The financial numbers game detecting creative accounting practices phần 7 doc

By reducing cost of goods sold as tory was increased and accounts payable were reduced, the company’s earnings werecorrespondingly increased.9inven-In a similar scheme, as noted in the o

34 Cendant Corp., 10-K annual report to the Securities and Exchange Commission, December

1997, p F-16

35 Statement of Financial Accounting Standards No 2, Accounting for Research and ment Costs (Norwalk, CT: Financial Accounting Standards Board, October 1974).

Develop-36 Accounting and Auditing Enforcement Release No 751, In the Matter of William F Moody,

Jr (Washington, DC: Securities and Exchange Commission, January 11, 1996).

37 Accounting and Auditing Enforcement Release No 895, In the Matter of Merle S Finkel, CPA, Respondent (Washington, DC: Securities and Exchange Commission, March 12,

1997)

38 Brooktrout, Inc., annual report, December 1999 Information obtained from Disclosure, Inc.,

Compact D/SEC, December 2000.

39 Accounting and Auditing Enforcement Release No 786, Securities and Exchange sion v Comparator Systems Corporation, Robert Reed Rogers, Scott Hitt and Gregory Armijo (Washington, DC: Securities and Exchange Commission, May 31, 1996).

Commis-40 Accounting and Auditing Enforcement Release No 764, In the Matter of Richard A Knight, CPA (Washington, DC: Securities and Exchange Commission, February 27, 1996).

41 Accounting and Auditing Enforcement Release No 778, In the Matter of Sulcus Computer Corp., Jeffrey S Ratner, and John Picardi, CPA (Washington, DC: Securities and Exchange

Commission, May 2, 1996), §III B 3 a s

42 BCE, Inc., annual report, December 1999 Information obtained from Disclosure, Inc., pact D/SEC, March 2001.

Com-43 Sciquest.Com, Inc., annual report, December 1999 Information obtained from Disclosure,

Inc., Compact D/SEC, March 2001.

44 Sciquest.Com, Inc., Form 10-Q quarterly report to the Securities and Exchange Commission(September 2000), p 3

45 Pre-Paid Legal Services, Inc., annual report, December 1999 Information obtained from

Disclosure, Inc., Compact D/SEC, March 2001.

46 The Wall Street Journal, February 22, 2000, p A3.

47 Ibid., March 10, 1998, p C1

48 Accounting and Auditing Enforcement Release No 938, In the Matter of Ponder Industries, Inc., Mack Ponder, Charles E Greenwood, and Michael A Dupre, Respondents (Washing-

ton, DC: Securities and Exchange Commission, July 22, 1997)

49 Accounting and Auditing Enforcement Release No 1110, In the Matter of Sunrise Medical, Inc (Washington, DC: Securities and Exchange Commission, not dated).

50 Harrah’s Entertainment, Inc., annual report, December 1999 Information obtained from

Disclosure, Inc., Compact D/SEC, March 2001.

51 A Schulman, Inc., annual report, August 2000 Information obtained from Disclosure, Inc.,

Compact D/SEC, March 2001.

52 Engelhard Corp., annual report, December 1999 Information obtained from Disclosure, Inc.,

Compact D/SEC, March 2001.

53 Cypress Semiconductor Corp., annual report, January 2000 Information obtained from

Dis-closure, Inc., Compact D/SEC, March 2001.

54 Dallas Semiconductor Corp., annual report, December 2000 Information obtained from

Dis-closure, Inc., Compact D/SEC, March 2001.

Aggressive Capitalization and Extended Amortization Policies

55 Diodes, Inc., annual report, December 1999 Information obtained from Disclosure, Inc.,

Compact D/SEC, March 2001.

56 Vitesse Semiconductor Corp., annual report, September 2000 Information obtained from

Disclosure, Inc., Compact D/SEC, March 2001.

57 Analog Devices, Inc., annual report, October 2000 Information obtained from Disclosure,

Inc., Compact D/SEC, March 2001.

58 LSI Logic Corp., annual report, December 1999 Information obtained from Disclosure,

Inc., Compact D/SEC, March 2001.

59 Vitesse Semiconductor Corp., annual report, September 2000 Information obtained from

Disclosure, Inc., Compact D/SEC, March 2001.

60 Statement of Financial Accounting Standards No 121, Accounting for the Impairment of Long-Lived Assets (Norwalk, CT: Financial Accounting Standards Board, March 1995).

61 The Wall Street Journal, September 30, 1996, p B5 and May 18, 1998, p B2, respectively.

62 Eastman Kodak Co., annual report, December 1999 Information obtained from Disclosure,

Inc., Compact D/SEC, March 2001.

63 The Wall Street Journal, February 6, 1998, p A6.

64 Ibid., January 7, 1998, p B12

65 Unisys Corp., annual report, December 1995 Information obtained from Disclosure, Inc.,

Compact D/SEC, September 1996.

66 Waste Management, Inc annual report, December 1997 Information obtained from

Disclo-sure, Inc., Compact D/SEC, September 1996.

67 Market capitalization includes the market value of equity plus the book value of the currentportion and noncurrent portion of long-term debt

CHAPTER EIGHT

Misreported Assets and Liabilities

Xerox Corp said the Securities and Exchange Commission has begun

an investigation into accounting problems at its Mexico unit, where

the Company recently disclosed an internal probe involving issues of

unpaid bills 1

Perry Drug Stores, Inc.’s valuation of physical inventory counts

during the year generated results that were approximately $20 million

less than the inventory carried on Perry’s books Had Perry

followed its normal procedure of expensing inventory shrinkage to cost

of sales, Perry would have reported a net loss of close to $6 million

instead of the net income of $8.3 million it originally reported 2

[A Division Controller at Guilford Mills, Inc.] made a series of false

journal entries to decrease a trade accounts payable account in a

round-dollar amount ranging from $500,000, to $1,800,000, and

credit a purchase account (cost of sales) in the same amount, which

increased earnings 3

The claimed assets, which included up to 5,000,000 acres of

undeveloped land, a $328,000 note and $3.4 million in artwork

constituted between 78% and 96% of ANW, Inc.’s total holdings.

These false and misleading financial statements were included in

ANW, Inc.’s reports 4

The valuation of assets and liabilities reported on the balance sheet provide a convenientmethod for playing the financial numbers game As noted in the opening quotes, theassets and liabilities misstated might be common operating-related items such asaccounts receivable, inventory, or accounts payable Alternatively, the accounts mis-stated might be something a bit more unusual, such as undeveloped land or artwork Thenet result is the same, however: a misstatement of earning power and financial position

In most instances, assets are overvalued and/or liabilities are undervalued in an effort

to communicate higher earning power and a stronger financial position There is anexception, however, when, as part of a concerted effort to manage earnings, the balancesheet is reported in a conservative manner in an effort to store earnings for future years.Such tactics were discussed in Chapters 2 and 3

LINK WITH REPORTED EARNINGS

As was seen in Chapter 7, a direct link exists between earnings and amounts reported asassets When costs are capitalized, expenditures incurred are reported as assets on thebalance sheet as opposed to expenses on the income statement Current-period earningsare correspondingly higher

A similar link exists between earnings and assets that are not subject to amortization,including such items as accounts receivable, inventory, and investments When theseassets are valued at amounts higher than can be realized through operations or sale,expenses or losses are postponed, inflating earnings

For example, in 1992 Diagnostek, Inc., reported a $1.5 million receivable from UnitedParcel Service, Inc (UPS), for lost or damaged shipments Interestingly, this receivablewas reported without having submitted a claim to UPS that would have helped to verifythe amount due Ultimately Diagnostek recovered only approximately $50,000 on the

$1.5 million claim By then a significant charge was needed to write down the UPSreceivable Earnings in prior years had been overstated.5

As another example, it is not difficult to see that special charges will be needed toaddress questions of collectibility concerning accounts receivable at Xerox Corp.’s Mex-ico unit, as noted in the opening quotes to this chapter.6Also, as noted in the openingquotes, consider Perry Drug Stores, Inc The company did not record a $20 millionshrinkage in inventory identified when a physical count was made Instead, the companycarried the missing inventory in a suspense account known simply as “Store 100” inven-tory and included it within its consolidated inventory The net result was the postpone-ment of an after-tax charge of approximately $14.3 million.7

As another example that demonstrates how an overvaluation of assets will postponeexpenses and losses and overstate earnings, consider Presidential Life Corp The com-pany carried at cost its investments in the debt securities of several below-investment-grade issuers Because of financial difficulties, the market value of these securities haddeclined precipitously and was not expected to recover Presidential Life, however, con-tinued to carry the investments at cost By postponing a write-down, the company effec-tively reported the unrealized losses on its investments as assets.8

An undervaluation of liabilities also will inflate earnings temporarily Liabilities ofparticular concern are obligations arising from operations, including accounts payable,accrued expenses payable, tax-related obligations, and contingent obligations such as lia-bilities for environmental and litigation problems These amounts might be undervalueduntil true amounts owed are acknowledged and recorded

For example, at Material Sciences Corp not only was finished goods inventory tiously increased, reducing cost of goods sold, but false entries also were used to reduce

ficti-accounts payable and lower cost of goods sold By reducing cost of goods sold as tory was increased and accounts payable were reduced, the company’s earnings werecorrespondingly increased.9

inven-In a similar scheme, as noted in the opening quotes, a division controller at GuilfordMills, Inc., would routinely adjust accounts payable and cost of goods sold downward byround amounts ranging from $500,000 to $1,800,000 Across three quarters, the netresult was an overstatement of operating income by a cumulative $3,134,000.10

To overstate income, employees at Micro Warehouse, Inc employed a slight variation

on the same scheme When inventory was received that had not yet been invoiced, theproper accounting procedure was to increase inventory and a corresponding liabilityaccount, referred to as accrued inventory, for amounts ultimately due For some ship-ments, however, rather than increasing the liability account, cost of goods sold wasreduced instead The net effect was a direct increase in earnings.11

While Material Sciences, Guilford Mills, and Micro Warehouse all boosted earnings

by openly reducing a liability and an expense account, earnings also can be boosted byneglecting to accrue a liability for expenses incurred For example, as one of its manyaccounting irregularities, Miniscribe, Inc., did not sufficiently accrue obligations foroutstanding warranties Reported accrued liabilities for warranties declined even as salesgrew Related warranty expense was correspondingly understated.12

Also overstating earnings by understating a liability was Lee Pharmaceuticals, Inc.Although it learned as early as 1987 that it had contributed to high levels of contamina-tion in the soil and groundwater beneath and surrounding its facilities, and that it had anestimable obligation to effect a cleanup, as late as 1996 the company had not accrued aliability for estimated amounts due.13

Autodesk, Inc., and Tesoro Petroleum Corp show clearly the link between accruedliabilities and income In its fiscal 1999 annual report, Autodesk made the followingdisclosure:

Autodesk reversed $18.6 million of accruals associated with litigation matters Of theamount, $18.2 million related to final adjudication of a claim involving a trade-secret mis-appropriation brought by Vermont Microsystems, Inc.14

In a similar disclosure in 1988, Tesoro Petroleum Corp announced the “receipt” of $21million in pretax income that “was held as a contingency reserve for potential litigation [the Company] said the contingency reserve is no longer needed.”15In both cases,Autodesk and Tesoro Petroleum had accrued a contingent liability for litigation thatultimately did not result in loss As a result, the companies were in a position to reverse,

or add to, income amounts that had been accrued previously

BOOSTING SHAREHOLDERS’ EQUITY

As seen here, an overstatement of assets or understatement of liabilities can be directlylinked to an increase in earnings As earnings are increased, so are retained earnings,leading to a direct increment to shareholders’ equity

Misreported Assets and Liabilities

On some occasions, companies that play the financial numbers game will overstatethe value of assets received for the issue of stock While bypassing the income statement,the net effect is still an increase in shareholders’ equity The company appears to be morefinancially sound Only when the overvalued asset is written down or sold for a loss willthe fictitious increase in shareholders’ equity be reversed.

For example, in 1989 Members Service Corp issued stock to acquire certain oil andgas properties A valuation of approximately $3.3 million was assigned to the stock andinterests acquired Unfortunately, the properties acquired were nearly worthless Worse,

in 1991, even after losing its ownership interest in the properties through litigation,Members Service Corp reported a $2.1 million valuation for these same oil and gasinterests.16

As another example, in 1992 Bion Environmental Technologies, Inc., issued 250,000shares of company stock in exchange for a note receivable The valuation assigned to thestock issued was $748,798 This was a wildly optimistic valuation and had no relation tothe market value of the company’s stock, which at the time was hardly worth even onecent per share Even worse was the company’s chosen method of accounting for the notereceived in the transaction When stock is issued for a note to be paid at a later date, gen-erally accepted accounting principles call for the note to be subtracted from sharehold-ers’ equity rather than being reported separately as an asset The net effect is no change

in assets or shareholders’ equity However, in an effort to boost assets and shareholders’equity, Bion Environmental did, in fact, report the note receivable as an asset As aresult, the company’s shareholders’ equity increased from less than $10,000 to over

$750,000.17

Finally, as noted in the opening quotes, up to 96% of ANW, Inc., assets and holders’ equity were overstated Among its reported assets were up to 5,000,000 acres ofundeveloped land, a $328,000 note receivable, and $3.4 million in artwork According

share-to the SEC, the amounts reported were false and misleading.18

Having demonstrated the link between earnings and shareholders’ equity of misstatedassets and liabilities, attention now turns to a more careful examination of selectedaccounts The overvaluation of assets that are not subject to periodic amortization—inparticular, accounts receivable, inventory, and investments—is examined first Adetailed look at undervalued liabilities—in particular, accounts payable, accruedexpenses payable, tax-related obligations, and contingent liabilities—follows

OVERVALUED ASSETS

Accounts Receivable

As seen in Chapter 6, accounts receivable play a key role in detecting premature or titious revenue Such improperly recognized revenue leads to an uncollectible buildup inaccounts receivable As a result, the account grows faster than revenue, and accountsreceivable days (A/R days), the number of days it would take to collect the ending bal-ance in accounts receivable at the year’s average rate of revenue per day, increase to alevel that is higher than normal for the company and above that of competitors and the

fic-company’s industry in general However, even when revenue is recognized properly,earnings can be boosted, at least temporarily, by improperly valuing accounts receivable.Accounts receivable are reported at net realizable value, the net amount expected to

be received on collection An estimate of uncollectible accounts, also known as theallowance or reserve for doubtful accounts, is subtracted from the total amount due toderive net realizable value The allowance or reserve for doubtful accounts arises withthe recording of an expense, the provision for doubtful accounts When facts indicatethat some or all of a particular account receivable is uncollectible, the uncollectible por-tion is charged against the allowance for doubtful accounts That is, the actual loss,when it is known, is charged against the balance-sheet account, the allowance or reservefor doubtful accounts The expense effect of the loss, the provision for doubtful accounts,was recorded earlier as an estimate

A company that chooses to boost earnings temporarily can do so by minimizing theexpense recorded as the provision for doubtful accounts This, in turn, will understate theallowance or reserve for doubtful accounts and overstate the net realizable value ofaccounts receivable Only later, often in subsequent years, when the allowance or reservefor doubtful accounts proves inadequate to handle actual uncollectible accounts, will theproblem surface Then an additional provision or expense must be recorded to accom-modate the additional uncollectible accounts Worse, the problem may not come to lightfor even longer periods if actual uncollectible accounts are not written off and instead arecarried as collectible claims Either way, the net realizable value of accounts receivablewill be overstated

While there is no reason to expect a conscious decision to minimize the provision fordoubtful accounts in prior periods, in 1999 Advocat, Inc., found its allowance or reservefor doubtful accounts to be inadequate As a result, an additional provision was needed,

as reported in this disclosure:

The provision for doubtful accounts was $7.0 million in 1999 as compared with $2.4 lion in 1998, an increase of $4.6 million The increase in the provision for doubtful accounts

mil-in 1999 was the result of additional deterioration of past due amounts, mil-increased write-offsfor denied claims and additional reserves for potential uncollectible accounts receivable.19

As is the case when earnings are boosted with premature or fictitious revenue, whenaccounts receivable are overvalued by consciously minimizing estimates of uncollectibleaccounts, accounts receivable, net of the allowance for doubtful accounts, can beexpected to increase faster than revenue Also, A/R days will increase to a level that ishistorically high for the company and above the levels of competitors and other compa-nies in the industry A key difference, however, is that revenue typically is rising when

a company reports premature or fictitious revenue While revenue also may be ing when a company consciously reports overstated accounts receivable, a financialstatement reader should be particularly on guard for overvalued accounts receivable inthe presence of flat to declining revenue Declining revenue indicates declining demandfor a company’s products and services and possible inroads by competitors There alsomay be overall economic or industry-specific weakness that is affecting not only thecompany but its customers, affecting their ability to pay In addition, the company may

increas-Misreported Assets and Liabilities

be selling to less creditworthy customers in an attempt to maintain previous revenue els All such factors lead to the reduced collectibility of accounts receivable and to aheightened risk that they are overvalued.

lev-Many of these problems were being experienced by Springs Industries in 1998 Anearnings shortfall in the second quarter of that year was blamed “on a larger-than-expected provision for bad debts and ‘disappointing’ sales of bedding.”20One analystsaw the company’s earnings warning as a sign that “Springs was losing market share inbedding to WestPoint Stevens, Inc., Dan River, Inc and Pillowtex Corp.”22 Clearly,sales problems were showing up not only in declining revenue but in collection problems

as well

Collection problems also pestered Ikon Office Solutions, Inc., in 1998 In the pany’s quarter ended June 1998, a pretax charge of $94 million was recorded, largely toreflect “increased reserves for customer defaults.”22 Sales that quarter were slightlyhigher, rising 6 percent over the same quarter in 1997

com-Simply because a company records a special provision or charge for uncollectibleaccounts receivable does not necessarily mean that a conscious effort had been made inprior periods to boost earnings artificially Even a best estimate of uncollectible accountscan prove inadequate as circumstances change Nonetheless, the impact of a specialcharge to adjust for a large unexpected increase in uncollectible accounts will have thesame effect on earnings—a precipitous decline Moreover, the company’s earning powerimplied by reported profits in prior years was, whether consciously or not, overstated.Accordingly, a financial statement reader must be attuned to the risk of overvaluedaccounts receivable, whether the overvaluation is a purposeful act or not Consider, forexample, the cases of Planetcad, Inc., and Earthgrains Co

mil-as compared to $85,000 in 1998, mil-as the Company recognized the expense related to a fewlarge balance accounts The Company believes future charges will not be at the levelincurred in 1999.23

According to its note, in 1999 the company recorded an outsize increase to bad debtexpense, or provision for doubtful accounts as it is referred to here, to account for a fewquestionable receivables While the company had been profitable in 1998, reporting pre-tax income of $598,000 on revenue of $14,350,000, the additional provision for doubtfulaccounts, along with other problems, pushed the company into a loss position in 1999.That year the company reported a pretax loss of $2,754,000 on revenue of $14,900,000

It is instructive to look at the company’s revenue and accounts receivable balances inthe years leading up to the special charge for uncollectible accounts in 1999 Amountsfor the years 1996 through 1999 are reported in Exhibit 8.1

In examining the exhibit, it is clear that over the course of the period reviewed, thecompany had a chronic and worsening collection problem Across the period, accountsreceivable, net of the allowance for doubtful accounts, continued to increase at rateshigher than that of revenue As a result, the company’s A/R days continued to grow By

1999, A/R days were up to 101.8 days By then it was taking nearly twice as long as itdid in 1996 to collect amounts due

In reviewing the data in the exhibit, it can be seen that evidence of collection problemsand an impending write-down were available well before the actual event in 1999 In theperiods preceding 1999, the company’s estimate of its uncollectible accounts was opti-mistic and unrealistically low Expectations of earning power formed over those yearswould likely have been optimistic as well

Earthgrains Co.

In its fiscal year ended March 2000, Earthgrains Co also recorded a special charge forproblem accounts receivable In this instance, however, the problem was attributed to asingle customer, as relayed in this disclosure:

Marketing, distribution and administrative expenses increased in 2000 to 39.4% from38.0% on a percentage-of-sales basis The increase is a result of the one-time, $5.4 millionaccounts receivable write-off related to a customer bankruptcy filing, increased goodwillamortization, and inflationary cost pressures, including increases in employee-related costs,and other expenses, including fuel.24

While the company attributed the collection problem to a single customer, the allowancefor doubtful accounts should have been large enough to handle that customer’s prob-lems The company’s revenue and receivable figures for the years leading up to 2000provide some insight into the problem Consider the figures reported in Exhibit 8.2

Misreported Assets and Liabilities

Exhibit 8.1 Revenue and Accounts Receivable with Related Statistics:

Planetcad, Inc., Years Ending December 31, 1996–1999 (thousands of dollars, except percentages and A/R days)

1996 1997 1998 1999

As can be seen in the exhibit, accounts receivable at Earthgrains Co increased fasterthan revenue for each of the years 1998, 1999, and 2000 The year 2000 was particularlytroublesome, with accounts receivable increasing 41.6% on a 5.9% increase in revenue.

As a result, A/R days increased to 46.8 days in 2000 from 35.0 days in 1999 and 31.1days in 1997 This information indicates that the company appeared to be experiencingcollection problems

A review of quarterly statistics for the fourth quarter of the company’s year endingMarch 2000 and for the first three quarters of the year ended March 2001 indicate that thecompany was beginning to gain control of its problems Data are provided in Exhibit 8.3

In reviewing this exhibit, it can be seen that using quarterly revenue figures, A/R dayswere nearly 50 days in the quarter ended March 28, 2000, the last quarter of the fiscalyear In the quarters that followed, however, both through write-offs and increased col-lection efforts, the company’s A/R days gradually declined, returning to 30.3 days in thequarter ended January 2, 2001

At both Planetcad and Earthgrains Co., accounts receivable were overvalued It not be known for sure whether this overvaluation was the result of a conscious effort toreport higher earnings in prior years or simply due to a miscalculation of the collectibil-ity of accounts receivable Either way, however, earnings were temporarily overstatedand subject to decline as each company came to grips with its collection problems

can-Inventory

Inventory represents the cost of unsold goods on the balance sheet When those goodsare in fact sold, their cost is transferred to the income statement and reported as cost of

Exhibit 8.2 Revenue and Accounts Receivable with Related Statistics:

Earthgrains Co., Years Ending March 25, 1997, March 31, 1998, March 30,

1999, and March 28, 2000 (thousands of dollars, except percentages and A/R days)

1997 1998 1999 2000

Accounts receivable, net $141,500 $156,500 $184,500 $261,300

goods sold, known also as cost of sales An overvaluation of inventory will understatecost of goods sold and, correspondingly, overstate net income.

There are many approaches available to a company intent on overvaluing inventory.For example, a very direct approach is simply to overstate the physical quantity of itemsincluded in inventory Such an approach may employ the use of fictitious counts for fakegoods or the reporting as valid inventory merchandise that should be considered as scrap

or defective As a second approach, a company simply may increase the reported tion of inventory without changing its physical count This approach entails the simplestep of valuing the inventory on hand at a higher amount As a third method, a companymay overvalue inventory by postponing a needed write-down for value-impaired goodsthat are obsolete or slow-moving

valua-All three approaches for overvaluing inventory are detailed below They are followedwith a close look at the last-in, first-out (LIFO) method of inventory and how it can beemployed as a creative accounting practice

Overstating Physical Counts

The act of overstating the physical quantity of inventory held is a rather brazen act of ative accounting Unfortunately, there are many examples available of companies thathave attempted to overvalue their inventory in this manner

cre-Consider, for example, Centennial Technologies, Inc According to the SEC, agement at the company altered inventory tags used by counters as they counted inven-tory on hand in an effort to overstate quantities reported.25

man-Also consider Bre-X Minterals, Ltd Acts of fraudulent inventory reporting do not getmuch worse than this The company reported a significant gold find in the jungles ofIndonesia A flurry of public announcements, including press releases and televisionappearances, each pointing to increased amounts of discovered gold reserves, created

Misreported Assets and Liabilities

Exhibit 8.3 Revenue and Accounts Receivable with Related Statistics:

Earthgrains Co., Quarters Ending March 28, 2000, June 20, 2000, September

12, 2000, and January 2, 2001 (thousands of dollars, except A/R days)

March ’00 June ’00 Sept ’00 Jan ’01

excitement and a buying frenzy in the company’s stock Heads turned and questionsbegan to surface, however, when, at the height of activity and excitement, the company’sgeologist committed suicide by “jumping” from a company helicopter Ultimately itwas determined that Bre-X personnel had “salted,” or added gold to, core test samples.

In reality, as the facts of the case unfolded, the company owned little if any gold Thatrevelation was, of course, after investors had lost millions of investment dollars.26

Another gold company, International Nesmot Industrial Corp., was accused by theSEC of engaging “in a deliberate scheme to overstate the company’s income and inflateits reported assets by including in inventory fake gold materials .”27According to theSEC, the company made up brass bars to look like gold bars The only likely real use forsuch fake gold bars would be in the making of a movie

At Perry Drug Stores, Inc., an accurate physical count was in fact taken nately, as noted in the opening quotes to this chapter, the company did not record a noted

Unfortu-$20 million shrinkage in inventory as a reduction in reported inventory and an addition

to cost of goods sold.28A similar physical inventory shortfall was noted at Fabri-Centers

of America, Inc Here, too, a valid physical count was taken, but once again, a notedshortfall was not recorded, leading to an overstatement of inventory.29

Taking an alternative tack to overstate inventory, Miniscribe Corp., a computer drive manufacturer, actually packaged as good inventory scrap items that had little or

disk-no value.30Once properly packaged, of course, the goods appeared to be valid tory It was only when those packages were opened that the true value of their contentswas seen

inven-A similar approach was used at Craig Consumer Electronics, Inc The company’scredit line was secured by its inventory Borrowings were permitted against new goodsand, to a lesser extent, refurbished ones In an effort to boost inventory levels that wereused to secure the company’s line of credit, managers transferred defective goods intothe new and refurbished categories This tactic, at least temporarily, permitted the com-pany to exceed its credit limit by a significant amount.31

Increasing Reported Valuation

A company need not change the physical count of its inventory to boost its reported uation A journal entry designed to increase inventory and reduce cost of goods sold willachieve the same effect The impact, however, like a fast-acting drug, is immediate Asinventory is increased, so are current assets and the company’s apparent liquidity Byreducing cost of goods sold, the company’s gross profit margin, or gross profit divided

val-by revenue, benefits along with net income.32 Retained earnings are also increased,adding to shareholders’ equity

Inventory fraud was only one component of the elaborate financial fraud carried out

at the electronics manufacturer Comptronix Corp in the late 1980s In a regular, almostroutine fashion, approximately once per month management simply journalized anincrease to inventory and a reduction in cost of goods sold Aware that an unexplainedincrease in inventory would likely be a warning sign to some analysts, some of thebogus inventory was periodically transferred to property, plant, and equipment The rea-soning was that the falsely recorded amounts would be less apparent if carried in prop-

erty, plant, and equipment Fake invoices for equipment purchases were prepared tomake it appear as though equipment additions were actually being made.33Of course,using the steps outlined in Chapter 7, in particular, a careful review of the relationshipbetween revenue and property, plant, and equipment, a financial statement reader would

be attuned to potential problems

The value of inventory on hand was also overstated at Leslie Fay Companies, Inc Themethod used, however, was a bit more covert than simply journalizing an increase toinventory What the women’s apparel maker did was to overstate the number of gar-ments manufactured, effectively reducing the manufacturing cost of each one Then asgarments were sold, a smaller cost was recorded in cost of goods sold, leaving more ofthe manufacturing cost in ending inventory.34It was an interesting scheme, although onethat would be picked up by an accurate physical inventory count and price extension

Delaying an Inventory Write-down

Inventory write-downs are a routine occurrence Inventory is reported at cost, or, if thecost to replace inventory on hand is lower, at that lower replacement cost When goodsbecome obsolete or slow-moving, replacement cost is likely to decline Replacementcost also can be expected to decrease in the presence of general price declines Eitherway, a write-down is needed

The conscious postponement of an inventory write-down is a form of creativeaccounting The company has reported earnings and financial position that convey a per-ception of business performance that is contrary to reality An inventory write-down,however, is not prima facie evidence that inventory has been consciously overvalued inprior periods Conditions and circumstances change, sometimes quickly As they do,management periodically must evaluate its inventory levels, mix, and valuation in light

of changes in such factors as demand, customer tastes, and technology With this ation comes the need for professional judgment to determine whether a write-down is, infact, necessary

evalu-Whether a write-down is due to a conscious decision to overvalue inventory in priorperiods or due to a valid judgment call, it is important to remember that an overly opti-mistic assessment of earning power has been conveyed by amounts reported in priorperiods The write-down serves as a jolt back to reality and signals the need for a soberreappraisal of business prospects

Consider the case of Cisco Systems, Inc As late as November 2000, orders at thecompany were reportedly growing at rates approaching 70% per annum In fact, thebiggest problem the company expected to face was having sufficient inventory to meetits burgeoning demand Accordingly, the company took steps to increase its supply line

of parts for manufacture It made commitments to buy components months before theywere expected to be needed

In December 2000, the company hit a wall as orders declined precipitously in adelayed reaction to the burst of the Internet bubble and a shriveling in the investmentsmade by its telecommunications equipment customers Commenting on its swift rever-sal of fortune, John Chambers, the company’s CEO, noted, “I don’t know anybody thatcan adjust to that.”35 In fact, the company’s business seemed to change virtually

Misreported Assets and Liabilities

overnight from revenue growth that averaged in the 60% to 70% range in late 2000 to adecline in revenue expected to be as much as 30% in mid 2001 As a result, the companyfound itself with more inventory than it needed, forcing it to take a write-down of $2.5billion in April 2001 That write-down was a sobering jolt indeed.

Note that there is no evidence of a conscious effort to overvalue inventory at CiscoSystems The write-down was due to a rapid change in business conditions that arguablycould not have been anticipated earlier Nonetheless, the write-down is still painful, and

it serves as a reminder that the company’s prospects are not what they were as recently

as six months earlier

It is interesting to look at selected financial statement accounts and statistics from thecompany’s quarterly reports in the periods leading up to its inventory write-down Theinventory buildup is certainly apparent Consider the data provided in Exhibit 8.4

In reviewing the exhibit, it can be seen that inventory is growing much faster than enue For every quarter examined, inventory increased more than 25%, with increases of40.3% and 58.8% in the June-to-July 2000 and September-to-October 2000 quarters,respectively During the period under review, inventory days, or the number of days itwould take to sell the ending balance in inventory at the quarter’s average rate of cost ofgoods sold per day, increased to 89.6 days in the January 2001 quarter This was up from

rev-as little rev-as 41.3 days in January 2000 In one year the company’s supply of inventory ative to sales had more than doubled

rel-Exhibit 8.4 Revenue, Cost of Goods Sold, and Inventory with Related

Statistics: Cisco Systems, Inc., Quarters Ending January 29, 2000, April 29,

2000, July 29, 2000, October 28, 2000, and January 27, 2001 (millions of

dollars, except percentages and inventory days)

Jan ’00 April ’00 July ’00 Oct ’00 Jan ’01

According to the company, the inventory buildup was to ensure that it had the parts

on hand it needed to fill expected future orders of its manufactured goods and was notthe result of slowing demand There was evidence of slowing revenue growth in the Jan-uary 2001 quarter, as evidenced by an unexpectedly small increase in revenue of 3.5%.The company’s inventory mix, however, attested to its views that future orders would behigher and parts were needed to fill them

At fiscal year end July 2000, the company reported raw materials and finished goodsinventory levels at 11.8% and 49.9% of total inventory, respectively At the end of thesecond quarter in January 2001, raw materials and finished goods inventory were at37.2% and 27.2% of total inventory, respectively

When a company faces an expected decline in orders, it will slow purchases of rawmaterials in an effort to limit the amount of goods put into the manufacturing pipeline.Such an action will help prevent an unwanted buildup in finished goods inventory In theCisco Systems example, much of the inventory growth was in the raw materials category,consistent with an expectation of increased orders It was when those orders did not mate-rialize by April 2001 that the company found it necessary to write down its inventory

LIFO Method

LIFO, the last-in, first-out method of inventory cost calculation, assumes that inventorycosts included in cost of goods sold were of the last units purchased during a year.Inventory reported on the balance sheet thus consists of older purchase costs The pri-mary alternative to LIFO, the FIFO, or first-in, first-out method, includes older costs incost of goods sold and leaves more recent purchase costs on the balance sheet.36

When inventory costs are rising, the LIFO method will result in lower earnings thanthe FIFO method However, as a benefit, a LIFO company’s taxable income and theamount of income taxes paid are reduced When costs are rising, FIFO will report higherincome and provide a higher inventory valuation than LIFO

Statistics indicate that in 1999, about one-third of large, public companies used theLIFO method for at least part of their inventories while about 44% of them used theFIFO method For companies that do not wish to select one extreme or the other, theaverage-cost method provides results that are somewhat between the LIFO/FIFOextremes In 1999 the average-cost method was used by about 19% of large, publiccompanies with other miscellaneous inventory cost methods being used by the remain-ing firms.37

LIFO and Interim Results While the LIFO method would not be expected to be a cle for misstating inventory and cost of goods sold, for interim financial statements, itcan be used to do just that Companies that report using the LIFO method typicallymaintain their internal books and accounts on a FIFO basis and adjust to LIFO for report-ing purposes This provides them with access to current cost or FIFO cost data for inter-nal decision making and also provides a ready source of information for fulfilling SECdisclosure requirements of the current cost of their inventory Thus, at the end of areporting period a company will adjust amounts for inventory and cost of goods soldfrom their FIFO internal account valuations to LIFO amounts For example, in order to

vehi-Misreported Assets and Liabilities

incorporate the inflationary effects of rising costs, inventory will be reduced and cost ofgoods sold will be increased to adjust them from FIFO to LIFO.

The LIFO method is, however, an annual inventory cost approach That is, the cial adjustment to LIFO is made at the end of the year after all actual purchase informa-tion and price change data for the full year are known What that means is that forinterim periods, companies must adjust to LIFO for estimates of what they think theannual rate of price change in inventory will be The effects of any errors in estimationare corrected after the end of the year and reflected in the fourth quarter’s results.Consider the selected interim results for Winn-Dixie Stores, Inc., a grocery chain, forthe year ended June 30, 1999, presented in Exhibit 8.5

offi-The quarterly data presented in the exhibit indicate that in 1999, Winn-Dixie mated that inflation’s after-tax effect on inventory and cost of goods sold was

esti-$2,444,000 in the September 1998 and January 1999 quarters Note how the companyreported a net LIFO charge, or increase to expense and reduction in earnings, for

$2,444,000 net of tax in each of the first two quarters of the year Apparently, by theMarch 1999 quarter, price increases were seen to be moderating; the inflation adjustmentfor that quarter was only $1,833,000 By the end of the year, the company became awarethat it had overstated inflation’s effect on inventory and cost of goods sold As a result,

a credit and increase to earnings of $4,030,000 was needed to counter the excessive mates of inflation and accompanying adjustments made earlier in the year To the extentthat earlier interim results were relied on, expectations about the year’s performancewould have been somewhat pessimistic

esti-Accompanying the information provided in Exhibit 8.5 was this disclosure made bythe company:

During 1999, the fourth quarter results reflect a change from the estimate of inflation used

in the calculation of LIFO inventory to the actual rate experienced by the Company of 1.1%

to 0.3%.38

In other words, early in the year the company estimated the year’s inflation rate to be1.1% for 1999, and by the end of the year the actual rate of inflation was a more moder-ate 0.3% Interestingly, in 2000 the company’s estimate was very close to the actualinflation rate That year the company’s estimate for inflation was 1.0%; by the end of theyear the actual rate of inflation was 1.1%

Thus, while Winn-Dixie overestimated inflation’s effects during the year, a companythat wished to report higher earnings during a year could purposefully underestimateinflation’s effect Such a benefit would be short-lived, however Assuming the companywished to adjust back to actual price changes by year-end, the fourth quarter’s resultswould need to include an addition to expense and reduction in earnings

While the LIFO interim adjustment is not a particularly troublesome amount to derivefor well-established companies like Winn-Dixie, with experienced accounting staffs, itcan pose a problem to smaller, younger companies With a less sophisticated accountingstaff, such companies may make only a rough guess at the effects of price changes onLIFO amounts during interim periods Such a step is not inconceivable given that interim

results are not audited, even for public companies Worse, some companies may leaveany needed LIFO adjustments to the auditors to be effected at year-end This is a prob-lem particularly for nonpublic companies For such companies that have only partiallyadjusted or that have not adjusted to LIFO during interim periods, the income statementwill effectively be on a basis that approximates FIFO, being adjusted to LIFO only atyear-end.

To detect whether a complete adjustment to LIFO has been effected, the interim grossprofit margin should be compared with the prior year’s annual gross profit margin Thepremise here is that the prior year’s annual gross profit margin will include the effects of

a complete adjustment to LIFO If the current year’s interim results have not beenadjusted to LIFO, then to the extent they reflect FIFO amounts, the interim gross profitmargin will exceed the prior year’s annual gross profit margin This comparison assumes

a constant inventory sales mix If the mix has changed, then adjustments for the pated effects on gross profit of that change must be taken into account before a mean-ingful comparison of gross profit margins can be made

antici-LIFO Liquidations A reduction in inventory quantities by a company that uses theLIFO method is termed a LIFO liquidation Here, current-period purchases or production

of inventory fall behind sales As a result, older LIFO inventory costs will be reflected

in cost of goods sold Assuming rising prices, these older LIFO costs will be lower thancurrent purchase or production costs, leading to a reduction in cost of goods sold and anincrease in net income Consider this disclosure of a LIFO liquidation provided byTesoro Petroleum Corp.:

During 1999, certain inventory quantities were reduced, resulting in a liquidation of able LIFO inventory quantities carried at lower costs prevailing in previous years ThisLIFO liquidation resulted in a decrease in cost of sales of $8.4 million and an increase inearnings from continuing operations of approximately $5.3 million aftertax ($0.16 pershare) during 1999.39

applic-Misreported Assets and Liabilities

Exhibit 8.5 Selected Quarterly Data: Winn-Dixie Stores, Inc., Quarters

Ending September 16, 1998, January 6, 1999, March 31, 1999, and June 30,

Source: Winn-Dixie Stores, Inc 10-K annual report to the Securities and Exchange Commission,

June 30, 1999, p F-30.

Many business reasons justify a reduction in inventory quantity Two such reasonsinclude a move toward just-in-time inventory practices and a concerted effort to out-source more of a firm’s production needs It is possible, however, that a company mayeffect a LIFO liquidation in an effort simply to report higher income It should be appar-ent that such income is not sustainable and will disappear when older inventories arereplaced at higher costs.

A decline in LIFO inventory is evidence of a LIFO liquidation The earnings effect

of that liquidation, however, must be obtained elsewhere Public companies arerequired to disclose that information and typically will do so in the footnotes, as was thecase with Tesoro Petroleum Corp.40 This disclosure should be examined carefully todetermine the extent of the liquidation’s effect on earnings Unfortunately, for nonpub-lic companies, such a disclosure may not be available In such cases, an improvement

in gross margin over a prior year may be the result of the liquidation If the ment is significant, management should be questioned regarding the role, if any, played

improve-by the LIFO liquidation

Detecting Overvalued Inventory

Whether inventory is overvalued due to an overstated physical count, an increase in thevalue assigned to inventory on hand, or a delayed write-down of obsolete or slow-mov-ing goods, the same steps can be used for detection As a result of these inventory mis-deeds, there will be an unexplained increase in inventory that is outsize relative to anobserved increase in revenue Moreover, inventory days will rise and reach levels thatare higher than the statistic for key competitors and other companies in the industry Aninventory that is fictitiously increased will also result in an unexpected improvement ingross profit margin This is, of course, not to say that an improvement in gross profitmargin is a sign of inventory fraud The point is that gross profit margin benefits fromsteps taken to overstate inventory improperly However, a decline in gross profit marginassociated with business difficulties, which include obsolete or slow-moving merchan-dise, likely will offset any improvement that may be derived from an overvaluation ofinventory arising from a conscious decision to delay an inventory write-down

Consider again the case of Cisco Systems and the data reported in Exhibit 8.4 Thecompany’s inventory was increasing at a rate that was much faster than revenue Withthis increase in inventory came an increase in inventory days that reflected the bloat thecompany was experiencing

Also refer to the case of Perry Drug Stores introduced earlier in the chapter At PerryDrug, an accurate physical count of inventory on hand at its fiscal year end in 1992 wastaken The problem was, however, that the company did not record an inventory shrink-age of approximately $20 million that was discovered with the count Thus, after thephysical count, the company carried inventory on its balance sheet at $20 million greaterthan the amount of inventory known to be physically on hand Exhibit 8.6 presentsselected data for Perry Drug Stores for a five-year period surrounding 1992, the year inquestion

In reviewing the exhibit, it can be seen that revenue grew slightly over the period 1989through 1993 Inventory, however, grew rapidly, particularly in 1992, the year in ques-

tion In fact, after remaining around $120 million for the years 1989 through 1991,inventory jumped suddenly to $140 million in 1992, an increase of 13.4% on a revenueincrease of 5.2% Inventory days, which had remained at 96 to 97 days in the 1989 to

1991 period, jumped suddenly to 103.5 days in 1992 Recall that it was at year-end 1992that the company’s physical count came in approximately $20 million less than what wasreported on its books The $20 million overstatement of inventory is especially evident

in examining the data provided in Exhibit 8.6 In fact, if $20 million were subtractedfrom the $140,202,000 in inventory reported at year-end 1992 and added to the cost ofgoods sold, inventory days would be reduced to 85 days, which is more in line withamounts reported in previous periods Note that by the end of 1993, the company hadcome to grips with its inventory difficulties and was now carrying only $111,263,000 ininventory, or 74.6 days’ worth

Investments

The range of investments available to a company is wide and includes debt securities,such as commercial paper, treasury bills and notes, and both corporate and treasurybonds, and equity securities, such as common and preferred stock Companies also mayinvest in certain financial derivatives, such as options to purchase or sell stock or com-modities, warrants to purchase stock, commodity futures and forwards, and certain swapagreements The focus here is on the use of creative accounting practices for more

Misreported Assets and Liabilities

Exhibit 8.6 Revenue, Cost of Goods Sold, and Inventory, with Related

Statistics: Perry Drug Stores, Inc., Years Ending October 31, 1989, 1990, 1991,

1992, and 1993 (thousands of dollars, except percentages and inventory days)

traditional investments in debt and equity securities Investments in financial derivativesare beyond the chapter’s scope.41

Investments in Debt Securities

Investments in debt securities, including both short-term and long-term fixed-incomeinvestments, can be held as trading instruments, held to maturity, or carried as availablefor sale The classification affects how the investments are reported.42

Investments in debt securities that are made with the intention of selling within a shortperiod of time are considered to be debt securities held for trading purposes Tradingentails the frequent buying and selling of securities in an effort to generate profits fromshort-term changes in price Holding periods likely are to be measured in terms ofmonths or less and may even be as short as several days or even several hours

Debt securities held for trading purposes are reported at fair market value Unrealizedholding gains and losses arising from periodic changes in fair market value are included

in income as they arise

The intent with investments in debt securities held to maturity is to hold the ments until the scheduled maturity date The sole purpose of the investment is to gener-ate interest income over the holding period Such investments are carried at amortizedcost, that is, cost net of any unamortized discount or plus any unamortized premium.Interest income, consisting of cash interest plus any amortized discount, or less anyamortized premium, is included in income as it accrues No adjustment is made to fairvalue unless that value has declined below cost and is not expected to recover In suchcases, where the decline in fair value is considered to be an other-than-temporarydecline, the investment is written down to fair value and the decline is reported in earn-ings as a loss That fair value becomes the investment’s new cost basis

invest-Investments in debt securities that are held as available for sale do not meet the ria as trading securities or as debt securities held to maturity The securities are notexpected to be held until maturity, but neither is the holding period expected to be asshort as what is typical of a trading position The classification available for sale iseffectively a default category for investments in debt securities that cannot be classified

crite-as either trading or held to maturity

Investments in available-for-sale debt instruments are reported at fair value ized holding gains and losses arising from changes in fair value are not reported in earn-ings but rather as part of accumulated other comprehensive income, a component ofshareholders’ equity Like debt securities that are classified as held to maturity, an other-than-temporary decline in the fair value of an available-for-sale debt security would berecorded and included in earnings as a loss

Unreal-ABC Bancorp reports investments in held-to-maturity and available-for-sale debt rities Consider this statement regarding the company’s classification of its investments:Securities are classified based on management’s intention on the date of purchase Securi-ties which management has the intent and ability to hold to maturity are classified as held

secu-to maturity and reported at amortized cost All other debt securities are classified as able for sale and carried at fair value with net unrealized gains and losses included in stock-holders’ equity, net of tax.43