A continuing excess of earnings growth over the rate of growth in operating cash flow may indicate that earnings have been boosted by artificial means, including premature or fictitious revenue recognition, aggressive cost capitalization, extended amortization periods, or intentionally overstated assets or understated liabilities. Earnings are at increased risk for decline. Through this post, I discuss how this aggressive [or creative] accounting works. It is not proposed to be implemented in anyways, we all know, it is ugly. But as they are presented in this post, many people been put and resulting remarkable aggressive accounting scandals, either they love or are forced to do it.
During the late 1990s and the early part of this decade, we witnessed untold numbers of companies that resorted to creative accounting practices to prop up or manage earnings by artificial means. As recently as 1998, such practices were not widely viewed as a problem. However, a former commissioner of the Securities and Exchange Commission [SEC], Arthur Levitt, thought differently. He referred to the accounting actions being taken by corporate managers at the time as a game and sounded an alarm bell regarding the developing problem:
I’d like to talk to you about another widespread, but too little-challenged custom: earnings management. This process has evolved over the years into what can best be characterized as a game among market participants. A game that, if not addressed soon, will have adverse consequences [A. Levitt, “The Numbers Game,” Remarks to New York University Center for Law and Business by the Chairman of the Securities and Exchange Commission (New York: New York University Center for Law and Business, 1998), para. 4. The speech is available at www.sec.gov/news/speeches/spch220.txt].
Levitt’s words were prophetic. At the time of his talk, the average person had never heard of Enron Corp., HealthSouth Corp., and Tyco International, Ltd. However, within only a few years of his admonishment, those companies, plus hundreds of others, became an unfortunately large part of everyday talk in the United States and abroad.
To varying degrees, the managers at these companies and others used creative accounting practices to cover up operational problems and alter otherwise disappointing financial results into measures of performance that pleased investors. In the process, investors were misled as they made investment decisions based on reported numbers that were false. In the aftermath and cleanup that followed the accounting debacle of the late 1990s and early 2000s, we witnessed the restatement of financial statements at hundreds of companies that reversed the effects of aggressive and often fraudulent accounting practices.
New regulations were put in place, including the far-reaching Sarbanes-Oxley Act, in an effort to maintain the integrity of our financial reporting system and the all-important trust and confidence of investors. It remains to be seen whether Sarbanes-Oxley “fixed” the U.S. accounting system. Importantly, it does appear that investors’ trust and confidence in U.S. financial reporting has been maintained. However, unfortunately, it is only a matter of time before the next big accounting fiasco is uncovered.
The potential rewards for playing the financial numbers game are too great. Such rewards include higher stock-based compensation and bonuses, lower borrowing costs, and less stringent loan terms, and for some firms for which lower earnings might lessen the public glare, lower political costs. With rewards like these and human nature being what it is, civil and criminal penalties notwithstanding, there will be managers who succumb. However, it does not require accounting steps that take a company’s reporting practices beyond the boundaries of generally accepted accounting principles (GAAP) to mislead investors. Aggressive accounting practices that are within the boundaries of GAAP likely would not result in a restatement, but they can mislead investors. Such practices still can lend a positive spin to financial results, helping a firm meet the earnings expectations of investors.
Earnings But No Cash Flow Provided
Earnings that have been inflated, whether through aggressive accounting practices that are within the boundaries of GAAP or due to steps taken that extend beyond GAAP, will not provide operating cash flow. Instead, other assets on the balance sheet, possibly accounts receivable or inventory, maybe even prepaid expenses, other assets, or property, plant, and equipment, will increase. Sometimes liabilities may be reduced. The point is that such practices will result in earnings growth that is not accompanied by growth in cash flow, disrupting any characteristic relationship between the two. Accordingly, when earnings growth exceeds the rate of growth in operating cash flow, especially for extended periods, it may provide evidence that accounting practices are being employed to provide a temporary boost to earnings. At a minimum, the financial statements should be examined to find out why.
Some of the more common actions used to inflate earnings artificially, both within the boundaries of GAAP and beyond them, include:
- Premature or fictitious revenue recognition
- Aggressive cost capitalization
- Extended amortization periods
- Overvalued assets
- Undervalued liabilities
Let’s go to the details. Read on…
Premature or Fictitious Revenue:
Generally, before revenue can be recognized, there must be a valid order, a completed shipment, and a collectible sales amount. If any one of these parts is missing, revenue recognition should be postponed.
Revenue is recognized prematurely when a valid order has been received but shipment has not yet occurred. For example, Twinlab Corp. restated results for 1997 and 1998 because “some sales orders were booked but not ‘completely shipped’ in the same quarter”. As another example, Peritus Software Services, Inc., recorded revenue in its quarter ended September 30, 1997, for an order received during the quarter even though shipment did not take place until November of that year.
Fictitious revenue recognition entails the recording of revenue for nonexistent sales. Such acts might involve revenue recorded for shipments made that have not been ordered. For example, Digital Lightwave, Inc., recorded revenue on the shipment of demonstration units for which there was never a firm commitment for purchase.
At least in the Digital Lightwave example, a shipment was made to a potential customer. In more egregious cases such shipments are not made. For example, Boston Scientific Corp. leased commercial warehouses to which it shipped its medical devices. Disturbingly, the company recognized revenue even though it had no order and had not shipped to a customer. Of course, it gets even worse. Some companies do not even bother to manufacture or ship a product. California Micro Devices Corp. employed a policy of “booking bogus sales to fake companies for products that didn’t exist”.
The biggest difference between premature and fictitious revenue is one of degree. Premature revenue entails early recognition for legitimate sales. In particular, a customer order exists. Fictitious revenue is revenue recorded for nonexistent sales. However, both premature and fictitious revenue recognition are considered to be practices that extend beyond the boundaries of GAAP.
Revenue recognized in an aggressive manner but within the boundaries of GAAP would involve aggressive sales-related assumptions. For example: optimistic estimates of sales returns might be employed. Or a company that issues rebate coupons might optimistically understate its estimate of the rebates that will need to be paid. Both actions could be used to increase revenue. As long as the estimates employed are considered to be reasonable in the circumstances, they would not viewed as violating GAAP. If it were determined later that the judgment-based estimates were overly optimistic, a special charge would be needed to lower current-year earnings.
Premature and fictitious revenue as well as revenue recognized aggressively but within the boundaries of GAAP will be accompanied by an otherwise unexplained increase in assets, typically accounts receivable, or reduction in liabilities, primarily deferred revenue. Revenue and earnings will grow, although operating cash flow growth will lag.
Aggressive Cost Capitalization:
Under GAAP, expenses incurred that benefit future periods should be capitalized, that is, reported as assets. Later, as those assets are consumed, they are expensed in the form of amortization. Examples of costs that are properly capitalized include software development, direct-response advertising, interest on borrowed funds related to construction activities, and costs related to oil exploration and movie production.
Whether costs will benefit future periods is a judgment call. Some managers may take a particularly aggressive stance in the matter and capitalize costs that others expense. An aggressive stance would not necessarily make the decision to capitalize an incorrect one or one that is in violation of GAAP. Much depends on whether the capitalized costs ultimately were realized. For example: many software companies expense all software development costs when those costs are incurred. Questions of realizability and whether software development reaches what is referred to as technological feasibility—the software will do what it is designed to do—lead them to a conservative decision.
For software firms that do capitalize such costs, approximately 26 percent of software development costs incurred is capitalized. Among the firms on the higher end of those that capitalize such costs is American Software, Inc. In 1999 and 2000, the company capitalized approximately 50 percent of software development costs incurred.
A decision to capitalize more software development costs than the average firm does not mean that American Software violated GAAP. However, questions concerning realizability did force the company to take a $9.1 million charge in 2001 for the “write-off of certain capitalized software development costs”. Had the company capitalized a lesser proportion of software development costs incurred, that charge may not have been necessary. Perhaps acknowledging a rather aggressive stance on its capitalization practices, in 2001, American Software reduced the capitalization percentage of software development costs incurred to approximately 25 percent.
Unfortunately there have been numerous examples of companies that have ventured well beyond the boundaries of GAAP in their capitalization practices. WorldCom, Inc., is a case in point. The company capitalized billions of dollars of what amounted to “charges paid to local telephone networks to complete calls”. Such costs do not benefit future periods and should have been expensed as incurred.
Aggressive cost capitalization will result in increases in any number of assets, including prepaid expenses, property, plant, and equipment, and other assets. Expenses will be reduced, increasing earnings. However, those increases in earnings will not result in similar increases in operating cash flow.
Extended Amortization Periods:
The cost of assets that benefit future periods must be amortized, that is, expensed over the periods receiving benefit. For example: property, plant, and equipment items, excluding land and construction in progress, are depreciated. Intangible assets, such as patents, franchise rights, and capitalized software development costs, but excluding goodwill, which has an indefinite life, are amortized. Natural resources are depleted. All are examples of the broader concept of amortization.
Generally accepted accounting principles provide no specifically defined asset amortization periods. That decision is left to judgment. Much like the cost capitalization decision, some companies will decide optimistically that the usefulness of assets will extend over longer periods. As a result, amortization charges will be lower and income higher.
Selection of an extended amortization period is a GAAP violation when it is determined that judgment has been applied improperly. However, whether reasonable or unreasonable, if judgment calls have been employed in the selection of an amortization period that is longer than an underlying asset’s usefulness, prior-year earnings and asset balances will have been overstated. Typically, a charge is needed to write down the book values of any overstated assets. For example, in 1997, Qualcomm, Inc., took a $8.8 million charge to write down longlived assets that had become value impaired. Had the company used a shorter period in amortizing the assets, such a charge may not have been necessary.
Extended amortization periods reduce amortization expense. The resulting increase in earnings is not accompanied by an increase in operating cash flow but rather by otherwise higher valuations for assets subject to amortization. This can include property, plant, and equipment; natural resources; and intangible assets with finite lives.
The focus here is on assets that are not subject to amortization. Examples include accounts receivable, inventory, investments, and goodwill. Judgment plays a significant role in the valuation of these assets. Aggressive judgment decisions may be used to value them at overstated amounts, boosting earnings in the process.
For example: accounts receivable are reported at amounts due less an estimate of uncollectible accounts. An optimistic assessment of collectibility can lead to an understatement of an expense provision for uncollectible accounts and an overstatement of accounts receivable.
Inventory is valued at the lower of cost or an estimate of market value. An aggressive assumption about the market value of obsolete inventory can lead to an overstatement of inventory and an understatement of cost of goods sold.
Investments in debt securities that are held to maturity are carried at cost. However, such investments must be written down when a nontemporary decline reduces market value below cost. Such a write-down may be postponed by judging that a market value decline is temporary.
Goodwill is subject to annual impairment reviews. Judgment is clearly needed in deciding whether the fair value of an acquired entity has declined below book value, necessitating a write-down.
As an example of the application of judgment in the valuation of goodwill, consider AOL-Time Warner, Inc. In the first quarter of 2002, the company took a $54.2 billion pretax charge to write down a portion of the goodwill recorded in the merger with Time Warner, Inc. However, even after the write-down, over $80 billion of goodwill remained on the balance sheet. During 2002, as the market value of the company continued to decline, management argued that “it’s absolutely premature and inappropriate to take an impairment charge at this time”. Yet within a few months of that statement, the company took an additional goodwill impairment charge for approximately $46 billion.
The overstatement of earnings that accompanies an overvaluation of assets does not provide operating cash flow. The resulting boost to earnings will show up as increases in such items as accounts receivable, inventory, investments, and goodwill.
Earnings may be overstated when liabilities, such as accrued expenses payable or estimated reserves for future payment commitments, are understated. As was the case with an overvaluation of assets, judgment enters into the valuation of liability accounts. For example, an optimistic assessment of an estimated warranty obligation may lead to an understatement of that liability and an overstatement of earnings.
When pushed beyond reasonable limits, so-called optimistic assessments stretch beyond the boundaries of GAAP. That is what happened at Miniscribe Corp., a company that filed for bankruptcy protection in 1990. In 1986, the company reduced its warranty reserve even as revenue increased to $185 million from $114 million in 1985.
Normally, an increase in revenue would indicate that an increase in the warranty reserve was needed. Earnings were later restated downward as the warranty reserve, among other accounts, was adjusted.
An undervaluation of liabilities will raise earnings but will not be accompanied by an increase in operating cash flow. Earnings boosted in this manner will result in reductions in liabilities such as accrued expenses payable and reserves for future payment commitments.
Losses But No Cash Flow Used
Some managers may use overly conservative accounting practices to lower current earnings while providing a boost to future earnings. For example: an overly conservative restructuring charge may be used to write down property, plant, and equipment and intangible assets or to expense currently future operating costs and report them in a restructuring reserve. The charge may be taken in a down year when earnings expectations are low. Future earnings then can be reported at higher amounts as depreciation and amortization expenses are reduced, as operating costs are charged to the previously recorded restructuring reserve or the reserve is simply reversed into earnings. In fulfilling accounting guidance from Statement of Position No. 98-9, the company changed its policy and reduced the portion of software revenue that was deferred. When earnings are artificially understated, assets will have been written down and liability balances raised. In the process, operating cash flow will increase relative to earnings.