Creative Accounting: Four Areas
To Buff Up a Company's Picture
By KEN BROWN, Staff Reporter of THE WALL STREET JOURNAL, Feb. 21, 2002
Corporate financial statements, with their numbers calculated down to the dollar and even the penny, have always seemed to be etched in stone. In these Enron-tainted days, regulators and investors are finding out that the numbers often are scratched in Silly Putty.
Accounting never has been an exact science. Auditors must distill a company's many broad and often complex transactions into a just a few key numbers, making dozens if not hundreds of judgment calls along the way, in an effort to reflect accurately its underlying financial condition.
Now, in the wake of Enron Corp.'s collapse and subsequent revelations of accounting irregularities at other big corporations, it has become increasingly clear that number crunchers often present a company's finances in the most flattering way.
"That's what creative accounting is, it's trying to alter perceptions of business performance," said Charles W. Mulford, an accounting professor at the Georgia Institute of Technology in Atlanta.
Here's a guide to four areas where accounting standards are loose enough for even troubled companies to make themselves appear robust:
A SALE ISN'T ALWAYS A SALE: If you sell a cup of lemonade on a street corner, it's pretty clear that you should book the 25 cents as revenue. But what if a runner passing by grabs a glass and promises to pay later? Can you book the revenue? Yes, as long as you think the runner's IOU is good.
When to recognize revenue is one of the oldest problems around. And the issue boils down to one simple fact: Under generally accepted accounting principles, a company can book a sale before it gets paid. Businesses, of course, have been extending credit to customers for centuries, so accounting rules need the flexibility to recognize such sales. But Enron and others -- while often technically adhering to the rules -- stretched them to post huge revenue growth even though they had little actual cash coming in the door to pay the bills.
A particular hotbed of debate: the software industry, because these companies often sign long-term contracts to supply and service their products. Some companies take a conservative approach and book the revenue of a multiyear contract equally for each year over the life of the contract. Others are more aggressive, booking the bulk of the revenue in the first or second year, say, of a five-year contract, justifying the practice by saying that the bulk of the services is delivered in those years.
This involves a judgment call, because the level of services supplied in the later years often isn't clear until the end of the contract is near.
Among companies that have landed in hot water for abusive revenue-recognition practices is Microstrategy Inc. In December 2000, three top executives agreed to $11 million in fines to settle a Securities and Exchange Commission inquiry into its accounting practices. The SEC had accused the company of prematurely recording revenue from software sales by booking sales before determining the full extent of services it would have to provide in connection with those sales.
Companies such as Sunbeam Corp. and Bausch & Lomb Inc. took a different route to enhance revenue. In both cases, the companies cut deals for customers to take far more merchandise than needed and not pay for it immediately, according to their settlements with the SEC. Others have promised customers unlimited rights to return the goods. By "stuffing the channel," as it is called, companies appear to be selling lots of goods, though some of those goods end up back with the company.
For investors, the good news is that the trick can often be spotted: If buyers aren't paying for goods sold, a company's accounts receivable will grow at a faster rate than sales. In Sunbeam's case, sales rose 18.7% from 1996 to 1997, but accounts receivable ballooned 38.5%.
VALUING ASSETS: Everyone knows what they paid for their house. And most people have a rough idea what their house is worth today. But no one knows for sure exactly what it's worth until they sell it, because a house is only worth what someone will pay for it at a given moment.
So it is with the assets of a lot of companies. A bank that makes a $5 million loan to a company gives that loan a value and records it as an asset on its balance sheet. But a year or two later, when the borrower runs into financial trouble and misses some payments, how should the loan be valued on the bank's books? At what point -- and how much -- should it be marked down to reflect the risk that it might not be repaid? Banks have a lot of leeway to determine the level of reserves to set aside for troubled loans like this; the less they set aside, the better their earnings look.
But valuing assets can get even more complicated. Imagine, for example, trying to estimate what your house will be worth 20 years from now. Impossible, of course. But companies are forced to do just that for assets such as long-term contracts to sell energy.
The rise and fall in the value of these contracts is included in corporate earnings, making it a very important calculation. Energy-trading companies such as Enron and Dynegy Inc. use complicated mathematical formulas to come up with the value of the energy contracts on their books.
Critics say it's little more than guesswork. Indeed, one of the biggest problems is that the accounting rules are vague on how to value these assets. "Accountants don't know how to come up with that fair value," says David Zion, an accounting analyst at Bear Stearns Cos. At Enron, such gains accounted for about half of its $1.41 billion of originally reported pretax profit in 2000.
OFF THE BOOKS: Individuals don't have balance sheets in the legal sense, but they can have the equivalent of off-balance-sheet liabilities, as Enron did to the tune of billions of dollars. Say your brother wants to buy a house, but because of his lousy credit history, he can't get a mortgage unless a more upstanding citizen co-signs for the loan. If you agree, you have just added an off-balance-sheet liability.
There's nothing wrong with that -- unless you borrow money for a new car and neglect to tell your lender about the arrangement, which could hurt your ability to repay the new-car loan.
The key issue is whether the liabilities can come back to hurt a borrower financially. If they can, they must be disclosed as contingent liabilities, because it is vital information for investors.
In come cases, regulators have found that companies still have some financial responsibility for obligations moved off their books. PNC Financial Services Group Inc., which had put some bad loans into three off-balance-sheet companies, thought it had walled off its liability. But last month, regulators forced the bank to bring the loans back onto its books, a move that reduced its 2001 earnings by 28%.
Another area of off-balance-sheet financing is the so-called synthetic lease. Here, a company leases a property but takes on some ownership risk. For example, if the property falls in value, the company may owe some amount to the landlord. Companies like synthetic leases because the liability doesn't go on the balance sheet as it would if the company borrowed money to buy the building; moreover, the lease payments get favorable tax treatment. But the move is riskier than a straightforward lease. "You're effectively committed to this thing in an amount that goes beyond your lease payments," says Prof. Mulford, the accounting professor who is the co-author of a new book, "The Financial Numbers Game: Detecting Creative Accounting Practices."
Some companies disclose the existence of synthetic leases. Others don't, and the only way investors can tell they exist is by looking for mention of a "restricted cash balance," meaning some of the company's cash is set aside for the potential liability.
MULTIPLYING THE PROBLEMS: Given all the judgment calls accountants must make, it's hard enough to get a full understanding of a big company's far-flung operations. The task becomes even harder when companies merge -- especially when they engage in lots of mergers.
The books of General Electric Co. and Tyco International Ltd., for example, can be difficult to understand because some portion of each company's growth is the result of newly acquired companies, while another indeterminable portion comes from previously existing operations.
Tyco shares have been hammered in recent weeks amid criticism that its strong earnings growth is dependent, among other things, on certain accounting maneuvers at companies being acquired. Some critics cite a series of charges by finance company CIT Group just before Tyco closed its pact to acquire CIT. The charges for such things as a bigger bad-debt allowance depressed CIT's pre-merger earnings, but didn't show up on Tyco's books.
Determining a bad-debt allowance is subjective, because no one knows for sure how many loans will go bad until they actually do. In this case, the accounting move enabled Tyco to show CIT's results surging after Tyco took control. Tyco executives have acknowledged that the move improved comparative results, but dispute suggestions of accounting gimmickry.
In other cases, companies set up merger-related reserves, for such things as anticipated layoffs, that they then partially unwind in subsequent years. Over-reserving, and then dipping into the pot, is an old earnings-management trick used by acquirers and nonacquirers alike. For chronic over-reservers, the SEC has made life harder by requiring companies to show when and why they are dipping into their reserves. This information will appear in footnotes to a company's financial filings.
HOLDING DOWN COSTS: For every product or service a company sells, there are costs. Long ago, financial executives realized that if those costs could be reduced, profits would go up. So began the game of capitalizing operating expenses, which means taking the daily costs of running a business and spreading them out over time by treating them as if they are long-term assets. The cost is then written down slowly.
In 1996, America Online Inc. was forced to take a $385 million pretax charge, which effectively wiped out every dollar of pretax profit the company had made over the previous five years, when the SEC ruled that the cost of those ubiquitous disks with AOL software was an immediate advertising expense, not a capitalized item that could be written off over time.
Many companies that are aggressive with their accounting use a whole menu of options to beautify their image. Telecom provider Global Crossing Ltd., which filed for bankruptcy-court protection last month, sold capacity on its network using 20-year contracts; at the same time, it leased capacity from other companies. In some instances, Global Crossing booked the "cash revenue" up front as one lump sum, while spreading out the costs of the leased capacity over many years.
Together, these maneuvers improved its bottom line.
Write to Ken Brown at firstname.lastname@example.org
Many companies use a whole menu of accounting options to beautify their images. Global Crossing and other telecom companies booked so-called cash revenues from the sale of capacity on their networks, while at the same time buying capacity from competitors, but capitalizing the cost of the deal, rather than booking it as an expense, meaning it has little impact on earnings. In other words, the telecoms booked 'cash revenues' as the seller, even though little cash changed hands, but didn't book an offsetting expenses as buyers.
In this transaction, Company A sells Company B a 20-25 year lease on fiber-optic capacity and gear at low rates for $100 million, while Company B sells Company A a different Indefeasible Right of Use, or IRU for $100 million dollars.