Macy’s, America’s iconic department store chain, delayed third-quarter earnings in November, pending investigation into an accounting discrepancy which allegedly hid more than $132 million in expenses over a three-year period through to November this year.
The discrepancy, allegedly perpetrated by an undisclosed employee who has since left the company, involved the incorrect recording of small package delivery expenses. Since these expenses totalled $4.36 billion during the period in question, a very large sum, small expenses were easily hidden. Macy’s has assured shareholders that the incorrect expense billing had no impact on its cash management or payments to vendors. Thus, only the revenue statement and the balance sheet were impacted.
Macy’s internal investigation is scheduled to end on Dec. 11. While the company has taken swift action, the incident has set the company on an uncertain course, not least with a looming takeover. In July, Macy’s board terminated discussions with Arkhouse Management and Brigade Capital Management, investors who had offered to buy Macy's with a bid valued at a 53% premium to its share price.
In rejecting this bid, Macy’s potentially impacted its parent, Banco de Sabadell, which is itself battling a hostile takeover. By rejecting the buyout offer and disclosing accounting violations, Macy’s board has created something of a poison pill for its parent. Whatever happens, Macy’s will be sold once the takeover battle for the parent is resolved.
The accounting event underscores the need for transparency at all levels of operations. Without transparency one cannot implement effective internal controls and thereby safeguard business integrity.
In this day and age, boards simply must confirm the quality of their financial accounts. It is an essential part of their governance mandate.
Could Macy’s board have detected the problem much earlier if it had the right system in place? The answer is yes, and Transparently.AI has the perfect tool.
The Transparently.AI risk analyser provides a rating of accounting manipulation risk ranging from A+ to F, with A+ representing the lowest risk and F the highest. This rating reflects a company's accounting quality, transparency, and governance. It combines a company's accounting quality risk score with its relative position within its market and sector in the same region and year. It is the perfect tool for a board to assess account quality.
But the system does more than simply offer a risk score. It provides detailed diagnostics, explaining what investigative steps should be taken in response to potential issues. It can even provide a list of penetrating questions to ask the CEO.
While the system cannot predict specific events like the Macy’s employee’s fraudulent activity, it did highlight several red flags that align with the manipulation. The Transparently system could have warned Macy’s board there were problems afoot and provided the necessary steps to investigate the issue.
From the outset, we know that Macy’s cash-flow statement was not affected. We are told by Macy’s that inappropriate accrual accounting was used to conceal expenses. The objective here was to inflate earnings.
The mechanics of accrual manipulation are straight forward. Instead of booking an expense in the current period, one books it as an accrued expense in the balance sheet. The idea here is that one has paid for a product or service not yet delivered, and it will be expensed when it occurs in the future. The entry shifts expenses to future periods, making the current period's financial performance appear better than it actually is. It inflates long-term assets and boosts shareholder equity.
The Transparently.AI system delivers its assessment of account quality with reference to 14 risk clusters. The type of manipulation that occurred at Macy’s should have been reflected in two main risk clusters: smoothing activity and working capital signals. It might also have been flagged in risk clusters for income, asset quality and corporate governance.
The Transparently.AI system gave strong warning signals in all of these areas.
The smoothing activity cluster is specifically designed to detect unusual patterns in financial data that suggest attempts to minimize earnings fluctuations. Since manipulating accruals to hide expenses aims to create this artificial stability, it would most likely be flagged by this cluster.
While the smoothing activity cluster is a primary indicator for accruals manipulation, other clusters can provide a more comprehensive view. Working capital signals are paramount here because abnormal use of accruals will cause unusual changes in the linkages between working capital accounts (accounts payable, accounts receivable, provisions) and cash flow.
These sorts of abnormalities can be difficult to discern but are usually captured by the Transparently risk engine. If the use of accruals is aggressive, it will show up in the asset quality cluster as a warning for unusual growth of “other long-term assets” or possibly intangible assets. Companies experiencing a downturn should demonstrate shrinking intangibles. Growing intangibles would be a red flag.
Frequent use of accruals to hide expenses is typically associated with frequent abnormal losses or restatement of accounts. Investors rarely look at past quarters so moving an accrual back to where it belongs will improve the current quarterly result. Frequent restatement of accounts shows up in the risk cluster for corporate governance.
Signs of account manipulation rarely appear in just one isolated part of the accounts.
Signs of account manipulation rarely appear in just one isolated part of the accounts. If there are problems with accruals, there will often be tell-tale evidence of smoothing in other areas of the accounts. Most notably, we should look at asset quality for signs of understated depreciation expense. One should also look at the income quality cluster for signs of hidden expenses. This should be apparent in risk warnings for such things as aggressive capitalization of interest expense or high income from non-operating areas.
As mentioned, the Transparently system gave strong warning signals in all of the areas just discussed. The system gave Macy’s a risk rating of C- in the period of alleged manipulation, which put it in the bottom 40% of all companies in Transparently’s global database, and warned of significant issues with account quality.
Through this period smoothing activity, working capital signals, income quality, asset quality and corporate governance were the principal risks flagged by the system although the exact order changed from year to year.
Transparently’s system provides detailed risk reports for each year of a company in the database. Figure 1 provides an overview of Macy’s risk assessment for 2022. Here we see red flags for all five of the risk clusters we expected to find in a company experiencing manipulation of expenses.
Figure 1: An overview of the Transparently risk report for Macy’s in 2022
Figure 2 shows a more granular view of the risk clusters causing concern. Most of the risk signals mentioned, such as growth of other long-term assets, high intangibles, interest capitalization and accounts restatement, are shown.
Figure 2: Granular view of the Transparently risk report for Macy’s in 2022
Faced with these red flags, the system made numerous suggestions, including:
The bottom line is that the Transparently system anticipated various problems at Macy’s, all closely related to the disclosed problem and some of which went beyond the disclosure made in late November.
All of these red flags warrant further investigation by the board. The main message is that software exists to enable boards and senior managers to rigorously test the quality of the accounts of the companies they represent. There is no longer any excuse for negligence in this matter.
Disclaimer: Views presented in this blog are the author’s own opinion and do not constitute financial research or advice. Both the author and Transparently Pte Ltd do not have trading positions in the companies it expresses a view of. In no event should the author or Transparently Pte Ltd be liable for any direct or indirect trading losses caused by any information contained in these views. All expressions of opinion are subject to change without notice, and we do not undertake to update or supplement this report or any of the information contained herein.
About the author: Mark Jolley has been an investment strategist for almost 40 years and has advised some of the world’s biggest investment funds, public companies and notable investors. In the mid-1990s, as a global investment strategist with Deutsche Bank, Mark produced a daily note read by more than 16,000 investment professionals including voting members of the Federal Reserve and the European Central Bank. In the 2000s, Mark worked as Deutsche Bank’s Asian strategist and then as strategist for China Construction Bank. He is now an independent analyst.