First Union Corp. managed to meet Wall Street’s forecasts for its third-quarter profit, in part because of a one-time gain the bank didn’t disclose in its initial report on the quarterly results. . . .1
The principal adjustments to net income are the result of improper capitalization of overhead expenses, improper charges to acquisition reserves and recognition of certain income in periods prior to earning such income.2
. . . it appears to have been simple. . . . People just made things up.3
The financial numbers game is played by actively altering reported financial results (i.e., the income statement and statement of cash flows) or reported financial position (i.e., the balance sheet) in some desired amount and/or some desired direction. A company can achieve this end through accounting policy choice, accounting policy application, or out- right fraudulent financial reporting.
ACCOUNTING POLICY CHOICE AND APPLICATION
One way that the financial numbers game is played is through a firm’s selection of the accounting policies it employs in the preparation of its financial statements or in the manner in which those accounting policies are applied. The companies involved are sim- ply using available flexibility in accounting principles.
Consider MicroStrategy, Inc., discussed in Chapter 1. The company’s problems arose from its revenue recognition practices. Historically, the company had separated the rev- enue earned from large, complex contracts into elements, recognizing some elements up front while deferring others. On the surface, there was nothing wrong with such a prac- tice provided the company could demonstrate that the up-front revenue had been earned
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at the time it was recognized. In early 2000 the company admitted to the difficulty of demonstrating that certain portions of contract revenue had been earned up front and decided to begin deferring entire contract amounts, recognizing the related revenue over the lifetimes of the related contracts. The company’s former practice had seemed innocent enough. However, with the new policy in place, the company’s results for 1999 were re- stated to a per-share loss from what had been an earnings-per-share amount of $.15.
As noted in Chapter 1, Baker Hughes, Inc., was also employing flexibility in ac- counting principles. The extent of the company’s problems, however, leads one to ques- tion whether it had sufficient internal controls and accounting oversight at certain foreign subsidiaries. The company’s consolidated 1999 results were misstated by $31.0 million, net of taxes, due to miscalculations in the collectibility of accounts receivable and of in- ventory shortages, asset impairments, and in the amounts of certain current liabilities.4
Flexibility in Financial Reporting
The selection and application of generally accepted accounting principles (GAAP) is flexible, leaving much room for judgment in certain areas. As a result, through their choice and application of accounting policies, companies in similar circumstances may report dissimilar results. Consider the flexibility available in three areas common to modern financial reports: inventory cost determination, software revenue recognition, and goodwill amortization periods.
Inventory Cost Determination
One of the more common examples of flexibility in the selection and application of accounting policies and the impact that flexibility can have on amounts reported in the financial statements is the selection of the method used to determine inventory cost.
Companies have many inventory methods from which to choose. The more likely can- didates are either the first-in, first-out (FIFO) method; the last-in, first-out (LIFO) method; or the average cost method. Data on the popularity of each of these methods taken from a survey of 600 companies conducted by the American Institute of Certified Public Accountants is provided in Exhibit 2.1. Companies are actively using the differ- ent methods available to them, with FIFO being the more popular and LIFO following closely behind.
When inventory costs are changing, each inventory cost method will result in a dif- ferent earnings amount on the income statement and different amounts for inventory and shareholder’s equity on the balance sheet. Longview Fibre Co. uses the LIFO method of inventory cost determination for all of its inventories except supplies. Exhibit 2.2 pro- vides the company’s inventory amounts taken from its 1999 annual report.
In the exhibit, Longview Fibre Co. discloses a LIFO reserve. For inventories carried on the LIFO method, the LIFO reserve measures the difference between inventories measured at LIFO cost and those same inventories measured at replacement cost—
roughly FIFO cost. It is a SEC requirement that public companies using LIFO disclose the excess of replacement cost, generally approximated by FIFO, over LIFO cost.5
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How the Game Is Played
Exhibit 2.1 Inventory Cost Determination
Number of Companies
1997 1998 1999
Methods
First-in first-out (FIFO) 415 409 404
Last-in first-out (LIFO) 326 319 301
Average cost 188 176 176
Others 32 40 34
Source: American Institute of Certified Public Accountants, Accounting Trends and Techniques, 54th ed. (New York: 2000), p. 201.
Note: Columns total more than 600 because many firms report the use of more than one inventory method.
Exhibit 2.2 Inventory Cost Disclosures: Longview Fibre Co., October 31, 1997, 1998, and 1999 (thousands of dollars)
1997 1998 1999
Finished goods $ 43,571 $ 35,645 $ 36,248
Goods in process 28,881 32,730 30,768
Raw materials 11,879 20,676 13,200
Supplies (at average cost) 42,322 42,907 39,797
———– ———– ———–
126,653 131,958 120,013
LIFO reserve (42,151) (47,999) (40,450)
———– ———– ———–
$ 84,502———–———– $ 83,959———–———– $ 79,563———–———–
Source: Longview Fibre Co. annual report, October 31, 1999. Information obtained from
Disclosure, Inc., Compact D/SEC: Corporate Information on Public Companies Filing with the SEC (Bethesda, MD: Disclosure, Inc., March 2000).
As can be seen from the exhibit, there is a substantial difference between the com- pany’s inventories measured at LIFO cost and FIFO cost. That difference totaled
$42,151,000 in 1997, $47,999,000 in 1998, and $40,450,000 in 1999. Had the company used the FIFO method of inventory for those inventories for which it used the LIFO method, its reported inventories would have been higher by 50%, 57%, and 51%, re- spectively, in 1997, 1998, and 1999. The company’s shareholders’ equity also would
have been affected. Under the FIFO method, and assuming a combined federal and state income tax rate of 40%, shareholders’ equity would have increased by $25,291,000, or 6%, in 1997, $28,799,000, or 7%, in 1998, and $24,270,000, or 6%, in 1999.
Under the FIFO method the company’s pretax earnings also would have differed from the amounts reported under LIFO. In 1998, had the company employed the FIFO method, its reported pretax loss of $14,152,000 would have been lower by $5,848,000, calculated as the increase in the LIFO reserve ($47,999,000 minus $42,151,000). In 1999 the com- pany’s pretax earnings of $31,484,000 would have been lower under the FIFO method by $7,549,000, calculated as the decrease in the LIFO reserve ($47,999,000 minus
$40,450,000).
Under GAAP, companies are relatively free to choose the inventory methods they wish. The decision is a function of whether inventory costs are rising or falling, tax con- sequences, and the desired direction for reported earnings to shareholders. There are also other regulatory constraints on the decision. A company that elects the LIFO method for tax purposes also must use the LIFO method for financial reporting purposes. Also, while a company generally can discontinue use of the LIFO method when it chooses to do so, Internal Revenue Service guidelines prevent that company from returning to LIFO once again for 10 years.6Subject to these constraints, however, the choice of inventory cost method offers firms much flexibility and room for judgment in deciding how their financial results and position are reported.
Software Revenue Recognition
One example of flexibility in the application of accounting principles that has recently been tightened significantly by accounting regulators is in the area of software revenue recognition. The Microsoft example provided in Chapter 1 illustrated how changes in ac- counting standards have forced the company to accelerate the recognition of its software revenue. Additional sweeping changes in software revenue recognition have affected many other software firms.7
As an example of how software revenue recognition practices have changed, consider the following revenue recognition practices taken from the footnotes to the annual re- ports of four software companies in early 1991 and 1992.
From the annual report of BMC Software, Inc.:
Revenue from the licensing of software is recognized upon the receipt and acceptance of a signed contract or order.8
From the annual report of American Software, Inc.:
Upon entering into a licensing agreement for standard proprietary software, the company recognized eighty percent (80%) of the licensing fee upon delivery of the software docu- mentation (system and user manuals), ten percent (10%) upon delivery of the software (computer tapes with source code), and ten percent (10%) upon installation.9
From the annual report of Autodesk, Inc.:
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Revenue from sales to distributors and dealers is recognized when the products are shipped.10
From the annual report of Computer Associates International, Inc.:
Product license fee revenue is recognized after both acceptance by the client and delivery of the product.11
At the time, all four companies were following their interpretation of existing ac- counting rules for revenue recognition—generally, that software revenue, like revenue in other transactions, was recognized when earned and collectible. However, the flexibil- ity that existed in that general rule was great and led to significant differences in ac- counting policies for companies even in the same industry.
BMC Software recognized software revenue upon receipt and acceptance of an order.
At that point, the company likely had not shipped the software. By recognizing revenue at this early stage, the company was able to boost reported earnings. Any amounts rec- ognized, however, were at risk of order cancellation. American Software recognized the bulk of its revenue at the time the user manuals were shipped, even if that shipment time was before shipment of the software product itself. With this policy, a shipment of man- uals at the end of an accounting period could result in an increase in revenue recognized.
In contrast, Autodesk waited until its software products had been shipped before recog- nizing revenue. In this more conservative stance, the earning process was linked to actual shipments.
As noted, accounting principles for software revenue recognition have been tightened in recent years. Today, at a minimum, software companies must have shipped their soft- ware products before recognizing revenue. All of the companies identified here now abide by that rule. However, when greater flexibility existed, they used it.
That is not to say that no flexibility remains in GAAP for software revenue recogni- tion. For example, while shipment remains the primary trigger for revenue recognition in the software industry, Computer Associates continues to be more conservative, waiting until its software products have been not only shipped but accepted by their customers before recognizing revenue. Further, using the example provided in Chapter 1, Microsoft accelerated recognition of revenue for software elements earned over an extended license period. This was done to be consistent with new accounting principles. However, that change notwithstanding, flexibility and judgment continue to play a significant role in its revenue timing. As noted by the company in the footnotes to its 1999 annual report:
The percentage of revenue recognized ratably decreased from a range of 20% to 35% to a range of approximately 15% to 25% of Windows desktop operating systems. For desktop applications, the percentage decreased from approximately 20% to a range of approxi- mately 10% to 20%.12
With such broad ranges of up-front software fees being deferred and recognized over more extended license periods, the company continues to have flexibility in its recogni- tion of revenue.
How the Game Is Played
Goodwill Amortization Periods
Another example of flexibility in the application of accounting principles is in the choice of amortization periods, that is, an estimate of the useful lives of assets. Consider the fol- lowing amortization periods for goodwill taken from the footnotes to the 1999 annual re- ports of three medical products companies.
From the annual report of Matria Healthcare, Inc.:
Intangible assets consist of goodwill and other intangible assets, primarily resulting from the company’s acquisitions. . . . Goodwill is being amortized using the straight-line method over periods ranging from 5 to 15 years.13
From the annual report of Allergan, Inc.:
Goodwill represents the excess of acquisition costs over the fair value of net assets of pur- chased businesses and is being amortized on a straight-line basis over periods from 7 to 30 years.14
From the annual report of C. R. Bard, Inc.:
Goodwill is amortized straight-line over periods of 15–40 years as appropriate.15
All three companies share the same general industry group, yet all three have chosen amortization periods for goodwill that differ. The periods range from as little as five years to as many as 40. At the time of this writing, generally accepted accounting prac- tices require amortization of goodwill but permit companies to choose the amortization period. The only requirement is that the amortization period cannot exceed 40 years. The longer the amortization period, the lower the annual charge to expense. As a result, dif- ferent companies can report different earnings amounts for no other reason than their choice of amortization period. The accounting standard requiring amortization of good- will is, however, changing. For fiscal years beginning in the second half of 2001 or later, goodwill will no longer be amortized but will be reviewed periodically to determine if it is value impaired.16Thus, the accounting flexibility derived from the choice of amorti- zation period will no longer exist.
Collection of Estimates
The goodwill amortization example demonstrates clearly that estimates must be em- ployed in the application of accounting principles. To a significant extent, financial statements are a collection of estimates. As can be seen from the following note taken from the Citigroup, Inc., 1999 annual report, the use of estimates adds to the flexibility inherent in the preparation of financial statements:
As a result of these processes and procedures, the reserves carried for environmental and asbestos claims at December 31, 1999 are the company’s best estimate of ultimate claims and claim adjustment expenses, based upon known facts and current law. However, the
25
conditions surrounding the final resolution of these claims continue to change. Currently, it is not possible to predict changes in the legal and legislative environment and their impact on the future development of asbestos and environmental claims. Such develop- ment will be impacted by future court decisions and interpretations as well as changes in legislation applicable to such claims. Because of these future unknowns, additional liabil- ities may arise for amounts in excess of the current reserves.17
The Citigroup, Inc., note makes it clear that the company must use estimates in de- termining its liabilities for environmental and asbestos claims. There is ample room for the company to use inherent flexibility in the estimates employed and sway its financial reporting if it were so inclined.
Why Does Flexibility Exist?
Inventory cost determination, software revenue recognition, and goodwill amortization periods are only three examples among a multitude of accounting policy-choice and estimation decisions that offer companies flexibility in the recording of transactions and the preparation of financial statements. It is through the presence of this flexibility that managements can get creative in the preparation of financial statements and play the financial numbers game.
Of course, the natural question is, why does flexibility exist? Why do accounting reg- ulators—for example, the Financial Accounting Standards Board and the Securities and Exchange Commission—permit companies to have such flexibility? Would it not make sense for regulators to require all companies to report their financial transactions in the same way?
Unfortunately, it is not that simple. Financial transactions and the economic condi- tions surrounding them are not sufficiently similar to warrant use of identical account- ing practices, even by companies within the same industry.
Consider the determination of inventory cost. Even if the focus is on the financial statements exclusively, ignoring the benefits of LIFO for tax purposes, there are valid reasons for some companies to use the LIFO method and others to use the FIFO method.
The LIFO method uses more current inventory costs—amounts closer to replacement cost—in the calculation of cost of goods sold. As a result, with LIFO, the income state- ment provides a more realistic and meaningful measure of operating performance. For companies with large inventories, especially when inventory costs are rising dramati- cally, LIFO is a likely choice. However, LIFO uses older, more out-of-date costs in the valuation of inventory for the balance sheet. Accordingly, with LIFO, the balance sheet is less useful in determining a current valuation for inventory on hand. Thus, depending on the materiality of inventory and the direction of inventory costs, companies have valid reasons to gravitate to one extreme or the other for inventory cost determination. Adding to these financial reporting considerations are income tax considerations. When inven- tory costs are rising sufficiently fast that LIFO provides tax advantages not available under the FIFO method, companies have additional reasons to select the LIFO method.
Requiring all companies to use one inventory method or the other would ignore and assume away the varying economic conditions that brought the different methods into
How the Game Is Played
existence in the first place. Such an act, even in the name of consistency, would not ben- efit financial reporting.
In the case of software revenue recognition, accounting regulators have considered it necessary to better define the earning process for software revenue. However, flexibil- ity has not been eliminated. Subject to the new standards, the software companies them- selves are best equipped to determine when software revenue is earned.
In the goodwill amortization example, there are valid reasons for varying amortization periods. Goodwill arises in an acquisition when an acquiring company pays a premium over the fair market value of the acquired firm’s net assets—its assets less its liabilities.
In the opinion of the acquiring company, the acquired firm as a whole is worth more than the sum of its parts.
Goodwill might arise for many reasons, including a well-recognized brand name, a particularly loyal customer base, an efficient distribution system, or even adept manu- facturing practices. The acquiring firm anticipates earning above-average returns from its acquisition over some predetermined future period. It is over that period that the acquiring firm’s management should amortize the acquired goodwill.
The periods over which above-average returns from acquisitions can be realized will certainly vary across acquired firms. Thus, requiring identical amortization periods would not result in more meaningful financial reporting. Here again, reporting flexibil- ity is appropriate.
For valid reasons, flexibility in financial reporting exists. It will and should remain as long as circumstances and conditions across companies and industries vary. The exis- tence of flexibility in the choice and application of accounting policies, however, should not result in misleading financial statements. Rather than using that flexibility to mislead financial statement users, companies should employ it to provide a fair presentation of their financial results and financial position. In the vast majority of financial reports, this does take place.
For example, Longview Fibre Co.’s use of the LIFO method of inventory cost deter- mination is not done to mislead. Rather, in the company’s opinion, that inventory method gives a fairer view of its financial performance. Similarly, using judgment to select the timing of software revenue recognition or an amortization period for goodwill does not, on the surface, indicate use of creative accounting practices. The examples cited of software revenue recognition, after being tightened by accounting regulators, and goodwill amortization periods are of normal applications of accounting flexibility done to achieve a fair presentation.
Aggressive Application of Accounting Principles
When the financial numbers game is played, however, rather than using reporting flexi- bility for fair presentation, companies select accounting principles and apply them in an aggressive manner. They push the envelope and stretch the flexibility of GAAP, some- times beyond its intended limits. The purpose of this aggressive application of account- ing principles is to alter their financial results and financial position in order to create a potentially misleading impression of their firms’ business performance. The ultimate objective is to achieve some of the game’s rewards that may accrue to them.