BusinessAllstars.com1 Accounting Principles & Creative Accounting Techniques BUSINESSALLSTARS.COM Presents Copyright © 2007 by WACGA All right reserved This material may not be used or reproduced without permission of the WACGA

2 ADEQUATE DISCLOSURE means there is enough information in financial statements and footnotes for stakeholders to make informed decisions. CONSISTENCY requires applying the same recording methods and procedures from period to period.

3 CONSERVATISM provides that accounting for a business should be fair and reasonable and neither overstates nor understates the results of operation. OBJECTIVITY EVIDENCE means there is independent documentation to support accounting entries.

4 INDEPENDENT ENTITY is that accounting and reporting relate only to the activities of a specific business entity and not to the owners of the entity. MATCHING requires the recognition of all costs that are directly associated with the revenue reported within a period.

5 MATERIALITY is the magnitude of a change to accounting information that would influence the decisions of a reasonable person. GOING CONCERN is the underlying assumption that the business will remain in existence for many years into the future.

BusinessAllstars.com6 Creative Accounting Techniques Management’s Violation of Accounting Principles

BusinessAllstars.com 7 CAT 1- “The Big Bath" A company sets up a large restructuring charge which "cleans up" their balance sheet -- giving them a so-called "big bath.” They might write-off an asset they don’t think is worth anything. The charge is "conservatively estimated" or padded with an extra cushion. When future earnings fall short, the cushion or excess is reversed and ends up as income. This violates Consistency and is a manipulation of Conservatism.

BusinessAllstars.com 8 CAT 2- “In-Process Charges” Some companies classify a large portion of the price to purchase another company as "in- process" Research and Development, which can be written off in a "one-time" charge -- removing any future earnings drag. Sometimes, large liabilities for future operating expenses are created to protect future earnings. This violates the Consistency principle.

BusinessAllstars.com 9 CAT 3- “Cookie Jar Reserves" Some companies estimate excessive liabilities for such items as sales returns, loan losses or warranty costs. They may even set up excessive allowances for bad debts. In doing so, they stash accruals in "cookie jars" during the good times and reach into them when needed in the bad times. This violates the Consistency principle.

BusinessAllstars.com10 Cookie Jar Accounting Balance SheetIncome Statement Asset ClaimsRevenue $18,000 $200, ,000Expenses Net Inc.- 2,000 3,000-17,000$203,000 1,000 By taking too much expense in the past and artificially lowering either asset or liabilities, you can now reverse a portion of that entry and improve the current net income.

BusinessAllstars.com 11 CAT 4- "Materiality" Some companies misuse the concept of materiality. They “intentionally” record errors within a defined percentage ceiling. This is justified on the basis that the effect on the profit is too small to matter. When management is questioned about these clear violations of accounting principles, they answer sheepishly, “It doesn't matter. It's immaterial.” This is a manipulation of Materiality.

BusinessAllstars.com 12 CAT 5- Revenue (expense) recognition Some companies try to boost earnings by manipulating the recognition of revenue. They recognize Revenue before a sale is complete, before the product is delivered to a customer, or at a time when the customer still has the option to terminate, void or delay the sale. This violates the Matching and Consistency principles.

BusinessAllstars.com 13 CAT 5- Recognition (continued) Rather than recognizing revenue early, some companies boost earnings by delaying the recognition of an expense, often pushing it into a future year. This is easy to do because invoices are sometimes not received until long after the year is over. This violates the Matching and Consistency principles.

BusinessAllstars.com14 By shifting Revenue or Expenses from one year to the next, one year looks great, but the next year is terrible. Revenue/Expense Recognition 2,000 JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV DEC Revenue 1, ,500 Expense 2,000JAN FEB 1,500 2,000 4, , ,000

BusinessAllstars.com 15 CAT 6- “Off Balance Sheet” Accounting Some companies own Fixed Assets, but finance them using an operating lease. Since the asset is leased it does not appear as an asset or a liability on the Balance Sheet. The economic reality is that the asset is in fact owned by the company and should be treated as such. This violates the Adequate Disclosure principle.

BusinessAllstars.com 16 CAT 6- “Off Balance Sheet” (continued) Some companies set up Special Purpose Entities and transfer assets and liabilities to a subsidiary company that are never shown on the parent company’s books. If the parent company is still at risk then the SPE should be disclosed. SPV or Special Purpose Vehicle is a synonym for SPE. VIE or Variable Interest Entity is now the term used by the FASB in place of SPE. Not disclosing VIES is a violation of the Adequate Disclosure principle.

BusinessAllstars.com17 Off Balance Sheet Balance SheetIncome Statement Asset ClaimsRevenue $18,000 Expenses -16,000 $200,000 Net Inc. 2,000 30,000 By taking the asset and liability off the books the performance (net income per assets) is higher. 30,000$170,000

BusinessAllstars.com18 CAT 7- “Manipulating Cash-flow” Some companies manipulate the categorization of investing, and financing cash-flows on the Statement of Cash- Flows to improve operating cash-flow. They even sell Accounts Receivable, dump inventory, or hold off paying Accounts Payable to improve operating cash-flow.

BusinessAllstars.com 19 Case #1: Enron Enron officials used complex structures, straw men, hidden payments, and secret loans to appearance that entities they funded and controlled were independent of Enron. They moved their interests in these entities off Enron’s balance sheet when they should have been consolidated into the company’s financial statements. As a result, Enron engaged in various transactions with these entities that were designed to improve its apparent financial results. Executives exploited the fiction that these entities were independent to misappropriate millions of dollars representing undisclosed fees and other illegal profits.

BusinessAllstars.com20 Enron SPE Deception

BusinessAllstars.com 21 Case #2: Adelphia According to the SEC complaint, filed on July 24, 2002, Adelphia, at the direction of the individual defendants: (i) fraudulently excluded billions of dollars in liabilities from its consolidated financial statements; (ii) falsified operations statistics and inflated Adelphia's earnings to meet Wall Street's expectations; and (iii) concealed rampant self-dealing by the Rigas Family that founded and controlled Adelphia.

BusinessAllstars.com 22 Case #3: Bristol-Myers Bristol-Myers inflated its results primarily by: (1) stuffing its distribution channels with excess inventory near the end of every quarter---to meet sales and earnings targets ("channel-stuffing"); and (2) improperly recognized about $1.5 billion in revenue from sales associated with the channel-stuffing. When Bristol- Myers' results fell short of the Wall Street analysts' earnings estimates, the Company used improper accounting, including "cookie jar" reserves, to further inflate its earnings.

BusinessAllstars.com 23 Case #4: Symbol Technologies [Symbol Technologies, Inc.] used fraudulent schemes: (a) a "Tango sheet" process where baseless accounting entries were made to conform quarterly results to projections; (b) the fabrication and misuse of restructuring and other non- recurring charges to artificially reduce operating expenses and create "cookie jar" reserves; (c) channel stuffing and other revenue recognition schemes, involving both product sales and customer services; and (d) manipulate inventory levels and accounts receivable data to conceal the adverse side effects of the revenue recognition schemes.

BusinessAllstars.com 24 Case #5: Del Del improperly (1) recognized revenue when it prematurely shipped products to third-party warehouses, and recorded sales on products not yet manufactured; (2) accounted for inventory by recording obsolete inventory at full value and overstating certain engineering work-in-process values; and (3) characterized certain ordinary expenses as capital expenditures. These actions resulted in the overstatement of Del's reported pre-tax income by at least $3.7 million (110%) in fiscal year 1997, $5.2 million (161%) in fiscal year 1998, and $7.9 million (466%) in fiscal year

BusinessAllstars.com 25 Case #6: Lucent Lucent improperly granted, and/or failed to disclose, various side agreements, credits and other incentives (collectively "extra-contractual commitments") to induce Lucent's customers to purchase the company's products. These extra-contractual commitments were made in at least ten transactions in fiscal 2000, and Lucent violated GAAP by recognizing revenue on these transactions both in circumstances: (a) where it could not be recognized under GAAP; and (b) by recording the revenue earlier than was permitted under GAAP.

BusinessAllstars.com 26 Case #7: Dynegy Dynegy negligently failed to disclose that increases in energy trading volume, revenue and notional trading value were materially attributable to “round-trip trades.” Because the round-trip trades lacked economic substance, Dynegy's statements were materially misleading to the investing public. This case was the first enforcement action resulting from an energy trading company's misleading disclosures regarding use of "round-trip" or "wash" trades.

BusinessAllstars.com 27 Case #8: U.S.Foodservices U.S. Foodservices carried out a fraudulent scheme by improperly inflating promotional allowance income. A significant portion of operating income was based on payments by its suppliers, referred to as promotional allowances. Typically, USF would pay the full wholesale price for a product, then receive rebates of a portion of that price from the supplier if certain purchase volume and other conditions were met. They "booked to budget" by, recording fictitious promotional allowances sufficient to cover shortfalls to budgeted earnings.

BusinessAllstars.com 28 Board Questions 1.Does Net Income translate into Cash Flow? 2.What’s causing the growth in Revenue? 3.Is there substantial non-operating activity? 4.Are entries based on estimates disclosed? 5.Are the external auditors free to do their job? 6.Are financial ratios consistent over time? 7.Are Internal Controls a high priority? 8.Do you have any reason to doubt management? 9.Are Related Party Transactions fully disclosed? 10.Are changes to A/R, Inventory, and A/P proper?