CASE STUDY: LONE STAR POWER

Ward Johnson stared out the window. In the three months since he had assumed the role of chief investment officer at Lone Star Power, Johnson thought the company's communications with the investing public had been superb, particularly with respect to its SEC filings. A single letter from an apparently upset analyst had changed that view.

Lone Star Power was a midsize power generation and power distribution company based in the Southwest. It provided electrical power to more than 750,000 homes, businesses, and government agencies. In addition to power generation and distribution, Lone Star sold and installed a wide-ranging array of products, from appliances to power-generation backup systems. It also offered service and repairs to customers throughout its territory. Total revenues for the quarter ended December 31, 2016, had topped $1 billion for the first time. With only one exception, the company had managed to grow both revenues and profits in each quarter since 2000. Put in place in early 2014, the company's formal investor-relations function was relatively new. Prior to that, Lone Star had a small support staff that would send annual reports and similar literature in response to phone requests and handle other routine investor inquiries. In addition to his other duties, Johnson was expected to develop the investor-relations department in a way that would enhance Lone Star's standing with the investing community.

Marianne Relzo was a senior, all-star equity analyst with Pitt Financial, a well-regarded U.S. investment bank. In a letter Johnson, Relzo detailed her discontent with the company's external financial communications. She complained about items as specific as Lone Star's financial-statement footnote disclosures and as general as the company's composite accounting policies. Johnson knew he would have to meet with Lone Star's senior financial staff and receive input as to whether these issues had merit and how he should respond. With a red pen in hand, he read the letter once again.

Dear Mr. Johnson: this letter is written with some trepidation as it is usually not my style to openly question a company's financial report- ing practices. My job, as you well know, is to objectively analyze a company through its public communications and to then state my conclusion regarding the merits of an investing strategy. I have followed your company for nearly five years and am increasingly concerned that your reported financial results do not reflect the actual underlying performance of your firm. Much of my concern comes from what was communicated through your company's most recent 10-K filing and from what I know to be trends in your business. Unfortunately, there were numerous areas of unnecessary ambiguity in your latest report. Below are six specific examples I bring to your attention. These examples are chosen because they capture each of six items I find important in firms' financial reporting policies: (1) revenue recognition across periods, (2) consistent application of accounting policies, (3) cost allocation across periods, (4) classification of reported line items, (5) supplemental interpretive guidance from management, and (6) interim voluntary disclosures. I think you can understand that my reports are more favorable toward companies that meet a high standard of reporting on these dimensions, if for no other reason than I do not have to discount for significant uncertainties In your most recent 10-K your company's revenue recognition policy is described as "revenue is recog- nized based upon services rendered to customers during each accounting period." This is quite generic, 1. of course, and I believe there are trends in your business that warrant elaboration. a. From your own segment disclosure, your Business Sales Division represents a large share of opera- tions. Past conversations I have had with your staff reveal that a large chunk of the contracts in this division represent equipment sales, with the remainder ongoing service revenue contracted at the time of sale. This most recent quarter, conveniently, you have met your projected revenue growth of 4% for this segment, but I also note that accounts receivable have risen 25% over this time. I was hoping the MD&A would have provided some elaboration, but it merely listed these percentage changes. b. I know from conversations with some of your customers that in December there were significant discounts given for their prompt signing of a contract. Was there indeed a push-through of January 2017 contracts to boost 2016 revenue? I believe that in some cases the equipment portion of a contract with both an ongoing service com- ponent and an equipment sale was just a mere "pass-through sale" of the equipment (.e., the equip- ment was delivered and installed by the third-party vendor of that equipment). How does Lone Star c. recognize revenue for pass-through equipment sales? 2. Your MD&A states that $52 million of assets were impaired during 2015 due to a lower than expected utility rate increase during 2014. Since these losses had such a material impact on operations, why didn't the company issue a press release or 8-K disclosure describing this event in a more timely fashion? In addition, what circumstances might have led to the impairment a full year after the rate effects were known? 3. Your accounting policy for marketing and promotions indicates these costs are "expensed as incurred. Incurred costs for these items are further provided by year as $25 million, S45 million, and $20 million for 2016, 2015, and 2014, respectively. I find it odd that for the year 2015 there was the spike in both expenses and cash outlays without much of a noticeable change in your promotional policies. I can find no evidence of these items being treated as prepaid assets. Are these amounts related to the large impairments taken in 2015? Do managers at the unit level have the ability to choose their own accounting policies? In the telecommu- nications industry, for instance, AT&T uses a group method, where the depreciation rate for a specific asset group is based on the average useful life for all assets in that group. This would avoid the unintended con- sequence of department managers manipulating profits by extending useful lives and decelerating depre- ciation charges. From prior conversations, I believe that when Lone Star acquires other companies it does not convert the acquired assets to a method consistent with existing assets. You recently merged with Texas Light and Gas. In a review of their financial statements just prior to the merger, I noticed they used 4. different depreciation methods and lives than did Lone Star for similar assets. Now what is happening? 5. In response to a direct question during Lone Star's conference call, your CEO indicated that as of 2016 your company is now classifying all contract acquisition costs as an operating expense, as opposed to a net against top-line revenue. The argument made was that this would be consistent with industry disclo- sure practice. Why was this fact not addressed in your 10-K when revenue growth comparisons were made from 2015 to 2016? 6. During 2016 "net regulatory assets" increased by $75 million, the largest annual increase in the company's history. Since your operations were unaffected by acts of nature during 2016, and I know of no efficiency programs put into place during the year, how does one know that this asset growth is not the mere deferral of costs to a future period? I am scheduled to issue a report on your company by March 1. I hope by then you can find the time to address my questions. Sincerely, Marianne C. Relzo PFC Senior Vice President

Relzo's letter raised a number of issues for Johnson to consider. In the margins of the letter, he jotted notes regarding each one. From his experience, Johnson knew it was an analyst's objective to gather as much information about a company as possible. Regulation FD, however, defined the landscape regarding how he and other Lone Star officer should release information, but he was unsure what was implied regarding how he should deal with financial-reporting questions.

Johnson was not an accountant, and was not at all confident that he could articulate Lone Star's position on what revenues and expenses were recorded. On the expense side, in particular, he was perplexed as to why it was even an issue if the company were to negotiate a discount that required promotional fees to be paid in advance, charging net income when paid. By recording in this fashion, he thought Lone Star was only being conservative by accelerating a loss.

The company was also being questioned on its overall financial-reporting "transparency." Lone Star followed Generally Accepted Accounting Principles (GAAP) to the letter and filed timely reports with the SEC. Its financial statements were audited, and each major topic required in the Management Discussion and Analysis (MD&A) was dutifully disclosed. It seemed unreasonable to Johnson that the company be expected to provide real-time details on such items as negotiations with specific customers and write-offs of assets.

Required

1. What are Johnson's options regarding how he might respond to the issues raised by Relzo?

2. Items 1 and 3 deal specifically with revenue and expense recognition in the income statement. What principles and guidelines govern when and how each of these items should be recorded?

3. Relzo raises issues with the consistent application of accounting methods (item 4) and the consistent classification of certain line items (item 5). Do you think it is within the rights of a company to vary accounting methods and reclassify certain line items?