By allowing a choice of operating or financing for the placement of interest and dividends received or paid, IAS 7 gives a company’s managers the opportunities to select the presentation that gives the best-looking picture of operating performance.
An example is Norse Energy Corp. ASA, a Norwegian gas explorer and producer, which changed its classifications of interest paid and interest received in 2007 (Gordon, Henry, Jorgensen, and Linthicum, 2017). Interest paid was switched to financing instead of decreasing cash generated from operations. Norse Energy also switched its classification of interest received to investing from operating cash flow. The net effect of these changes was to report positive, rather than negative, operating cash flows in both 2007 and 2008. With these simple changes, the company could also change the perception of its operations. The cash flow statement formerly presented the appearance of a company with operations that used more cash than it generated, and it possibly raised questions about the sustainability of operations. After the revision, the operating section of the cash flow statement depicted a much more viable operation.
Exhibit 25 shows the net effect of the reclassifications on Norse Energy’s cash flows.
Exhibit 25: Reclassification of Cash Flows (amounts in USD millions)
As Reported (following 2007 reclassification)
Adjustments (without reclassification*)
Pro forma (without reclassification)
2008 2007 2008 2007 2008 2007
Operating USD5.30 USD2.80 (USD13.70) (USD14.40) (USD8.40) (USD11.60)
Investing USD0.90 (USD56.80) (USD9.00) (USD3.50) (USD8.10) (USD60.30)
Financing (USD16.60) USD34.50 USD22.70 USD17.90 USD6.10 USD52.40
Total (USD10.40) (USD19.50) USD0 USD0 (USD10.40) (USD19.50)
* The adjustments reverse the addition of interest received to investing and instead add it to operating.
The adjustments also reverse the deduction of interest paid from financing and instead subtract it from operating.
ACCOUNTING CHOICES THAT AFFECT FINANCIAL
Accounting Choices that Affect Financial Reporting 369
Exhibit 26: Areas in Which Choices and Estimates Affect Financial Reporting
Area of Choice/Estimate Analyst Concerns
Revenue recognition ■ How is revenue recognized: upon shipment or upon delivery of goods?
■ Is the company engaging in “channel stuffing”—the practice of overloading a distribution channel with more product than it is normally capable of selling? This can be accomplished by inducing customers to buy more through unusual discounts, the threat of near-term price increases, or both—or simply by shipping goods that were not ordered. These transactions may be corrected in a subsequent period and may result in restated results. Are accounts receivable relative to revenues abnormally high for relative to the company’s history or to its peers? If so, channel stuffing may have occurred.
■ Is there unusual activity in the allowance for sales returns relative to past history?
■ Does the company’s days sales outstanding show any collection issues that might indicate shipment of unneeded or unwanted goods to customers?
■ Does the company engage in “bill-and-hold” transactions? This is when a customer purchases goods but requests that they remain with the seller until a later date. This kind of transaction makes it possible for a seller to manufacture fictitious sales by declaring end-of-period inventory as “sold but held,” with a minimum of effort and phony documentation.
■ Does the company use rebates as part of its marketing
approach? If so, how significantly do the estimates of rebate fulfillment affect net revenues, and have any unusual breaks with history occurred?
■ Does the company separate its revenue arrangements into multiple deliverables of goods or services? This area is one of great revenue recognition flexibility and also is one that pro- vides little visibility to investors. They simply cannot examine a company’s arrangements and decide for themselves whether or not revenue has been properly allocated to different com- ponents of a contract. If a company uses multiple deliverable arrangements with its customers as a routine matter, investors might be more sensitive to revenue reporting risks. In seeking a comfort level, they might ask the following questions: Does the company explain adequately how it determines the different allocations of deliverables and how revenue is recognized on each one? Do deferred revenues result? If not, does it seem reasonable that there are no deferred revenues for this kind of arrangement? Are there unusual trends in revenues and receivables, particularly with regard to cash conversion? If an investor is not satisfied with the answers to these questions, he or she might be more comfortable with other investment choices.
Area of Choice/Estimate Analyst Concerns Long-lived assets:
Depreciation policies
■ Do the estimated life spans of the associated assets make sense, or are they unusually low compared with others in the same industry?
■ Have there been changes in depreciable lives that have a pos- itive effect on current earnings?
■ Do recent asset write-downs indicate that company policy on asset lives might need to be reconsidered?
Intangibles: Capitalization policies
■ Does the company capitalize expenditures related to intangi- bles, such as software? Does its balance sheet show any R&D capitalized as a result of acquisitions? Or, if the company is an IFRS filer, has it capitalized any internally generated development costs?
■ How do the company’s capitalization policies compare with the competition?
■ Are amortization policies reasonable?
Allowance for doubtful accounts/loan loss reserves
■ Are additions to such allowances lower or higher than in the past?
■ Does the collection experience justify any difference from historical provisioning?
■ Is there a possibility that any lowering of the allowance may be the result of industry difficulties along with the difficulty of meeting earnings expectations?
Inventory cost methods ■ Does the company use a costing method that produces fair reporting results in view of its environment? How do its inven- tory methods compare with others in its industry? Are there differences that will make comparisons uneven if there are unusual changes in inflation?
■ Does the company use reserves for obsolescence in its inven- tory valuation? If so, are they subject to unusual fluctuations that might indicate adjusting them to arrive at a specified earnings result?
■ If a company reports under US GAAP and uses last-in, first- out (LIFO) inventory accounting, does LIFO liquidation (the assumed sale of old, lower-cost layers of inventory) occur through inventory reduction programs? This inventory reduc- tion may generate earnings without supporting cash flow, and management may intentionally reduce the layers to produce specific earnings benefits.
Accounting Choices that Affect Financial Reporting 371
Area of Choice/Estimate Analyst Concerns Tax asset valuation
accounts
■ Tax assets, if present, must be stated at the value at which management expects to realize them, and an allowance must be set up to restate tax assets to the level expected to eventually be converted into cash. Determining the allowance involves an estimate of future operations and tax payments. Does the amount of the valuation allowance seem reasonable, overly optimistic, or overly pessimistic?
■ Are there contradictions between the management commen- tary and the allowance level, or the tax note and the allowance level? There cannot be an optimistic management commentary and a fully reserved tax asset, or vice versa. One of them has to be wrong.
■ Look for changes in the tax asset valuation account. It may be 100 percent reserved at first, and then “optimism” increases whenever an earnings boost is needed. Lowering the reserve decreases tax expense and increases net income.
Goodwill ■ Companies must annually assess goodwill balances for impair- ment on a qualitative basis. If further testing appears necessary, it is based on estimates of the fair value of the reporting units (US GAAP issuers), or cash-generating units (IFRS issuers), associated with goodwill balances. The tests are based on sub- jective estimates, including future cash flows and the employ- ment of discount rates.
■ Do the disclosures on goodwill testing suggest that the exercise was skewed to avoid impairment charges?
Warranty reserves ■ Have additions to the reserves been reduced, perhaps to make earnings targets? Examine the trend in the charges of actual costs against the reserves: Do they support or contradict the warranty provisioning activity? Do the actual costs charged against the reserve give the analyst any indication about the quality of the products sold?
Related-party transactions ■ Is the company engaged in transactions that disproportion- ately benefit members of management? Does one company have control over another’s destiny through supply contracts or other dealings?
■ Do extensive dealings take place with non-public companies that are under management control? If so, those companies could absorb losses (e.g., through supply arrangements that are unfavorable to them) to make the public company’s per- formance look good. This scenario may provide opportunities for an owner to cash out.
The most important lesson is that choices exist among accounting methods and estimates, and an analyst needs a working knowledge of these options to understand whether management may have made choices to achieve a desired result.