acquisitions strategy is now at risk given its stock price decline. Tyco's problems center around aggressive merger-related accounting, including restating downward the results of acquired companies before the deals close to make its future results look better. Most of Tyco's biggest acquisitions are accounted for using pooling accounting. This means Tyco restates its financials, effectively pretending the acquired company was part of Tyco long before the deal closed. These restatements make it difficult to compare one period to the next. Adding to the confusion, Tyco has taken $4 billion in merger-related charges in recent years, changed the end of its fiscal year from December to September, and moved its headquarters from the U.S. to Bermuda for a lower tax rate. One analyst claims that Tyco is using huge charges to create "cookie jars" of reserves against future operating expenses.

Indeed, Tyco's earnings look anything but stellar once the massive charges are taken into account. With these charges, Tyco shows huge net losses in both fiscal 1996 and 1997 and an 83 percent drop in net income in the first nine months of fiscal 1999. However, Wall Street convention is to overlook such charges, figuring that pro-forma earnings provides a better picture of "normalized" earnings.

Tyco rejects all allegations. Its CEO says the SEC conducted full legal and accounting reviews of filings for Tyco's three largest deals over the past two years. The CEO also says only 6 of the 120 recent deals involved pooling, although it was applied to some of its biggest deals. Accounting questions aside, Tyco is adept at cutting costs. For example, Tyco has cut annual operating costs by $200 million at U.S. Surgical since its acquisition in 1988. However, former U.S. Surgical execs and competitors say Tyco may have lost some of the innovation needed to ensure its future in an evolving medical supply business. Said one exec, "They had a lot of interesting products in the pipeline, but [Tyco] pulled the plugs on all of that."

Required:

a. Describe how merger-related accounting inhibits a user's ability to use accounting reports to make period-to-period comparisons. Is this true for both the purchase method and the pooling method? Explain.

b. Explain why a high price-to-earnings ratio is crucial to Tyco's acquisitions strategy.

c. How do merger-related charges potentially enable a company to inflate future operating earnings? How can a user of financial statements assess whether this is occurring?

d. Many short-term gains in acquisition come from cutting costs. What potential long-term harm can cost-cutting create?

e. Tyco's controversy is arguably a quality of earnings concern, where Tyco strategically used the discretion in GAAP. Why is the market's reaction to this alleged behavior so severe?

f. Many companies report pro-forma earnings that exclude one-time acquisition costs and, increasingly, goodwill amortization. Critique the use of pro-forma earnings for financial statement analysis.