Earnings Management - Accounting Red Flags
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Richard J. Wayman

Accelerating Expenses
In order to improve future earnings, companies will "front-load" expenses and book them in the current quarter. Cisco Systems and Tyco have been accused of having the companies they were acquiring write off as much as possible in order to maximize earnings per share (EPS) after the acquisition was finalized. Investors can spot these techniques by looking for "nonrecurring" expenses such as "in-process R&D" charge-offs, and most recently, "impaired goodwill" writeoffs. Regardless of what it is called, management decided to take an earnings "hit" instead of recording the expense over a number of quarters, as was previously planned.

"Nonrecurring" Expenses

Nonrecurring expenses is the generic term used for supposedly one-time charge-offs. This technique deserves special mention because it's a classic--and an oxymoron if ever there was one. These one-time charges were meant to take care of extraordinary--in other words, nonrecurring--events in order to separate them from "normal"--in other words, recurring--expenses. But, it seems like some companies take a "nonrecurring" charge each year. During the 1980s, Borden made many acquisitions in the food and chemical sectors. When management started to integrate the operations, it posted a string of one-time charges that were for restructuring charges and severance payments. To be fair, it takes time to integrate new operations and nonrecurring expenses represent management's best guess at any one time. When new information is available, companies adjust their estimates and this creates the "new" nonrecurring expense. I expect many of Wall Street's favorite stocks of the late 1990s to start posting nonrecurring expenses as the downturn in the economy has made many of their investments go bad.

Goodwill Impairment (FAS 142)

Goodwill represents an amount paid above book value to buy something because the buyer perceives a greater value in that something. For example, people go to Starbucks and pay $3.00 for a cup of coffee when you can get a cup of coffee for $1.50 at McDonalds. The $1.50 more you pay at Starbucks represents the goodwill you perceive in that particular cup of coffee.

Companies record goodwill on their balance sheets when they paid more than book value for an acquisition. The acquiring companies were willing to pay more than the value of the plant and equipment because of the value they perceived in the technology or brand name they were buying. Under the old accounting rules, companies had to periodically expense, or amortize, this goodwill over a period of years. However, a recent change in GAAP will eliminate the amortization of many forms of goodwill, but another change is expected to result in large charge-offs in 2002.

The new accounting rule is called FAS 142 and will generate a flood of "impaired goodwill" charges this year. If the goodwill on the books of a company is greater than the current market value of the asset, then the goodwill is deemed "impaired" and it must be charged off. The best example of this is any dot-com acquisition that occurred in 1999 where the buyer used its stock. After the bubble bursting and stock market crash, the value of that "business" is much less than the millions in stock that was paid for it and which is sitting on the balance sheet. Under FAS 142, it must all be written off. Think of it like your stock portfolio: In 1999, you may have bought tech stocks for $10,000. Today the market value is more like $500. Since you can't keep valuing your portfolio at $10,000, the $9,500 loss represents impaired goodwill that the market has written off for you.

The most recent example of this was AOL Time Warner's announcement in January 2002 that it will take a $60 billion hit to write down bad assets. Other sectors that will be hit hard by this new accounting rule are the darlings of the dot-com era that acquired other companies at inflated prices and paid with stock. Under the new rules, many of these deals can be viewed as "impaired." The way FAS 142 was written, it behooves companies to take their "hit" as soon as possible in 2002. If the charge is taken now, it will be treated as a nonoperating expense and will not reduce EPS. If a company waits too long, the charge will be treated as an operating expense and will reduce EPS.

"In-Process R&D" Charge-Offs

This is a type of nonrecurring charge that graced many a tech stock's income statement during the 1990s. A large tech firm often acquired smaller companies that were heavily involved in developing new technologies or software. Because the technology was not yet commercially viable (thus "in process") the acquiring company could deem it worthless and write off the related costs. However, there could be some future revenue derived from the technology, otherwise why would the company have been acquired? Any future revenue would thus be recorded without the expense of the related R&D and EPS would be overstated.

You don't see much "in-process R&D" writeoffs these days because it is being replaced by goodwill impairment charges. But it is useful to know that charging off capitalized expenses has been around for some time.

Other Income

This category is especially susceptible to earnings manipulation because it houses a multitude of sins. It is a catchall for other revenue and expenses that aren't classified in the other major line items or are not large enough to be "material" in the eyes of the company's executives. This is the category where companies book any "excess" reserves from prior charges (nonrecurring or otherwise) and offset them with "other" income.