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Short-term solutions spell disaster

Quick-fix solutions and not making provisions for unforeseen circumstances can cost a company dearly and substantially erode investor confidence, says R. Srinivasan.

COMPANIES are under such pressure to maintain growth in turnover and profitability that their managements often look for short-term solutions to problems that could strike at the very roots of their existence. Top management tends to take a myopic view of the potential of these problems to cause unmitigated disasters in the long term. These ad hoc, short-term, solutions are a virtual minefield for the unwary investor whose investments in the company could be wiped out, in value terms, in a matter of days. This article seeks to highlight the dangers of quick-fix solutions by studying some recent cases of mismanagement that eroded credibility and investor confidence.

In recent weeks, Japan has been rocked by a number of crises in corporate management, even involving the retrograde step of recalling defective products from the market. Food products have been seriously hit, as some have caused widespread food-poisoning and pose a serious health hazard. Snow Brand Milk Products, which commands market shares of 19 per cent in milk and 44 per cent in cheese and grossing sales of over $12 billion last year, decided to shut down its 21 factories in the country for emergency inspections following reports of more than 14,000 people falling ill after consuming its low-fat milk. The problem is attributed to the company recycling all milk products returned from retail stores, including milk past its expiry date and milk from open containers. These were mixed with fresh milk, re-pasteurised and resold.

In addition, the milk was collected and mixed in an unrefrigerated tank before being re-processed. The processing equipment was not been cleaned for three weeks, and was infected. The company has also withdrawn other products from the market. Preliminary investigations reveal that the plants tried to cut corners by dispensing with the continuous cleaning and maintenance of the equipment. Such short-term measures have now boomeranged on the company, besides causing irreparable loss of credibility in the long-term.

The second case relates to Mitsubishi Motors, which has always been proud of its reputation for quality engineering. Since 1977, the company took no notice of 64,000 consumer complaints that reported defects such as failed brakes, fuel leaks and malfunctioning clutches. Such reports were routinely filed. However, it was found that government regulations to ensure passenger safety had not also been complied with. By end of August, the company agreed to recall for repairs 620,000 vehicles in the US and Japan and, another 200,000 sold in the rest of the world. The repair bill is expected to exceed $69 million. The company's President offered to resign, assuming full responsibility for the failure to highlight the vehicles' defects to its customers. An annual provision in the accounts for these defects on vehicles to be recalled could have adequately served the purpose, instead of the knee-jerk reaction involving massive losses to be borne in one year.

The third case that is hogging the limelight in the US and Japan is also a Japanese company. Bridgestone/Firestone is one of the world's oldest and largest tyre makers with a long-term relationship with the Ford Motor Company, supplying the tyres for the cars rolling out of the latter's assembly units in North and South America. Following reports of deaths and injuries from accidents involving vehicles fitted with Firestone tyres, Ford Motor has been replacing Firestone tyres with Goodyear tyres on its cars in use in Venezuela. This step was based on its own initiative but in expectation of Firestone taking appropriate measures for the rectification of the defects on its tyres. However, only in mid-August, when over 54 fatalities and 100 injuries were reported from owners of vehicles using Firestone tyres, Firestone began recalling its tyres. Over 6.5 million potentially defective tyres would be recalled and replaced with tyres with Nylon caps. All the cars presently on recall would be replaced with new Firestone tyres. However, what is surprising is that this is happening to a company that had to recall 14 million Firestone 500 tyres in 1978. A provision for the costs of such replacements could have been made since 1998, when the existence of the defects first became known, instead of the entire cost of replacements being borne in a single year.

The fourth case is that of a well-known software and service provider based in the US, which recognised as income a software sale of over $50 million in one year's accounts when performance under the sale and service would extend over several years. This company, like all Internet companies, was woefully short of revenues in 1998 and 1999 and treated the accounts thus as it was going in for a rights issue of shares and did not want to jeopardise the issue price with the low revenues reported in its accounts. Surprisingly, the auditors also did not advise the company about complying strictly with accounting standards that exist for revenue recognition.

The accounts of the company had to be restated, following which sales were revised downward from $205 million to about $150 million. The company's shares suffered deep erosion on the bourses as a result of the downward restatement of revenues. There have also been cases of other companies according this treatment to the revenues in the accounts, necessitating a restatement of the accounts. This should act as an eye-opener for all investors in Internet and other software companies as income that should be spread over a period of time is likely to be over-stated by being recognised in the year in which the sale was concluded but for which performance is still due. What is more surprising is that even the auditors, an international firm of repute, did not report this aspect until the accounts were restated.

One of the most devastating blows that any company could suffer is that of claims with respect to loss of life from any of its products which could not be foreseen. Johns Manville Corporation is an American corporation that manufactures asbestos, which in recent years has been branded extremely dangerous to human beings due to its carcinogenic nature. The company had to shell out huge sums on asbestos-related damages and the volume of these claims overwhelmed the company. It had to file a petition for bankruptcy, its assets being far short of potential claims. The other US asbestos manufacturers that also suffered huge losses on claims were Owens Corning and Armstrong Industries, both suffering from downgraded credit ratings. These asbestos-related claims also undid a venerable British insurance corporation in the business for over three centuries. The magnitude of claims from Johns Manville and others was so huge that the British insurance corporation had to approach the capital market for a fresh infusion of capital. But with financial results resplendent with losses from asbestos-related claims, there was no way it could meet the liabilities without going to the shareholders for a rights issue. To garner subscriptions for such a rights issue, the British corporation dressed up its accounts, closing the books well in advance with huge losses lurking in the horizon to be met immediately after the closure of accounts. Notwithstanding the imminent losses to be met from the rights issue proceeds, shareholders were more than willing to subscribe for their rights as it was a rare honour and privilege to own shares in the three centuries-old company -- an institution by itself. The expediency or the short-term solution to the impending problem through the share rights issue, overlooking the purpose for which the proceeds would be deployed, was clearly a suppression of material facts from those shareholders. However, even such a big corporation was not averse to finding a quick-fix solution.

Another instance of a company using expediency to solve its problems and not disclose adequate information to its investors is that of an American software company, whose application for an IPO issue is currently under process. This company, though calling itself a software company, deals in everything from auto dealerships to a mutual fund and has shareholdings in about 30 Internet companies. None of the company's operations, or that of its associate companies, is profitable, yet its latest accounts show an impressive profit figure of $118.5 million, all of which have accrued from the sale of shares held by it in its investee companies. Revenues from this source, although strictly falling under `other income' and not from its regular operations, have been classified as its own revenues and the final profit, therefore, derived from such revenues. It has no worthwhile business portfolio, as yet, of its own other than collecting small management fees from each of these investee companies and periodically showing profits from the sale of shares held by it in the investee companies. Analysts have commented that ``the core operations of the company are not profitable. They are not covering any of their costs. It looks like it is going to be a long time before they are anywhere near profitability on the basis of their own operations''.

In conclusion, one can only keep one's fingers crossed as business, in general, is a minefield -- no one can say when a seemingly profitable company could become a bete noire, with liabilities arising from nowhere and plunging the company into a quagmire of losses.