Many firms recognize that investors and analysts focus on their operating efficiency and use accounting that will indicate reductions in operating expenses. The accounting methods used to achieve this goal are not necessarily illegal, but may be misleading to those investors and analysts who rely on financial statements. Many of the methods shift some operating expenses to other parts of the financial statements, so that operating expenses are reduced, and operating income (revenue minus operating expenses) is increased.
Since some investors derive values of a firm according to its operating earnings, for example, they may value a firm higher if it reduces its operating expenses as a means of increasing its operating earnings.
Some of the common methods for deflating expenses are summarized in this post. Enjoy!
Classifying Expenses as Capital Expenditures
A firm’s common expenses such as labor and materials should be classified as operating expenses. Conversely, the expense of a long-term asset such as machinery is depreciated over time because its use is spread over time. In the year that the asset is obtained, the reported expense is only a fraction of the total expense due to depreciation. Accountants are well aware of the difference between common operating expenses versus capital expenditures that allow for the expense to be spread over time.
WorldCom misclassified some of its operating expenses as capital expenditures. The result is that these expenses in 2000 and 2001 were underestimated, which caused its earnings to be overestimated. This faulty accounting was the primary reason why WorldCom’s earnings were overstated by $3.85 billion over a five-quarter period.
Classifying Expenses as Write-offs
A write-off is viewed as a one-time charge against earnings. For example, consider a firm with a subsidiary that was attempting to create a new product that would be added to the firm’s product line. Assume that after a year, the firm gave up on the idea of adding a new product and it shut down the subsidiary. It could record the expense of this subsidiary as a write-off.
The separation of a write-off from other expenses is useful to investors because it indicates which expenses are nonrecurring. There is some flexibility within accounting guidelines on whether a particular expense is classified within a write-off or under the firm’s normal operating expenses.
Using the previous example, labor costs incurred by the subsidiary may be part of the write-off. What about general research and development expenses for the firm?
Since these expenses would occur every year, they should not be included within the write-off. Yet, the more expenses that the firm can include within the write-off, the lower will be its normal operating expenses.
Even if a firm does not hide any normal (year-to-year) expenses within a write-off, investors should not presume that the write-off is a one-time charge. Based on this presumption, investors would ignore the write-off this year when attempting to predict expenses and earnings in future years.
Some firms tend to have large and frequent write-offs, although the write-off in each period may be for a different reason. Investors who use earnings before write-offs to predict future earnings will likely overestimate future earnings, and therefore overestimate the firm’s value today.
Writing Off Inventory Expenses
Rather than account for wasted inventory in the operating expenses, some firms commonly write off obsolete inventory. One common accounting tactic is to include inventory write-offs with other write-offs.
An inventory write-off represents a cost of holding some inventory that is no longer useful. For example, an inventory of products may be written off because the product has been discontinued. If the expense of wasted inventory was included within operating expenses, then it would be considered an expense that could occur in any period. However, when it is included in write-offs, it might be perceived as a one-time cost that will not occur again. Therefore, when investors assess a firm’s earnings to forecast future earnings or cash flows, they may ignore the write-off. Yet, if firms consistently have inventory write-offs, they are repeatedly incurring this expense.
Investors who do not recognize the expense as recurring will underestimate the firm’s future expenses, and will overestimate the firm’s future earnings and cash flows. One indicator of a potential write-down of inventory is when inventory levels build up over time on quarterly financial statements, which could imply that there is some obsolete inventory that has not yet been eliminated and may be written off in the future.
Timely Write-offs [a Reality Check]
Firms in some industries have substantial flexibility to stretch expenses over time. Boeing spread its expenses to make its financial condition appear more attractive in 1997 when it merged with McDonnell Douglas Corp. Boeing’s cost overruns on production were not completely divulged at the time because they were able to delay reporting some of the expenses until after the merger with McDonnell Douglas was completed. On October 22, 1998 Boeing announced that it would have a write-off of $4.3 billion. The stock price declined by 20 percent over the next week. Some of the write-off could have been taken in previous quarters when the cost overruns occurred. Since shareholders rely on the firm to disclose expenses, they were taken by surprise when Boeing announced the huge write-off.
Boeing was hit with a securities fraud lawsuit by shareholders that it ultimately agreed to pay more than $90 million to settle. Some critics may argue that the accounting guidelines were at fault for the creative accounting used by Boeing. Others may suggest that Boeing’s auditors were at fault for signing off on Boeing’s financial reports.
Classifying Expenses as Nonrecurring
When a firm forecasts its future earnings [called “pro forma earnings“], it excludes expenses that recently occurred but will not happen again. For example: a firm may incur expenses when it discontinues a product, because it will discard machinery and inventory. These expenses are considered to be “nonrecurring” because the product is no longer offered, and there should be no more expenses associated with the product. Therefore, it is logical to exclude those specific expenses when forecasting earnings.
However, some firms mistakenly ignore all nonrecurring expenses when forecasting earnings. If a firm discontinues a product every year, it will have a specific type of nonrecurring expense every year. In essence, the expense from discontinuing a product is a recurring expense, and should be considered when this firm forecasts earnings. For firms that have some form of restructuring charges every year, pro forma earnings that do not account for restructuring will likely be overestimated. Firms tend to be too optimistic when forecasting earnings, and one of the reasons is that firms are unwilling to recognize that some “nonrecurring” expenses will continue to occur.
Classifying Expenses as Depreciation
If a firm develops computer software for its business this year, it can depreciate this expense over a period. Alternatively, it could classify this expense as an operating expense, so that the entire expense is reported this year. If it depreciates the expense, it can spread the expense out over several years. The software development expense reported for this year would only be a small portion of the total software development expense. Therefore, this year’s earnings will be inflated.
Classifying Expenses Due To Acquisitions
When a firm engages in acquisitions, its earnings can be substantially affected by the accounting method it uses when consolidating the two entities.
Consider a firm that acquires another firm [called the target] for $500 million. The purchase results in a reduction of $500 million in its cash account. There must be offsetting entries to keep the balance sheet balanced. In general, the acquirer adds the book value of the target’s assets to its own assets. The excess paid for the assets beyond the book value is called “goodwill,” which is an intangible asset. That is, goodwill suggests that there is more value in the existing assets than their book value. If the acquirer paid $500 million for the assets, and it determines that the book value of the assets is $500 million, then the goodwill is zero. If these assets have a useful life of 4 years, accounting rules would allow the assets to be amortized by $125 million each year. This creates an expense to the firm of $125 million in the next 4 years, which will reduce the level of reported earnings.
Now consider how the annual expense reported by a firm can reduce the book value. Assume that it judges the assets to have a book value of $300 million, which means that the goodwill is $200 million. The depreciation on the book value of acquired assets would be $300 million over the 4-year period, or $75 million per year. Thus, if the firm judges its book value of acquired assets to be $300 million instead of $500 million, it can reduce its annual amortization expenses, and therefore boost its earnings.
In the past, goodwill was also expensed (amortized) over time, but over a much longer period of time, and therefore at a slower pace. Consequently, there was an incentive to overestimate goodwill, because it resulted in a lower book value of acquired assets, a lower amortization expense, and therefore a higher level of reported earnings.
WorldCom used this deceptive accounting method after acquiring MCI. In 2000, it reduced the book value of its tangible assets that it acquired, thereby adding to the goodwill (intangible assets). This reclassification of assets enabled WorldCom to report lower annual depreciation expenses, which led to higher reported earnings. By some estimates, this accounting method inflated WorldCom’s pre-tax earnings in 2000 by more than $600 million.
Recently, the accounting rules for goodwill have been changed. According to accounting rule FASB 142, firms must annually adjust their reported goodwill if they had initially overestimated it at the time of the acquisition. The firm must record that adjustment as a cost to completely reflect the degree to which the goodwill is overestimated. In essence, the accounting rules now require the goodwill to be written down immediately (rather than over a long-term period) when it reflects a permanent decline in value. Consequently, firms that overpaid on recent acquisitions may have large write-offs, which will reduce the reported earnings. In essence, the large write-offs within a single quarter may not necessarily be due to poor performance within that quarter, but to a previous acquisition.
In the fourth quarter of 2002, AOL Time Warner took a one-time noncash charge (or write-off) of $54 billion. While it may be unfair to interpret the charge as an expense of $54 billion in a single quarter, it is also dangerous to just ignore such a large write-off. A portion of this huge write-off is due to poor acquisition decisions.
Many other firms also had accumulated a large amount of goodwill from acquisitions, including WorldCom, Tyco, and Qwest. The goodwill must be written down to reflect the market values of the acquired units, which creates an expense for the firm. Some of the write-offs were due to poor acquisitions that the firms made a few years earlier. Many of these firms used their highly priced stock as currency in the late 1990s to buy other companies. At the time, it seemed like they were buying companies for a reasonable price by providing their stock to owners of the acquired companies. However, these transactions flooded the market with their stock, which led to lower valuations of their stock.
Lack of Disclosure about Acquisitions [a Reality Check]
Shortly after the publicity about Enron’s accounting, Tyco’s accounting methods were questioned. Its financial statements were difficult to decipher because of the firm’s many acquisitions. In February, 2002, Tyco International experienced a major decline in its stock price upon concerns about its accounting methods. Tyco was publicly criticized because it had not disclosed some of the 600 acquisitions that it made during the 1999–2001 period. In addition, Tyco initially did not disclose that it paid $20 million to a director ($10 million to him and a $10 million donation to a charity he selected) for his services in an acquisition by Tyco.
There were even allegations about its accounting of the acquisitions by some employees of the companies that it acquired. When investors became aware of this information, they sold the stock, causing the stock price to decline by more than 50 percent. The investor response was at least partially attributed to the uncertainty surrounding Tyco’s financial condition, and the lack of trust in Tyco’s financial reporting.
Firms should disclose any loans provided to its executives. That money could have been used by the firm to serve shareholders rather than to serve the executives. WorldCom provided a loan of more than $400 million at a low interest rate to its CEO, so that he could pay off loans that he used to buy WorldCom stock. The stock price declined substantially after his investments, and he could not cover the debt payments. The loan from the firm to him is classified on the firm’s balance sheet under “other assets.”
Deferring Credit Loss Expenses
In the summer of 2001, Providian Financial changed the manner in which it accounted for credit losses, which deferred about $30 million of credit losses into the third quarter. In this way, its pre-tax earnings during the second quarter were $30 million higher. The stock price was above $45 per share at the time. In July, one Providian executive sold a large amount of his Providian stock while another executive sold some of his stock options.
Their actions occurred before the $30 million of credit losses was reported. The stock price declined once the credit losses were reported, and declined further to just $5 per share in October when Providian announced that its earnings would be weak. Some investors responded by filing lawsuits, alleging that the firm’s executives inflated the earnings temporarily so that they could sell their options or shares at a higher price.
Applying Gains to Reduce Reported Expenses
Accounting rules allow firms to account for gains from the sale of assets as a reduction in expenses, which creates the appearance of lower operating expenses. For example: in January, 2001, an IBM news release stated that its “selling, general, and administrative” expenses were reduced. It used an accounting method in which it classified the gains from sales on some assets as a reduction in expenses instead of revenue.