Accounting Tomfoolery

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Accounting Tomfoolery

• A Cynical View of Financial Reporting

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Howard Schilits Seven Deadly Sins

• 1 Recording revenue too soon
• 2 Recording bogus revenues
• 3 Boosting income with one-time gains
• 4 Shifting current expenses to a later period
• 5 Failing to record or disclose all liabilities
• 6 Shifting current income to a later period
• 7 Shifting future expenses to current period
• from Financial Shenanigans

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1 - Recording Revenues Too Soon

• Recording Revenue too Soon
• Recording Revenue when future services remain to
  be provided.
• Recording revenue before shipment or before
  customers unconditional acceptance.
• Recording revenue even though customers is not
  obligated to pay.
• Recording Revenue of Questionable Quality
• Selling to an affiliated party.
• Giving customer something of value as a quid pro
  quo.
• Grossing up revenue.

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1 - Recording Revenues Too Soon

• Examples
• Sunbeam
• Tactics exaggerated revenues and overstated
  earnings
• Harnischfeger Industries
• Accused of improperly recognizing profits
  associated with long-term contracts in Indonesia.
• First Plus Financial Group
• Money Store (First Union)
• First Plus Money Store misused gain-on-sale
  accountingan aggressive form of accounting

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1 - Recording Revenues Correctly

• Guiding Principle
• Revenue should be recorder after the earnings
  process has been completed and an exchange has
  taken place.
• Correct Way to Record Revenue
• Sell the product to an unaffiliated customer with
  no financial incentives as quid pro quo.
• Deliver the product and receive customers
  unconditional acceptance.
• Confirm the customer is responsible for paying
  (no seller financing)
• Record as revenue only the net proceeds from the
  customer.
• Provide all services required under the contract.

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2 - Recording Bogus Revenues

• Recording Fictitious Revenue
• Record sales lacking economic substance side
  agreements contingent sales.
• Recording cash received from lending transactions
  as revenue upfront recognition of lease fees
  for future services .
• Recording investment income as revenue from
  asset sales or other investment income.
• Recording as revenue supplier rebates tied to
  future required purchases.
• Releasing revenue that was improperly held back
  before a merger.

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2 - Recording Bogus Revenues

• Examples
• MicroStrategy, Inc.
• Charged with overstating revenues and earnings.
• Priceline.com
• Reported sales that didnt belong to themshould
  have only reported commissions.
• Telxon Corporation
• During its MA, 14M in extra revenue from
  questionable shipments was discovered.
• Exide Corp.
• Altered inventory accounting system to inflate
  profits.
• Boston Scientific Corp.
• Allegedly issued false and misleading statements.

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3 Boosting Income With One-time Gains

• Recording One-Time Gains as Revenue
• Boost profits by selling undervalued assets and
  report as revenue result of pooling accounting
  in mergers or real estate acquired in past.
• Recording investment income or gains as revenue
  from asset sales or other investment income.
• Recording investment income or gains as reduction
  in operating expenses from asset sales or other
  investment income.
• Creating income by reclassifying Balance Sheet
  accounts.

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3 Boosting Income With One-time Gains

• Examples
• Lucent Technologies
• Pushing the envelope with GAAP
• Rite-Aid
• Pooling obscured no unit growth
• Companies using pooling method for acquisitions
  (no longer allowed)
• Could record assets at book value and then resell
  at fair market value.
• Companies with bonds at deep discount to B/S
• A company can retire the bonds and then record an
  immediate gain.

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3 Boosting Income With One-time Gains

• Guiding Principle
• Investors should be alert for one-time gains or
  income from non-core activities that camouflage a
  firms deteriorating core business.
• One-time gains are not troublesome if the firms
  core operations are strong.
• Accounting Issues
• Business combinations accounted for using
  pooling of interest method have the potential
  for abuse in this area.
• Business combinations generating large amounts of
  Goodwill have similar risks.
• Accounting rules have changed to end pooling of
  interest accounting for mergers. Goodwill is
  also now subject to evaluation and write-downs
  rather than amortization.

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4 - Shift Current Expenses to Later Period

• Through Asset Account Manipulation
• Capitalize normal operating expenses to avoid
  immediate expense and then amortize over long
  period.
• Change accounting policies to shift current
  expenses to an earlier period.
• Amortize costs over too long a period to be
  justified economically.
• Fail to write down or write off impaired assets.
• Reduce asset reserve accounts

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4 - Shift Current Expenses to Later Period

• Examples
• Internet companies
• Capitalize start-up costs and make assumptions on
  future sales, longevity of the business, etc.
• Japanese banks
• Many did not write down or off the worthless
  loans they had on their books.

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4 - Shift Current Expenses to Later Period

• Relevant Guiding Principles
• A firm should capitalize costs incurred to the
  extent that they produce future benefits, and
  expense those that produce no such benefit.
• Watch for software expenses, advertising, store
  pre-opening, etc.
• When there is a sudden and substantial impairment
  in an assets value, the asset should be written
  off immediately and in its entirety, rather than
  gradually.
• Watch for bad loans that are not written off

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5 - Failing to Record/Disclose Liabilities

• Through Liability Account Manipulation
• Failure to record expenses and related
  liabilities when future obligations remain.
• Reduce liabilities by changing accounting
  assumptions pension fund expense.
• Release questionable reserves into income
  overly large merger or restructuring reserves
  that are reversed into income later.
• Create sham rebates frequent flyer obligations.
• Recording revenue when cash is received even
  though future obligations remain.

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5 - Failing to Record/Disclose Liabilities

• Examples
• Airlines in the US
• Did not record liability from frequent flier
  campaign.
• Cendant
• Did not record the liability from memberships.
• KnowledgeWare, Inc.
• Did not anticipate rate of return for unsold
  products.
• BankAmerica
• Failed to disclose exposure to investments or
  loans to hedge funds and to changes in global
  markets.

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6 - Shift Current Income to Later Periods

• Smoothing Income
• Creating reserves and releasing them into income
  in alter period when revenues are lower than
  desired.
• Improperly holding back revenue just before an
  acquisition closes or year-end.
• Guiding Principle
• Revenue should be recorded in the period in which
  it is earned.
• If service provided in the current period it is
  inappropriate to report the revenue in alter
  period.

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6 - Shift Current Income to Later Periods

• Examples
• H J Heinz
• Management incentives hit pre-determined ceilings
  for sales.
• W.R. Grace Co.
• Set up a reserve for excess earnings which they
  drew on later to mask lower earnings.
• Swiss and German companies
• Didnt adhere to GAAP (not a requirement)
• Daimler-Benz

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7 Shift Future Expense to Current Period

• Smoothing Income
• Improperly inflating the amount included in a
  current special charge large Goodwill
  write-offs.
• Improperly writing off in process RD costs from
  an acquisition.
• Accelerating discretionary expenses into the
  current period.
• Guiding Principle
• Expense should be charged against income in the
  period in which the benefit is received.

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7 Shift Future Expense to Current Period

• Examples
• Excite
• Netscape
• Excite wrote off funds and Netscape did not take
  funds as a one-time gain.
• McDonalds
• Expensed full contribution charge rather than
  amounts paid out.

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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.

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Valuing Equity

• When it comes to investing, everything begins and
  ends with accounting. Within the ledgers lie
  stories revealing both risk and opportunity for
  investors.
• You must understand the underlying fundamentals,
  current investing fashion to the contrary.
• It is not easy to figure it all out, but it can
  be done.
• The numbers are revealed in documents filed with
  the SEC. The standards are more or less in place.
  
• And the underlying goal of business remains
  immutable you sell something, you pay your
  expenses. More must come in than goes out.
• You return a portion of that to owners.
• To prosper for more than a slice of Internet
  time, business must continue to generate cash and
  profits over the long haul.
• Everything else is fairy dust.
• thestreet.com 1/20/1999

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Analysis of Financial Statements A Synthesis

• Investment Tools
• Financial Statement Analysis Special
  Considerations

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Detecting Lower Earnings Quality
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Indicators of High Earnings Quality

• Conservative revenue recognition methods
• Use of LIFO accounting in times of rising prices.
• Bad debt reserves high relative to receivables
  and past credit losses.
• Use of accelerated depreciation methods and short
  lives.
• Rapid write-off of acquisition goodwill and other
  intangibles.
• Minimal capitalization of interest and overhead.
• Minimal capitalization of software costs.

• Expensing startup costs of new operations.
• Use of completed contract method of accounting.
• Conservative assumptions in employee benefit
  plans.
• Adequate provisions for lawsuits and other loss
  contingencies.
• Minimal use of off-balance sheet financing
  techniques.
• Absence of non-recurring gains.
• Absence of non-cash earnings.
• Clear and adequate disclosures.

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Strategy for Determining Earnings Quality

• How to remember all of this?
• 1. Work down the balance sheet. Each item
  outside of current assets has assumptions that
  impact the income statement. Look for assumptions
  that yield the smallest revenue or the highest
  expense among the possible choices.
• 2. Work through the income statement. Look for
  assumptions that yield the smallest revenue or
  the highest expense among the possible choices.
• 3. Work through the footnotes. Make sure that
  there is disclosure of all liabilities and that
  loss provisions appear on the balance sheet or
  flow through to income statement.

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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.

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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.

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Normalizing Income

• Normal Operating Income adjust reported income
  by removing the effects of nonrecurring items,
  such as

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Comprehensive Income Adjustments

• Comprehensive Income measures the change in
  equity (net assets) from transactions and other
  events and circumstances from non-owner sources.
  
• It includes all changes in equity over the period
  except those resulting from investment by owners
  and distribution to owners. (SFAC 6)
• Arrive at Comprehensive income by adjusting
  reported income by removing the effects of
  nonrecurring items, such as
• Cumulative Translation Adjustment if Foreign
  subsidiaries,
• Unrealized gains/losses on marketable securities,
  
• Funded status of employee benefit plans
• Adjustments of other assets or liabilities to
  fair market value.

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Cash Flows Accounting Choices

• illustrate how accounting choices affect whether
  cash flows are classified as operating,
  financing, or investing.
• Examples
• Capitalization of fixed assets.
• Exclusion of off-balance-sheet obligations.
• Nonrecurring cash flows.
• Reclassifying interest paid from CFO to CFF.
• Segregating capital expenditures from other
  investment cash flows.