Accounting Assignment

Tread Lightly Through These Accounting Minefields

by H. David Sherman and S. David Young

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Taking the Stress Out of r0107h Stressful Conversations Holly Weeks

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Tool Kit r0107k Tread Lightly Through These Accounting Minefields H. David Sherman and S. David Young

July–August 2001

This document is authorized for use only in Kris Michaelson's ACT580-1 course at Colorado State University - Global Campus, from May 2017 to November 2017.

Copyright © 2001 by Harvard Business School Publishing Corporation. All rights reserved. 3

Illegal? Maybe not, but many of today’s

accounting moves are clearly

aggressive. Shareholders – and their

representatives on corporate boards –

need to be aware of six danger zones.

TREAD LIGHTLY THROUGH THESE

Accounting Minefields

by H. David Sherman and S. David Young

To o l K i t

BACK IN THE 1980S, Tandem Computers’ robust earning reports madeit a darling of Wall Street. Its CEO and cofounder James Treybig hadpioneered a superhot technology, a way to make “fault tolerant” com- puters for companies like banks and telecommunications businesses running data-processing operations around the clock. But in 1983, it came to light that Tandem had counted a chicken or two before they’d hatched. Some of the revenue reported in its most recent financial statements had not actually ma- terialized, and earnings had to be restated. The Street’s retribution was swift: Tandem’s share price immediately dropped 30%. In time, the company recovered (it was ultimately acquired by Compaq), but the event left a last- ing impression. When a Wall Street Journal reporter asked Treybig to recall his most exciting day at Tandem, he couldn’t. But when asked to pick his worst day, he answered without pause: “The day we restated.”

The nightmare of risky accounting is on the increase. In the current eco- nomic climate, there is tremendous pressure – and personal financial incen- tive for managers – to report sales growth and meet investors’ revenue ex- pectations. According to the SEC, misleading financial reports, especially

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involving game playing around earn- ings, are being issued at an alarming rate. Needless to say, it’s a nightmare that affects more than CEOs’ sleep. The shareholders suffer most – and today’s stock price volatility makes Tandem’s 30% hit look mild. Little wonder that lawsuits related to financial reporting are on the rise. Back in 1991, 55 security class-action suits alleging accounting fraud were filed in the United States. By 1998, the number had nearly tripled.

To avoid such a calamity, shareholders and their representatives on corporate boards should keep their eyes peeled for common abuses in six areas: revenue measurement and recognition, provi- sions for uncertain future costs, asset valuation, derivatives, related-party trans- actions, and information used for bench- marking performance. If disaster strikes, it will most likely occur in one of these accounting minefields.

MINEFIELD1 Revenue Measurement and Recognition Determining when a sale is complete or a service fully rendered is simple for many businesses: revenue is most often recorded when the product is shipped or received or when the service is per- formed. But for some businesses, pin- pointing exactly when revenue has been earned requires considerable judgment.

For example, how should revenue be recognized if a customer takes delivery of a product but makes payments on it over several years? One approach is to consider all of the revenue as earned upon product delivery. But an alterna- tive approach is to consider the cus- tomer’s ability to pay its commitment in

the future. What if the customer is a dot- com that might not survive?

Judgment is also required on the ques- tion of what constitutes revenue. Suppose an auction business sells an item for $100. Of that amount, $5 goes to the auctioneer as commission. On its financial state- ments, should the auctioneer include the total amount of the sale as revenue and call the $95 payment to the item’s original owner an expense? Or should it count only the commission as revenue and show no expense? Most accountants would say the latter approach is prefer- able. But some Internet companies, rec- ognizing the importance investors place on sales growth, have taken advantage of ambiguities in revenue recognition rules to effectively do the former.

By contrast, suppose Dell sells a com- puter monitor it purchased from an in- dependent manufacturer. Does it call only its profit margin revenue, or the full price? Obviously, revenue is recog- nized on the full price, with the cost of the monitor treated as an expense. But what if Dell were to arrange for the monitor to be shipped directly from the manufacturer to the customer (as it often does)? Should Dell include the monitor’s selling price in its revenue, or only the profit on the transaction? In other words, should Dell’s sales figures suffer just because of an efficient logis- tics arrangement? Or should the deci- sion hinge on some technical legal ques- tion, such as who would be responsible if the goods were damaged in shipping?

The ambiguities suggested in just these simple examples begin to explain how one of the biggest accounting deba- cles in recent history could have hap- pened. MicroStrategy, a producer of data-mining software, announced in March 2000 that it was restating its rev- enues and earnings for fiscal years 1998 and 1999. A change in revenue recogni- tion policies transformed its reported profit of $12.6 million into a loss of more than $34 million.

What could account for such a drastic shift? The problem developed because MicroStrategy usually sells its software bundled with multiyear consulting en- gagements; customizing the software

to a client’s unique circumstances is a complex undertaking. But rather than spreading the revenue from the soft- ware sale over the life of the contract, the company was recording it immedi- ately. It was a tactic the SEC had begun to see more often in software compa- nies and had complained about. When MicroStrategy announced the restate- ment, it emphasized that it anticipated no reduction in the revenue it would ultimately realize. Even so, its stock price plummeted by a staggering 62% in a single day, destroying $12 billion of market value – and it kept on falling. All told, shares fell from $333 in March 2000 to less than $22 in May 2000, at which time MicroStrategy faced at least three class-action lawsuits by share- holders and investigations by the SEC.

Evidently, no one on MicroStrategy’s board asked the right questions – or what came to be called the “Micro- Tragedy” never would have occurred. Shareholders who want to avoid the same fate should pass along these ques- tions to the board audit committee: • How is revenue defined? And what

event triggers its recognition? • Does this present a reasonable

measure of the revenue earned by the business during the reporting period? Is it consistent with revenue measures used by domestic and global competitors? And is it clearly described in the financial statement footnotes?

• If revenue is measured in an unusual or new way, is that disclosed? Is the approach justified in terms of its risks and advantages?

MINEFIELD2 Provisions for Uncertain Future Costs Companies must make provisions for costs they know will arise, even if the amounts can’t be known with any cer- tainty: losses from inventory obsoles- cence, uncollectible accounts, product returns, restructuring costs, damages from product recalls – the list goes on. But precisely because there’s so much latitude in this area, it can be a minefield

4 harvard business review

H. David Sherman is the Cowan Research Professor of Accounting at Northeastern University in Boston. He can be contacted at [email protected]. This is his third HBR article. S. David Young is a professor at INSEAD in Fontainebleau, France, and the coauthor of EVA and Value-Based Management: A Practical Guide to Im- plementation (McGraw-Hill, 2001). He can be reached at [email protected].

T O O L K I T • A c c o u n t i n g M i n e f i e l d s

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of earnings management. Estimates can either be inflated to create hidden re- serves so that profits can be boosted in some future period to project a mis- leading earnings stream, or they can be diminished to enhance reported profits.

Xerox has found itself in this mine- field lately; despite evidence of a grow- ing number of slow payments, the com- pany made no greater allowance for bad debts. Could someone on the board have spotted this and averted the cri- sis? Xerox’s former assistant treasurer thought so and told the Wall Street Jour- nal as much in a highly damaging story.

A second common form of mischief to watch for involves overstated restruc- turing costs. Restructuring expenses are segregated from other expenses on the typical income statement. The idea is to isolate the impact of nonrecurring items on net income, thus helping the reader to better understand the prof- itability of normal, recurring business activities. But what are readers to think when restructuring charges appear for several years running? Digital, now part of Compaq, reported restructuring ex- penses for three consecutive years in the early 1990s. It seems obvious that

classifying charges as nonrecurring is designed to mask management error and overstate operating (recurring) profitability. It’s become common for companies to employ a “big bath” strat- egy with their restructuring charges, making them so large as to flush out any possible future impact on earn- ings. And while companies are eager to highlight these nonrecurring busi- ness losses, they call far less attention to their actions when they need to re- verse restructuring charges. Heinz, for example, overestimated the costs of its restructuring in 1997 by some $25 mil- lion. When it subsequently reversed that amount, it did not disclose the fact

on the face of its income statement, al- lowing the adjustment to enhance oper- ating income. The SEC took a dim view of this type of reporting. In fact, the SEC sued WR Grace for fraud in 1999 be- cause the company failed to highlight just such a reversal.

And finally, managers play just as cre- atively with what’s known as “compre- hensive income.” This category, which appears in the shareholders’ equity sec- tion of the balance sheet, is designed to cover a variety of gains or losses that do not appear on the income statement because their true impact on earnings is not yet certain and irreversible. Exam- ples include gains or losses caused by translating financial statements of sub- sidiaries from local currency to the par- ent company’s currency, and unrealized gains and losses on investments in fi- nancial securities. Judgment calls are re- quired on which gains and losses should be reflected on the income statement and which should be captured in com- prehensive income. But there is defi- nitely an incentive to park losses in the comprehensive income category, be- cause the only income incorporated into the highly visible earnings per share

figure (the basis of a company’s price- earnings ratio) is that shown on the in- come statement.

For instance, in 2000, Coca-Cola added $965 million of translation losses to its comprehensive income, bringing the cumulative comprehensive loss to $2.5 billion. Indeed, as the euro’s decline in value throughout 2000 reduced the dollar earnings of U.S. companies with large European sales, many of them managed to defer the impact on earn- ings through clever use of the compre- hensive income line.

A prudent director would certainly consider how such treatment affects investors’ perceptions of the business’s

profitability. To discover if a company is wandering into one of these minefields, ask these pointed questions: • Are estimates for uncertain events

(such as doubtful accounts and restructuring reserves) included in the financial statements?

• Do the financial statements present a reasonable measure of current period operating expenses and revenues, with sufficient disclosure in the footnotes of these estimates and the accounting treatment?

• Should gains and losses included in comprehensive income (foreign currency, investment gains and losses) and in the footnotes instead be included in the current period’s net income?

MINEFIELD 3 Asset Valuation On the most basic level, an asset is some- thing that has current or intrinsic value, like cash, or that can be used to generate future revenues – such as a building that is used to produce or manufacture a product, for example, or inventory that will be sold for a profit. Assets are gen- erally carried at cost less estimated amor- tization or depreciation – and deprecia- tion requires an estimate of its useful life. But the latitude given to manage- ment in making such estimates can raise questions about motivation when esti- mates are changed.

For example, Delta Airlines revised the useful life of aircraft in its fleet twice in ten years; in both cases, the change created sizable increases in reported profits. Were these adjustments moti- vated by any real change in the air- planes’ life spans, by a desire to match competitors’ accounting methods, or by some other reason?

Companies that use accounting meth- ods to keep their research and develop- ment expenses from reducing earnings also frequently find themselves in this minefield. One common approach, in cases where an acquisition has been made, is to accelerate the write-off of all R&D in process at the acquired company. Another is to conduct R&D through in-

A c c o u n t i n g M i n e f i e l d s • T O O L K I T

Evidently, no one on MicroStrategy’s board asked

the right questions – or what came to be called the

“MicroTragedy” never would have occurred.

july–august 2001 5

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vestments in partners to avoid treating the costs as current expenses. If analysts interpret such moves as being motivated by a desire to manage earnings, compa- nies can seriously damage their reputa- tions in the capital markets. Elan, an Irish pharmaceutical company and the sub- ject of SEC reviews, scared off some ana- lysts and investors when it used just this kind of treatment on its R&D costs. A board member at Elan would have done well to ask whether the accounting prac- tices being used by an otherwise strong company really provided a more com- plete earnings picture for shareholders. In the same spirit, you should ask the following: • Do tangible and intangible asset val-

ues and write-downs of assets reflect real values and changes in value during the current period?

• Are these value adjustments fully disclosed?

• Is the accounting treatment consis- tent with industry and global com- petitors? If not, are the differences justifiable and adequately discussed in the financial statements?

MINEFIELD 4 Derivatives The use of derivatives to manage finan- cial risk deserves careful and constant scrutiny. These complex financial in- struments were famously implicated in the downfall of Barings Bank, in the travails of Bankers Trust, and in the near bankruptcy of Orange County, Califor- nia – but the heightened awareness of them has not made them any easier for nonexperts to judge. Derivatives have, in fact, been usefully employed for decades to hedge risks related to commodity prices, foreign exchange fluctuations, and interest on debt. The great difficulty for board members, managers, and share- holders is in recognizing when their use introduces more risk than it mitigates.

For German conglomerate Metallge- sellschaft, that risk equation came down on the wrong side. The company’s energy group had contracted with customers to sell petroleum at prices fixed in 1992 for a maximum of ten years. Because the

6 harvard business review

T O O L K I T • A c c o u n t i n g M i n e f i e l d s

Are You Sitting in a Minefield?

Recent history has shown that businesses with the following charac-

teristics are more likely to feature manipulation of company accounts.

Look sharp if you’re associated with a business that falls into one of

these categories:

High-growth companies entering a low-growth phase. Managers

used to a seemingly endless stream of ever higher numbers may be

tempted to mask the decline in profit and sales growth.

Companies that receive extensive coverage in the business and

popular press (such as Priceline and Amazon.com). Here, even small

problems attract widespread media coverage, placing added pressure

to manage the reporting of business results that might prove disap-

pointing.

New businesses where there are ambiguities about how key transac-

tions are and should be measured. Companies in new industries, such

as those in the Internet sector, may engage in business transactions that

were uncommon in the old economy, such as the advertising barters pop-

ular among Web sites. Accounting standards, which tend to be anchored

in the old economy, may be silent, or at least ambiguous, on important

transactions, thus providing corporate managers with considerable scope

for manipulation.

Weak control environments in which managers can manipulate re-

ported financial results with relative impunity. The seriousness of this

problem varies considerably from country to country, reflecting wide

diversity in corporate governance, securities regulation, and reporting

requirements.

Companies that are followed by a small number of analysts. Less cap-

ital market scrutiny of performance and corporate financial statements

increases the risk for accounting manipulation to go unchecked until it

eventually explodes.

Companies with complex ownership and financial structures. By mak-

ing key transactions less transparent, these structures give rise to related-

party transactions and conflicts of interest.

Naturally, having any one of these characteristics does not mean that a

company is engaging in questionable accounting practices. But it should

prompt directors to exercise special care in scrutinizing a company’s

financial reporting practices.

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over the company, including other busi- nesses, shareholders, directors, lenders, vendors, and customers. Disclosure of these transactions varies based on the regulatory environment and each com- pany’s policies. But investors always have an interest in knowing about them

because they can allow a company to arbitrarily increase or decrease earnings or to divert profits, sometimes enriching a subgroup of shareholders or managers.

Investors in the Belgian company Lernout & Hauspie Speech Products, a maker of speech recognition software, learned about this minefield when their shares dropped from $65 to $9 in the spring of 2000. An internal audit discov- ered that 30 customers, all start-ups and most based in Singapore, were responsi- ble for about a quarter of the company’s revenues. It turned out L&H had helped create those companies – and many had received seed money from a venture capital firm linked to L&H’s founders. The story has since featured earnings restatements, bankruptcy, and the delist- ing of L&H stock from the Nasdaq.

This particular field is most heavily mined for companies that operate in countries where business practices and disclosure requirements are less regu- lated than in the United States or West- ern Europe. Some Korean companies, for example, have engaged in shady practices like purchasing assets unre- lated to their business needs for future sale at a discount to related companies or shareholders, writing off loans to friendly parties in order to move cor- porate cash to select related parties, or selling products at discounts – or above market prices – to related businesses to transfer profits between parties.

Although the more egregious forms of abuse might be identified under U.S. reporting and auditing standards, the potential for manipulation is very real

in subsidiaries of U.S. companies or in companies being considered for merg- ers or acquisitions. Even within coun- tries, though, differences in the practices and disclosures of competitors can cre- ate misleading financial results. To avoid presenting information that may lead to erroneous conclusions and faulty val- uations, investors and their representa- tives on boards should ask the following questions: • Are all significant related-party trans-

actions and commitments disclosed? • What policy determines which trans-

actions will be disclosed and what level of detail will be included in the financial statements?

• Are there conflicts of interest that could damage or benefit specific groups of shareholders that should be disclosed?

MINEFIELD 6 Information Used for Benchmarking Performance The last accounting minefield has to do with manipulating a company’s perfor- mance numbers in relation to prior pe- riods, investor expectations, and com- petitors. This minefield becomes more explosive as more businesses go global.

Imagine the difficulty a U.S. telecom- munications business would have in comparing performance with, consider- ing acquisition of, or trying to under- stand the business model of Deutsche Telekom in Germany. According to its fi- nancial reports, prepared under German accounting rules, Deutsche Telekom’s earnings stream has risen “smoothly” – but under U.S. accounting principles, its progress has been more erratic. Using German principles, earnings nearly dou- bled from 1996 to 1997; using U.S. prin- ciples, they declined. Thus, if a U.S. com- petitor, parent, or partner experienced 50% earnings growth, that might be con- sidered poor compared to Deutsche Telekom with German accounting – or outstanding with U.S. accounting. In an increasingly global industry, should in- vestors be allowed to misunderstand this, or should it be explicitly discussed in the financial statements?

A c c o u n t i n g M i n e f i e l d s • T O O L K I T

company would lose money if oil prices rose, it decided to hedge away the risk by using a “stack” hedging strategy, which employs derivatives. In doing so, it stacked the deck in the opposite di- rection, so that when the price of oil suddenly declined, the losses started to

mount. The situation cost the company some $1.5 billion, leading the Economist to observe: “As Chernobyl was to nuclear power, so Metallgesellschaft has be- come to financial derivatives.”

Still, derivatives remain in wide use for all kinds of good reasons, and in many companies their potential impact on income is substantial. These compa- nies should continually scrutinize their use to ensure that the risks are managed responsibly, to determine whether real- ized and unrealized gains and losses should be included in the earnings, and to ensure that the risks and accounting treatments are clearly disclosed so that shareholders can understand their po- tential impact. How can a sharp-eyed director defend the interests of share- holders in this regard? Again, the pro- cess begins with some basic questions: • What hedging programs are in place? • To what extent are derivatives used? • Are proper safeguards in place to

protect against their abuse? • What are the worst-case scenarios of

the company’s use of derivatives? • Is the accounting treatment complete

and in the spirit of generally accepted accounting principles (GAAP)? Is GAAP treatment sufficient to describe the business value and risks of the derivative program?

MINEFIELD 5 Related-Party Transactions Related-party transactions are those made with entities that are controlled by the company or that have control

july–august 2001 7

The NYSE, Amex, and Nasdaq have all revised their

requirements for listing companies, explicitly stating that

some board members must be “financially literate.”

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gets, and against domestic and global competitors. To serve those interests, it’s reasonable to expect board members to ask: • Are there aspects of the accounting

methods used that may cause invest- ors, security analysts, compensation committees of the board, or others to under- or overassess the business’s financial performance during the current reporting period?

• Are there differences between the company’s financial reports and its competitors’ that need to be disclosed?

Financial Literacy Accounting game players are adroit, to be sure, and most investors and board members believe it takes one to know one. But it’s foolish – and dangerous – to declare oneself ignorant and hence powerless against their machinations.

We don’t argue that board members and senior managers must become ex- perts on all aspects of financial report- ing. That would be an unreasonable goal. However, to be effective, board members – particularly those serving on audit committees – must have enough knowledge of financial reporting issues to draw on experts as needed and have the ability to raise key questions to de- termine whether shareholder interests

8 harvard business review

are adequately protected. Indeed, it is now a formal requirement. In 1999, the NYSE, Amex, and Nasdaq all revised their requirements for listing compa- nies, explicitly stating that some board members must be “financially literate.”

Financial literacy is defined as the “ability to read and understand funda- mental financial statements, including a company’s balance sheet, income state- ment, and cash flow statement.” It also requires understanding the supporting notes found at the back of corporate annual reports. But financial literacy ex- tends beyond comprehension of finan- cial reports. Financially literate business people can make well-reasoned judg- ments about the quality of a company’s financial reporting, the clarity of its fi- nancial disclosures, and the appropriate degree of aggressiveness or conservatism of its accounting policies.

This article aims to arm more man- agers and board members with this kind of literacy – and also to remind them of their obligations. The issue facing any business is whether or not its accounting methods present a reasonable picture of earnings compared with prior periods and compared with domestic and for- eign competitors. Do yours?

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Microsoft is one company that be- lieves the differences should be trans- parent, so it voluntarily provides earn- ings information under several different accounting methods. Should more busi- nesses follow its lead? Naturally, the challenge is to present a fair view of financial results while not providing so much information as to damage the company’s competitive position.

Equally important are the needs to understand the performance of a busi- ness compared with its competitors and to develop stock price-related reward sys- tems that motivate executives to excel. Performance comparisons require an understanding of how profits and assets are measured in domestic and foreign competitors. If Wal-Mart, the world’s largest retailer, wants to compare its fi- nancial performance with Carrefour, the second largest retailer, it will have to convert Carrefour’s earnings, assets, and liabilities to U.S. accounting methods – or restate its own reports using reporting policies consistent with Carrefour’s.

Worldwide, companies have different reporting standards with respect to fre- quency, detail, and audit requirements, and it’s unlikely that even board mem- bers with financial backgrounds can be fully apprised of them all. But investors must be able to benchmark perfor- mance against prior periods and bud-

T O O L K I T • A c c o u n t i n g M i n e f i e l d s

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