Tread Lightly Through These Accounting Minefields

Your reporting practices can help your business avoid the pitfalls of creative accounting. Make sure you can answer these questions

The Idea in Brief

The nightmare of risky accounting is growing more frightening. Facing tremendous pressure—and personal incentive—to report sales growth and meet investors' revenue expectations, managers are issuing increasingly misleading financial reports, especially regarding earnings.

Though not necessarily illegal, these aggressive accounting strategies often hurt shareholders most—leaving them with worthless stock when a company's problems come to light.

Your company's defense against creative accounting calamities? Use reporting practices that are consistent with industry norms and that present a reasonable picture of earnings. And beware of dangerous accounting minefields.

The Idea in Practice

Investors, corporate boards, and managers can spot accounting minefields by asking pointed questions, including:

1. Revenue measurement and recognition. For some businesses, pinpointing when revenue has been earned—and even what constitutes revenue—requires judgment. Some firms record revenue they don't expect to receive until later.

Software producer MicroStrategy immediately recorded revenues it expected to earn over multi-year consulting engagements—rather than spreading revenues over the life of the contract. When the company restated its 19981999 earnings, its $12.6 million profit became a $34 million loss. Share price plummeted 62% in one day, destroying $12 billion of market value.

Ask: How is revenue defined? Is this a reasonable measure of the revenue earned during the reporting period? Is it consistent with competitors' measures?

2. Provisions for uncertain future costs. Companies can't precisely estimate future costs, such as obsolete inventory, uncollectible accounts, or product returns. So they may diminish costs to enhance reported profits. Or, they may overstate restructuring costs. Repeatedly classifying charges as nonrecurring masks management errors and overstates profitability.

Managers may also play with "comprehensive income"—gains and losses that don't appear on income statements because their true impact on earnings isn't certain yet. For example, Coca-Cola added $965 million of translation losses to its comprehensive income—and deferred the impact on earnings of the euro's declining value.

Ask: Do financial statements include estimates for uncertain events? Do estimate footnotes provide sufficient disclosure? Should gains and losses in comprehensive income be included in net income instead?

3. Asset valuation. Assets are carried at cost minus amortization or depreciation—which requires estimates of assets' useful life. Changing estimates can raise questions about a company's motivations. When Delta Airlines revised the useful life of its aircraft—twice in ten years—its reported profits soared.

Ask: Do asset write-downs reflect real values? Are value adjustments fully disclosed? Is the accounting consistent with industry standards?

4. Related-party transactions. Firms make these transactions with entities they control or that control them—other businesses, shareholders, vendors, or customers. Using these transactions, companies can arbitrarily increase or decrease earnings or divert profits, enriching shareholder or manager subgroups.

Speech-recognition software company Lernout & Hauspie Speech Products helped create 30 customers—all start-ups—that became responsible for one-fourth of L&H's revenues. Many received funding from a venture-capital firm linked to L&H's founders. When investors learned of the deal, L&H restated earnings, suffered bankruptcy, and saw its stock delisted from the Nasdaq.

Ask: Are all significant related-party transactions disclosed? Do conflicts of interest exist that could benefit or damage shareholder groups?

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