1 Copyright © 2002 by Thomas Z. Lys. All rights reserved. Microsoft CFO Summit: Looking for Trouble in all the Right Places © Professor Thomas Z. Lys Kellogg

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Copyright © 2002 by Thomas Z. Lys. All rights reserved.

Microsoft CFO Summit:

Looking for Trouble in all the Right Places©

Professor Thomas Z. LysKellogg School of

ManagementNorthwestern University

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TopicsTopics Tax v Financial ReportingTax v Financial Reporting Conformity between financial reporting and Conformity between financial reporting and

tax filingtax filing

Reporting v Disclosure - understand what is Reporting v Disclosure - understand what is being recognized versus what is being being recognized versus what is being disclosed disclosed

Inter-temporal effects: Relation between Inter-temporal effects: Relation between asset and liabilities valuations in one period asset and liabilities valuations in one period and performance metrics in subsequent and performance metrics in subsequent periodsperiods

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The basic accounting modelThe basic accounting model• Difference between the stock view of the balance Difference between the stock view of the balance

sheet and the flow perspectives in the income and sheet and the flow perspectives in the income and cash flow statementscash flow statements

• Linkages between the income and cash flow Linkages between the income and cash flow statements and successive balance sheet statements and successive balance sheet statementsstatements

Looking for problemsLooking for problems• Revenue recognitionRevenue recognition• Asset valuationAsset valuation• Liability valuationLiability valuation

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Tax v Financial ReportingTax v Financial Reporting There are only very few conformity There are only very few conformity

requirements between US GAAP and US tax requirements between US GAAP and US tax reporting!reporting!

As a result, companies can pursue different As a result, companies can pursue different goals for financial reporting (communication) goals for financial reporting (communication) and tax:and tax:• Often, companies try to present themselves as Often, companies try to present themselves as

favorably as possible in their financial disclosuresfavorably as possible in their financial disclosures• To minimize taxes, companies often present To minimize taxes, companies often present

themselves in the worst possible light for tax themselves in the worst possible light for tax purposes.purposes.

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These differences in goals between financial These differences in goals between financial reporting and tax result in (potentially) large reporting and tax result in (potentially) large differences between the numbers reported to differences between the numbers reported to the IRS and the numbers reported to the IRS and the numbers reported to shareholdersshareholders

The differences can be eitherThe differences can be either• Timing differences (e.g., depreciation, leases, etc.) Timing differences (e.g., depreciation, leases, etc.)

which give rise to deferred taxes, orwhich give rise to deferred taxes, or• Permanent differences (amortization of non-tax Permanent differences (amortization of non-tax

goodwill) which does not give rise to deferred goodwill) which does not give rise to deferred taxestaxes

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Book–Tax Conformity: The Book–Tax Conformity: The Current DebateCurrent Debate Many countries have full book–tax conformityMany countries have full book–tax conformity There are voices in the US to require conformity There are voices in the US to require conformity

between book and tax, particularly in light of the between book and tax, particularly in light of the recent financial disclosure failuresrecent financial disclosure failures

Such conformity would limit companies’ Such conformity would limit companies’ communication optionscommunication options• Limiting degrees of freedom is good if you are trying to Limiting degrees of freedom is good if you are trying to

stop cheaters, but stop cheaters, but • it also constrains the communication options available it also constrains the communication options available

to honest firmsto honest firms

Imposing conformity will criminalize financial Imposing conformity will criminalize financial reporting errorsreporting errors

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Recognition v DisclosureRecognition v Disclosure Recognition refers to reporting the $ Recognition refers to reporting the $

amounts of a transaction in the financial amounts of a transaction in the financial statement (e.g. balance sheet).statement (e.g. balance sheet).

Disclosure refers to reporting transactions Disclosure refers to reporting transactions outside of the financial statement (e.g., outside of the financial statement (e.g., footnotes).footnotes).

Example:Example:• Salaries are recognized as expenses and reduce Salaries are recognized as expenses and reduce

net income.net income.• Executive stock options are often only disclosed Executive stock options are often only disclosed

in the footnotes and not reflected in net in the footnotes and not reflected in net income!income!

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A Word of Caution!A Word of Caution!A Word of Caution!A Word of Caution!

Accounting numbers areAccounting numbers are

neither innocent neither innocent

nor objective!nor objective!

Accounting numbers areAccounting numbers are

neither innocent neither innocent

nor objective!nor objective!

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The Basic Accounting ModelThe Basic Accounting Model

Balance sheet reports the stock view ofBalance sheet reports the stock view ofcorporate resourcescorporate resourcesclaims on those resourcesclaims on those resources

Balance sheet equation:Balance sheet equation:

Assets = Liabilities + Owners’ EquityAssets = Liabilities + Owners’ Equity

Balance sheet reports the stock view ofBalance sheet reports the stock view ofcorporate resourcescorporate resourcesclaims on those resourcesclaims on those resources

Balance sheet equation:Balance sheet equation:

Assets = Liabilities + Owners’ EquityAssets = Liabilities + Owners’ Equity

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Income statement provides flow view of the Income statement provides flow view of the CHANGES IN NET ASSETS DUE TO CHANGES IN NET ASSETS DUE TO BUSINESS ACTIVITIESBUSINESS ACTIVITIES

Acceleration of Revenue RecognitionAcceleration of Revenue Recognition• Increases current incomeIncreases current income• Increases current assetsIncreases current assets• Decreases future incomeDecreases future income

Understatement of assets increases income Understatement of assets increases income in subsequent periodsin subsequent periods• Purchase Accounting v Pooling of InterestPurchase Accounting v Pooling of Interest• In-process R&D write offIn-process R&D write off• Asset write downsAsset write downs

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Statement of cash flows provides a flow Statement of cash flows provides a flow view of changes in cash balances, broken view of changes in cash balances, broken down by cash provided from/used bydown by cash provided from/used by

Continuing operationsContinuing operations

Discontinued operationsDiscontinued operations

InvestingInvesting

FinancingFinancing

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The Accounting Model: Revenue Recognition

Incur a cost toobtain a benefit

Future benefit or current benefit?

Future benefit can be estimated with reasonable

certainty?

Recognize as assetuntil benefits occur

Expense now

Expense when benefit occurs

Expense now

Current

Future

No

Yes

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An Example: World Inc.CONSOLIDATED STATEMENTS OF

OPERATIONS Dollar amounts in

1,000,000

Years ending December 31

1999 2000 2001Revenues $35,908 $39,090 $35,179

Op

erating

expen

ses

Line costs 14,739 15,462 14,739SG&A 8,935 10,597 11,046Depreciation 4,354 4,878 5,880Other

(8) 0 0

Operating Income $7,888 $8,153 $3,514

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Dollar amounts in 1,000,000

Years ended December 31

1999 2000 2001

Operating Income $7,888 $8,153 $3,514Interest expense (966) (970) (1,533)Miscellaneous 242 385 412Income before taxes 7,164 7,568 2,393Provision for Taxes 2,965 3,025 927Minority interest (186) (305) 35Cumulative effect of Accounting change 0 (85) 0

Net Income $4,013 $4,153 $1,501

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An Example: World Inc.CONSOLIDATED STATEMENTS OF

OPERATIONS Common Size Income

Statement

Years ending December 31

1999 2000 2001Revenues 100% 100.00% 100.00%

Op

erating

expen

ses

Line costs 41.05% 39.55% 41.90%SG&A 24.88% 27.11% 31.40%Depreciation 12.13% 12.48% 16.71%Other

-0.02% 0.00% 0.00%

Operating Income 21.97% 20.86% 9.99%

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CONSOLIDATED BALANCE SHEETS

Dollar amounts in 1,000,000December 31

2000 2001Current Assets $9,755 $9,205

Prop

erty &

equ

ipm

ent

Transmission 20,288 23,814Communication 8,100 7,878Furniture and other 9,342 11,263Const. in progress 6,897 5,7060Accum. depreciation

(7,204) (9,852)

Goodwill & other intangibles 46,594 50,537Other 5,131 5,363TOTAL ASSETS $98,903 $103,917

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2000 2001Current liabilities $17,673 $9,210

Lon

g-term Long-term debt 20,288 23,814

Deferred taxes 8,100 7,878Other 9,342 11,263

Total liabilities $40,104 $43,890

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2000 2001Total liabilities $40,104 $43,890Par value of common stock 29 30Add. Paid-in capital 52,877 54,297Retained earnings 3,160 4,400Unrealized holding gain on marketable securities 345 (51)Cumulative foreign currency translation (817) (562)Treasury stock (185) (185)Total shareholders’ equity 55,409 57,930TOTAL EQUITIES $98,903 $103,917

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Example: WorldCom On June 25, WorldCom announced that

$3.8 billion in line costs were capitalized In terms of the diagram on slide 12,

WorldCom treated the $3.8 billion as if there were to benefit future periods

Thus in 2001 and 2002• Assets were overstated by $3.8 billion

• Net income were also overstated by $3.8 billion

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WorldCom Restatement of 2001 Consolidated Statements of Operations

Dollar amounts in 1,000,000 Reported Adjust Corrected

Revenues $35,179 $0 $35,179

Op

erating

expen

ses

Line costs 14,739 +3,055 17,794SG&A 11,046 0 11,046Depreciation 5,880 (382) 5,498Other

0 0 0

Operating Income $3,514 ($2,673) $841

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Reported Adjust CorrectedOperating Income

$3,514 ($2,673) $841

Interest expense (1,533) 0 (1,533)Miscellaneous 412 0 412Income before taxes 2,393 (2,673) (280)Provision for Taxes 927 (927) 0Minority interest 35 0 35

Net Income $1,501 ($1,746) ($245)

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To Summarize: WorldCom 2001 Restatements (in $ Millions)

Line costs increased by 3,055 from $14,739 to $17,794

Depreciation decreased by $382from $5,880 to $5,498

Provisions for income taxes decreased by $927,000from $927,000 to $0

Net Income was restatedfrom $1,501 to ($245)

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Assessing Earnings QualityAssessing Earnings QualityAssessing Earnings QualityAssessing Earnings Quality

Earnings persistenceEarnings persistence

Cash component of earningsCash component of earnings

Earnings persistenceEarnings persistence

Cash component of earningsCash component of earnings

Earnings quality has two main Earnings quality has two main dimensions:dimensions:Earnings quality has two main Earnings quality has two main dimensions:dimensions:

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Organization of the Income Organization of the Income StatementStatement

Income from continuing operationsIncome from continuing operations

Income from discontinued operationsIncome from discontinued operations

Extraordinary gains or losses, net of taxExtraordinary gains or losses, net of tax

Cumulative effect of changes in accounting Cumulative effect of changes in accounting principles, net of taxprinciples, net of tax

Net income, and earnings per share Net income, and earnings per share (regular and fully diluted)(regular and fully diluted)

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Simple Tests to Pick-up the TrailSimple Tests to Pick-up the TrailSimple Tests to Pick-up the TrailSimple Tests to Pick-up the Trail

First, determine quality of earnings: First, determine quality of earnings:

1.1. Where on the income statement is earnings Where on the income statement is earnings recognized? recognized?

2.2. Compare Operating Cash-Flows to Operating Compare Operating Cash-Flows to Operating IncomeIncome

3.3. How stringent are the accounting rules?How stringent are the accounting rules?

4.4. Are there any income-increasing accounting Are there any income-increasing accounting changes?changes?

5.5. Are there any income-increasing transactions?Are there any income-increasing transactions?

First, determine quality of earnings: First, determine quality of earnings:

1.1. Where on the income statement is earnings Where on the income statement is earnings recognized? recognized?

2.2. Compare Operating Cash-Flows to Operating Compare Operating Cash-Flows to Operating IncomeIncome

3.3. How stringent are the accounting rules?How stringent are the accounting rules?

4.4. Are there any income-increasing accounting Are there any income-increasing accounting changes?changes?

5.5. Are there any income-increasing transactions?Are there any income-increasing transactions?

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Second, analyze “suspect” accounts:Second, analyze “suspect” accounts: Account Receivables and related allowancesAccount Receivables and related allowances InventoriesInventories IntangiblesIntangibles Other “large accounts” (using common size Other “large accounts” (using common size

statements)statements)

Timing of balance sheet issue date.Timing of balance sheet issue date.Presence of audit report qualifications.Presence of audit report qualifications.

Second, analyze “suspect” accounts:Second, analyze “suspect” accounts: Account Receivables and related allowancesAccount Receivables and related allowances InventoriesInventories IntangiblesIntangibles Other “large accounts” (using common size Other “large accounts” (using common size

statements)statements)

Timing of balance sheet issue date.Timing of balance sheet issue date.Presence of audit report qualifications.Presence of audit report qualifications.

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Example: Consumer Products CoExample: Consumer Products CoExample: Consumer Products CoExample: Consumer Products Co

1986 1987 1988Net Sales $76,144 $128,234 $181,123

Cost of Goods Sold $46,213 $70,756 $94,934Selling, Distribution and Administrative $10,366 $14,621 $21,870Advertising $8,557 $26,449 $39,992Research and Development $1,182 $1,530 $2,423Total Operating Expenditures $66,318 $113,356 $159,219

Operating Income $9,826 $14,878 $21,904

Interest Expense $1,930 $1,584 $3,189Income before Income Taxes $7,896 $13,294 $18,715Tax Expense $3,807 $6,189 $7,761

Net Income $4,089 $7,105 $10,954

Years Ended June 30,Income Statement

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1987 1988AssetsCash $514 $885Accounts Receivable, net $28,277 $51,502Allowance for doubtful accounts ($476) ($426)Inventories $19,577 $39,135Other $1,449 $3,015Total Current Assets $49,341 $94,111

Property Plant and Equipment at cost, less accumulated depreciation $14,788 $21,548Other Assets $1,112 $2,481Long-term Assets $15,900 $24,029

Total Assets $65,241 $118,140

June 30,

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1987 1988Current Portion of Long Term Debt $900 $1,250Account Payable $15,072 $13,288Accrued Liabilities $5,468 $4,710Income Taxes Payable $2,619 $3,782Total Current Liabilities $24,059 $23,030

Industrial Revenue Bonds $13,900 $12,650Mississippi State Debt $1,975Bank Debt $5,941 $47,432Total Long-Term Debt $19,841 $62,057

Deferred Taxes $1,254 $1,881

Preferred Stock $1 $1Common Stock at Par $8,018 $8,023Additional Paid-In Capital $12,315 $23,269Cumulative Foreign Currency Translation $126Treasury Stock ($247) ($247)Total Stockholders' Equity $20,087 $31,172

Total Equities $65,241 $118,140

EquitiesJune 30,

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Cash Flow Statement Year ended June 30, 1988, Dollar amounts in 000

Cash Flows from OperationsNet Income $10,954Depreciation and Amortization 1,601Deferred Taxes 627Increase in Accounts Receivable (23,275)Increase in Inventories (19,556)Increase in Other Assets (1,566)Decrease in Current Liabilities (1,029)Cash from Operations ($32,246)

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Cash Flows from InvestingPurchase of Property Plant and Equipment ($8,148)Other Investment (1,882)Cash Flows form Investing ($9,730)

Cash Flows from FinancingSale of Common Stock $5Net Increase in Debt 42,216Cash Flows form Financing $42,221

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Cash Flow Statement Year ended June 30, 1988, Dollar amounts in 000

Cash from Operations ($32,246)Cash Flows form Investing ($9,730)Cash Flows form Financing $42,221

Foreign Currency Adjustments $126Total change in Cash $371

Beginning Cash Balance $514Total change in Cash $371Ending Cash Balance $885

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1987 1988AssetsCash 0.79% 0.75%Accounts Receivable, net 43.34% 43.59%Allowance for doubtful accounts -0.73% -0.36%Inventories 30.01% 33.13%Other 2.22% 2.55%Total Current Assets 75.63% 79.66%

Property Plant and Equipment at cost, less accumulated depreciation 22.67% 18.24%Other Assets 1.70% 2.10%Long-term Assets 24.37% 20.34%

Total Assets 100.00% 100.00%

Common Size Balance SheetJune 30,

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CorrectNet Revenue $280Purchases 225- End Inv. 25Cost of Goods Sold 200Gross Margin $ 80

Gross Margin Ratio 28.6%Ending Inventory 25Accounts Receivable 70

(40,000-5,000) ×$8.00

(45,000) ×$5.00

5,000 ×$5.00

$280,000 - $210,000

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Correct (2a)Net Revenue $280 320Purchases 225 225- End Inv. 25 25Cost of Goods Sold 200 200Gross Margin $ 80 $ 120

Gross Margin Ratio 28.6% 37.5%Ending Inventory 25 25Accounts Receivable 70 110

Assume now that the firm does not reduce revenues and Accounts Receivable by the 5,000 units that were returned as defective

(45,000) ×$8.00

$320,000 - $210,000

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Correct (2a) (2b)Net Revenue $280 320 320Purchases 225 225 225- End Inv. -25 -25 -50Cost of Goods Sold 200 200 175Gross Margin $ 80 $ 120 $145

Gross Margin Ratio 28.6% 37.5% 45.3%Ending Inventory 25 25 50Accounts Receivable70 110 110

Assume now that the firm does not reduce Revenues and Accounts Receivable by the 5,000 units that were returned as defective but at the same time, increases inventory by those 5,000 units

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The CompanyChange in Accounts Receivable

% Increase in Net Sales = (181,123 - 128,234)/128,123 = 41%% Increase in A/R = (51,076 - 27,801)/27,801= 84%

1987 1988Accounts Receivable Turnover

Net Sales/Ending A/R 4.61 3.55Expressed in days 79 days 103 days

0.741

0.473

0.281 0.278

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

70.0%

80.0%

1st Qtr 2nd Qtr 3rd Qtr 4th Qtr

Sales Growth

Can this growth from FY87 to FY 88 be attributed to a seasonal effect in the company’s sales pattern?

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Increases in A/R and Inventory“Normal” and “Abnormal”

0

10

20

30

40

50

60

A/R Inventory

1987 1987 + 28% 1988

Abnormal A/R (15.5)

Abnormal Inventory (14.0)

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The Regina Company

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Regina Company Overview

-$20

-$15

-$10

-$5

$0

$5

$10

$15

1985 1986 1987 1988

Profits

Restated Profits

LBO Favorable review, New products, Disasterwent public triple advertising

45


ConclusionsConclusions Accounting numbers are neither innocent Accounting numbers are neither innocent

nor objective!nor objective! You need to understand the incentives of You need to understand the incentives of

the persons producing the numbersthe persons producing the numbers You need to understand the accounting You need to understand the accounting

modelmodel If everything fails, you need ME!If everything fails, you need ME! And, If you don ‘t understand how And, If you don ‘t understand how

strategic other beings are …strategic other beings are …

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FINITOFINITO

Documents

1 Copyright © 2002 by Thomas Z. Lys. All rights reserved. Microsoft CFO Summit: Looking for Trouble in all the Right Places © Professor Thomas Z. Lys Kellogg