Unsound Corporate Expansion and Manipulative Accounting Practices

Key Insight

Aggressive, debt-fueled corporate expansion and deceptive accounting characterize several cases of financial collapse. Ling-Temco-Vought, for instance, expanded twentyfold from 1960 to 1967-1968, with sales reaching 2.8 billion dollars, but its debt simultaneously skyrocketed from 44 million dollars to 1653 million dollars. By 1969, combined debt hit 1865 million dollars, marking the start of its downfall, culminating in a 70 million dollar net loss in 1970 and its largest bond issue trading at 15 cents on the dollar. Commercial bankers were criticized for lending huge sums despite the company's interest coverage and other financial ratios failing conservative standards.

The NVF Corporation's takeover of Sharon Steel in 1969 exemplifies extreme financial disproportion. NVF, with 4.6 million dollars in long-term debt and 31 million dollars in sales, acquired Sharon Steel, a company seven times its size, with 43 million dollars in debt and 219 million dollars in sales. The deal involved issuing 102 million dollars in NVF junior 5 percent bonds, causing NVF's pro forma debt to swell to 163 million dollars against only 2.2 million dollars in tangible stock capital for the combined entity. NVF's bonds immediately traded at 42 cents on the dollar, signaling severe financial doubt, yet management leveraged this low bond price for tax advantages.

NVF's post-takeover financial statements included unusual entries: 58.6 million dollars in 'deferred debt expense' as an asset, exceeding total stockholders' equity, while 'excess of equity over cost of investment in Sharon' was excluded from equity. Reclassifying these revealed a reduction of NVF's real equity from 17.4 million dollars to 2.2 million dollars, or from 23.71 dollars to about 3 dollars per share. Further 'accounting gimmicks' involved amortizing deferred debt expense alongside an offsetting credit for 'amortization of equity over cost of investment in subsidiary,' designed to exploit the low initial price of debentures for tax benefits. Additionally, Sharon Steel, under NVF control, changed its pension cost calculation and adopted lower depreciation rates, artificially boosting reported earnings by about 1 dollar per share.