Accounting Practice Now and Then –What a Board Member Must Know

Dr. Wayne H. ShawRobert B. Cullum Distinguished

Professor of AccountingEdwin L. Cox School of Business

Southern Methodist University

Accounting Restatements

• Descriptive data from the 1990’s

• Impact of Sarbanes-Oxley

• Examples by areas of concern

Restatements by Year 1990-2000

3348 58

156

1

150

91

5932

51 6150

9

57

0

50

100

150

200

250

19901991199219931994199519961997199819992000

IPR&DAll others

Restatements by Reason

37

360

305

30

94

39

67

24

5569

UnknownRevenueCostRevenue & costLoan lossAcquisitionIP R&DReclassificationBookkeeping errorOthers

Restatements by Year and Reason

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

199019921994199619982000

UnknownRevenueRevenue & costCostLoan lossAcquisitionIP R&DReclassificationBookkeeping errorOthers

Restatements by Market Value of Restating Company 1995-2000

3655

46

389

105

$5B+$1B to $4.99B$500M to $999M<$500MN/A

Observations – Market Value Losses

• 1995 - 2000 average = $13.1 billion / year

• 1995 - 2000 total = $78.3 billion

• Losses averaged 0.09% of total equity market value

Sarbanes-OxleyCertification Under SEC.302

Principal executive officer, financial officer or other persons performing similar functions must certify each annual or quarterly financial statement:• “does not contain any untrue statement of a material

fact or• omit to state a material fact necessary in order to

make the statements made,• in light of the circumstances under which such

statement were made, not misleading”

Certification Under SEC.302

Principal executive officer, financial officer or other

persons performing similar functions must certify each

annual or quarterly financial statement (cont’d):• “The financial statements, and other financial

information included in the report, fairly present in all material respects the financial condition and results of operations of the issuer as of, and for, the periods presented in the report”

Certification Under SEC.302

Signing officers:• Are responsible for establishing and maintaining internal

controls• Have designed internal controls so that material

information relating to the issuer and consolidated subsidiaries is made known to such officers by others within the entities

• Have evaluated the effectiveness of the internal controls within 90 days of the report

• Have presented in the report their conclusions about the effectiveness of their internal controls

Certification Under SEC.302Signing officers have disclosed to the auditor and audit committee:• All significant deficiencies in the design and operation

of internal controls that could adversely affect the issuer’s ability to report financial data

• Any fraud, whether material or not, by those having a significant role in issuer’s internal control – Can be by any employee

Enhanced Financial Disclosures

Financial report are required to:• Be prepared in accordance with GAAP• Reflect all material correcting adjustments that

have been identified by the auditor• Disclose all material off-balance-sheet

transactions and other relationships with unconsolidated entities or persons– SEC will issue a study within a year

Enhanced Financial Disclosures

Pro forma financial data released must be

presented in a manner that:

• “Does not contain an untrue statement of a material fact or omit to state a material fact necessary”

• Is reconciled with the GAAP-based presentation

Improper Influence on Audits

• Unlawful for any officer or director to take any action to– Fraudulently influence– Coerce– Manipulate– Or mislead

• Any auditor engaged in performance of an audit

Areas of Most Concern

• Revenue recognition

• Expense deferral or avoidance

• Off-balance sheet financing

• Acquisition accounting

• Stock transactions

• Pro forma earnings

Revenue Recognition

• SAB 101– Fulfillment costs– Barter revenues– Gross vs. net

• Stuffing the channels

• Mark-to-market

Fulfillment Costs

• Fulfillment costs(in thousands)Sales 16,443    16,443Cost of goods sold 14,786    16,286

Gross profit 1,657        157Operating expenses 49,724    48,224

Net income before taxes (48,067) (48,067)

• The stock price of Fogdog fell 90% upon revision of disclosure

Barter Revenues - SwapsWhat if you swap ability to use telecommunications networks with other firms in areas outside your area of coverage?• Global Crossing and others booked the transactions as

follows:– Property, Plant and Equipment

Cash– Cash

Property, Plant & EquipmentProfit on sale of network

• Therefore, while revenue is recorded immediately the expense is recognized as depreciation over the life of the agreement

Barter Revenues – Swaps UpdateAugust 22, 2002 - WSJ

• The Securities and Exchange Commission has formally concluded that telecommunications companies acted improperly in booking revenue from capacity swaps with other companies.

• For example, in early 2001, Global Crossing and Qwest entered into such a swap with each side valued at $100 million. The SEC ruling says that such exchanges shouldn't be considered revenues, though companies are still free to exchange telecom assets on a cashless, or barter, basis.

• The amount of revenue that could be traced to the practice for some companies was significant. Qwest , for example, said it is reviewing its accounting for over $1 billion in telecom capacity sales during the last two years. Some of those may be swap transactions.

Gross versus NetFranchise Fees

• How to handle franchise fees?• Comcast, prior to the AT&T acquisition netted

franchise fees paid to municipalities for the right to provide service against revenues only disclosing the net amount.

• AT&T, post acquisition reported gross revenues and deducted the franchise fee as an expense.

• Current treatment varies across firms. For example,– Charter Communications – gross– AOL/Time Warner – net– Cox – net– AT&T – gross

Stuffing the Channel• Network Associates Announces SEC Probe

(March 27, 2002 – WSJ)– SEC officials declined to comment on the investigation, which could

include a look at the company’s former practice of booking revenue on products shipped into distribution channels before they got to customers. The practice, sometimes derided as “stuffing the channel,” isn’t illegal as long as it is fully disclosed to investors.

– The company’s new management abolished this practice when it took over at the end of 2000. The practice has hurt several other software companies in the past, testing their credibility with Wall Street and forcing them to restate revenue.

– Many analysts and accounting experts favor a more conservative method of revenue recognition based on when the software reaches the business or consumer that will ultimately use it. By recording sales when the software reaches a distributor, a company can inflate revenue and takes the chance that software could accumulate in a warehouse without reaching a buyer.

Segment Reporting - AOL

• SEC Probes AOL-Oxygen Pact For Double-Booking of Revenue (October 6, 2002 –WSJ)– By MARTIN PEERS and LAURIE P. COHEN

• Oxygen signed a complex deal with AOL in April 2001 under which Time Warner Cable agreed to put the women-focused cable channel on its systems without a launch fee while Oxygen agreed to spend about $100 million in advertising at AOL, mostly on America Online. People familiar with the situation say AOL engineered inter-company advertising transactions so that the ad revenue was effectively reflected both in America Online's divisional numbers and those of Time Warner Cable.

Mark-to-Market• You made a stock investment that had declined in

value during the year• Do you record the decline in value?• Depends on your investment horizon

– Trading in stock• Reduces asset value and net income

– Available-for-sale• Reduces asset value but not net income

– Long-term investment• Reduce asset value and net income only if permanently

impaired• Who decides investment horizon and permanent impairment?

– You, of course!

Expense Deferral and Avoidance

• Positioning of costs to affect cash flow source – Capitalization or financing

• Change in asset lives

• Asset write-downs

• Use of reserves

Expense Capitalization WorldCom (June 26, 2002 – New York Times)

• WorldCom, the nation’s second-largest long-distance carrier, said last night that it had overstated its cash flow by more than $3.8 billion during the last five quarters in what appears to be one of the largest cases of false corporate bookkeeping yet.

• WorldCom’s board said it had fired Mr. Sullivan after discovering a strategy in which operating costs like basic network maintenance had been booked as capital investments, an accounting gimmick that enabled WorldCom to hide expenses, inflate its cash flow and report profits instead of losses.

Choice of Asset Life

• Longer live leads to less current depreciation

• Shifts costs to future years

• Can be changed anytime circumstances indicate a need

• No cash implications since no effect on tax depreciation or amortization

Choice of Asset Life - Example• Rental Library – Blockbuster

Prior to July 1, 2001, the cost of non-base stock videocassettes, defined as new release product, was amortized on an accelerated basis over three months to an estimated $4 residual value. The cost of base stock videocassettes, defined as catalogue product, was amortized on an accelerated basis over three months and then on a straight-line basis over thirty-three months to an estimated $4 residual value. The cost of new release, or non-base stock DVDs, was amortized on an accelerated basis over six months to an estimated $4 residual value. Video games and base-stock DVDs were amortized on an accelerated basis over a twelve-month period to an estimated $10 and $4 residual value, respectively.

Beginning July 1, 2001, the cost of non-base stock videocassettes is amortized on an accelerated basis over three months to an estimated $2 residual value. The cost of base stock videocassettes is amortized on an accelerated basis over three months and then on a straight-line basis over six months to an estimated $2 residual value. The cost of a new release DVD is amortized on an accelerated basis over six months to an estimated $4 residual value. Video games and base-stock DVDs are amortized on an accelerated basis over a twelve-month period to an estimated $5 and $4 residual value, respectively

Choice of Asset Life - Example

• Nextel – Change in Amortizable Life of Intangible Assets

As a result of customer acceptance and support of the financial community which became specifically apparent in the fourth quarter of 1997, we increased the amortization period from 20 years to 40 years for all of our domestic FCC licenses and the excess of purchase price over the fair value of net assets acquired (goodwill) related to all domestic acquisitions. International licenses and the excess of purchase price over the fair value of net assets acquired related to our international acquisitions are amortized on a straight-line basis over 20 years. The change in the estimated useful lives of these intangible assets had the effect of decreasing amortization expense by $28 million for the quarter and year ended December 31, 1997.

Asset Write-Down Example: Cisco

• Cisco issues revenue warning: Says sales will be down 30% in third quarter; announces write-down, new layoffs (April 17, 2001 – WSJ).

• Telecom-equipment maker Cisco Systems warned late yesterday that its revenue will be down 30 per cent in the third quarter, compared with the previous quarter, and it is writing off $2.5 billion in excess inventory.

• What if inventory later sold?– Revenue equals net income from sale since there are no costs left to offset

the revenues.

• Cisco Systems Reports First Quarter Earnings (November 5, 2001 - WSJ)

Cisco Systems, Inc., the worldwide leader in networking for the Internet, today reported its first quarter results for the period ending October 27, 2001.

Net sales for the first quarter of fiscal 2002 were $4.4 billion, a sequential increase of 3% from the $4.3 billion in net sales for the fourth quarter of fiscal 2001. This compares to $6.5 billion in net sales for the same period last year, a decrease of 32%. Pro forma net income excludes the effects of acquisition charges, payroll tax on stock option exercises, net gains (losses) on investments, and an excess inventory benefit.

Asset Write-Down Example: Cisco

Use of Reserves to Shift Income Between Periods

• Increase expenses currently by setting up a reserve (liability) account

• Later years income will be higher when expenses are paid since payment reduces the liability in the future rather than shown as an expense

• Used to smooth income reported

Examples of Income Smoothing Using Reserves

• Fuzzy accounting raises flags Investors feel the pain when companies fudge the facts (June 22, 2001 – USA Today)

– By MATT KRAMTZ and GREG FARRELL

• Kroger, one of the USA’s largest grocery chains, told investors in March that it was reducing earnings for its fiscal 1998 and 1999 years and the first 2 quarters of fiscal 2000 by a total of roughly $14 million. Several managers within the company’s Ralph’s chain were using a general fund to pad earnings in years they feared they’d miss sales quotas, says spokeswoman Kathy Kelly.

Even Kroger’s external auditor, PricewaterhouseCoopers, was fooled. The slush money was spread over many accounts, so no single account was big enough to raise concerns of the external accounting firm that audits the books, she says. “This was not an error. These individuals were managing earnings,” Kelly says.

Issues of Off-Balance-Sheet Accounting

• Pension plans

• Debt defeasance

• Operating leases

• Special Purpose Entities (SPEs)

Operating Leases

• Do not book the present value of the lease asset or lease obligation at the time of the lease agreement

• Rent expense recognized at the time of payment

• Understates fixed payment liabilities• Indicates firm has greater debt capacity than

it might actually have

Special Purpose Entities Example

• Get unrelated party to buy an asset for you – Unrelated party must have a 3% equity investment in a

special purpose entity

– Remaining capital a loan to the SPE

• Lease it from them through an operating lease• Result

– Debt does not appear on your balance sheet

– Only expense to you is rent

Special Purpose Entities

• New FASB proposal will– Increase unrelated ownership to 10% from 3%– Will enact a set of variable interest rules that

will result in someone recording the lease when control based rules do not work

Acquisition Accounting Issues

• Initial valuation

• Establishment of reserves

• Suspension of goodwill amortization

• Write-down of goodwill and intangibles with indefinite lives

Establishment of Reserves• In connection with the Merger, the Company has reviewed its

operations and implemented several plans to restructure the operations of America Online and Time Warner (“restructuring plans”). As part of the restructuring plans, the Company accrued an initial restructuring liability of approximately $965 million during the first quarter of 2001. The Company accrued an additional liability of approximately $375 million during the year as additional initiatives met the accounting criteria required for accrual. The restructuring accruals relate to costs to exit and consolidate certain activities of Time Warner, as well as costs to terminate employees across various Time Warner business units. Such amounts were recognized as liabilities assumed in the purchase business combination and included in the allocation of the cost to acquire Time Warner. Accordingly, such amounts resulted in additional goodwill being recorded in connection with the Merger.

Suspension of Amortization• AOL Time Warner is in the process of finalizing the impact of

adopting the provisions of FAS 142, which is expected to be significant. Upon adoption, AOL Time Warner will stop amortizing goodwill, including goodwill included in the carrying value of certain investments accounted for under the equity method of accounting. In addition, AOL Time Warner will stop amortizing approximately $38 billion of intangible assets deemed to have an indefinite useful life, primarily intangible assets related to cable franchises and certain brands and trademarks. Based on the current levels of goodwill and intangible assets deemed to have an indefinite useful life, the adoption of FAS 142 will reduce annual amortization expense by approximately $6.7 billion.

Impairment Testing

• From footnote in 2001 AOL Time Warner annual report:

As a result of this initial review for impairment, AOL Time Warner expects to record a one-time, non-cash charge of approximately $54 billion upon adoption of the new accounting standard in the first quarter of 2002. Such charge is non-operational in nature and will be reflected as a cumulative effect of an accounting change.

Impairment Testing - Example

• On March 28, 2002, News Corp. acknowledged a $2 billion write-down of its investment in Genstar-TV Guide

• WSJ highlighted that it was non-cash• Also suggested the write-down “is not

expected to alter analysts’ fundamental view of News Corp’s continuing operations…”

Issues in Equity Accounting

• Stock compensation

• Performance stock options

• Stock warrant accounting

• Financing with puts

Stock Compensation Update

• Recently, several firms including Coca Cola and General Electric have announced they will expense incentive stock options

• MicroSoft and Intel have stated they will not change• Why?

– Possibly because the effect of the change on net income is greater for technology firms

Issues of Stock Put ExposureDell Computer - 2002

• At end of fiscal year 2002, Dell had outstanding put options on 51 million and 122 million shares at $45 and $44 per share– Options exercisable in 1st quarter of 2004– Holder can force settlement at $8 currently

• Net share settlement allowed so no liability is booked

• Based on current stock price, the exposure is approximately $3 billion

Pro Forma Earnings• Attempt by firms to eliminate from reported

earnings one-time items and non-operating items – Concern is that the eliminations are inconsistent across firms– SEC issued cautionary advice to investors on December 1, 2001 that

some disclosures may be incomplete or misleading

• Items often eliminated– Restructuring charges– Stock compensation costs– Effects of asset sales– Amortization expense

• Viewed by some, including the past Chief Accountant of the SEC, as EBS (“earnings before bad stuff”)

Pro Forma Earnings

• First action taken against Trump Hotels• Firm announced quarterly net income of $14 million

compared to $5.3 million after elimination of a one-time charge of $81.4 million, which exceeded expectations– Discussion suggested positive results due to improved operations– Stock price rose by 7.8%

• However, a one-time gain on lease termination of • $17.2 million was not eliminated (included in revenues)

– If excluded result would have been shortfall in both revenues and earnings

– Stock price fell 6% when disclosed

Survey of the IT Technology services industryWhat type of items might you expect to be eliminated?

• All firms eliminatedRestructuring chargesMerger integration costsIntangible amortization

• Some eliminated one or more of the following:(1) Stock compensation expenses(2) Depreciation(3) Contract cost overruns and losses (4) In-process research and development (5) Losses on lease settlements (6) Losses on equipment sales(7) Costs associated with settlement of client disputes(8) Employee hiring and retention bonuses(9) Consultant training expenses