Financial Investigation :Mendoza is considering investing in IBM. However, he is captivated by IBM's growth at an average of 27 percent per year since 1994.
IBM had made a remarkable change from a struggling company to a leading company in the personal computer market. Mendoza has asked for your advice as to whether the growth is genuine. He suspects there might have been some fraudulent or unethical actions taken by IBM to increase its income.
After a brief look at the recent history and performance of IBM, you decide to look more closely at the financial statements. As you review the financial statements, you begin to have some concerns about the true nature of IBM's growth.
Certain accounting procedures cause doubts as to whether the growth came from IBM's core business operations or from carefully planned accounting adjustments that seem to be unethical. As you proceed in your investigations, you pay particular attention to the following areas: Pensions: IBM changed its pension plan to a cash balance plan.
The returns of this plan exceeded the amount recognized as an expense. Accounting rules require the company to add the excess returns to earnings, but the gains cannot be spent on anything other than pension benefits.
IBM increased its earnings per share by making this adjustment.
Stock Repurchases: Since 1995, IBM spent a lot of money making stock repurchases. A stock repurchase may be beneficial to a company by increasing earnings per share, because earnings will be spread across fewer shareholders.
Questions: You conclude that the financial statements are in accordance with GAAP, and are confident that all accounting rules were followed.
However, you have to explain to Mendoza whether the behavior was ethical.
What would you tell him? How do you explain your findings to the average potential investor?