affiliate marketing كتب وابحاث فى المحاسبة والمراجعة : The Financial Numbers Game (part 1)

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الخميس، 21 فبراير، 2013

The Financial Numbers Game (part 1)




Financial Numbers Game








CHAPTER ONE







I’d like to talk to you about another widespread, but too little-
challenged custom: earnings management. This process has evolved
over the years into what can best be characterized as a game among
market participants. A game that, if not addressed soon, will have
adverse consequences . . .1



With an all-too-frequent occurrence, users of financial statements are shaken with dis-
closures by corporate managements that certain “accounting irregularities” have been
discovered and, as a result, current- and prior-year financial results will need to be re-
vised downward. Consider these examples:

Sybase’s shares dropped an additional 20% when the company reported improper practices
at the Japanese subsidiary, which Sybase said included booking revenue for purported sales
that were accompanied by side letters allowing customers to return software later without
penalty.2
Bausch & Lomb oversupplied distributors with contact lenses and sunglasses at the end
of 1993 through an aggressive marketing plan. . . . The company said yesterday that in the
fourth quarter of 1993 it “inappropriately recorded as sales” some of the product it sent to
distributors.3
Nine West Group Inc. said its revenue-booking practices and policies are under investi-
gation by the Securities and Exchange Commission. The company’s shares plunged 18%
on the news.4
MicroStrategy Inc., the high-flying software company . . . announced it would signifi-
cantly reduce its reported revenue and earnings for the past two years. . . . Shares of Micro-
Strategy plummeted 62%, slicing about $11 billion off its market value.5
In a long-awaited restatement, Sunbeam Corp. slashed its reported earnings for 1997 by
65%. . . . Sunbeam said the robust profit reported for 1997 resulted largely from an overly
large restructuring charge in 1996, premature booking of revenue, and a variety of other ac-
counting moves that have been reversed.6
California Micro Devices Corp., a highflying chip maker, disclosed that it was writing
off half of its accounts receivable, mostly because of product returns. Its stock plunged 40%

1


THE FINANCIAL NUMBERS GAME


after the announcement on August 4, 1994, and shareholders filed suit alleging financial
shenanigans.7
Waste Management Inc., undoing years of aggressive and tangled accounting, took
$3.54 billion of pretax charges and write-downs, and said more conservative bookkeeping
going forward would significantly crimp its earnings.8
The once-highflying stock of Cendant Corp. plunged 46.5%, knocking $14 billion off
the company’s market value, after the marketing and franchising concern said accounting
problems would require it to reduce last year’s earnings and would hurt this year’s results.9
Aurora Foods Inc.’s chief executive and three other top officers resigned as the company
disclosed an investigation into its accounting practices that it said could entirely wipe out
1999 profit.10
Baker Hughes Inc. said it discovered accounting problems at a business unit that will
result in pretax charges of $40 million to $50 million, a disclosure that sent its stock falling
15% and revived Wall Street’s questions about the company’s performance.11

Every one of the above examples entails, in one form or another, participation in the
financial numbers game. The game itself has many different names and takes on many
different forms. Common labels, which depend on the scope of the tactics employed, are
summarized in Exhibit 1.1.
While the financial numbers game may have many different labels, participation in
it has a singular ultimate objective—creating an altered impression of a firm’s business
performance. By altering financial statement users’ impressions of a firm’s business per-
formance, managements that play the financial numbers game seek certain desired real
outcomes.


REWARDS OF THE GAME

Expected rewards earned by those who play the financial numbers game may be many
and varied. Often the desired reward is an upward move in a firm’s share price. For oth-
ers, the incentive may be a desire to improve debt ratings and reduce interest costs on bor-
rowed amounts or create additional slack and reduce restrictions from debt covenants. An
interest in boosting a profit-based bonus may drive some. Finally, for high-profile firms,
the motivation may be lower political costs, including avoiding more regulation or higher
taxes. These rewards are summarized in Exhibit 1.2 and discussed below.


Share Price Effects
Investors seek out and ultimately pay higher prices for corporate earning power—a com-
pany’s ability to generate a sustainable and likely growing stream of earnings that pro-
vides cash flow. That cash flow either must be provided currently, or there must be an
expectation among investors that it will be provided in future years.
Firms that communicate higher earning power to investors will tend to see a favorable
effect on their share prices. For the firm, a higher share price increases market valuation
and reduces its cost of capital. For managers of the firm with outright equity stakes or op-
tions on equity stakes, a higher share price increases personal wealth. Playing the finan-

2

Financial Numbers Game



Exhibit 1.1   Common Labels for the Financial Numbers Game


Label

Aggressive accounting




Earnings management




Income smoothing



Fraudulent financial reporting




Creative accounting practices

Definitiona

A forceful and intentional choice and application of
accounting principles done in an effort to achieve
desired results, typically higher current earnings,
whether the practices followed are in accordance with
GAAP or not
The active manipulation of earnings toward a
predetermined target, which may be set by
management, a forecast made by analysts, or an
amount that is consistent with a smoother, more
sustainable earnings stream
A form of earnings management designed to remove
peaks and valleys from a normal earnings series,
including steps to reduce and “store” profits during
good years for use during slower years
Intentional misstatements or omissions of amounts or
disclosures in financial statements, done to deceive
financial statement users, that are determined to be
fraudulent by an administrative, civil, or criminal
proceeding
Any and all steps used to play the financial numbers
game, including the aggressive choice and application
of accounting principles, fraudulent financial
reporting, and any steps taken toward earnings
management or income smoothing

aRefer also to the glossary at the end of this Chapter and to Chapter 2 for additional elaboration.




cial numbers game may be one way to communicate to investors that a firm has higher
earning power, helping to foster a higher share price.
Strong earning power and higher earnings were expected from Centennial Technolo-
gies, Inc., in the quarters and months leading up to a peak share price of $58.25 on De-
cember 30, 1996. However, playing a role in the company’s supposedly bright future
were many creative and fictitious accounting practices that boosted the company’s
prospects. Among the accounting practices employed were the overstatement of revenue
and such assets as accounts receivable, inventory, and investments. As the company’s
true financial position came to light over a two-month period following its share-price
peak, investors bid the share price down 95%.12
During 1997 and early 1998, Twinlab Corp. saw a dramatic increase in its share
price. From just under $12 per share at the beginning of 1997, the company’s share
price increased to the high $40s per share in July 1998. However, during that time

3


THE FINANCIAL NUMBERS GAME



Exhibit 1.2   Rewards of the Game


Category

Share-price effects




Borrowing cost effects



Bonus plan effects
Political cost effects

Rewards

Higher share prices
Reduced share-price volatility
Increased corporate valuation
Lower cost of equity capital
Increased value of stock options
Improved credit quality
Higher debt rating
Lower borrowing costs
Less stringent financial covenants
Increased profit-based bonuses
Decreased regulations
Avoidance of higher taxes





period, the stellar results that investors grew to expect from the company were not en-
tirely real. The company later announced that it would restate its results for 1997 and
for the first three quarters of 1998 because “some sales orders were booked but not
‘completely shipped’ in the same quarter.”13By the end of 1998, the company’s share
price had declined back to $12.
In 1997 Sylvan Learning Systems, Inc., received a $28.5 million breakup fee when it
was outbid for National Education Corp. The company established two not-for-profit or-
ganizations with the proceeds of the breakup fee to avoid paying income taxes on it. That
is, the taxable income associated with the proceeds was offset with a contribution to the
newly established not-for-profits. The not-for-profits, however, had a link to Sylvan
Learning. They contributed to marketing efforts of Sylvan Learning, doing advertising
for the company and promoting Sylvan’s software training and licensing programs. Had
these promotional costs been borne by Sylvan Learning, they would have been reported
as expenses on Sylvan’s income statement. Under the current arrangement, however,
Sylvan was able to keep the marketing and promotion costs off of its income statement,
boosting pretax income.14
Between January and July 1998, Sylvan Learning’s share price rose from the low
$20s per share to the high $30s per share. The unusual reporting scheme may have
played a role in this share price rise. However, when knowledge of the arrangements
made with the not-for-profits became widely known, the company’s share price declined
rather abruptly to around $20 per share.
The financial numbers game was being played, although to different degrees, at Cen-
tennial Technologies, Inc., Twinlab Corp., and Sylvan Learning Systems, Inc. While the
game was being played, and before it became evident, all three companies enjoyed
higher and rising share prices. Those higher share-price rises may be attributed, at least
in part, to the higher earning power implied by the financial results reported by the com-

4


Financial Numbers Game


panies. An interesting aside from the examples provided is just how punishing the mar-
kets can be when news of accounting gimmickry becomes widely known.
Investors also seek and ultimately pay higher prices for the shares of firms whose
earnings are less volatile. Reduced volatility implies less uncertainty about the direction
of earnings, fostering an impression of reduced risk. The financial numbers game can be
used to reduce earnings volatility and, in the process, encourage a higher share price.


Borrowing Cost Effects
Higher reported earnings, and the higher assets, lower liabilities, and higher sharehold-
ers’ equity amounts that accompany higher earnings, can convey an impression of im-
proved credit quality and a higher debt rating to a lender or bond investor. As a result,
the use of creative accounting practices to improve reported financial measures may lead
to lower corporate borrowing costs.
Sales at Miniscribe Corp. grew from just over $5 million in 1982 to approximately
$114 million in its fiscal year ended in 1985. Profits, however, were elusive as the com-
pany continued to report losses from operations. In 1986 the company’s financial fortunes
changed for the better as sales grew to $185 million and the company reported a profit
from operations of $24 million. The timing was perfect as the company was able to use
the strength of its latest financial statements to successfully issue $98 million in bonds.
Unfortunately for bond investors, the improved financial results of the company were
mostly fabricated, including fictitious shipments to boost revenue and manipulated re-
serves to reduce expenses. Reported net income for 1986 of $22.7 million was later re-
stated to a greatly reduced $12.2 million. Without the altered financial results, it is
unlikely that the company would have been able to sell its bonds as successfully as it did,
if at all. Unable to recover from the debacle, the company sought bankruptcy protection
and sold its assets in 1990.
Miniscribe Corp. was a public company issuing publicly traded debt. The temporary
benefit derived from its use of creative accounting practices, including an ability to se-
cure lower interest rates on the debt issued, was clearly evident from the example. An-
other potential benefit for borrowers derived from playing the financial numbers game
is less stringent financial covenants. This benefit can accrue to borrowers whether they
are public companies or privately held.
Debt agreements typically carry loan covenants—express stipulations included in the
loan agreement, which are designed to monitor corporate performance and restrict cor-
porate acts—that afford added protection to the lender. Positive loan covenants typically
express minimum and maximum financial measures that must be met. For example, a
positive loan covenant might call for a minimum current ratio (current assets divided by
current liabilities) of 2, or a maximum total liabilities to equity ratio of 1, or a times-in-
terest-earned ratio (typically, earnings before interest, taxes, depreciation, and amortiza-
tion divided by interest) of 5. Failure on the part of a borrower to meet these covenants
is a covenant violation. Such violations may be cured with a simple waiver, either tem-
porary or permanent, from the lender. However, they also may give the lender the op-
portunity to increase the loan’s interest rate, to seek loan security or guarantees, or even
in extreme cases, to call the loan due.

5

THE FINANCIAL NUMBERS GAME


Negative loan covenants are designed to limit corporate behavior in favor of the
lender. For example, a negative covenant might restrict a company’s ability to borrow
additional amounts, pay cash dividends, or make acquisitions.
Creative accounting practices can play a very direct role in relaxing the restrictive na-
ture of financial covenants. Steps taken to boost revenue will increase earnings, current
assets, and shareholders’ equity and, in some instances, reduce liabilities. Such changes
in a company’s financial results and position improve its ability to meet or exceed finan-
cial ratios such as the current ratio, liabilities-to-equity ratio, and times interest earned
ratio mentioned above. Steps taken to reduce expenses have a similar effect. As creative
accounting is used to improve a company’s apparent financial position and build a cush-
ion above its existing financial covenants, those covenants become less restrictive.


Bonus Plan Effects
Incentive compensation plans for corporate officers and key employees are typically
stock option and/or stock appreciation rights plans. With such plans, employees receive
stock or the right to obtain stock, or cash, tied to the company’s share price. When prop-
erly structured, such plans successfully link the officers’ and employees’ interests with
those of other shareholders’. Occasionally companies use a measure of earnings—for ex-
ample, pretax income—in calculating a cash or stock bonus. When such bonus schemes
are tied to reported earnings, officers and employees have an incentive to employ cre-
ative accounting practices in an effort to maximize the bonuses received.
Few bonus plans were as lucrative as the plan in place for Lawrence Coss, chairman
of Green Tree Financial Corp., a subprime lender. Mr. Coss’s bonus was calculated at
2.5% of Green Tree’s pretax profit—a significant amount being paid to a single person.
The bonus was paid in shares of stock as opposed to cash. However, helping to increase
the amount of the payout, the price used in determining the number of shares of stock to
issue to Mr. Coss was set at a much lower, and fixed, historical amount of approximately
$3 per share. For example, during 1996, Green Tree’s shares traded between the low
$20s and low $40s per share. That year, a $3,000 bonus would effectively buy 1,000
shares of Green Tree stock at the fixed price of $3 per share. If the stock were selling at
$30 per share, that $3,000 bonus actually would be worth $30,000 (1,000 shares times
the current market value of $30 per share).
In the years ended 1994, 1995, and 1996, Green Tree Financial’s pretax earnings were
$302,131,000, $409,628,000, and $497,961,000, respectively. A bonus computed at
2.5% of this amount would be $7,553,000, $10,241,000, and $12,449,000, respectively,
for that three-year period. Yet Mr. Coss received an annual bonus in stock worth $28.5
million in 1994, $65.1 million in 1995, and $102.0 million in 1996. Clearly, with
amounts such as these involved, there is considerable motivation to use creative ac-
counting practices in an effort to boost the company’s pretax earnings.
Green Tree’s business was to make consumer loans, package them into investment
pools, and sell interests in the pooled loans to investors in the form of asset-backed se-
curities. The company would receive funds for the securities sold and pay an agreed in-
terest amount to investors in those securities. When its loan-backed securities were sold,
the company immediately recorded as profit an amount based on the estimated interest

6

Financial Numbers Game


income it was scheduled to receive on the loans underlying the securities over and above
the interest the company had agreed to pay the investors in those securities. The estimate
of the amount of interest to be received from the underlying loans was very sensitive to
assumptions on such factors as changing interest rates, loan prepayments, and loan
charge-offs. Green Tree was aggressive in the assumptions it used, thus increasing the
amount of operating profit reported on sales of the loan-backed securities.
In 1997 the company adopted less aggressive assumptions on the repayment of its
consumer loans. The company restated its 1996 net income downward to $184.7 million
from the previously reported $308.7 million. As a result, Mr. Coss returned a substantial
portion of the bonus shares he received for that year.
Another bonus plan that was tied to reported profits and offered a motivation to its
management to engage in creative accounting practices was the plan in place at Leslie
Fay Companies, Inc. In 1991 the company’s plan paid a bonus to certain key officers of
the company if net income exceeded $16 million. No bonus was paid if net income fell
short of that amount.
Whether it was the bonus plan that encouraged questionable behavior on the part of
the company’s management is not clear. What is clear in hindsight is that earnings re-
ported by the company in 1991 and 1992 were largely fictitious. Until the company’s fic-
titious profit scheme was uncovered, Leslie Fay’s management enjoyed higher bonuses
than they would have if the altered amounts had not been reported.


Political Cost Effects
Large and high-profile firms may have the motivation to manage their earnings down-
ward in an effort to be less conspicuous to regulators. Few readers old enough to have
experienced firsthand a strong Organization of Petroleum Exporting Countries (OPEC)
and the price effects of the oil embargoes of the 1970s will forget the term obscene prof-
its as it was applied to the earnings of the oil companies during that period. The earn-
ings of those companies were viewed as sufficiently high that Congress enacted a
special “windfall profits tax” in an effort to rein them in. Oil prices moved so quickly
during that period that likely there was very little these companies could have done to
mitigate the positive earnings effect. Given time, however, they might have been en-
couraged to take steps, such as deferring revenue or accelerating expenses, in an effort
to lower reported income.
A company that has been very clearly in the spotlight of regulators in recent years is
Microsoft Corp. Although it has a market share of as much as 90% of the personal com-
puter operating systems market, the company has unsuccessfully argued in federal court
that it does not have monopoly power. Like the oil companies in the 1970s, reporting
lower profits could actually be in Microsoft’s interest. A review of the company’s ac-
counting policies does show instances where it has taken a very conservative stance.
Consider, for example, its accounting for software development costs. As is detailed
more carefully later, accounting principles for software development costs call for cap-
italization of these costs as opposed to expensing them once technological feasibility—
that the software can be produced to meet its design specifications—is reached.
Interestingly, the company expenses 100% of its software development costs, capitaliz-

7

THE FINANCIAL NUMBERS GAME


ing none. This approach is taken even though research and development (R&D) at the
company, primarily software development, totaled $1.8 billion, $2.6 billion, and $3.0
billion, or 28%, 29%, and 23%, respectively, in 1997, 1998, and 1999, of operating in-
come before R&D expense. By expensing all of these costs as incurred, the company’s
earnings are reduced, helping it to appear to be less profitable and, it is hoped, less of a
regulatory target.
Microsoft also has taken a conservative approach in the determination of unearned
revenue, or the portion of revenue that, while collected, is not yet recognized in earnings.
Instead, such unearned revenue is reported as a current liability on the company’s bal-
ance sheet. The company describes its policy for determining the unearned portion of its
software revenue in this way:

A portion of Microsoft’s revenue is earned ratably over the product life cycle or, in the case
of subscriptions, over the period of the license agreement. End users receive certain ele-
ments of the Company’s products over a period of time. These elements include browser
technologies and technical support. Consequently, Microsoft’s earned revenue reflects the
recognition of the fair value of these elements over the product’s life cycle.15

Under this accounting policy, Microsoft correctly defers or postpones recognition at
the time of sale of a portion of the revenue associated with services to be provided over
an extended license period. The amount deferred is a function of the value assigned to
these undelivered elements. Under this policy, the higher the value assigned to the un-
delivered elements, the greater the amount of revenue deferred at the time of sale.
Microsoft has deferred significant amounts of revenue under this policy. Unearned
revenue reported on the company’s balance sheet grew from $1.4 billion in 1997 to $2.9
billion in 1998 and $4.2 billion in 1999. However, late in 1999 the company adopted a
new accounting principle and altered how it calculated the amount of revenue to be de-
ferred. Here is how the company described its adoption of the new principle:

Upon adoption of SOP 98-9 during the fourth quarter of fiscal 1999, the Company was re-
quired to change the methodology of attributing the fair value to undelivered elements. The
percentages of undelivered elements in relation to the total arrangement decreased, reduc-
ing the amount of Windows and Office revenue treated as unearned, and increasing the
amount of revenue recognized upon shipment.16

Whether the company, before adoption of this new principle, was being overly con-
servative in its revenue recognition practices cannot be known. However, what is known
is that the company was being more conservative than what accounting regulators
deemed appropriate.


CLASSIFYING CREATIVE ACCOUNTING PRACTICES

Using creative accounting practices, managements can alter impressions about their
firms’ business performance. Assessments of corporate earning power can be rendered
inaccurate, leading to inappropriate prices for debt and equity securities. When resulting
misstatements are discovered, the markets can be unforgiving, causing precipitous de-

8



Financial Numbers Game


clines in debt and equity prices. The objective of this book is to enable the financial state-
ment reader to better detect the use of creative accounting practices. As a result, the
reader will be better able to assess corporate earning power and avoid equity-investment
and credit-granting mistakes.
A practical classification scheme is especially valuable in determining whether one or
more creative accounting practices are being employed. Such a scheme provides order
and helps the financial statement reader to become more focused in his or her search for
items that may indicate that earning power may not be what is implied by a cursory read.
The classification scheme that is used here begins with groups based on the mea-
surement of revenue and expense and assets and liabilities: Recognizing Premature or
Fictitious Revenue, Aggressive Capitalization and Extended Amortization Policies, and
Misreported Assets and Liabilities. Additional classes are added for creativity em-
ployed in the preparation of the income statement and cash flow statement. These
classes are known as Getting Creative with the Income Statement and Problems with

Cash Flow Reporting.

FLY
F

These five categories will provide the detail needed to represent the kinds of creative
accounting practices employed in contemporary financial statements. They are applied
as labels to the accounting practices employed, whether those practices are the result
AM

AM
of aggressive policies, both within or beyond the boundaries of generally accepted

accounting principles (GAAP), or whether they are the result of fraudulent financial
reporting. The classification scheme is summarized in Exhibit 1.3 and explained fur-
ther below.                             TETE
Recognizing Premature or Fictitious Revenue
Given the prominence of revenue on the income statement and its direct impact on earn-
ings, it is not surprising that creative accounting practices often begin with revenue
recognition. In fact, premature or fictitious revenue recognition is an almost indispens-
able component of the financial numbers game. This should be clear from the examples
already cited because many of them involved some form of premature or fictitious rev-
enue recognition. In those cases, reported revenue was boosted, at least in the near term,
positively impacting earnings and communicating higher earning power.
Premature revenue recognition refers to recognizing revenue for a legitimate sale in a
period prior to that called for by generally accepted accounting principles. In contrast,
fictitious revenue recognition entails the recording of revenue for a nonexistent sale.



Exhibit 1.3   Classification of Creative Accounting Practices

Recognizing Premature or Fictitious Revenue
Aggressive Capitalization and Extended Amortization Policies
Misreported Assets and Liabilities
Getting Creative with the Income Statement
Problems with Cash-flow Reporting



9


®


THE FINANCIAL NUMBERS GAME


Much like the gray area that exists between the aggressive application of accounting
principles and fraudulent financial reporting, however, it is often difficult to distinguish
between premature and fictitious revenue recognition. It is a matter of degree.
Revenue for ordered goods that have not left the shipping dock might be recognized
as though the goods had already been shipped. Such an act would entail premature rev-
enue recognition. More aggressively, product might be shipped and revenue recognized
in advance of an expected order. Given the lack of an order, such an act would, in our
view, entail fictitious revenue recognition. However, many financial statement users
would reserve the derogatory term, fictitious revenue recognition, for cases of even more
blatant abuse of revenue recognition principles. Examples would include recording sales
for shipments for which orders are not expected, or worse, recording sales for nonexis-
tent shipments.
For purposes of analysis, a careful demarcation between premature and fictitious rev-
enue recognition is less important than determining that, in both cases, revenue has been
reported on the income statement that does not belong. Expectations about earning
power will have been influenced accordingly.
In its 1994 annual report, Midisoft Corp. described its accounting policy for revenue
recognition in this way: “Revenue from sales to distributors, other resellers and end
users is recognized when products are shipped.”17While the policy, as expressed, and
subject to a proper accounting for estimated returns, is consistent with GAAP, the com-
pany was recognizing revenue improperly in two ways. First, in an act of premature rev-
enue recognition, the company recognized revenue on goods that were not shipped until
after the end of its fiscal year. Second, in an act of fictitious revenue recognition, the
company recognized revenue on transactions for which products were shipped on a
timely basis, but for which, at the time of shipment, the company had no reasonable ex-
pectation that the customer would accept and pay for the products shipped. These ship-
ments were eventually returned to the company as sales returns. However, at the time of
shipment, an insufficient provision for returns had been recorded. As a result of these ac-
tions, the company overstated revenue for 1994 by approximately $811,000, or 16%.18
For firms receiving up-front fees that are earned over an extended period, recognition
might be accelerated to the time of receipt. For years prior to 1998, The Vesta Insurance
Group, Inc., recognized revenue for reinsurance premiums in the year in which the re-
lated reinsurance agreements were contracted. This policy was followed even though the
terms of those contracts bridged two years, calling for those premiums to be recognized
ratably over the contract period. As a result, over the period from 1995 through the first
quarter of 1998, the company had overstated earnings and shareholders’ equity by a cu-
mulative $75,200,000.19
Premature or fictitious revenue recognition will appear often in examples of the ag-
gressive application of accounting principles and fraudulent financial reporting. As such,
the revenue recognition group is an important category of creative accounting practices.

Aggressive Capitalization and Extended Amortization Policies
Rather than taking steps to boost revenue, or in some cases, in addition to taking steps to
boost revenue, some firms will increase reported earnings by minimizing expenses. In

10

Financial Numbers Game


this category, Aggressive Capitalization and Extended Amortization Policies, companies
will minimize expenses by aggressively capitalizing expenditures that should have been
expensed or by amortizing capitalized amounts over extended periods.
In many cases, determining the portion of an expenditure to capitalize is straightfor-
ward. For example, amounts paid to purchase equipment and prepare it for use are cap-
italized into the equipment account and amortized, or depreciated, over the equipment’s
useful life. Often, however, the items involved are a bit more esoteric, including such
items as direct-response advertising, software development, and landfill site acquisition
and development costs, entailing judgment in determining whether capitalization is ap-
propriate or not.
When capitalized, an expenditure creates an asset that is amortized over some prede-
termined useful life. When contrasted with the more conservative expensing option,
near-term earnings are increased, implying higher earning power.
American Software, Inc., has historically capitalized software development costs.
The practice is consistent with GAAP, which permit capitalization of software develop-
ment costs, including such costs as software coding, testing, and production, after tech-
nological feasibility is reached. As noted earlier, technological feasibility occurs when
it is determined that the software can be produced to meet its design specifications.20
However, the proportion of these costs that was being capitalized by the company was
somewhat aggressive. Using figures available in its annual report, for the years ended
April 30, 1997, 1998, and 1999, the company capitalized $7,363,000, $12,112,000, and
$11,511,000, respectively, of software development costs incurred. During those same
years, the company amortized software development costs that had been capitalized pre-
viously in the amounts of $4,700,000, $6,706,000, and $6,104,000, respectively. The dif-
ference between these amounts each year, the amounts capitalized and the amounts
amortized, or $2,663,000 in 1997, $5,406,000 in 1998, and $5,407,000 in 1999, boosted
the company’s pretax income in each of those years. However, in the year ended April
30, 1999, the company wrote off $24,152,000 in capitalized software development costs,
as a result of “ongoing evaluations of the recoverability of its capitalized software pro-
jects.”21The company apparently had capitalized more software development costs than
could be realized through operations, and it therefore became necessary for the company
to write those costs off. In the intervening years leading up to the write-off, however, the
company’s capitalization policy had boosted its reported earnings and its apparent earn-
ing power.
Before its acquisition, Chambers Development Company, Inc., was in the business of
collecting, hauling, and disposing solid waste and of building and operating solid waste
sanitary landfills and related operations. During the period 1989 to 1990, the company
capitalized significant amounts of landfill development costs. Generally accepted ac-
counting principles permit capitalization where future realization of the costs through an-
ticipated revenue is given careful consideration. In the case of Chambers, however,
future realization was not considered in determining the amounts to be capitalized. In-
stead, Chambers calculated expenses and determined amounts to be capitalized based on
targeted profit margins determined in advance. As a result, the company appeared to be
more profitable, indicating higher earning power, than it otherwise would have been. In
fact, the company’s capitalization policy converted it from a loss to a profitable opera-

11

THE FINANCIAL NUMBERS GAME


tion. Using amounts provided by the Securities and Exchange Commission, the company
originally reported pretax income of $27.1 million and $34.4 million in 1989 and 1990,
respectively. Revised amounts, restated to correct for improperly capitalized landfill de-
velopment costs, were pretax losses of $16.5 million and $40.6 million, respectively.22
Another practice used to reduce expenses and boost earnings is to lengthen amortiza-
tion periods for costs that have been capitalized previously. This practice might be used
for such assets as property, plant, and equipment, or any of the assets, including capital-
ized software development and capitalized landfill development costs, mentioned above.
In an example provided earlier in this chapter, Waste Management, Inc., took a spe-
cial charge of $3.54 billion to, among other things, write-down fixed assets that had not
been depreciated quickly enough. The company adopted new, more conservative ac-
counting practices that included shorter useful lives for fixed assets. Examples such as
Waste Management, and others, where earnings have been boosted through aggressive
cost capitalization or through extended amortization periods, are grouped in this category
of creative accounting practices.

Misreported Assets and Liabilities
In the category of misreported assets and liabilities, we include assets that are not subject
to annual amortization, such as accounts receivable, inventory, and investments. Ex-
penses and losses can be minimized through an overvaluation of such assets. For exam-
ple, by overestimating the collectibility of accounts receivable, the provision for doubtful
accounts, an operating expense, is reduced. Similarly, a loss can be postponed by ne-
glecting to write-down slow-moving inventory or an investment whose value has declined
and is not expected to recover. An example noted earlier was that of Centennial Tech-
nologies, Inc. The company’s fraudulent acts to misreport its earning power included
overstatements of all three assets, accounts receivable, inventory, and investments.
Also included in this category are steps taken to boost earnings by understating lia-
bilities. While the example entailed an error and was apparently not deliberate, the direct
link between accounts payable and cost of goods sold was apparent in the case of Micro
Warehouse, Inc. The company understated inventory purchases and accounts payable,
understating cost of goods sold and overstating its operating income by a cumulative
amount of $47.3 million.23Other liabilities that might be understated, boosting reported
earnings, include accrued expenses payable, environmental claims, and derivatives-re-
lated losses. All of these liabilities, in addition to assets that are not subject to amortiza-
tion, such as accounts receivable, inventory, and investments, are included in this group
of creative accounting practices.

Getting Creative with the Income Statement
Getting creative with the income statement includes steps taken to communicate a differ-
ent level of earning power using the format of the income statement rather than through
the manner in which transactions are recorded. Companies may report a nonrecurring gain
as “other revenue,” a recurring revenue caption, or a recurring expense might be labeled
as nonrecurring. Such practices result in higher apparent levels of recurring earnings
without altering total net income. One example is that of International Business Machines

12

Financial Numbers Game


Corp. (IBM), which in a 1999 interim report netted $4 billion in gains on an investment
against selling, general and administrative expense.24As a result, the company imparted
an impression that recurring operating expenses were being reduced.

Problems with Cash Flow Reporting
A company can communicate higher earning power not only by reporting higher earn-
ings but by reporting higher and more sustainable cash flow. The statement of cash flow
divides the total change in cash into three components: cash flow provided or used by
operating activities, investing activities, and financing activities. Given the potential re-
curring quality of operating cash flow, the higher the apparent level of that cash flow
statement subtotal, the greater will be a company’s apparent earning power.
In order to boost operating cash flow, a company might classify an operating expen-
diture as an investing or financing item. Similarly, an investing or financing inflow
might be classified as an operating item. Such steps will not alter the total change in cash.
Companies that capitalize software development costs will, in most instances, report
the amount capitalized as an investing cash outflow, keeping it out of the operating sec-
tion. Accordingly, a company that capitalizes a greater portion of its software develop-
ment costs, as American Software did, will report higher amounts of operating cash flow
than companies that expense all or most of their software development expenditures. In-
terestingly, if a company, such as American Software, later writes down its capitalized
software development costs, the resulting noncash charge does not penalize operating
cash flow.
Certain accounting guidelines for cash flow reporting may result in reported operat-
ing cash flow amounts that are misunderstood. For example, cash provided by operating
activities includes nonrecurring cash flow arising from the operating income component
of discontinued operations. Also, all income taxes are reported as operating cash flow,
including taxes related to items properly classified as investing and financing actions.
Accounting rules for cash flow reporting that may be misunderstood combined with
steps taken by some managements to boost apparent operating cash flow may result in
cash flow amounts that yield misleading signals. All such items that may render operat-
ing cash flow a less effective tool in evaluating financial performance are referred to here
as problems with cash flow reporting.



PLAN OF THIS BOOK

As noted, the objective of this book is to equip the financial statement reader to better de-
tect the use of creative accounting practices and avoid equity-investment and credit-
granting mistakes. This objective is achieved with the chapters detailed below.
In Chapter 2, “How the Game Is Played,” we look at the flexibility that is available to
those preparing financial statements and how that flexibility can be used, and often
stretched, sometimes to the point of fraud, in an effort to achieve desired results. By bet-
ter understanding this reporting flexibility, the reader will be more prepared to see how
it might be used to mislead. Chapter 3, “Earnings Management: A Closer Look,” pro-

13

THE FINANCIAL NUMBERS GAME


vides an in-depth look at the use of earnings management and income smoothing tech-
niques, a subset of creative accounting practices. In Chapter 4, “The SEC Responds,” we
describe how the SEC has become more diligent in recent years in pursuing creative ac-
counting practices. However, even though the commission is more actively pursuing the
use of creative accounting practices, it cannot eliminate them. The financial statement
reader will need to remain on guard. In Chapter 5, “Financial Professionals Speak Out,”
we report the findings of a survey of many different groups of financial professionals, in-
cluding financial analysts, chief financial officers, commercial bankers, certified public
accountants, and accounting academics, on their views regarding the detection of cre-
ative accounting practices. The objective is to supplement our knowledge on the subject
with information gleaned from professionals who prepare, use, and instruct others on the
use of financial statements.
In Chapters 6 through 11 we detail our recommendations for detecting creative ac-
counting practices. In Chapter 6, “Recognizing Premature or Fictitious Revenue,” we de-
tail certain likely signs that revenue may have been recorded in a premature or fictitious
manner. Expenses and losses become the focus in Chapters 7 and 8. In Chapter 7, “Ag-
gressive Capitalization and Extended Amortization Policies,” attention is directed to as-
sets that are subject to periodic amortization. In Chapter 8, “Misreported Assets and
Liabilities,” the focus is directed to assets that are not subject to periodic amortization
and to liabilities.
Creative financial statement presentation is the subject for the last three chapters of
the book. In Chapter 9, “Getting Creative with the Income Statement: Classification and
Disclosure,” and Chapter 10, “Getting Creative with the Income Statement: Pro-Forma
Measures of Earnings,” the focus is on the reporting of earnings, both in accordance with
the guidelines of generally accepted accounting principles and in pro-forma reports,
where such formal guidelines do not presently exist. The book concludes with Chapter
11, “Problems with Cash Flow Reporting.” Even when total cash flow is reported accu-
rately, the manner in which those cash flows are reported can alter a reader’s impression
of recurring cash flow. Collectively, the final three chapters look at the creative use of
reporting formats to alter impressions of earning power.


SUMMARY

This chapter establishes an organization for the entire book. Key points raised include
the following:

• Examples of creative accounting practices, attributable to managements engaged in
the financial numbers game, occur often in contemporary financial statements.
• Potential rewards for playing the financial numbers game can be substantial. Included
among them are positive share-price effects, lower borrowing costs and less-stringent
financial covenants, boosted profit-based bonuses, and reduced political costs.
• Markets can be very unforgiving when news of accounting gimmickry becomes
widely known.


14

Financial Numbers Game


• Given the various creative accounting practices that can be used to play the financial
numbers game, a classification scheme was devised to facilitate their discovery. The
scheme has five categories:
1.   Recognizing premature or fictitious revenue
2.   Aggressive capitalization and extended amortization policies
3.   Misreported assets and liabilities
4.   Getting creative with the income statement
5.   Problems with cash flow reporting
Separate book chapters are devoted to each of these categories of creative accounting
practices.


GLOSSARY

Accounting Errors        Unintentional mistakes in financial statements. Accounted for by restating
the prior-year financial statements that are in error.
Accounting Irregularities        Intentional misstatements or omissions of amounts or disclosures in
financial statements done to deceive financial statement users. The term is used interchangeably
with fraudulent financial reporting.
Aggressive Accounting        A forceful and intentional choice and application of accounting prin-
ciples done in an effort to achieve desired results, typically higher current earnings, whether the
practices followed are in accordance with generally accepted accounting principles or not. Ag-
gressive accounting practices are not alleged to be fraudulent until an administrative, civil, or
criminal proceeding takes that step and alleges, in particular, that an intentional, material mis-
statement has taken place in an effort to deceive financial statement readers.
Aggressive Capitalization Policies        Capitalizing and reporting as assets significant portions of
expenditures, the realization of which require unduly optimistic assumptions.
Big Bath      A wholesale write-down of assets and accrual of liabilities in an effort to make the
balance sheet particularly conservative so that there will be fewer expenses to serve as a drag on
future earnings.
Bill and Hold Practices        Products that have been sold with an explicit agreement that delivery
will occur at a later, often yet-to-be-determined, date.
Capitalize      To report an expenditure or accrual as an asset as opposed to expensing it and
charging it against earnings currently.
Creative Accounting Practices         Any and all steps used to play the financial numbers game, in-
cluding the aggressive choice and application of accounting principles, both within and beyond
the boundaries of generally accepted accounting principles, and fraudulent financial reporting.
Also included are steps taken toward earnings management and income smoothing. See Finan-
cial Numbers Game.
Earning Power        A company’s ability to generate a sustainable, and likely growing, stream of
earnings that provide cash flow.
Earnings Management       The active manipulation of earnings toward a predetermined target.
That target may be one set by management, a forecast made by analysts, or an amount that is con-
sistent with a smoother, more sustainable earnings stream. Often, although not always, earnings


15

THE FINANCIAL NUMBERS GAME


management entails taking steps to reduce and “store” profits during good years for use during
slower years. This more limited form of earnings management is known as income smoothing.
Extended Amortization Periods           Amortizing capitalized expenditures over estimated useful
lives that are unduly optimistic.
Fictitious Revenue       Revenue recognized on a nonexistent sale or service transaction.
Financial Numbers Game        The use of creative accounting practices to alter a financial state-
ment reader’s impression of a firm’s business performance.
Fraudulent Financial Reporting          Intentional misstatements or omissions of amounts or dis-
closures in financial statements done to deceive financial statement users. The term is used in-
terchangeably with accounting irregularities. A technical difference exists in that with fraud, it
must be shown that a reader of financial statements that contain intentional and material mis-
statements must have used those financial statements to his or her detriment. In this book, ac-
counting practices are not alleged to be fraudulent until done so by an administrative, civil, or
criminal proceeding, such as that of the Securities and Exchange Commission, or a court.
Generally Accepted Accounting Principles (GAAP)              A common set of standards and proce-
dures for the preparation of general-purpose financial statements that either have been estab-
lished by an authoritative accounting rule-making body, such as the Financial Accounting
Standards Board (FASB), or over time have become accepted practice because of their univer-
sal application.
Income Smoothing       A form of earnings management designed to remove peaks and valleys
from a normal earnings series. The practice includes taking steps to reduce and “store” profits
during good years for use during slower years.
LIFO      The last-in, first-out method of inventory cost determination. Assumes that cost of goods
sold is comprised of newer goods, the last goods purchased or manufactured by the firm.
Loan Covenants       Express stipulations included in loan agreements that are designed to moni-
tor corporate performance and restrict corporate acts, affording added protection to the lender.
Negative Loan Covenants         Loan covenants designed to limit a corporate borrower’s behavior
in favor of the lender.
Political Costs      The costs of additional regulation, including higher taxes, borne by large and
high-profile firms.
Positive Loan Covenants        Loan covenants expressing minimum and maximum financial mea-
sures that must be met by a borrower.
Premature Revenue        Revenue recognized for a confirmed sale or service transaction in a pe-
riod prior to that called for by generally accepted accounting principles.
Securities and Exchange Commission (SEC)          A federal agency that administers securities leg-
islation, including the Securities Acts of 1933 and 1934. Public companies in the United States
must register their securities with the SEC and file with the agency quarterly and annual finan-
cial reports.


NOTES

1. A. Levitt, The “Numbers Game,” remarks to New York University Center for Law and Busi-
ness, September 28, 1998, para. 4. Available at: www.sec.gov/news/speeches/spch220.txt.
2.   The Wall Street Journal, February 26, 1998, p. R3.
3. Ibid., January 26, 1995, p. A4.

16




4. Ibid., May 7, 1997, p. A4.
5. Ibid., March 21, 2000, p. B1.

Financial Numbers Game

6. Ibid., October 21, 1998, p. B6.
7. Ibid., January 6, 2000, p. A1.
8. Ibid., February 25, 1998, p. A4.
9. Ibid., April 17, 1998, p. A3.
10. Ibid., February 22, 2000, p. A3.
11. Ibid., December 10, 1999, p. A4.
12. Accounting and Auditing Enforcement Release No. 883, Securities and Exchange Commis-
sion v. Emanual Pinez (Washington, DC: Securities and Exchange Commission, February
14, 1997).
13.   The Wall Street Journal, February 25, 1999, p. B9.
14. Refer to The Wall Street Journal, December 22, 1998, p. C2.
15. Microsoft Corp., Form 10-K annual report to the Securities and Exchange Commission,
June 1999, Exhibit 13.4.
16. Ibid. SOP 98-9 refers to Statement of Position 98-9, Modification of SOP 97-2, Software
Revenue Recognition with Respect to Certain Transactions (New York: American Institute
of CPAs, 1998).
17. Midisoft Corp., annual report, December 1994. Information obtained from Disclosure, Inc.,
Compact D/SEC: Corporate Information on Public Companies Filing with the SEC
(Bethesda, MD: Disclosure, Inc., December 1995).
18. Accounting and Auditing Enforcement Release No. 848, In the Matter of Alan G. Lewis, Re-
spondent (Washington, DC: Securities and Exchange Commission, October 28, 1996).
19. The Vesta Insurance Group, Inc., Form 10-K annual report to the Securities and Exchange
Commission, December 1998, pp. 20–21.
20. SFAS No. 86, Accounting for the Costs of Computer Software to Be Sold, Leased, or Other-
wise Marketed (Norwalk, CT: Financial Accounting Standards Board, August 1985).
21. American Software, Inc., Form 10-K annual report to the Securities and Exchange Commis-
sion, April 1999, p. 35.
22. Accounting and Auditing Enforcement Release No. 767, In the Matter of John M. Gold-
berger, CPA and C. Kirk French, CPA, Respondents (Washington, DC: Securities and Ex-
change Commission, March 5, 1996).
23. Micro Warehouse, Inc., Form 10-K annual report to the Securities and Exchange Commis-
sion, December 1996, Exhibit 11.
24.   The Wall Street Journal, November 24, 1999, p. C1.


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