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03.07.2005 | 14:34   By Uri Ronnen

On Thursday, slightly before the witching hour Israel time, Taro Pharmaceutical Industries (Nasdaq: TARO) filed its report for 2004, the so-called 20-F, with the U.S. Securities and Exchange Commission. On Friday I surfed to the SEC website to read it.

In item 18, including the audited financial statement, Taro revealed its cash flow statement for 2004 for the first time. It showed a negative cash flow from operations: minus $1.8 million. But in item 5, the management's discussion & analysis, Taro wrote that its cash flow from operations had been minus $21.8 million.

It was no typo: Taro related to the $20 million difference in its notes, where it unveiled the financial details of the Medicis deal, which had appeared somewhat more creatively in its books.

I therefore emailed its chief financial officer, Kevin Connelly, and investor relations manager Daniel Saks, who work out of New Jersey. I suggested that the mistake indicates an argument between the company and its auditors over how to classify the $20 million in the cash flow statement: in practice the mistake shows that even the management thinks the "real" cash flow is minus $21.8 million, not minus $1.8 million.

Three hours later the company corrected course

Three hours after I sent that email, Taro filed an amended 20-F, replacing $21.8 million with $1.8 million, so the executive analysis no longer contradicted the audited financials. Saks said the company was correcting a typo.

The origin of the mistake was a deal dating from July 2004, when Taro acquired licenses from Medicis to market four products, with an option to purchase these product lines in the future. Medicis reported the transaction to the SEC in July, clarifying that the financial terms of the deal have not been disclosed. The secrecy was odd, as Taro had been open about a similar deal in January 2003.

In its 20-F last Thursday, Taro discloses for the first time that the aggregate purchase price will be $35.6 million and as part of the agreement, Taro received $20,000 from Medicis with which it established a reserve, reducing accounts receivable and including it in cash flows from operating activities.

For that $20 million, Taro undertook to handle refunds and other rights that Medicis granted to customers.

A Freudian slip of the keyboard

Taro defined the $35.6 million as negative cash flow for investment, and that $20 million as positive cash flow from operations in 2004. The difference begs two questions.

First of all, if the four product lines were considered stand alone "business", then under accounting rules, the net of the two sums - $15.6 million - would have appeared as cash flow used for investment. It makes no sense that buying an activity, bundled with service to customers, will create instant cash flow upon the acquisition.

Secondly, both sums result from the same commercial agreement, meaning both parties care only about the net cash exchanged. So splitting the net into two sums reeks of artificiality. Taro doesn't mention if it used an independent appraiser when splitting the net into two sums.

The auditors' hesitance about classifying the $20 million as operating cash flow is evident. Unusually, the part of the cash flow report relating to the flow from operations refers the reader to the note discussing the Medicis deal. The referral and the disclosure of ostensibly secret figures seem to indicate that somebody thought their absence would mislead the reasonable investor.

In any case, it is clear that the $20 million were one-time in nature, so the mistake in the executive review had been highly Freudian in nature, exposing what the management really thinks about the magnitude of negative cash flow in 2004.

Greg is surprised

As in 2004, this year Taro took advantage of its status as a foreign issuer not to release quarterly cash flow statements, and to publish its annual report six months after the year ended.

Taro's cash flow from operating activities, excluding the Medicis one-time effect (USD Millions):

One person nastily surprised by the negative cash flow for 2004 is probably Merrill Lynch analyst Greg Gilbert, who's been tracking the company. On May 17, Gilbert wrote that the company had reached $110 million cash flow from operations in 2004 and that's no typo either. In June 2004, Taro surprised investors by presenting an extraordinarily low cash flow for 2003, but at least it was still positive.

Meanwhile, in its 2004 statement Taro reveals that Israeli banks and institutional investors from which it had borrowed $110 million in 2003, had agreed a few months ago to waive a covenant, under which Taro was to have a coverage ratio (between Ebitda, and net interest and principal payments) of 2 or more.

Expert Opinion Charles Mulford, a professor of accounting at Georgia Tech and the coauthor of "Creative Cash Flow Reporting: Uncovering Sustainable Financial Performance," kindly expressed his opinion on Taro's creative deal with Medicis: "If we take the transaction at face value, it appears to be an acquisition of assets with a fair value of $35,565, accompanied by an assumption of certain of the seller's liabilities, valued at $20,000. My view of the proper accounting for such a transaction is to treat it as a net investment of $15,565, which should be reported as an investing use of cash. "Most analysts and investors consider operating cash flow to be a recurring, sustainable, renewable source of cash. The $20,000 received from Medicis related to the product line purchase certainly does not have these qualities."

Taro doesn't say so explicitly, but clearly it couldn't fulfill that undertaking. The loan agreement was amended so the covenant would only apply from 2005. The original agreement banned Taro from raising more debt financing if it failed to fulfill the covenant, but now Taro says that under the amended agreement, failure to meet it "may restrict its ability to incur additional debt in Israel".

The company opaquely adds that it agreed that two investors, who had lent to $6.5 million, check its coverage ratio on August 15, for the 12 months ending on June 30. But the company doesn't say what the investors can do if it fails the test.

A few months after raising money locally, Taro shocked the market by presenting especially weak results for the first half of 2004. Class action motions, accusing Taro of stuffing wholesalers with goods in 2003 and hiding the deterioration of its cash flow, did not delay. In its report for 2004 Taro sheds some light on the 2003 affair, and to a degree justifies the claims. More about that in the next column.

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22.12.03 | 01:40   By Uri Ronnen

What would you say if you found the Health Ministry sampled fewer cold cuts imported from America than it did Israeli produced ones, even if they carried the same risk of failing to meet standards?

What would you say if the ministry defended its policy by saying "American Health Department supervision is among the most stringent in the world" -- although the U.S. regulator barely checks cold cuts exported to Israel?

You would probably say the Health Ministry was sacrificing consumers' safety to importers' profits.

This scenario is purely fictitious. But if you substitute the ISA (Israel Securities Authority) for the Health Ministry and the financial reports of dual-listed companies for cold cuts, you would move from fiction to fact.

This worrying situation exists because the ISA has declared it does not check financial reports of dual-listed companies as stringently as it does for companies traded only in Israel -- even though the American SEC (Securities and Exchange Commission) doesn't properly oversee reports of dual-listed companies either.

Every year since 2000 the ISA has said in its annual report to the Finance Minister and the Chair of the Knesset Finance Committee that although the ISA's authority over the dual-listed companies and other publicly traded companies is identical, the ISA "takes it into consideration that these [dual-listed] companies are already supervised by SEC, whose level of supervision is among the highest in the world."

This is an outrageous statement because the ISA chooses to ignore the fact that two types of companies are traded on U.S. stock exchanges -- domestic and foreign stock issuers. All the dual-listed companies on the Tel Aviv Stock Exchange are foreign issuers in America. Everyone who knows a bit about the enforcement policy of the SEC -- analyst, lawyer, journalist, accountant or academic researcher -- is aware that the SEC knowingly neglects enforcement on foreign issuers.

True, the level of SEC supervision is indeed "the highest in the world" -- but only for domestic issuers. In a December 2001 Forbes magazine article, Elizabeth MacDonald, one of its senior editors, highlighted serious problems in the financial reports of a few foreign issuers, and then warned: "Don't count on the SEC to monitor this situation closely. The agency is preoccupied with domestic problems."

MacDonald said that "while the agency says it's on guard, the SEC Web site shows just two accounting enforcement actions since 1998 against foreign companies that trade as ADRs, as opposed to 388 filed against U.S.-based companies."

Urban Myth

Dr. Amir Licht of the Interdisciplinary Center in Herzliya, one of the world's experts in dual listing, says the ISA's attitude is based on an urban myth. In an article in "Mishpatim," the Hebrew University's legal journal, that cast doubt on the ISA's assumption, Licht cites a study conducted by Prof. Jordan Siegel of the Harvard Business School, indicating that "the SEC tends to refrain from regulating non-American issuers."

Siegel first examined the enforcement regarding Mexican companies that are registered in the United States, where it was public knowledge that some companies were guilty of serious fraud. Siegel found, however, that no steps were taken against them or against their controlling shareholders. A broader survey conducted by Siegel regarding all the foreign issuers revealed a similar situation. Licht says the findings were confirmed by senior SEC officials whom Siegel interviewed.

Siegal's research confirms what Israeli investors have suspected for a long time -- the SEC neglects them. This is how they felt, for example, when the SEC ignored the class action suits filed against Israeli companies such as ECI Telecom (Nasdaq: ECIL), Nice Technologies (Nasdaq: NICE) and Commtouch (Nasdaq: CTCH), for inflating revenues -- and which ended in compromises in which the companies agreed to compensate investors. If those companies had been local issuers the SEC would certainly have opened its own investigations.

Commtouch case is particularly interesting, since it and its U.S. competitor Critical Path have restated revenues that were manipulated more or less in the same quarters and by the same tricks. The SEC filed and settled a civil fraud action against the American company but ignored the Israeli company.

Prof. Eli Amir of the London Business School says there are several instances of Israeli companies registered for trade in the U.S. and applying accounting practices a local company would never dream of using.

"Every time I see this, I am surprised all over again, especially when one considers the stiff regulatory environment in the U.S.," Amir said. "Then I met an investment banker at HSBC, who explained that the SEC cannot justify the allocation of limited resources for enforcement against companies whose shareholders are mostly not Americans."

The SEC also avoids investigating suspicious reports by foreign companies, due to the high costs involved in gathering evidence in foreign countries, and the difficulties in obtaining the cooperation of accountants and foreign supervisory bodies.

Insult to Injury

The ISA's declaration that it relies on American supervision is reflected too in the field. For example, the ISA has a good record of successfully forcing companies to disclose the financial covenants to which they were committed in financial agreements. But when asked why it did not demand similar disclosure in the financial reports of the leveraged Koor conglomerate, an ISA official said Koor is a dual-listed company and cited ISA's enforcement policy declaration.

Does that ISA official truly believe that Koor's shares are of any more interest to the SEC than the snow that fell in Tel Aviv in 1951? The ISA's disregard for the SEC's dismal enforcement on foreign issuers makes matters even worse: a 2000 amendment to the Securities Law, approved under pressure from the TASE and the Association of Publicly Traded Companies, allows Israeli companies that are traded in the U.S. to register for trade in Israel on the sole basis of sparse reports they file in the U.S. as foreign issuers.

Last week it became known that Alvarion (Nasdaq: ALVR), a dual-listed company that provides even less quarterly disclosure than other foreign issuers, will be joining the prestigious Tel Aviv 25 Index next week. A few weeks ago, for the first time and without a public debate, the ISA granted its approval to dual-listed Sapiens Software Systems to raise capital in Israel based solely on its scanty reports as a foreign issuer in the U.S.

Given these two instances, we asked the ISA last week whether the time had not come to desist from granting enforcement discounts to dual-listed companies. "These are companies that issue according to American law," responded the ISA's spokesman. This statement ignores the fact that the U.S. has different disclosure regimes for domestic and foreign issuers, and gives no hint of the gap between the written law and the reality of the SEC's non-enforcement on foreign issuers. One has to wonder if by the end of the day, the ISA has adopted the Association of Publicly Traded Companies' propaganda as its official policy.

"The ISA's assumption that the SEC is overseeing dual-listed companies is erroneous," said Amir, who has been chairman of the Israel Accounting Standards Board. "This is liable to cause serious harm to Israeli investors, particularly because the scope of their quarterly financial reports is substantially narrower than that required from Israeli companies."

Licht says the ISA must recognize the reality documented in the academic studies and calls for a reexamination of ISA policy. He suggests the ISA should first attempt to put into use the memorandum of understanding it signed with the SEC. And if that doesn't work, the ISA itself will have to enforce the rules and regulations.

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28.09.06 | 10:54   By Uri Ronnen

When a company and its auditor part ways, it's like a no-fault divorce, wrote Floyd Norris in the New York Times two months ago.

When the divorce is consensual, the parting pair tend to stay silent about each other's fault, avoiding public humiliation. And indeed, Glass, Lewis & Co, a San Francisco consulting firm that advises institutional investors, found that in 72% of the 1,430 cases in which American listed companies changed auditors in 2005 - they didn't say why.

Norris supports a campaign that Glass, Lewis is conducting, to change the rules when it comes to replacing one's auditor. The main reason is two common scenarios.

In one, the company feels the auditor insists on accounting policies that are too conservative, or it doesn't want to disclose information that the auditor insists it should. The company asks the auditing firm to replace the engagement partner, but the auditing firm refuses. The company decides to accept the position of the stern auditor, but once the financial statements are signed, sealed and delivered with a sigh, it shakes hands bye bye and seeks a more amenable accounting firm.

Under the second scenario, the accounting firm orders the engagement auditor to bend, but clarifies that it will not do it again. The company says thanks, and once the financial statements are in, it fires its accountants and looks for new ones.

Under present rules, neither case requires the company or its auditors to disclose their dispute, because technically they resolved it.

But Glass Lewis feels that a company's insistence on a certain accounting or disclosure policy, or on replacing a member of the engagement team, is a red flag for investors and if it leads to a divorce from its auditors, investors should know about it.

On March 21, 2005, the Israeli accounting firm of Kesselman & Kesselman, a member of PricewaterhouseCoopers International Limited, signed Retalix (Nasdaq: RTLX) financial statements for the year 2004.

A week later, on March 28, 2005, Retalix, a software firm dually-listed in Tel Aviv and New York, asked its shareholders to approve replacing Kesselman & Kesselman with Kost Forer Gabbay et Kasierer, a member of the Ernst & Young Global. The shareholders agreed.

A year has passed, and on March 27, 2006, Retalix announced its results for the year 2005. It reported $191.3 million revenues, slightly above the average analyst forecast of $191.23 million. The financial statement had not been "audited", but as Retalix said in response to our article of August 14, it had been "reviewed by a top-tier accounting firm", by which it meant Kost Forer.

Retalix files reports based on U.S. accounting rules, and submits its reports to the U.S. Securities and Exchange Commission. Therefore, Kost Forer signs the reports, rendering them "audited", only after Ernst & Young is satisfied that the reports comply with American rules.

The profit & loss statement for 2005 included in the press announcement in March, over which Retalix held a conference call with analysts, did not receive the American E&Y stamp of approval.  To get that, Retalix had to adopt a more conservative method of recognizing revenues.

Bad practice in recognizing revenue

The issue at stake is revenue recognition from multi- element transaction involving software license and a maintenance arrangement. Revenue from licensing software is recognized immediately, but revenue from maintenance services is spread over years.

Retalix's method for allocating the sale price was deemed improper by E&Y. Not surprisingly, it attributed too much revenue to licensing and too little to maintenance services.

The shift to an acceptable method reduced its 2005 revenues by $3.9 million. Kost Forer signed the audited report for 2005 on July 21: it showed $187.4 million in sales, well below analysts' expectations of $191.23 million.

On July 12, which was nine days before Retalix announced the change in its accounting practice, it issued a revenue warning for the second quarter of 2006. But it did not change its forecast for the year 2006, which it had declared in March. At an investors' conference last Wednesday, Retalix chief financial officer Danny Moshaioff remarked that the company would be challenged to meet its forecasts for 2006, and sent the stock falling 4.6% on Thursday. Unarguably, the new revenue allocation method and Ernst & Young's stringency are the factors making it hard for Retalix to meet its guidance.

Ernst & Young found that Retalix had used unacceptable revenue allocation in 2004 as well. Retalix was therefore forced to restate its 2004 audited sales figures, which were blessed by PWC Israeli member.

Recall SEC Staff Accounting Bulletin No. 99 - Materiality: "Among the considerations that may well render material a quantitatively small misstatement of a financial statement item are … whether the misstatement hides a failure to meet analysts' consensus expectations for the enterprise."

The original 2004 P&L statement, signed by Kesselman & Kesselman when the stock traded at $25, showed $124.4 million in revenues, a million above analyst expectations at the time 2004 results were first announced. The amended one -- issued when the stock crashed to $17 -- has revenues slightly below those expectations.

In March 2005, when Kesselman & Kesselman approved the disputable revenue recognition method, Retalix needed to meet expectations, partly because it was using its shares as currency to buy other companies (see here and here). Failure to meet expectations would have slammed its share price, devaluating its currency, as it were. 

Consistently with Glass, Lewis' findings, Retalix and Kesselman & Kesselman did not tell anybody why they parted ways. In retrospect, Kesselman & Kesselman's dismissal could be seen as a warning to investors that the share price would slide. At the start of July, before the 2004 restatement, 2005 revision and Q2 revenue warning, Retalix was trading in Tel Aviv at NIS 100. Today you can buy it for NIS 77.

Going home

NOW, guess what? In two weeks, Retalix's shareholders will be convening again, to vote on the company's desire to return to Kesselman & Kesselman.

It's like a kid whose mother chastises him. The kid huffs off in a snit, crying that he'll go look for a new mama. He can find plenty of candidates, but none is as nice as his old mama. So he crawls home, teary and humbled, to shelter in her arms.

There is perhaps nothing like PWC Israei member Kesselman & Kesselman when it comes to meeting revenue expectations.

Oscar Gruss analyst Roni Biron wrote in a report dated Sep 18: [w]e believe that the Company's intent to re-appoint PWC as its auditor could indicate a still challenging revenues recognition process.

Retalix says in response: "The analysis of the writer is completely baseless, and constitutes  harm to Retalix's good name and to the offices of Kesselman & Kesselman. To remove any doubt, the company did not decide to replace its accountants because of accounting issues of recognizing revenues." Kesselman & Kesselman of PwC chose not to comment.

The shareholders should reject Retalix's effort to fire Ernst & Young. As a matter of public policy, investors should not punish strict auditors. It is regrettable that Kost Forer first agreed to the lax method of recording revenue, but that is not relevant as long as the American parent company Ernst & Young is properly supervising the Tel Aviv staff.

The shareholders should refuse to let Retalix re-hire Kesselman & Kesselman until they fully understand what led that accounting firm to sign reports whose revenues beat analyst expectations, due to material accounting mistake.

There is another issue that begs clarification. In its original 2004 20-F, filed with the SEC in March 2005 and included the skewed 2004 financial statement, Retalix stated: ""[O]ur chief executive officer and our chief financial officer have concluded that our disclosure controls and procedures are effective."

Now, in its amended 2004 20-F, filed with the SEC in July 2006, it explains that "our chief executive officer and our chief financial officer have concluded that our disclosure controls and procedures were not effective as of December 31, 2004." Thus, the company is trying to institute stronger controls, and is looking for suitable accountants. Thank you, Ernst & Young America, for increasing the demand in Israel for good accountants.

Beyond the 2004 restatement and 2005 revision of its financial statements, Retalix also revised its reports for the second and third quarters of 2005. Given the mess in its reports over the last 18 months, one has to wonder where its audit committee has been.

But Retalix thinks it's audit committee directors done spectacularly well. "To recognize their contribution to the company's performance," it wants its shareholders to approve a bonus of thousands of stock options -- in the money -- for two of its members: Ian O'Reilly and Brian Cooper, who had been at the audit committee throughout said mess. The shareholders should oppose this reward, and also the suggestion that both be re-elected to the board of directors.