Fluent Essays

I. To prepare for this Discussion question, think about a time in your professional experience when a decision was made based on inaccurate financial information or unethical behavior resulting in fraudulent financial information. If you do not have professional experience directly related to accounting and decision making, research a situation where inaccurate or fraudulent financial information was provided by a company. Consider the outcomes of utilizing fraudulent financial information for decision making and research how to avoid such situations. Prepare the following: Describe the situation from either your professional experience or your research.Explain the steps you would take to address unethical behavior and remedy the situation of utilizing the inaccurate or fraudulent financial information you described and why you would take these steps.Explain the steps that you, as a manager, might take to ensure that all financial information you review accurately reflects the organization’s true financial situation and why this is important to prevent unethical behavior and the use of inaccurate or fraudulent financial information. II. To prepare for this Discussion question, “Financial vs. Managerial Accounting,” take a moment to think about the implications of these two kinds of accounting.Prepare the following: Describe one or two examples of decisions that could be made using the information provided by financial accounting. Provide specific examples and explain how decisions are improved when the information is used accurately. Then, explain the risks of not having the information when making such decisions. Your examples should be real world, specific situations from your experience, observations, and research.Describe one or two examples of decisions that could be made using the information provided by managerial accounting. Provide specific examples and explain how decisions are improved when the information is used accurately. Then, explain the risks of not having the information when making such decisions. Your examples should be real world, specific situations from your experience, observations, and research. accounting_minefields.pdf accounting_for_decision_making_and_control.pdf sec.gov___beginners__guide_to_financial_statement.pdf sec.gov___how_to_read_a_10_k.pdf Unformatted Attachment Preview TOOL KIT TREAD LIGHTLY THROUGH THESE Accounting Minefields Illegal? Maybe not, but many of todays accounting moves are clearly aggressive. Shareholders-and their representatives on corporate boardsneed to be aware of six danger zones. by H. David Sherman and S. David Young B ACK IN THE igRos, Tandem Computers robust earning reports made it a darling of Wall Street. Its CEO and cofounder James Treybig had pioneered a superhot technology, a way to make fault tolerant computers 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 theyd hatched. Some ofthe revenue reported in its most recentfinancialstatements had not actually materialized, and earnings had to be restated. The Streets retribution was swift: Tandems share price immediately dropped 30\%. In time,the company recovered (it was ultimately acquired by Compaq), but the event left a lasting impression. When a Wall Street fournal reporter asked Treybig to recall his most exciting day at Tandem, he couldnt. 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 economic climate, there is tremendous pressure - and personal financial incentive for managers-to report sales growth and meet investors revenue expectations. According to the SEC, misleading financial reports, especially JULY-AUGUST 2001 129 TOOL KIT • Accounting Minefields involving game playing around earnings, are being issued at an alarming rate. Needless to say, its a nightmare that affects more than CEOs sleep. The shareholders suffer most-and todays stock price volatility makes Tandems 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 werefiledin 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, provisions for uncertain future costs, asset valuation, derivatives, related-party transactions, and information used for benchmarking performance. If disaster strikes, it will most likely occur in one of these accounting minefields. MINEFIELD 1 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 performed. But for some businesses, pinpointing 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 alternative approach is to consider the customers ability to pay its commitment in the future. What if the customer is a dotcom that might not survive? Judgment is also required on the question 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 statements, should the auctioneer include the total amount of the sale as revenue and call the $95 payment to the items original owner an expense? Or should it count only the commission as revenue and show no expense? Most accountants would say the latter approach is preferable. But some Intemet companies, recognizing the importance investors place on sales growth, have taken advantage H. David Sherman is the Cowan Research of ambiguities in revenue recognition rules to effectively do the former. Professor of Accounting at Northeastern University in Boston. He can be contacted By contrast, suppose Dell sells a comat h.sherman@neu.edu. This is his third puter monitor it purchased from an inHBR article. S. David Young is a professor dependent manufacturer. Does it call at INSEAD in Fontainebleau, France, and only its profit margin revenue, or the the coauthor of EVA and Value-Based full price? Obviously, revenue is recogManagement: A Practical Guide to Im- nized on the full price, with the cost of plementation (McGraw-Hill, 2001). He can the monitor treated as an expense. But be reached at david.young@insead.fr. what if Dell were to arrange for the 130 monitor to be shipped directly from the manufacturer to the customer (as it often does)? Should Dell include the monitors selling price in its revenue, or only the profit on the transaction? In other words, should Dells sales figures suffer just because of an efficient logistics arrangement? Or should the decision hinge on some technical legal question, such as who would be responsible if the goods were damaged in shipping? The ambiguities suggested in just these simple examples begin to explain how one ofthe biggest accounting debacles in recent history could have happened. MicroStrategy, a producer of data-mining software, announced in March 2000 that it was restating its revenues and earnings forfiscalyears 1998 and 1999. A change in revenue recognition policies transformed its reported profitof$i2.6 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 enHARVARD BUSINESS REVIEW Accounting Minefieids • TOOL KIT gagements; customizing the software to a clients unique circumstances is a complex undertaking. But rather than spreading the revenue from the software sale over the life of the contract, the company was recording it immediately. It was a tactic the SEC had begun to see more often in software companies and had complained about. When MicroStrategy announced the restatement, 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 shareholders and investigations by the SEC. Evidently, no one on MicroStrategys board asked the right questions-or what came to be called the MicroTragedy never would have occurred. Shareholders who want to avoid the same fate should pass along these questions to the board audit committee: • How is revenue defined? And what event triggers its recognition? • Does this present a reasonable measure ofthe 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? MINEFIELD Provisions for Uncertain Future Costs Companies must make provisions for costs they know will arise, even if the amounts cant be known with any certainty: losses from inventory obsolescence, uncollectible accounts, product returns, restructuring costs, damages from product recalls-the list goes on. But precisely because theres so much JULY-AUGUST 2001 latitude in this area, it can be a minefield of earnings management. Estimates can either be infiated to create hidden reserves so that profits can be boosted in some future period to project a misleading earnings stream, or they can be diminished to enhance reported profits. Xerox has found itself in this minefield latelj^ despite evidence of a growing number of slow payments, the company made no greater allowance for bad that amount, it did not disclose the fact on the face of its income statement, allowing the adjustment to enhance operating income. The SEC took a dim view of this type of reporting. In fact, the SEC sued WR Grace for fraud in 1999 hecause the company failed to highlight just such a reversal. Andfinally,managers play just as creatively with whats known as comprehensive income. This category, which Evidently, no one on MicroStrategys board asked the right questions-or what came to be called the MicroTragedy never would have occurred. debts. Could someone on the board have spotted this and averted the crisis? Xeroxs former assistant treasurer thought so and told the Wall Street fournal as much in a highly damaging story. A second common form of mischief to watch for involves overstated restructuring 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 profitability 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 expenses 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. Its become common for companies to employ a big bath strategy with their restructuring charges, making them so large as to flush out any possible future impact on earnings. And while companies are eager to highlight these nonrecurring business losses, they call far less attention to their actions when they need to reverse restructuring charges. Heinz, for example, overestimated the costs of its restructuring in 1997 by some $25 million. When it subsequently reversed appears in the shareholders equity section ofthe 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. Examples include gains or losses caused by translating financial statements of subsidiaries from local currency to the parent companys currency, and unrealized gains and losses on investments in financial securities. Judgment calls are required on which gains and losses should be reflected on the income statement and which should be captured in comprehensive income. But there is definitely an incentive to park losses in the comprehensive income category, because the only income incorporated into the highly visible earnings per share figure (the basis of a companys priceearnings ratio) is that shown on the income 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 euros decline in vaiue throughout 2000 reduced the dollar earnings of U.S. companies with large European sales, many of them managed to defer the impact on earnings through clever use ofthe comprehensive income line. A prudent director would certainly consider how such treatment affects 131 T O O L K I T • Accounting Minefields Are You Sitting in a Minefield? Recent history has shown that businesses with the following characteristics are more likely to feature manipulation of company accounts. Look sharp if youre associated with a business that falls into one ofthese 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 disappointing. New businesses where there are ambiguities about how key transactions 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 popular 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 reported financial results with relative impunity. The seriousness of this problem variesconsiderablyfromcountrytocountry, reflecting wide diversity in corporate governance, securities regulation, and reporting requirements. Companies that are followed by a small numberof analysts. Less capital 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 making key transactions less transparent, these structures give rise to related-party transactions and conflicts of interest. Naturally, having any one ofthese 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 companys financial reporting practices. 132 investors perceptions ofthe businesss profitability. To discover if a company is wandering into one ofthese 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 ofthese estimates and the accounting treatment? • Should gains and losses included in comprehensive income (foreign currency, investment gains and losses) and in the ftx>tnotes instead be included in the current periods net income? MINEFIELD J Asset Valuation On the most basic level, an asset is something 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 generally carried at cost less estimated amortization or depreciation-and depreciation requires an estimate of its useful life. But the latitude given to management in making such estimates can raise questions about motivation when estimates are changed. For example. Delta Airlines revised the useful life of aircraft in itsfleettwice in ten years; in both cases, the change created sizable increases in reported profits. Were these adjustments motivated by any real change in the airplanes life spans, by a desire to match competitors accounting methods, or by some other reason? Companies that use accounting methods to keep their research and development expenses fTom reducing eamings 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. HARVARD BUSINESS REVIEW Accounting Minefields • TOOL KIT Another is to conduct R&D through investments in partners to avoid treating the costs as current expenses. If analysts interpret such moves as being motivated by a desire to manage eamings, companies can seriously damage their reputations in the capital markets. Elan, an Irish pharmaceutical company and the subject of SEC reviews, scared off some analysts 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 practices being used by an otherwise strong company really provided a more complete eamings picture for shareholders, in the same spirit, you should ask the Do tangible and intangible asset values 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 consistent with industry and global com- petitors? If not, are the differences justifiable and adequately discussed in the financial statements? on the wrong side. The companys energy group had contracted with customers to sell petroleum at pricesfixedin 1992 for a maximum of ten years. Because the company would lose money if oil prices MINEFIELD * T rose, it decided to hedge away the risk Derivatives by using a stack hedging strategy, The use of derivatives to manage finan- which employs derivatives. In doing so, cial risk deserves careful and constant it stacked the deck in the opposite discrutiny. These complex financial in- rection, so that when the price of oil struments were famously implicated suddenly declined, the losses started to in the downfall of Barings Bank, in the mount. The situation cost the company travails of Bankers Trust, and in the near some $1.5 billion, leading the Economist bankruptcy of Orange County, Califor- to observe; As Chemobyl was to nuclear nia-but the heightened awareness of power, so Metallgesellschaft has bethem has not made them any easier for come to financial derivatives nonexperts to judge. Derivatives have, in Still, derivatives remain in wide use fact, been usefully employed for decades for all kinds of good reasons, and in to hedge risks related to commodity many companies their potential impact prices, foreign exchange fiuctuations, on income is substantial. These compaand interest on debt. The great difficulty nies should continually scrutinize their for board members, managers, and share- use to ensure that the risks are managed holders is in recognizing when their use responsibly, to determine whether realintroduces more risk than it mitigates. ized and unrealized gains and losses For German conglomerate Metallge- should be included in the eamings, and sellschaft, that risk equation came down to ensure that the risks and accounting This is your captain speaking, hease put your tray tables i and prepare for landing. THE ONLY THING DRY IS THE INK. Economis TOOL KIT • Accounting Minefields treatments are clearly disclosed so that shareholders can understand their potential impact. How can a sharp-eyed director defend the interests of shareholders in this regard? Again, the process 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 companys 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 ofthe derivative program? MINEFIELD J Related-Party Transactions Related-party transactions are those made with entities that are controlled by the company or that have control over the company, including other businesses, shareholders, directors, lenders, vendors, and customers. Disclosure of these transactions varies based on the regulatory environment and each companys policies. But investors always have an interest in knowing about them because they can allow a company to arbitrarily increase or decrease eamings or to divert profits, sometimes enriching a subgroup of shareholders or managers. Investors in the Belgian company Lemout & Hauspie Speech Products, a maker of speech recognition software, leamed about this minefield when their shares dropped from $65 to $9 in the spring of 2000. An intemal audit discovered that 30 customers, all start-ups and most based in Singapore, were responsible for about a quarter ofthe companys revenues. It tumed out L&H had helped create those companies-and many had received seed money from a venture capital firm linked to L&Hs founders ... Purchase answer to see full attachment