Accounting Tomfoolery

1
Accounting Tomfoolery

• A Cynical View of Financial Reporting

2
Other Shenanigans

• Miscellaneous Manipulations
• Accounting misclassifications.
• Big write-offs of RD expenses of an acquired
  company.
• Credits to income from an over-funded pension
  plan.
• Use of off-balance sheet companies.
• Making deals that turn balance sheet cash into
  sales.

3
Special Purpose Entities (SPEs)

• Special Purpose Entity (SPE) or Vehicle (SPV)
• Primary reason is to legally isolate assets from
  the seller of the assets and its creditors.
• Assets in the SPE can only be used to make
  payments to investors that hold securities of
  SPE.
• Qualifying SPE
• Assets and liabilities are not consolidated into
  balance sheet of selling corporation.
• Should have significant limits on its permitted
  activities.
• Should be distinct from seller of assets.
• Majority owner of SPE must be idnependent 3rd
  party from seller
• 3rd party must have control over SPE.
• 3rd party must have substantive risk of
  ownership in SPE generally means must
  contribute minimum 3 of SPE capital.

4
Uses of SPEs

• Securitization of Credit Card Receivables
• Card issuers moves O/S card balances into SPE in
  return for cash from SPE. Card issuers may
  guarantee up to certain of losses on
  receivables portfolio.
• Sole asset of SPE are the receivables. Easily
  valued allows SPE to raise funds through equity
  and low interest rate debt.
• Synthetic Leases
• GAP sets up SPE to buy/build retail store
  buildings.
• SPE sets up lease with GAP for building. Raises
  debt at low interest rate to put up building.
• Gap accounts for lease as operating lease, i.e.
  Income Statement entry only. Avoids having to put
  debt and assets on Balance Sheet.

5
Further Uses of SPEs

• Research Partnerships (Cash to Revenue)
• Elan contributes 24.25 million in cash to SPE.
  3rd party contributes 750,000 as outside equity.
  
• SPE immediately spends 24 million to buy RD
  processes from Elan. Elan books this as revenue.
  
• Note Cash almost back to where started.
• Enron- Mahonia (Make Losses Disappear at least
  for a year)
• Enron sets up SPE with 3 third party and 97
  loans.
• Right before current year-end, SPE signs a deal
  with Enron for delivery of oil/gas over the next
  year at fixed prices.
• SPE pays Enron a fee for the arrangement that
  Enron books as revenue this year.
• Over the next year, Enron pays SPE the difference
  between the market price and the contractual
  price. Difference is always positive and so Enron
  essentially is repaying a loan over the year.

6
Financial Shenanigans - Analyzing Financial
Reports
Aggressive accounting policies tend to overstate
reported earnings but may understate current
earnings to the benefit of future earnings.
Conservatism is reflected both in the choice of
accounting policies and in the timing of
recording business transactions. Indicators of
conservatism include

• LIFO vs. FIFO inventory costing
• Short vs. long depreciable lives/amortization
  periods
• Expensing vs. capitalizing costs
• Recording a liability vs. footnoting
  contingencies
• Higher vs. lower loss/warranty reserves
• Revenues at completed contract vs. of completion

• Maintaining vs. changing accounting policies and
  assumptions
• Maintaining vs. changing auditors
• High correlation between cash from operations and
  operating income
• Clear, concise, understandable disclosures
• Earnings that substantially reflect operations
• Minimizing special one time charges

7

• Balance Sheet Adjustments to reflect Economic
  Values

8
Off-Balance-Sheet Adjustments

• Off-Balance-Sheet Assets and liabilities should
  be added to the balance sheet.
• Off-balance-sheet activities (i.e. capitalizing
  operating leases),
• Off-balance-sheet debt,
• Consolidation of unconsolidated affiliates, and
• Recognition of the funded status of the pension
  plan.
• It is likely that these adjustments will not be
  given directly to you but will appear in the
  footnotes to the financial statements.
• It is also likely that you will need to adjust
  given values to reflect percent ownership or fair
  market value.

9
Current Value Balance Sheet Adjustments

• Adjustments to Assets Reported book values
  adjusted to current market value to approximate
  value as collateral to creditors.
• Market values should be used for all assets and
  liabilities that have determinable market values.
  This includes evaluations of reserve accounts and
  non-current assets that may have alternative
  uses.
• Other assets, mostly non-current and intangible
  assets, may be impossible to value reliably. No
  revaluation should take place from the book
  value.
• Adjustments to Liabilities Market value
  adjustments and recognizing the effect of
  accounting choices for liabilities.
• Some liability balances may also be eliminated
  because they do not represent future cash
  repayments, but are rather obligations to be met
  by future delivery of goods or services.
• They measure future revenue, not debt.
• Advances from customers, investment tax credits,
  deferred income taxes.

10
Adjusting the Balance Sheet

• Modify the balance sheet for
• assets and liabilities that are not recorded
• off balance sheet items that are reasonably
  estimable should be put on the balance sheet with
  a net adjustment to Stockholder Equity
• off balance sheet commitments such as leases,
  contingencies, and guarantees
• proportionate consolidation of equity affiliates
• funded status of a defined benefit pension plan
• current value of assets and liabilities that are
  recorded
• market values should be reflected where
  reasonably estimable
• LIFO inventories restated to FIFO - add the LIFO
  reserve to inventory
• PPE - restate to market value
• Goodwill in Intangibles - eliminated
• LT Debt - restated to fair market value
• Pension Asset/Liability - restated to equal the
  Funded Status less the PBO
• Deferred Income Taxes - determine probability of
  reversal
• Comprehensive loss/gains - eliminate

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Modify the Balance Sheet
Balance Sheet As Reported At Book Value
Add Off Balance Sheet items and Adjust for
differences in Accounting Methodologies
Adjust Book Value to Market Value and Balance the
Statement with a net adjustment to Stockholder
Equity
Perform Financial Statement and Ratio Analysis
12

• Adjustments to Earnings to reflect Economic Value

13
Normal Operating Earnings

• Normal Operating Income restated reported
  results that reflect the economic nature of a
  firms operations the ongoing operational
  earnings that an analyst can use to value a
  company. The analyst will normalize earnings
  by adjusting reported income by removing the
  effects of nonrecurring and non-operational
  items.
• Normal Operating Income is the analysts best
  estimate of sustainable ongoing and economic
  results.
• Normal Operating Income is also referred to as
  the earnings power of the firm and becomes the
  basis for establishing forecasted earnings in
  valuation models.

14
Non Recurring Items in Earnings

• Non recurring Items may be disclosed by the
  company as SPECIAL or EXTRAORDINARY items or may
  have to be determined by the analyst in reviewing
  footnotes to the financial statements.
• Items disclosed by the company in Income
  Statement Reporting include
• BEFORE TAX
• Unusual or infrequent (but not both!) -
  identified before tax usually referred to as
  SPECIAL ITEMS
• AFTER TAX
• Extraordinary both unusual and infrequent
  identified after tax and per share
• Discontinued operations segregated in company
  financials at the measurement date with expected
  losses taken immediately while gains are realized
  after disposal identified after tax, prior
  period income statements must be restated.
• Accounting changes voluntary, mandated, or
  correction of an error, either reported
  cumulative effect (all in the current period) or
  with restatement of prior periods. Errors
  require the prior period adjustment as a direct
  adjustment to retained earnings that does not
  flow through the income statement but goes to
  Comprehensive Income.
• Items identified by the analyst
• additional items disclosed in footnotes or press
  release deemed unusual or infrequent
• items disclosed as special by the company that
  actually advance expenses and should be smoothed
  forward
• items disclosed as special by the company that
  reflect deferral of expense recognition and
  should be smoothed backward
• chronic disclosure of Special losses that
  appear to be operational and should not be
  adjusted for

Order of Disclosure
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Comprehensive Income

• Comprehensive Income
• Measures the changes in Stockholder Equity in
  addition to Net Income but before dividends,
  share repurchases and tax effects of employee
  option plans.
• Includes PL items that GAAP allows for a direct
  adjustment to retained earnings rather than
  income statement handling.
• Direct-to-equity adjustments allowed by GAAP
  reflect accounting standards that delay
  recognition of the income statement impact of
  economic events - as the analyst adjusts the
  balance sheet to economic value, all existing
  comprehensive income/loss accounts should be
  eliminated including
• Minimum liability provision for pension plans
• Changes in market value of long term marketable
  securities
• Cumulative translation adjustment for foreign
  exchange rate effects
• Use comprehensive income to normalize reported
  earnings as an offset to all balance sheet
  adjustments for current cost basis.

16

• Financial Ratios for Business Risk versus
  Financial Risk

17
Financial Ratio Analysis - Business and Financial
Risk
Business Risk reflects uncertainty or volatility
of operating income that arises from variability
in revenues and/or production costs Business
Risk Stnd Deviation of Operating
Income/Mean Operating Income Sales Variability
Stnd Deviation of Sales/Mean
Sales Operating Leverage a measure of the
extent to which production costs are fixed rather
than variable higher fixed costs imply higher
volatility of earnings, therefore higher
operating leverage and higher risk. Financial
risk is the added volatility in ROE from debt
financing (since debt incurs fixed payments and
fixed interest costs) measured by Debt Equity
Ratio Total Long Term Debt/Total Equity LT Debt
to Total LT Capital Ratio LT Debt/LT Debt
Equity Total Debt Ratio Total
Liabilities/Total Assets Interest Coverage Ratio
EBIT/Interest Expense Fixed Financial Cost
Ratio EBIT Estimated Other Fixed Financial
Costs/Interest Expense Other Fixed Financial
Costs