Accounting

How a Loss Can Be Seen As A Win

Injured Piggy Bank WIth CrutchesDuring my undergraduate studies I had a professor that asked us to find a company on a large stock exchange that had posted a loss in the previous fiscal year and give a mock presentation about selling the shareholders on not dumping the stock or to even to buy more.  By the end of my presentation I had students telling me they actually planned to purchase the stock I mentioned, which was smart.  So what did I look for when choosing a company that had posted a loss?

 

The number one thing I was looking for was a company that had expended a large amount of funding in research and development in a thriving industry.  There can be a lot of candidates for this, but I had one in mind, pharmaceuticals.  There are plenty other analogs for this as well, it doesn’t have to be research and development, for example mining companies that have recently purchased large swaths of land and equipment, developers purchasing land, and building on that land.  Basically I was looking for an activity that caused the loss in the current year that would produce revenue in the future.

The truth is, investors, creditors, and management see a loss of this type as the halo effect.  This is because it is driving future business.  Most R&D can take years before it develops into a market-ready product, especially in the pharmaceutical industry where costs to bring a drug to market are extremely expensive but also heavily protected by bureaucratic red tape and huge barriers to entry in the market, not to mention patent rights.  The same can be said about a mining company that has purchased a mineral rich plot of land and the equipment to develop it, despite the fact that depletion and depreciation expenses may not occur in the current year, they may not have a product ready for sale for a number of years, as is the case in most diamond mines.

This doesn’t mean we should always look at a company that posts losses or marginally small profits as a good company, but there is a silver lining when certain companies post a loss, and if you understand financial statements enough you should be able to decipher when the loss is probably a good thing for the future of that company.

I’m sure you’re wondering what company it was that I had chosen. It was Seattle Genetics, a pharmaceutical company that solely makes gene targeting cancer treatment drugs, who in 2014 (the year prior to the presentation) had posted a $77 million loss, and had posted a loss every year since inception. What I saw was that their R&D costs were $230 million versus $286 million in sales revenue.  At the time of the presentation their stock price was around $37.00 per share, today their stock price is $67.96 per share, despite posting another $120 million loss in 2015.

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Tone at the Top

ethicsTone at the top is a very interesting predicament for management.  It means to create an environment where illicit activity is not only frowned upon but constantly discouraged by the upper management of an organization.  The tricky part is having an environment that discourages illegal or fraudulent activity while creating a culture that employees enjoy being a part of.  Tone at the top also means an environment that encourages employees to feel comfortable enough to come forward with claims of fraud.  It’s not hard to see the dilemma for upper management in this situation.

Regardless of the size of your organization the benefits of a strong tone at the top are plentiful and immeasurable.  Auditors are extremely cognizant of the relationship between tone at the top and risk factors for fraud, or unintentional material misstatement.  More importantly a strong tone at the top sets the table for the behaviors of every employee in an organization and ensure ethical behavior.  Ensuring that your organization has a strong tone at the top is not overly difficult, especially in comparison to the benefits you can objectively observe.  The ACFE wrote a wonderful research paper on tone at the top here.

The big question is how to behave as a manager so that you ensure a strong tone at the top.  First, you have to, obviously, walk the walk.  Telling someone how to act is one thing, but leading by example is another.  Tone at the top means that you have to behave with respect and act with integrity.  It also means you have to take every report of fraud seriously but treat it with professionalism and procedural justice.  In order to have great tone at the top your employees should observe you behaving in the manner in which you’d want them to behave.  Lastly, in order to ensure a strong tone at the top is to avoid the appearance of preference, bias, or impropriety regarding the aspects of the organization and its employees.

For information on testing you organizations tone at the top, check out this article by Deloitte/Wall Street Journal on measuring tone at the top.

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