(1) The Quality of Financial Information Referencing this week?s readings and lecture, describe the quality issues related to reporting revenue. What is the importance of understanding various inventory valuation methods in determining the quality of reported profits? (2) Conflicts with GAAP Even though firms follow the accounting rules (GAAP) when presenting their financial statements, it is still possible for conflicts of interest to exist between what management wants investors and creditors to see and the economic reality of transactions. Explain how this can occur.

5 Evaluating the Quality of Financial Reports amnarj2006/iStock/Thinkstock Learning Objectives After reading this chapter, you should be able to: 1. Understand the role of regulatory oversight. 2. Recognize the elements of quality financial reporting. 3. List key differences in how information is reported in the United States versus requirements of international reporting agencies. 4. Explain the role of the auditor. 5. Identify accounting tricks. eps81356_05_c05_161-196.indd 161 3/26/14 1:03 PM Introduction Pre-Test 1. What entity develops GAAP rules? a.\tGASB b.\tIASB c.\tFASB d.\tSEC 2. What are the two fundamental characteristics of a quality financial report? a. relevance and reliability b. relevance and faithful representation c. reliability and faithful representation d. reliability and verifiability 3. What entity develops international financial reporting standards? a.\tGASB b.\tIASB c.\tFASB d.\tSEC 4. What independent third party reviews the books of a company for the Securities and Exchange Commission (SEC)? a. financial examiner b. SEC staff person c. CPA who is an auditor d. independent member of the Board of Directors 5. What is a phrase that Arthur Levitt used to identify creative accounting? a. big bath b. merger mania c. cookie jars d. all of the above Answers can be found at the end of the chapter. Introduction Enron, a former Texas energy company, is known today primarily for its spectacular demise. But for years, the company was a respected presence in Houston: It employed 20,000 people and was one of the world's major electricity, natural gas, communications, and pulp and paper companies, with revenues of over $100 billion reported in 2000. By the time the company declared bankruptcy in 2001, however, it was best known for forever changing the public trust in a company's financial reports. Enron's massive financial report manipulation, revealed when the company filed for bankruptcy protection with $38 billion in outstanding debts, opened the eyes of the public to the games companies can play with their financial report numbers. eps81356_05_c05_161-196.indd 162 3/26/14 1:03 PM Introduction In fact, the former multi-billion-dollar company used almost every trick in the book to hide its losses from investors. This included keeping some of the biggest losses off its financial statements completely by using off-the-balance-sheet financing of its foreign projects. The Enron bankruptcy and revelations of its unethical and illegal financial reporting sent shock waves throughout the country and the world. The U.S. Justice Department initiated a criminal investigation, and executives from Enron and Enron's auditing firm, Arthur Anderson, were indicted on obstruction of justice charges relating to the shredding of documents and on conspiracy to commit wire and securities fraud. Some executives were convicted and served prison sentences. In 2002, Arthur Anderson voluntarily surrendered its license to practice as a Certified Public Accountant. Brett Coomer/Associated Press Energy company Enron's bankruptcy and illegal financial reporting were primary events that led to stricter government oversight. A new era of financial report oversight started with the passage of the Sarbanes-Oxley Act in 2002. Since the passage of Sarbanes-Oxley, top executives must certify the accuracy of their company's financial information. Penalties for fraudulent financial activity are much more severe. The law also increased the independence of outside auditors and increased the responsibilities of corporate boards of directors by giving them a greater oversight role in financial reporting. All managers in today's business world must be aware of the regulations and the agencies that enforce these regulations (Orin, 2008; Prawitt, 2012). In this chapter, we review the checks and balances that are in place for financial reporting. First we examine the regulators who maintain oversight of the financial reports filed by publicly traded companies in the United States and abroad. We also explore the elements of a properly prepared financial report and review some key differences between U.S. GAAP rules and international reporting rules. We probe the role of the auditor, who ensures that financial reports accurately represent a company's financial position. Finally, we examine some of the \"creative\" ways in which a firm might prepare its reports to hide its financial problems. eps81356_05_c05_161-196.indd 163 3/26/14 1:03 PM Regulatory Oversight Section 5.1 5.1 Regulatory Oversight We introduced the concept of generally accepted accounting principals (GAAP) in Chapter 1, but let's take a closer look at the entities that create these principles, as well as those responsible for making sure that they are followed in the reports released by publicly traded companies. Three critical U.S. organizations develop rules, monitor the issuance of financial reports, and police the sales of securities to the public (see Table 5.1): 1. The Financial Accounting Standards Board (FASB) develops the GAAP reporting principles that all public companies must follow. 2. The Securities and Exchange Commission (SEC), a part of the Federal government, monitors company financial reports and makes sure they meet the standards set by the FASB and the SEC. 3. The Financial Industry Regulatory Authority (FINRA) regulates the actual trading of securities and monitors securities brokers. We will take a closer look at the role of each of these entities. We will also review the role of the International Accounting Standards Board (IASB) and the ongoing efforts to develop worldwide financial reporting standards. Financial Accounting Standards Board (FASB) Since 1973, the Financial Accounting Standards Board (FASB) has developed the standards of financial accounting that all public companies in the United States must follow. These standards govern the preparation of financial reports by nongovernmental entities and are officially recognized as authoritative by the SEC (in Financial Reporting Release No. 1, Section 101, and reaffirmed in its April 2003 Policy Statement) and the American Institute of Certified Public Accountants (in Rule 203, Rules of Professional Conduct, as amended May 1973 and May 1979). The primary purpose of the FASB is to ensure that financial reports provide useful information for financial decision making. It does this by establishing and improving standards of financial accounting and reporting. Because so many entitiesincluding lenders, investors, governmental entities, managers, and employees, as well as the general publicdepend on credible, concise, and understandable financial information, the FASB standards enable the efficient functioning of the U.S. economy. The Enron scandal reminded everyone of the consequences of undermining this system of accurate, reliable, and credible information. Seven individuals serve on the FASB; most have worked for major accounting firms and major corporations, and some are drawn from academia. In order to serve, a member must sever all ties with his or her former organizations. This helps to ensure the independence of the FASB. Further, members must have demonstrated knowledge of accounting, finance, business, and research, and must show a desire to protect the public interest in matters of accounting and finance. eps81356_05_c05_161-196.indd 164 3/26/14 1:03 PM Section 5.1 Regulatory Oversight The seven board members maintain the FASB Accounting Standards Codification, which enables accounting professionals to access the rules and source of authoritative standards of accounting and reporting that make up the GAAP. One might think of this as the library of accounting standards. The FASB is part of a financial overview structure (see Table 5.1) that is independent of all other business and professional organizations. That structure includes the Financial Accounting Foundation, the FASB, the Financial Accounting Standards Advisory Council (FASAC), the Governmental Accounting Standards Board (GASB), and the Governmental Accounting Standards Advisory Council (GASAC). Collectively, these groups set rules for accountants to follow when preparing financial reports. Table 5.1: Financial overview structure Regulatory body Function Financial Accounting Foundation A 17-member board that oversees the work of the FASB. Financial Accounting Standards Board (FASB) Develops GAAP reporting principles that all public companies must follow. Financial Accounting Standards Advisory Council (FASAC) Advises the board members of the FASB regarding potential new projects and helps to set priorities for existing projects. Governmental Accounting Standards Board (GASB) Develops reporting principles that all governmental entities must follow. Governmental Accounting Standards Advisory Council (GASAC) Advises the board members of the GASB regarding potential new projects and helps to set priorities for existing projects. Although the FASB strives to accomplish its goals through broad participation, its work is subject to oversight by the Financial Accounting Foundation's Board of Trustees. The Financial Accounting Foundation is an independent, private sector organization run by a 17-member Board of Trustees from various backgrounds, including users of financial reports, financial report preparers, government financial report preparers, auditors, and academics. When technical issues arise involving accounting principles, the FASB looks to the FASAC to investigate and recommend any needed changes to the GAAP. (In Chapter 1, we discussed how the FASB develops new GAAP rules.) At the time of this writing, the FASAC had more than 30 members, who represent a broad cross section of the FASB's constituency. Note that standards for governmental agencies can be different. One significant difference, for example, is the reporting of revenue. For a government entity, revenue comes primarily from government sources, taxes, or user fees. The financial reporting rules for government entities are developed by the GASB and the GASAC. eps81356_05_c05_161-196.indd 165 3/26/14 1:03 PM Regulatory Oversight Section 5.1 Task Box 5.1: Exploring FASB Project Plans The FASB lists all of its current and past projects to revise or improve accounting standards on its website. Visit the Project Plans Archive page and click on the most recent technical plan to find out what issues are currently being considered for revision or which new sections of the GAAP are being proposed. One project involves the rules for revenue recognition and is a good example of the work being done by the FASB to converge U.S. rules with international practices. The world of business is changing, and countries are moving toward one set of accounting rules for international financial reporting. The United States is working toward adapting to this new standard; soon, managers in U.S. companies will be required to collect revenue data based on these worldwide rules. Review the Exposure Draft for the Revenue Recognition practice and note the number of issues being discussed that involve revenue recognition. Pick one issue and be prepared to discuss the changes being proposed and how you think that may impact financial reporting in the United States. Review the Proposed Amendments list and pick one for further reading. What aspect of revenue reporting did you choose? What key differences are being recommended, and why? Securities and Exchange Commission (SEC) Since 1934, the SEC has had the statutory authority to establish reporting standards for U.S. public companies. The SEC does not actually write the GAAP, but its enforcement of GAAP principles give it power to monitor and improve financial reporting. Managers must collect the financial transaction data that their companies report based on the GAAP rules. They need to work closely with the accounting liaisons in their offices to meet the requirements of these rules. Securities laws that give the SEC authority over financial reporting include: The Securities Act of 1933 (SEC, 2012b): This act is commonly referred to as the \"truth in securities\" law. The act mandates that investors receive financial and other significant information concerning securities that are offered for sale to the public. It also prohibits deceit, misrepresentations, and other fraud in the sale of securities. The Securities Exchange Act of 1934 (SEC, 2012c): This act created the SEC and gave it broad powers to register, regulate, and oversee firms that sold securities to the public. This is the act that empowers the SEC to require periodic reporting of information by companies that raise money through sales of publicly traded securities. Specifically, the act enables the SEC to require companies with more than $10 million in assets whose securities are held by 500 or more owners to file annual and other periodic financial reports. As discussed in previous chapters, these reports are available on the SEC's EDGAR database. The Investment Company Act of 1940 (SEC, 2012a): This act regulates the mutual fund industry. It requires companies to disclose their financial condition and investment policies to investors when stock is sold on the public markets. eps81356_05_c05_161-196.indd 166 3/26/14 1:03 PM Regulatory Oversight Section 5.1 The Sarbanes-Oxley Act of 2002 (SEC, 2005): This act mandated reforms to enhance corporate responsibility, enhance financial disclosures, and combat corporate and accounting fraud. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (SEC, 2014): This act reshaped the U.S. financial regulatory system to improve consumer protection, increase trading restrictions, regulate credit ratings, regulate financial products, and improve corporate governance and disclosures. The SEC is still working to implement the new rules under this act. The act contains over 90 provisions that require SEC rulemaking. Task Box 5.2: Staying Abreast of SEC Wall Street Reform The SEC still has much work to do to fully implement the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. Research its progress on implementing this act at http://www .sec.gov/spotlight/dodd-frank.shtml. Click on pending actions and review the key issues that are listed there. Pick one of the pending actions and discuss why rules are being considered, how you think those rules will impact financial reporting, and how you will collect data for accounting as a manager. Financial Industry Regulatory Authority (FINRA) The Financial Industry Regulatory Authority (FINRA) does not play a large role in financial report regulation; however, it is the largest independent regulator of securities firms doing business with the public in the United States. FINRA's mission is to protect investors and ensure market integrity. The authority oversees the U.S. brokerage industry, including, according to its website, more than 4,100 brokerage firms and more than 630,000 brokers. International Accounting Standards Board (IASB) The International Accounting Standards Board (IASB) is essentially the FASB's international counterpart. It is the independent standard-setting body of the International Financial Reporting Standards (IFRS) Foundation. The board's 15 full-time members develop and publish International Financial Reporting Standards. The board members come from various countries and work closely with stakeholders around the world, including investors, analysts, regulators, business leaders, accounting standard-setters, and others in the accountancy profession. Currently, the FASB is working closely with the IASB to develop a single international standard. However, although most other major countries have adopted an international standard, or have set a date to do so, no date has been set for the United States. The most recent report by the SEC on this issue was released in July 2012 (Work Plan for the Consideration of Incorporating International Financial Reporting Standards into eps81356_05_c05_161-196.indd 167 3/26/14 1:03 PM Section 5.2 Elements of Quality Financial Reporting the Financial Reporting System for U.S. Issuers; SEC, 2012d). Companies whose stock is issued in other countries can already use the international standards when complying with reporting requirements of the SEC for their U.S. entities. Many details regarding how the U.S. and international systems will be converged must still be worked out between the international body and the U.S. entities responsible for setting financial reporting standards. The entities have developed the basic elements for financial reporting into a \"Conceptual Framework for Financial Reporting\" (IASB, 2008, 2010, 2013). The elements of quality financial reporting discussed in the next section were developed using the concepts in this framework (Tysiac, 2013). 5.2 Elements of Quality Financial Reporting As we have discussed, the primary purpose of financial reporting is to provide useful financial information about the company to employees, vendors, suppliers, creditors, present and future investors, and anyone else who depends on accurate financial information to make decisions about the company. Whether this information will be truly useful to readers depends on its quality (Van Beest, 2009). Developers of the Conceptual Framework for Financial Reporting have divided qualitative characteristics that make financial reporting useful into two categories (see Table 5.2): 1. Fundamental qualitative characteristics: The two key characteristics defined as fundamental to all financial reports are relevance and faithful representation. 2. Enhancing qualitative characteristics: The characteristics that make financial reports even more useful to readers include comparability, verifiability, timeliness, and understandability. Table 5.2: Conceptual framework for financial reporting qualitative characteristics Fundamental qualitative characteristics Enhancing qualitative characteristics Relevance Comparability Faithful representation Verifiability Timeliness Understandability In addition, the presentation of financial reporting is limited by two constraints: 1. Materiality: Information is material if its omission or misstatement could influence the decisions a reader might make about the company. For example, a small business with profits of $200,000 that omits information about a $50,000 transaction is certainly leaving out crucial information that will be material to that company's profits. A major corporation with profits in the billions would not likely be materially affected by a $50,000 transaction that was omitted. (We will discuss materiality in more detail later in the chapter.) eps81356_05_c05_161-196.indd 168 3/26/14 1:03 PM Section 5.2 Elements of Quality Financial Reporting 2. Costs: If the costs of collecting certain information for financial reports exceed the benefits, collection is not required. This cost-benefit analysis is done each time a new reporting requirement is developed as part of the U.S. GAAP or the International Financial Reporting Standards. For example, say a company runs a machine that uses a part that costs just $2 to replace. That replacement is needed about every 100 hours of use. The cost of carefully tracking each replacement in the accounting system would cost more than the part. In a cost-benefit analysis, the company would likely decide not to track each part change because there is little added benefit to the task. Instead, the company would track the expenses of buying the supplies. The costs of providing information include the costs of collecting and processing the information, costs of verifying its accuracy, and costs of disseminating it. Users of the information incur additional costs to analyze and interpret it. There are also costs to consider if decision-useful information is not reported. Readers may not have the information they need to analyze and interpret the report for the purpose of making a critical decision. A decision made without complete information can be costly if the user ends up incurring costs from reduced returns if a poor decision is made, based on incomplete information. Let's now take a closer look at the qualitative characteristics being developed by the joint efforts of the FASB and the IASB to ensure that financial reports meet the needs of their users. Fundamental Qualitative Characteristics Fundamental qualitative characteristics differentiate between information that is useful and information that is not useful or is even misleading. As noted above, for the information to be useful, it must provide two critical characteristics: relevance and faithful representation. Relevance Financial report information is relevant if it could make a difference in someone's decision-making process. This is likely if the information has a predictive value (a value that can be used to form expectations of the future of the company) or a confirmatory value (a value that confirms or changes past or present expectations for the company) or both. Baoshan Zhang/iStock/Thinkstock Relevance and faithful representation are the two fundamental qualitative characteristics of financial reporting. eps81356_05_c05_161-196.indd 169 Not all information that has a predictive value will be useful to all financial report readers. For example, 3/26/14 1:03 PM Elements of Quality Financial Reporting Section 5.2 straight-line depreciation of assets may be highly predictable every year, but it may not be useful for assessing a company's cash flow. The roles of predictive and confirmatory information are interrelated. Often information that has a predictive value also has a confirmatory value. For example, information presented about a company's past assets and claims against those assets can help predict a company's ability to take advantage of economic opportunities in the future, or to react to unfavorable circumstances that might arise. Faithful Representation Faithful representation means that the information presented is complete, neutral, and free from material error. Information is considered complete if it includes all details necessary to make an informed decision. A report is considered neutral as long as there is no bias that leads the reader to a predetermined result, or to take a predetermined action. This does not mean that the information will not influence decision making, because all financial reports do, but the company should not present the information in a way that leads to a conclusion that could have been reached based on information known prior to the preparation of the report. The developers of these basic qualitative characteristics realize that faithful representation will not necessarily mean that the report will be 100% accurate. Financial reports do include management estimates of various types of assets and liabilities. For example, the funds estimated for future retirement obligations must be based on various assumptions set by management and actuarial staff. Instead, for a financial report to meet the criteria of faithful representation, the estimates must be based on appropriate inputs, given the best information available at the time the report is issued. Sometimes it may be necessary to disclose the uncertainty of the information presented to meet the criteria of faithful representation. For example, in the section of the Notes to the Financial Statement where a company discloses potential financial impacts of pending legal action, the only information the company can provide is that the lawsuit is pending, without an estimate of the costs of that action if the company loses in court or settles the case. It is still critical to report the potential of a financial cost at some point in the future to meet the faithful representation characteristic. These two characteristicsrelevance and faithful representationtogether make financial reports more useful for decision making. However, having one without the other can be problematic. For example, information that is faithfully represented may not be relevant, and therefore not useful for making many decisions. Enhancing Qualitative Characteristics The enhancing qualitative characteristicscomparability, verifiability, timeliness, and understandabilitycomplement the fundamental qualitative characteristics to differentiate between useful and less useful information. eps81356_05_c05_161-196.indd 170 3/26/14 1:03 PM Elements of Quality Financial Reporting Section 5.2 Comparability Comparability refers to the use of the same accounting policies and procedures (or information about the different policies or procedures used) to compare the financial results of one or more companies. For example, if one company uses the inventory method FIFO (first in, first out) and the company being compared uses LIFO (last in, first out), it is important for readers to know about these differences so they can adjust their analysis. If a company changes its inventory valuation method, then it needs to adjust prior year financial reports so the information will be comparable from year to year for the same company. The time period for the information also must be known so that the reports are clearly comparing apples to apples. For example, if one company reports based on a calendar year and another reports based on a fiscal year that goes from February 1 to January 31, this may affect the numbers. Since economic conditions change from year to year, if the exact same months are not compared, the results will not be useful. For example, a company that uses a calendar year would include January 2012 in the 2012 report, but a company that uses a fiscal year from February 1, 2012, to January 31, 2013, would use January 2013 in the 2012 report. If economic conditions of January 2012 were very different from those of January 2013, the results will not be comparable for these two companies. Comparability does not mean that all financial reports must look alike. Instead, this concept means that if the reports are presenting information differently, financial report readers must have the information they need to understand these differences and adjust their analysis in order to compare more than one entity or to compare the results of one year to those of another year for the same company. In many cases, the rules of the U.S. GAAP or the IFRS will require companies to use the same accounting methods for the same type of transaction, so the information can be comparable. Verifiability Verifiability of the quality of the information presented on the financial reports helps demonstrate that the information presented faithfully represents the results of the company. Verification is done within a company using various methods to measure the accuracy of the information. For example, a company may verify its inventory count periodically by doing a physical count of inventory on hand and comparing that to the inventory information in the accounting records. Accountants verify cash flow into and out of the business daily by various checks and balances, to be sure the numbers entered into the system match the deposits made to their banks or other financial institutions. All companies have ways to verify the accuracy of their transactions, and auditors review these internal controls as part of their audit and report in the financial report whether they believe improvements are needed. We talk more about the role of the auditors later in this chapter. eps81356_05_c05_161-196.indd 171 3/26/14 1:03 PM Section 5.3 How U.S. Reporting Requirements Compare to International Requirements Timeliness Financial reports meet the characteristic of timeliness provided they are released within an appropriate period to enable employees or managers to make decisions based on the report. For example, managers need timely reports so they can decide how much additional inventory is needed for the next month. A report that is one month late could result in the company running out of inventory at a crucial time. The SEC requires U.S. companies to report their quarterly information 40 to 45 days after the close of the quarter. Companies must report their year-end information within 60 to 90 days after the end of the calendar or fiscal year. The faster reporting times are required of the largest corporations, whereas smaller companies have longer to release their reports. Understandability Understandability means the information in the financial reports is presented clearly and concisely. Even if detailed lease obligation information is included, it should be written in a way that managers and employeesas well as investors and creditorscan understand. If an employee does not understand the lease arrangements, he or she can request additional explanation from the accounting liaison for that department. 5.3\u0007How U.S. Reporting Requirements Compare to International Requirements We discussed the key concepts that both the FASB and the IASB use to ensure quality financial reporting, but now let's examine some key differences between how information is reported in the United States and how international reporting agencies require it. These differences can make it difficult to compare U.S. companies to companies based outside the United States. If a manager wants to compare profitability between his or her company and a global company reporting under international rules, it will be critical to understand the differences. In today's global business environment, many U.S. companies compete with companies from other countries. Some employees working in the United States discover that their company is owned by a foreign entity. They may find their company's reports are completed according to international financial standards. In both cases, U.S. managers need to understand the differences between U.S. and international reporting. In addition, as noted earlier, efforts are underway to converge the U.S. GAAP rules with eps81356_05_c05_161-196.indd 172 Joris Van Ostaeyen/iStock/Thinkstock Currently there are differences between U.S. and international financial reporting requirements. 3/26/14 1:03 PM How U.S. Reporting Requirements Compare to International Requirements Section 5.3 international financial reporting rules. The project, which is being spearheaded by members of the FASB and IASB, has been in the works for years. There is no indication of how much longer it will take, but issues are being converged one by one. Asset Value One significant difference between GAAP and the International Financial Reporting Standards (IFRS) is that IFRS permits the revaluation of intangible assets; property, plant, and equipment; and investment property. GAAP prohibits revaluations except for certain categories of financial instruments that are carried at fair value, such as marketable securities. Many analysts believe that assets are undervalued on the balance sheets of major U.S. corporations that compile their reports based on GAAP, especially when it comes to the value of property and plants. Corporate headquarters and factories that were built 20 to 30 years ago are valued on the balance sheets of U.S. corporations at cost. In many cases, these assets likely have appreciated greatly, even though for some companies the buildings have been depreciated to near zero on the balance sheets. If U.S. corporations switch to IFRS, there may be a dramatic increase in the value of assets held by some companies, as they adjust the values of their property and plants on their balance sheets. Revenue Recognition Both GAAP and IFRS require the recognition of revenue when an item's ownership is transferred to the buyer of the goods, but GAAP gives much more detailed guidance for specific types of transactions. Later in the chapter, we examine the games that some companies play with regard to revenue recognition, even under the more detailed GAAP rules. For managers, accurate revenue reporting is critical in order to understand the company's profitability and cash availability. Research and Development Javier Larrea/age footstock/SuperStock GAAP rules regarding research and development can result in significantly decreased net income because, unlike IFRS rules, costs for both research and development must be expensed in the year of development. eps81356_05_c05_161-196.indd 173 Another key difference between IFRS and GAAP involves how research and development is reported. Under IFRS, research is expensed as a cost of doing business, but development costs are capitalized and amortized, which means they are written off over several years. Under GAAP rules, both research and development costs are expensed as incurred. 3/26/14 1:03 PM How U.S. Reporting Requirements Compare to International Requirements Section 5.3 This policy can have a major impact on a company's bottom line. For example, suppose a company determines that of the $10 million it spent on bringing a new product to market, $2 million was for research and $8 million was for development of the product after research was concluded. Under the GAAP rules, the $10 million would be expensed in each year of the development, based on when the expenses are recognized. Those expenses would decrease net income significantly. A company operating under the requirements of the IFRS would need to expense the $2 million spent on research as it was spent, but it could capitalize the $8 million and write it off more slowly as an amortization. Depending on the life span given the value of the development, it could be written off over 10 to 15 years or more, reducing the impact of development on the bottom line. Inventory Another key difference between IFRS and GAAP is the way inventory is valued. All companies that file reports under IFRS must use FIFO (first in, first out) or weighted-average inventory valuation methods, which we discussed in Chapter 2. Those filing under GAAP rules can also use LIFO (last in, first out). The FIFO type of inventory valuation assumes that the first item in the door is the first item sold. When the LIFO method is used, the last item bought will be the first item sold. In this case, the most expensive item is likely sold, while the older, cheaper items remain on the shelf. For example, suppose a hardware store buys hammers for $12 per unit to stock its shelves at the beginning of the year. Six months later, the store sees that the hammer supply is low and buys additional inventory, but now each unit is $12.50. The new units will likely be added to the front of the shelf, so the more expensive hammers would be sold first, while the cheaper hammers would remain on the shelf. In some industries, such as the energy sector, prices go up and down throughout the year. The price of gasoline, for example, is known to fluctuate because of seasonal and other factors. This can impact the net profit differently depending upon whether LIFO or FIFO is used. As prices are going up, such as we see with the hammers, the Cost of Goods Sold would be higher using LIFO. LIFO inventory value would be based on the last hammer sold, so Cost of Goods would be higher and net profit lower. If prices are dropping and LIFO is used, then the Cost of Goods would be lower and net profit higher. But, in the energy sector prices go up and down on a weekly basis. In this type of industry the average cost method will more likely be used. LIFO can increase the cost of goods sold and decrease net income, making it look like a company made less money and, therefore, reducing the company's income taxes when prices are going up. FIFO results in a lower cost of goods sold and higher net income when prices are going up. The opposite is true when prices are going down. When comparing companies using two different inventory valuation methods, determining the actual costs of doing business can be difficult. If all companies were required to eps81356_05_c05_161-196.indd 174 3/26/14 1:03 PM How U.S. Reporting Requirements Compare to International Requirements Section 5.3 use either FIFO or the weighted-average inventory valuation methods, comparing apples to apples would be easier. Discontinued Operations Under IFRS, if specific operations of an ongoing company are discontinued, the operations and cash flows must be clearly distinguished for financial reporting. The company must specify whether the discontinued operation is a separate line of business or geographical area of operations, including whether a subsidiary is acquired exclusively for the purpose of being sold. This happens often when a company buys another company for a specific purpose and is not interested in continuing every area of the newly acquired company's operations. Under GAAP, the lines are more blurred in regards to discontinued operations. A segment, operating segment, reporting unit, subsidiary, or asset group can be shown as separate losses for discontinued operations. Some analysts believe that companies filing under GAAP use this loophole to hide significant problems. Impairment Charges Sometimes an asset loses value. For example, a computer manufacturer may have inventory of older models that can no longer be sold at full price because newer, more advanced models are available. Their values become impaired and must be written down. Under GAAP, when an impairment charge is recorded in inventory, the company cannot reverse the impairment charge if assets subsequently increase in value. Under IFRS, however, the company is allowed to reverse the impairment charge if assets subsequently increase in value. This can impact both the income statement and the balance sheet, as assets whose values have been impaired are adjusted in later years. Managers need this information to make decisions regarding profitability and the availability of future cash that may or may not be available from these impaired assets. Task Box 5.3: Preparing for Changes to GAAP While no date has been set, the U.S. GAAP rules are expected to be merged with international financial reporting rules at some point. PricewaterhouseCoopers, one of the major global accounting firms, periodically prepares excellent reports about potential changes. Read its most recent IFRS reporting update on the company's website. Pick an accounting issue discussed by PricewaterhouseCoopers that you think relates to the role of a manager. How would the financial reporting for your company be impacted? eps81356_05_c05_161-196.indd 175 3/26/14 1:03 PM The Auditor's Role Section 5.4 5.4 The Auditor's Role Company outsiders need to be sure that the information they see on financial reports is an accurate reflection of the company's financial situation. This is accomplished by hiring an impartial third party to review the company's operations and financial statements and to confirm that the reports are materially correct and that proper internal controls are being used. This process is called an audit and is crucial for verifying the accuracy of a company's financial reports. Every public company that sells stock on one of the public markets must hire an independent certified public accountant (CPA) to audit its financial statements. Managers, employees, investors, financial institutions, vendors, suppliers, and everyone else who depends on knowledge about a company's financial status expect these audited statements to be materially correct. The CEO and CFO must approve the financial statements that are ultimately issued to the public. The auditors' only responsibility is to issue an opinion that the financial statements are materially accurate. Auditors must abide by the rules set by the Public Company Accounting Oversight Board (PCAOB), which is a private sector, nonprofit corporation created by the Sarbanes-Oxley Act to oversee the auditors of public companies. Even though the PCAOB is a private entity, it has many government-like regulatory functions in relation to setting rules for auditors and how they do their work, which is similar to the role of the FASB for setting GAAP rules. The PCAOB is considering rule changes regarding mandatory firm rotation, which is discussed in further detail in \"New World of Financial Oversight.\" The Sarbanes-Oxley Act also requires that public companies with market capitalizations of $75 million or more include an attestation report of their independent auditors on the effectiveness of the company's internal controls over financial reporting. This requirement has become part of the audit process. eps81356_05_c05_161-196.indd 176 3/26/14 1:03 PM Section 5.4 The Auditor's Role New World of Financial Report Oversight Research by Marion McHugh and Paul Polinski in the CPA Journal (2012) indicates that there is value to requiring firms to change their auditors more regularly. In fact, some findings indicate that it is important to change not only the lead auditor but audit firms as well. In this CPA Journal article, the authors indicate that the PCAOB is looking for ways to improve the quality of audits and whether there is a need for mandatory audit rotation. Now that it has been several years since Sarbanes-Oxley passed, the PCAOB has noticed that there are fewer changes in auditors from year to year, which the PCAOB believes may be due to a reduction in firm scrutiny and independence. The PCAOB is considering the costs and benefits of additional regulatory measures. Ievgen Chepil/iStock/Thinkstock Personal relationships can develop between auditors and company management that call into question the independence of the audit team. To address this issue, PCAOB is considering a regulation that would mandate regular changes in company auditors. The authors of this CPA Journal article believe that \"improved disclosures would give audit firms a formal opportunity to demonstrate their independence\" (McHugh, 2012, p. 30). They also believe that the necessary changes could result in the PCAOB requiring mandatory audit firm rotation to ensure independent audits. If this occurs, managers would need to adapt to regular changes in auditors, which would mean a reduction in personal relationships between auditors and company management. Consider This: 1. 2. Do you think it is important for auditors and company managers to develop personal long-term relationships? Why or why not? Will the public be better served by frequent changes of auditors? Why or why not? Meeting the Qualifications To become a licensed CPA, candidates must complete extensive training. This includes completing at least a bachelor's degree with a major emphasis in accounting, passing a state administered uniform CPA exam, and completing work under the supervision of a CPA to satisfy work-experience requirements that vary by state. To keep a current license, CPAs must take continuing education courses. The amount of time devoted to continuing education and educational requirements varies by state. Each state has a board of accountancy that monitors the activities of its CPAs. The state boards have the right to revoke or suspend a CPA's license if he violates the laws, regulations, or ethics governing CPAs. If a CPA's license is revoked or suspended, she can no longer serve clients as an independent CPA unless she can get her license reinstated. eps81356_05_c05_161-196.indd 177 3/26/14 1:03 PM The Auditor's Role Section 5.4 In order to audit a company's financial statements, a CPA must be in public practice and be an employee of a CPA firm. A CPA's independence from the companies he serves is critical to assure an independent report. Major publicly traded corporations usually use one of the top four CPA firms: PricewaterhouseCoopers, Deloitte, Ernst & Young, or KPMG. A good CPA will approach an audit with skepticism. He may need to challenge management's assertions if those assertions differ from the evidence collected in the audit. Sometimes independent auditors will have views different from those held by management about how to record a particular transaction or disclose accounting information. When there is a difference of opinion, the auditor must act in the public's interest, not the interest of company management. If differences cannot be resolved, the audit committee of the company's board of directors may be asked to step in. In rare circumstances, if the auditor cannot come to an agreement with the board, she may resign from the audit and inform the SEC of the issue. In these occasions, the SEC may open an investigation of the company. Usually when an auditor resigns in the middle of an audit, the company must send out a notice that its financial reports will be delayed. Discussion of an auditor change is typically found in the Notes to the Financial Statements, but it may also be discussed in the Management's Discussion and Analysis section. The Audit Process The audit process includes three key steps: defining the scope of the audit, performing fieldwork, and writing the audit report. Let's take a look at each of these crucial steps. Defining the Scope Auditors begin by meeting with top management and an internal committee of the board of directors (made up of directors appointed to this committee) to discuss the audit's scope and objectives. Managers will bring a list of issues that should be reviewed as part of the audit. An audit may include a complete review of the company's operations, or it may focus on just one aspect, such as collections from customers, which would be a limited scope audit. The objectives of a full audit are usually to validate the company's financial statements. The objectives of a more focused audit usually involve reviewing the operation's efficiency or finding possible internal control problems that might put the company at risk of theft or fraud. After determining the scope of the audit, the auditors meet with key managers to gather information about internal accounting processes, to evaluate existing controls, and to plan how the audit will be conducted inside the company. The internal accounting manager then sends a letter to the staff involved, announcing the audit and who has been assigned to conduct it. In the first meeting with accounting staff, the auditors review the available resourcesincluding personnel, facilities, and fundsthat are allocated to the audit. During these initial meetings, those involved identify areas of special concern. eps81356_05_c05_161-196.indd 178 3/26/14 1:03 PM The Auditor's Role Section 5.4 Auditors then meet with the departments being audited, which may include all departments or just a few that are directly involved in the issues being investigated. The auditors survey key personnel and review financial reports, files, and other information. The auditors also review each department's internal control structure. This review helps identify any holes in internal control processes and the key areas that need to be tested when auditing specific stores or other locations that the company owns. After the preliminary review, the auditors design the process that will be used to collect needed information and to meet the objectives set out in the initial meetings with top executives and the board of directors. Performing Fieldwork Auditors perform fieldwork when they visit a company's individual offices and locations to determine whether the internal controls discussed at the company's top levels are being implemented properly. For example, if a business requires a certain type of coding when an order is charged to a customer's account, and that coding is not being used consistently, some customers may be getting merchandise without being billed. In the field, auditors watch a company's employees carry out certain tasks to be sure that they are performing them correctly. Additionally, auditors review files to be sure all the paperwork is in order to back up reports sent to the central corporate offices. For example, if the company requires a manager's signature before a customer is given a refund, the auditor randomly reviews company refund records to be sure that the signature process is being followed. Although the top manager at a location likely knows when the auditors will arrive, the rest of the staff is usually surprised by their arrival. Any findings during the fieldwork become part of the draft audit report. After the auditors complete a preliminary review of the specific location, they randomly review various records to be sure that employees are following internal control procedures. For example, if an auditor is auditing a bank's operations, the auditor will want to know whether employees are following the bank's procedures for approving a loan. The auditor will likely check random loan files to be sure all needed approvals are in place. The type of fieldwork that is required of auditors depends on the business type and the audit's scope. Auditors for a bank will visit offices in the corporate headquarters as well as bank branches to complete their fieldwork. Auditors for a corporation with retail stores will do their fieldwork in the corporate headquarters, regional headquarters, and individual stores. If the scope of the audit is just to review the customer order and bill-paying process, the fieldwork may take place only in the corporate accounts receivable section of the accounting department. eps81356_05_c05_161-196.indd 179 3/26/14 1:03 PM Creative Accounting Section 5.5 Writing the Report As the auditors work in the field, they discuss any significant discrepancies with top management. Managers can comment on the findings before auditors submit a final report to the operating managers, top executives, and board of directors. Managers are usually given an opportunity to submit their own comments in areas of discrepancy. Auditors often work with management to determine how best to resolve any problems before they complete their final audit report. If a problem can be easily resolved, they can do so verbally. If the problems are more serious or complex, auditors compile written reports and circulate them to managers, corporate executives, and board members. These reports summarize the auditors' findings, identifying problems and making recommendations, before the auditors turn in their final report. Most companies work to fix problems internally to avoid being reported to their outside stakeholders: investors, creditors, employees, vendors, and suppliers. If the auditor concludes that changes need to be made within the corporation, managers submit their plans to improve processes based on the auditor's recommendations. If, for some reason, managers disagree with the auditor, they have to explain in the final report why they disagree and what they plan to do to fix the problem. Top management or members of the audit committee of the board of directors usually find out about problems long before they are detailed in the business press or on the front page of the newspaper, as some company scandals are. Audit reports from fieldwork are not released publicly, so when scandals do make it to the front pages, it is usually after a whistle-blower comes forward or the SEC announces an investigation. The summary of the audit report can be found in the annual report, as discussed in Chapter 1. The summary is usually one or two pages and does not provide significant detail about the audit's findings. 5.5 Creative Accounting Even after new controls were put in place following the Enron scandal, there have been instances of \"creative accounting\" being used to misinform the public. The 2007/2008 mortgage scandal and demise of financial institutions, such as at Lehman Brothers, shows that reporting problems can still arise. (For more information about the dissolution of Lehman Brothers, read \"World of Business.\") Former SEC Chairman Arthur Levitt calls creative accounting techniques \"accounting hocus-pocus\" (Carmichael, 1999, online). He exposed the creative accounting techniques we will discuss here from accounting practices he witnessed as chairman of the SEC over seven and a half years, from July 1993 to February 2001. eps81356_05_c05_161-196.indd 180 3/26/14 1:03 PM Section 5.5 Creative Accounting World of Business Destruction of a Corporate Powerhouse In 2007, Lehman Brothers was the fourth largest investment bank in the United States, but by September 2008, it was forced to file for bankruptcy protection. How did such a major bank fall so hardso fast? Creative accounting played a major role in its demise. The bank borrowed billions of dollars to buy subprime mortgages during the housing market boom between 2001 and 2007. Lehman used a financial trick called a repurchase agreement, which was a type of short-term loan, to sell these mortgage securities and agreed to buy them back in the future. Then, instead of showing these as loans on its financial statements, it showed them as sales and counted them as revenues. Zak Brain/SIPA/Associated Press Creative accounting led to the 2008 bankruptcy of Lehman Brothers. As the subprime market collapsedand Lehman didn't have the money to buy back the securitiesthe game of creative accounting was exposed. The securities were shown to be worthless to the entities that bought the mortgage securities from Lehman, but Lehman Brothers had no cash to buy them back. The companies holding the mortgage securities demanded that Lehman buy them back, as required by the repurchase agreements, but Lehman was out of cash. Lehman was forced to file for bankruptcy protection. Source: Onaran, Yalman and Scinta, Christopher. (2008, Sept. 15). Lehman Files Biggest Bankruptcy Case as Suitors Balk. Bloomberg. Retrieved from http://www.bloomberg.com/appsews?pid=newsarchive&sid=awh5hRyXkvs4. Consider This: 1. 2. Should banks that manage money for others face stricter scrutiny? Why or why not? The mortgage securities scandal has resulted in fines for many banks and more are likely to come. Do you think these fines are warranted? Why or why not? Big Bath Charges A company may \"clean up\" its balance sheet by giving it what Arthur Levitt has called the \"big bath\" (Carmichael, 1999, online), meaning the company washes away past financial problems. When earnings drop significantly, some executives hope that Wall Street will look beyond a one-time loss reported in one quarter or one year and focus on future earnings. For example, General Motors, which filed for bankruptcy in 2009, used the big bath strategy to attempt to clean out its losing assets and reduce the impact of reporting its income losses. In August 2008, GM reported $15.5 billion in net losses for the second quarter, including $9.1 billion in special items, such as write-downs for the value of vehicles and costs related to settling a strike of one its suppliers. eps81356_05_c05_161-196.indd 181 3/26/14 1:03 PM Creative Accounting Section 5.5 Companies sometimes use this practice when they decide to restructure some parts of their businessfor example, when two divisions of a company merge or a single division is split into two. During the restructuring process, executives can clean up any problems in previous reporting by including the losses not reported in previous quarters as part of the restructuring. This \"cleaning\" process may also include hiding past financial reporting problems. The accounting problems taken off the books can include deliberate or nondeliberate accounting errors made during previous reporting periods. By including these problems as part of the restructuring, companies hope to hide their previous errors as part of a larger change. Creative Acquisition Accounting Levitt refers to creative acquisition accounting as \"merger magic\" (Carmichael, 1999, online) because companies use acquisitions to hide their financial problems. Companies may use their reporting of mergers in a way similar to the big bath. They hide previous reporting problems as part of the merger, hoping the previous errors will not be noticed. This accounting trick is particularly effective when the acquisition consists of a stock exchange rather than a cash exchange. By setting a stock price for an acquisition that enables a company to hide previous problems, such as losses that were not reported, a lot of past accounting problems can \"disappear,\" thanks to the higher stock price. Usually, company management can erase financial problems in a popular write-off called in-process research and development, which is a one-time charge mentioned in the notes to the financial statements detailing an acquisition. Getting rid of previous reporting problems with this charge removes any future earnings drag of reporting the losses individually and makes future earnings statements look better (Giherai, 2011). Miscellaneous Cookie Jar Reserves Companies that use liabilities rather than revenue to hide problems do so by using what Levitt calls \"cookie jar reserves\" (Carmichael, 1999, online). When using this technique, company management makes unrealistic assumptions about the company's liabilities. In a good year, a company assumes that its sales returns will be much higher than they have been historically. These assumptions are \"banked\" as a liability, which means they are added to an accrual account that can be adjusted in a later year. For example, a company would reduce revenues using an account called \"Allowance for Bad Debts,\" which is set up to write off invoices customers do not pay. These supposed \"bad debts\" can be reversed in the future with an accounting entry. When a business has a bad year and needs to manage its earnings, it can massage those earnings by reducing the actual bad debts, using some of the banked bad debts from the cookie jar. eps81356_05_c05_161-196.indd 182 3/26/14 1:03 PM Creative Accounting Section 5.5 Revenue Recognition Another way in which companies can play games with their financial reports is to take liberties when reporting their revenue. We discussed the official rules for reporting revenue in Chapter 3, but let's take a look at how companies try to skirt the rules. Note that if a company uses the deceptive accounting techniques discussed here, it will probably not become known until an insider exposes the problem. We explore some of the most common revenue recognition techniques that were exposed in the late 1990s and early 2000s. Recognizing Revenue Before Shipping In some cases, a company considers goods that have been ordered but not yet shipped to be part of its revenue earned. In the long term, this system can create not only an accounting nightmare but also a nightmare for managers throughout the company. Orders can get severely backlogged, and ultimately, the company may experience problems satisfying the delivery of products to its customers on time. Additionally, this practice can have a big impact on a company's bottom line. Accrual accounting is specifically designed to match revenue with expenses each accounting period. As more and more goods that are ordered but not shipped build up, financial reports overstate the company's revenue and understate expenses until the deception is exposed. Eventually, the company will have to admit its game-playing and restate its net income, which will likely result in a profit reduction or possibly even a loss. Ultimately, executives and managers only delay the inevitable when they play the sales before shipping game. Some do it to maintain their bonuses as long as possible. Others do it because they do not want to face the reality of the company's financial position. Sending Goods Not Ordered Some companies get even more aggressive with their deception, recognizing revenue on goods that have been shipped but that customers have not ordered yet. Companies that use this technique commonly ship items for inspection or demonstration purposes in the hope that customers will buy the product. This tactic can help a company meet its revenue for the upcoming reporting period because it counts these unordered goods as sales, even though the products have not been sold. However, if some customers receive the goods, decide not to purchase them, and return the merchandise, the company must subtract these sales from its revenue during the next period. As the problem snowballs, the company has to ship more and more orders without actually having the sales to meet its revenue expectations. Each month, it has to reverse a greater percentage of its revenue, and as a result, it has to make up the shortfall by shipping an even greater number of units without actual orders. Eventually, the company will not be able to keep up the deceptive practices because third party distributors or retailers won't accept any more inventory. The company will have to correct its financial statements, lowering the amount it reported as revenue and reducing its net income. eps81356_05_c05_161-196.indd 183 3/26/14 1:03 PM Creative Accounting Section 5.5 Extending the Reporting Period Some companies try to meet Wall Street's revenue expectations by keeping their books open for a few daysor even a few weeksinto the next reporting period in order to generate last-minute sales. This tactic eventually creates major problems because it takes sales that should be reported as income during the next reporting period. Eventually, the company has to reveal its deceptive practices because it has to leave its books open longer and longer each period to meet the next period's expectations. When it becomes impossible to meet SEC reporting requirements, the company must reveal its deceptive practices or file SEC reports late, which can be an even bigger problem for management. Channel Stuffing Channel stuffing is a way for companies to get more products out of their manufacturing warehouses and onto distributors' and retailers' shelves. The most common method is to offer distributors large discounts so that they stock up on inventory. Distributors buy more product than they expect to sell because they can get it cheaper, then sell the product to their customers; however, several months or even a year may pass before all the products are sold. If the products do not sell, distributors may have the right to return the product. Although this strategy is a legitimate type of revenue, it will come back to haunt the company in later accounting periods, when distributors have so much product on their shelves that they do not need to order more. At some point in the future, new orders drop, which means fewer sales and a drop in revenue reported on the income statement. Side Letters Sometimes companies make agreements with their regular customers outside the documentation used for the corporate reporting of revenue. This agreement is called a side letter. The side letter involves the company and customer changing terms behind the scenes, such as allowing more liberal rights of return, or rights to cancel orders at any time that can, essentially, kill the sale. Sometimes these agreements go as far as excusing the customer from paying for the goods. Companies do this to make their revenue numbers look better on the next income statement, even though the income will need to be reversed in the future. The company's managers hope that they will be able to replace these sales in a future accounting period. In all cases, the side letter terms eventually result in turning revenue that was recognized on a previous income statement into a nonsale, either by the return of goods or the extension of credit beyond a 12-month payment period. This practice makes revenue from these sales look better initially, but the revenue is later subtracted when the goods are returned. eps81356_05_c05_161-196.indd 184 3/26/14 1:03 PM Creative Accounting Section 5.5 Rights of Return Giving customers liberal return rights is another way of getting them to order goods, even when they are not sure if they will be able to resell them. By offering distributors or retailers terms that allow them to order goods that they can return as much as 12 months later if they do not sell, the sales, in essence, are not really sales, and they should not be recognized as revenue on a company's financial report. Rights of return are offered to most customers, but when payment for goods depends on the need for the distributor or retailer to first resell the goods, the recognition of that revenue is questionable. Related-Party Revenue Related-party revenue comes from a company selling goods to another entity in which the seller controls the management of operating policies. For example, if the parent company of a toy manufacturer sells the raw materials needed for manufacturing the toys to its subsidiary, the parent company cannot count that sale of raw materials as revenue. Whenever one party can control or significant