Somewhere in the vast interior of China last year, almost a half-billion dollars of cash belonging to Caterpillar vanished. So how did the company soften the blow when it broke the news to investors?
Easy. Caterpillar said the loss was "non-cash." See? Accounting tricks don't have to be complex after all.
This sort of abuse of the English language is routine in corporate disclosures and has long been a pet peeve of mine. Here's the drill: First a company like Caterpillar makes a big acquisition. It pays cash. Then the company it bought turns out to be a wreck, maybe even a fraud.
The rules say Caterpillar must write down the value of what it bought – or, more precisely, what it mistakenly believed it had bought, because the assets it paid for never existed in the first place. Calling the loss non-cash makes it seem like Caterpillar didn't lose any real money. It's like reverse alchemy, turning gold into straw, at least for public-relations purposes.
Last June, Caterpillar paid $690 million – $475 million of which was cash – for a Hong Kong-based company called ERA Mining Machinery, which makes coal-mining equipment through a subsidiary in China called Zhengzhou Siwei Mechanical & Electrical Manufacturing. Caterpillar last week said it found "deliberate, multi-year, coordinated accounting misconduct" at Siwei. It said the tip-off came in November when it did a physical inventory count at Siwei and found it didn't match what the books showed. Caterpillar said it will record a "non-cash goodwill impairment charge" of $580 million for the fourth quarter, wiping out all but 16 percent of the purchase price.
Why did Caterpillar call it non-cash? "We characterise it as a non-cash item in the fourth quarter because it does not impact cash flow in the fourth quarter," said Jim Dugan, a spokesman for the maker of engines and machinery. That's technically accurate. It also ignores that the company blew $475 million of cash on the purchase during the second quarter.
There ought to be a rule that says companies aren't allowed to call writedowns "non-cash" if they paid cash to buy the assets they're writing down. The label might not be false. However, it is misleading.
Rio Tinto Group, the world's second-biggest mining company, last week said it will record a $14 billion "non-cash impairment charge" for the fourth quarter. Like Caterpillar, it paid cash for the acquisitions it's writing down. Last month, ArcelorMittal, the world's biggest steelmaker, reported a $4.3 billion "non-cash" writedown at its European businesses, which it had bought with cash.
Hewlett-Packard used the same label when it wrote down its 2011 cash acquisition of the software maker Autonomy by $8.8 billion. HP, much like Caterpillar, blamed most of the loss on accounting improprieties at the company it bought.
Back to Caterpillar, recall that the company said it was writing down goodwill by $580 million because of its findings at Siwei. That's odd, because Caterpillar in its most recent quarterly report said it allocated only $476 million of the company's purchase price to goodwill. (Goodwill is a plug number representing the difference between the purchase price and the fair market value of the acquired company's net assets.) Caterpillar didn't say how the goodwill grew before the writedown. Dugan, the Caterpillar spokesman, said the company will provide more information when it files its annual report in the coming weeks.
Then there's the question of why Caterpillar bought this piece of junk. ERA Mining was formed through a reverse takeover in 2010, which let Siwei obtain a Hong Kong stock listing without an initial public offering. That sketchy pedigree should have been a warning flag, especially after the dozens of Chinese reverse-merger stocks over the past few years that turned out to be frauds. ERA Mining's 2011 annual report noted that the structure of the deal meant "the assets and liabilities of the Siwei Group are recognised and measured at their pre-combination carrying amounts," which turned out to be false.
ERA and Siwei were barely profitable, even using the numbers that Caterpillar now says were phony. The company, which was audited by RSM Nelson Wheeler of Hong Kong, showed lifetime retained earnings of about $33 million as of December 31, 2011. Tangible shareholder equity, which excludes goodwill and other intangible assets, was about $98 million. Caterpillar paid about seven times that much. How much of the $580 million writedown was attributable to misconduct? And how much was due to the simple fact that Caterpillar overpaid? Dugan declined to answer.
The markets shrugged off the news of Caterpillar's China troubles as a one-off hit, which is understandable. (The stock price went up slightly on January 22, the first day of trading after Caterpillar's disclosure.) Caterpillar is one of America's most-admired companies. It has a $63 billion market value, about $90 billion of assets, and it has reported more than $1 billion of earnings for seven consecutive quarters. This scandalette should be a minor blow.
The bad news is it shows Caterpillar did a horrible job of due diligence. And its board – which includes Jon Huntsman, a former US ambassador to China – may be more of a rubber stamp than investors realised. Caterpillar's leaders have more explaining to do. Banning looking-glass language from their vocabulary would be a good start.
Jonathan Weil is a Bloomberg View columnist