Accounting Practice Now and Then –

What a Board Member Must Know

Dr. Wayne H. Shaw

Robert B. Cullum Distinguished
Professor of Accounting
Edwin 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
250

200
57
1
150
IPR&D
9
All others
100
150 156

50 91
61 58 59
48 51 50
33 32

0
1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000
 Restatements by Reason
69 37
55
24 Unknown
67 Revenue
360 Cost
39 Revenue & cost
Loan loss
Acquisition
94 IP R&D
Reclassification
30 Bookkeeping error
Others

305
 Restatements by Year
and Reason
1990 1992 1994 1996 1998 2000
0%
10% Others
20% Bookkeeping error
Reclassification
30%
IP R&D
40% Acquisition
50% Loan loss
60% Cost
Revenue & cost
70%
Revenue
80% Unknown
90%
100%
Restatements by Market Value of
Restating Company 1995-2000
36
105 55

46
$5B+
$1B to $4.99B
$500M to $999M
<$500M
N/A

389
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-Oxley
Certification 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.302
Signing 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 16,443
Cost of goods sold 14,786 16,286
Gross profit 1,657 157
Operating 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 - Swaps
What 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 & Equipment
Profit 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 Update
August 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 Net
Franchise 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.
 Asset Write-Down Example: Cisco
• 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.
 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 Exposure
Dell 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 industry
What type of items might you expect to be eliminated?

• All firms eliminated

Restructuring charges
Merger integration costs
Intangible 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