The importance of knowing accounting...

One of the more interesting items that has come out of the Bernie Ebbers case is his claim that he does not understand accounting. In a description of his testimony Ebbers is reported to have:

"....admitted he was a demanding and sometimes temper-prone boss at WorldCom, but he repeatedly said he was unfamiliar with the details of finances and accounting, and left the numbers-crunching to Sullivan."

The accounting issue that has caused Worldcom so much trouble is simply the capitalization of maintenance and line costs. Students in intermediate financial accounting understand the basic issue of capitalization versus expensing, it is difficult to believe that Ebbers did not grasp this basic issue.

Cash Flow Statement and Inventory Financing

An interesting development from the SEC that is applicable to the cash flow statement and inventory chapters.

The SEC is cracking down on companies that are "Presenting cash flows between the company and/or its consolidating subsidiaries as an investing cash outflow and an operating cash inflow when there has not been a cash inflow to the company on a consolidated basis from the sale of inventory..."

From the SEC:
In January 2005, the staff of the Division of Corporation Finance sent
letters to certain registrants related to their presentation of cash
receipts from inventory sales in their consolidated statements of cash
flows. In order to affect wide-spread awareness of this issue and to
refocus registrants on the proper presentation in their consolidated
statements of cash flows, we are providing publicly an example of
comments that registrants should consider as they prepare future
Commission filings.

The importance of appropriate classification and presentation of items
in the consolidated statement of cash flows cannot be overstated. The
statement of cash flows is one of the primary statements required with a
full set of financial statements. It is relied upon by analysts and
investors as much, if not more in some instances, as the statement of
net income. As such, we expect registrants to give significant attention
to the preparation of their consolidated statement of cash flows in
order to ensure it provides an accurate presentation of their actual
cash receipts and cash payments based on activity (operating, investing
and financing), which in turn assists the reader in determining the
registrant's ability to meet its obligations, pay dividends, generate
cash flows sufficient to grow its business, etc. While the staff
believes a statement of cash flows using the direct method provides
investors with more useful information than the short-cut indirect
method, we recognize that most companies use the indirect method.
Therefore, we encourage companies to put more time and effort into
ensuring that the statement of cash flows, and related disclosure in the
financial statement footnotes and in MD&A, is meaningful and useful to
users of the financial statements.
-Curt Norton

GenCorp and government contracts

There is an interesting article in the Wall Street journal today concerning how GenCorp recognizes reimbursements from government contracts. GenCorp is a defense contractor which owns a subsidiary called Aerojet. Aerojet makes propulsion systems for the Patriot and Tomahawk missile systems. However, Aerojet also created a large environmental pollution problem. From the Wall Street Journal article we find out:

The federal government in a 1999 settlement agreed to cover up to 88% of Aerojet's environmental cleanup costs in the form of future contracts.

Because of this GenCorp records a current asset for future recoverable amounts from the Government for cleaning up polluted sites. Here is the relevant information from GenCorp's footnotes:

The Company recognizes amounts recoverable from insurance carriers, the U.S. government or other third parties, when the collection of such amounts is probable. Pursuant to U.S. government agreements or regulations, the Company can recover a substantial portion of its environmental costs for its Aerospace and Defense segment through the establishment of prices of the Company’s products and services sold to the U.S. government. The ability of the Company to continue recovering these costs from the U.S. government depends on Aerojet’s sustained business volume under U.S. government contracts and programs (see Note 13).

Note 13 is the company's contingencies footnote which is 6 to 7 pages long. The relevant information about Aerojet is on page 91. The question is whether a company should recognize a receivable for future recoverable amounts when those amounts are not certain.

accounting and stock options

On Saturday there was a story on Marketwatch.com concerning Time Warner's decision to stop issuing stock options as compensation to MOST OF ITS employees. The article provides the following information:

The media giant said Friday that new financial reporting standards that require companies to treat stock options as expenses make it "prohibitively expensive" to grant the options to all employees, according to a New York Times report.

Time Warner said it will continue to grant stock options to some workers based on their job responsibilities and industry practice.

The accounting change for stock options can be summed up by this statement by the FASB about the revised standard for stock options (FAS 123R):

As stated by the FASB, "FAS 123R will provide investors and other users of financial statements with more complete and neutral financial information by requiring that the compensation cost relating to share-based payment transactions be recognized in financial statements. That cost will be measured based on the fair value of the equity or liability instruments issued. This Statement is the result of a two-year effort to respond to requests from investors and many others that the FASB improve the accounting for share-based payment arrangements with employees."

The change in accounting simply requires that companies that once disclosed the cost of stock options in the footnotes now show an expense and increase in equity for the fair value of the options granted. It is difficult to understand how simply the recognition of an expense as opposed to its disclosure can somehow make it "prohibitively expensive".

If Time Warner had paid for advertising by issuing stock options would that advertising have been less expensive than if it had been paid for with cash?

Stock option accounting can create great discussions in class as students examine the issues surrounding the topic.

Change and International Financial Reporting Stds

In 2005 International Financial Reporting Standards will be required in at least 65 countries for all of their domestic listed companies. Most importantly this includes companies in the 28 EU (Eurpean Union) and the EEA (European Economic Area). This change in reporting obviously may resuylt in some confusion and in difficulty comparing results from period to period. Take for example the following article concerning German Company Hochtief:

Hochtief AG, Germany's largest builder, said profit last year gained 17 percent, boosted by a change in accounting standards and by rising demand.

Pretax profit advanced to 187 million euros ($243.5 million) in 2004 from 159.5 million euros a year earlier, the Essen-based company said today in a statement.

The company gained from the International Financial Reporting Standards, which end the regular expensing of goodwill related to acquisitions.

One interesting piece in the article focuses on the question of whether the company's earnings really did improve as much as suggested:

Hochtief's earnings beat the 171.8 million-euro median estimate of six analysts surveyed by Bloomberg News.

The company wrote down 21.1 million euros of goodwill amortization in 2003. Pretax profit without this expense would have been 180.6 million euros instead of 159.5 million euros.

So without the expensing of goodwill earnings in the previous period would have been 180.6 euros and the improvement over the previous period would have been only 3.5% not 17%.

The changes that are occurring are just one more reason that it is important that accounting students be introduced to International Financial Reporting Standards.

SOX and errors

Previously, I have mentioned the numerous accounting restatements related to leases in the restaurant industry (here is a recent letter by the SEC's Chief Accountant clarifying some of the issues). These restatements seem to have been brought on by the compliance requirements of SOX 404. Many in practice have suggested that SOX may not provide any benefit or that its cost outstrips its benefit (for a discussion of both sides, see this debate).

For an example of how SOX made an extreme difference for one company and its investors, take a look at Sirva and its recent press release providing earnings guidance. Sirva had been projecting earnings of $.15 - $.17 per share, but due to finding errors in its insurance and European dividsions as a result of SOX 404 it is now projecting losses of ($.16)-($.20) per share. Here is one of the relevant paragraphs from the release:

In the fourth quarter of 2004, the company commenced a thorough review of its accounting practices and significant balance sheet accounts, which has led to the identification of $21 million to $25 million pre-tax, or $0.18 to $0.22 per fully diluted share, of charges in its Insurance and European operations. The review was undertaken in connection with implementing procedures to comply with Section 404 of the Sarbanes-Oxley Act, the disappointing performance of the company’s Insurance and European businesses in the third quarter of 2004, and as part of its year-end closing process.

Co-Cos

One item that has been creating a large number of restatements lately is "contingently convertible debentures" or Co-Cos. Co-Cos are a special type of convertible debt instrument that is convertible at the option of the holder into shares of common stock once the common stock trades above a certain price for a specified period of time (a market price trigger).

The Emerging Issues Task Force Issued "The Effect of Contingently Convertible Debt on Diluted Earnings per Share" ("EITF 04-08"). This new accounting rule requires companies with contingently convertible debt instruments to include the dilutive effect of the contingently convertible debt in diluted earnings per share calculations regardless of whether the market price trigger has been met. The rule requires retroactive application.

The rule basically requires that Co-Cos be treated like traditional convertible debt. One important question for students is why were Co-Cos created?

Actuant Corporation recently released a press release about its restatement of net income as a result of issuing contingently convertible debt, a small bit:

The impact of adopting the new accounting rule is a reduction in diluted earnings per share, but not net earnings. The quarterly restatement of diluted earnings per share for fiscal 2004 and 2005 is reported on the attachment to this press release. In calculating diluted earnings per share under the new rules, Actuant is required to add back the net of tax charges for interest expense and debt issuance cost amortization related to the 2% Co-Cos to net income (restated numerator) and increase the weighted average outstanding shares for the shares issuable under the 2% Co-Cos (restated denominator).

Taxes and losses

We are discussing deferred taxes this week and a company that has a number of interesting issues is Amazon.com The company reported its 2004 results this week and interestingly it is starting to finally use its loss carryforwards from all of the losses it generated. I found it interesting that the Wall Street Journal termed the recognition of the tax carryforward a "gain" from tax benefits. Here is a cut from Amazon's press release:

Net income was $347 million in the fourth quarter, or $0.82 per diluted share, compared with net income of $73 million, or $0.17 per diluted share, in fourth quarter 2003. Pro forma net income in the fourth quarter was $394 million, or $0.93 per diluted share, compared with $125 million, or $0.29 per diluted share, in fourth quarter 2003. Excluding the benefit from realizing a $244 million deferred tax asset related primarily to net operating loss carryforwards attributable to continuing operations, fourth quarter pro forma net income would have been $149 million, or $0.35 per diluted share.

One interesting item that can be brought out in class with Amazon is that the company only reports a deferred tax asset of $81,388,000 at Dec. 31, 2004 even though the net operating loss carryforwards are much greater.

Inventory write-downs

Normally when I talk about valuing inventory at its lower of cost or market (LCM) I state that one reason inventory can lose value is because of obsolscence or technological change, however my examples are usually not real world. However, today I saw a news release about Teletouch a company that operates a paging and two way messaging network. Cellphones and wireless networks are slowly making pagers obsolete and as this occurs we see companies in this area taking inventory write-downs. Here is a cut from the Teletouch's second quarter press release:

Teletouch recorded an operating loss of $457,000 for the latest quarter compared with operating income of $52,000 in the second quarter of fiscal 2004. The increased operating loss was primarily due to fewer pagers in service at the end of the period. The second quarter 2005 results include approximately $331,000 in inventory write-downs compared with $203,000 in the same quarter of last year. Adjusting for the inventory write-down, the Company would have recorded an operating loss of $126,000 for the quarter compared to an operating profit (net of inventory write-downs) of $255,000 in the comparative quarter last year.

More troubles with lease accounting

Hypercom reported that it will need to restate its results for the first three quarters of 2004 to correct how it accounts for its leases. Previously it had concluded that 3,200 of its leases should be accounted for as sales-type leases when instead it should have accounted for the leases as operating leases. The company stated that it will lower its revenue by over $4 million dollars for the first three quarters, it also reported that operating revenue would be cut by $2.6 to $3.0 dollars. The gross margins on these leases must have been large (somewhere between 65% to 75%), and this suggests the reason why Hypercom would want to treat the leases as sales type leases.

An examination of this restatement also allows for a good class discussion of the motivations for lessors and lessees. Most lessors want capital lease treatment, while lessees would rather have operating lease treatment. Students should be able to think about why lessors and lessees want differing treatment and how through proper structuring each can get what it wants. usually this is done by purchasing residual value insurance or more complex structuring.

FAS No. 153

The new FAS 153 changes the accounting rules for nonmonetary exchangesof assets. Previously, the accounting rule for "similar" assets was fairly close to the tax rule for Section 1031 exchanges. The new rule in FAS 153 refers to exchanges with "commercial substance" rather than on the similar/dissimilar distinction. A gain does not have to be recognized on those exchanges that are without commercial substance. This change in the rule was made in order to make the FASB Statement more consistent with the International standard (the so-called convergence). While it does make the rules more consistent with International standards, it makes them LESS consistent with tax rules. The result--an additional book-tax difference that may give rise to deferred tax calculations.
-Curt Norton

International Accounting Rules

One of the many issues we address in our textbook is the role of international accounting standards and issues. In January the IASB reported that it and the Accounting Standards Board of Japan had agreed to take steps towards international convergence. This is one more imporatnt move towards an international set of standards. Given that almost all listed companies in the European Union must adopt and apply International Financial Reporting Standards to their consolidated financial statements beginning in 2005, it is important that accounting majors become familar with international issues. I will try to highlight more items as we go forward.

Repatriation of Foreign Income and deferred taxes

One item affecting a number of company’s fourth quarter earnings releases is the tax effect of repatriating income held overseas by foreign subsidiaries. This provides an interesting discussion topic when covering deferred taxes. One provision in the big November 2004 tax bill (American Jobs Creation Act of 2004) was that companies could repatriate overseas profits at a rate of 5.25% (much lower than the normal 35%).

Previously the accounting for this item was based on what the company was expecting to do with the money.

• If a company was not expecting to repatriate the foreign profits and instead stated that it would permanently reinvest the foreign earnings it was not required to recognize any U.S. taxes on the profits. Usually companies would disclose the amount of permanently reinvested foreign earnings in the tax footnote. For example in its 2003 annual report Kellogg’s discloses the following:

At December 27, 2003, foreign subsidiary earnings of approximately $1.09 billion were considered permanently reinvested in those businesses. Accordingly, U.S. income taxes have not been provided on those earnings.

Companies that have not provided for taxes on their foreign earnings will recognize a tax expense (and tax liability) in the period they elect to repatriate foreign earnings. The amount of the tax expense will be 5.25% of the amount repatriated. In addition, these companies will have much higher effective tax rates in the period of the election. For an example of this take a look at Johnson and Johnson’s fourth quarter earning release.

• If a company has provided for U.S. taxes on its past foreign profits it set up a deferred tax liability (since the tax is not due until the actual profits are repatriated) equal to 35% of the foreign profits. If the company elects to repatriate the foreign income this period than it will result in a decrease in the deferred tax liability and an adjustment to the tax expense.

For an example of a company that had previously provided for U.S. taxes and is now able to get a benefit from the repatriation look at the earnings release of Autodesk.

Earnings Restatements

Most days the Wall Street Journal reports a list of the companies that are restating earnings for whatever purpose. January 31, 2005 had ten companies restating earnings and these restatements realated to the following:

Software Revenue Recognition issues - three companies
Other revenue issues - one company
Contingently convertible debt - one company
SFAS No. 140 - one company
Variable interest issue - one company
miscellaneous error(s) - one company
Deferred tax liab. - one company
Leases - one company (Pep Boys)

All of these are intermediate issues and provide great examples for the classroom. Right now my class is covering leases so I used the restatement that pertained to Pep Boys as an example in class. The restatement relates to property leases in which PepBoys has made improvements. This issue affects many companies in the restaurant and retail industry and results in most companies recognizing more rent expense or depreciation.

For a good article on the subject see this story in CFO Magazine

The beginning

I am starting this web blog to collect and share current thoughts and ideas about intermediate financial accounting, both issue oriented and teaching oriented. The web log will be updated as quickly as news about financial accounting comes about or a teaching idea comes into my head.

The site is used to support a new textbook written with Curt Norton and Mike Diamond with the title: Intermediate Accounting: Financial Reporting and Analysis. The first edition has just been released by Houghton Mifflin and you can learn more on our website.


I look forward to posting information related to accounting and teaching issues and hearing your feedback.

Don Pagach