Results of the 2002 Annual FASAC Survey

Wages of factory workers are traced directly into finished goods inventories and are "capitalized" costs rather than expenses.  They are carried in the balance sheet as "tangible assets" until the the inventory items are sold or perish.  Then these costs become "expenses" in the income statement and are written off to the Retained Earnings account.  Similarly, wages of construction workers on a building are capitalized into the Buildings asset account rather than expensed in the income statement.  These wages become expensed over time in periodic depreciation charges. Costs of labor and direct materials that can be traced to construction of tangible assets thereby become assets and are written off across future periods.  Even indirect labor and material charges may be capitalized as overhead applied to tangible assets.  Tangible assets depict "touchable" items that can be purchased and sold in established markets such as commodity markets, real estate markets, and equipment markets.   Wages and salaries of research workers can be traced to particular projects.  However, under most accounting standards worldwide, research costs, including all direct material, labor,  and overhead costs are expensed immediately rather than capitalized as assets even though the revenues from the projects may not commence until many years into the future.  Research projects are typically too unique and too uncertain to be traded in markets.  Accounting standard setters recognize that there are many "intangible" items having future benefits or losses that are not booked as assets or liabilities.  Outlays for development of intangibles are expensed rather than capitalized until they can be better matched with the revenues they generate.  Examples in include research for new or improved products.  Intangibles also include contractual items such as copyrights, advertising, product promotions, and public relations outlays.  When intangibles such as patents and copyrights are purchased, the outlays can be booked as intangible assets.  Costs are then amortized over time.  However, resources devoted to discovery and development of intangibles are generally not booked as assets.  They are expensed when incurred rather than capitalized.  Typical examples of intangible expenses include the following: Research (including development of patent and copyright items) Long-term development of patents, products, and copyrights Advertising and trademarks Employee training and development Public relations When an entire firm is purchased, the difference between the total price and the current value of all intangibles is typically booked to a "Goodwill" asset account.  When purchased as a lump sum, goodwill can be carried as an asset until its value is deemed to be "impaired."  However, when developed internally, goodwill is not booked as an asset.  This creates all sorts of problems when comparing similar companies where one company purchased its goodwill and the other company developed it internally.  In the U.S., goodwill accounting must be treated under purchase rather than pooling methods that, in turn, result in booking of "purchased goodwill."  FAS 141 spells out the accounting standards for Goodwill.    One requirement under FAS 141 is that contractual items such as patents and copyrights that can be separated from goodwill must be valued separately and be immediately expensed.  This is an attempt in FAS 141 to make it easier to compare a firm that acquires R&D in a business combination with a firm that develops its own R&D.  However, implementation of FAS 141 rules in this regard becomes very murky. FAS 142 dictates that firms are no longer required to amortize capitalized goodwill costs.  Instead firms are required to run impairment tests and expense portions of goodwill that has been deemed "impaired."  FAS 142 does not alter standards for intangibles that are not acquired in a business combination.  Hence, standards such as FAS 2 (R&D), FAS 19 (Oil and Gas), FAS 50 (Recording Industry), and FAS 86 (Computer Software) remain intact in situations apart from business combinations.  Paragraph 39(b) of FAS 142 admits to the following: In some cases, the cost of generating an intangible asset internally  cannot be distinguished from the cost of maintaining or  enhancing ... internally generated goodwill. There is nothing new about the sad state of accounting for intangibles.   In a working paper entitled "The Measurement and Recognition of Intangible Assets:  Then and Now," Claire Eckstein from Fairleigh Dickinson University quotes the following footnote from 1928: The Gold Dust Corporation August 31, 1928 In view of the available surplus, and in the fact that the corporation carries its most valuable asset, viz, its goodwill at $1, and also because of the uncertain market value of industrial plants, it was concluded that it would be entirely approprate for the corporation to carry its plants in a similar manner as its goodwill, viz, at the nominal value of $1. The FASB admits that accounting for intangibles is in a sad state in terms of providing relevant information to investors.  An agenda project has been created that is titled "Disclosure of Information about Intangible Assets not Recognized in Financial Statements."  Analysts bemoan the state of accounting for intangibles.  In April 2001, Fortune stated the following: In the Fortune 500 there are thousands upon thousands of statistics that reveal very little that's meaningful about the corporations they purportedly describe.  At least that's the verdict of a growing number of forward-thinking market watchdogs, academics, accountants, and others.  Convinced that accounting gives rotten information about the value of performance in modern knowledge-intensive companies, they are proposing changes that would be earthshaking to the profession. Because so much of the problem rests in "knowledge intensive companies," Baruch Lev and others have come to view unrecognized intangibles as being synonymous with unrecognized "knowledge capital." Measuring the Value of Intangibles and Valuation of the Firm Knowledge Capital Valuation Factors (terminology adapted from Baruch Lev's writings) Value Creators Scalability      Nonrivalry (e.g., the SABRE airline reservations system)      Increasing Returns (due to initial fixed cost followed by low marginal cost) Network Effects      Positive Feedback ¨(customer discussion boards)      Network Externalities (fast word of mouth)      Industry Standard (Microsoft Windows) Value Destroyers Partial Excludability (training of employees who cannot be indentured servants)      Spillovers      Fuzzy Property Rights      Private vs. Social Returns (training that creates immense competition other nations) Inherent Risk      Sunk Cost      Creative Destruction (Relational database and ERP destruction of COBOL systems)      Volatility of value due to competition and technological change      Risk Sharing (only a few products emerge as winners amidst a trail of road kill) Non-tradability      Contracting Problems      Negligible Marginal Cost A few years ago a hardback set of the thirty-two volumes of the Britannica cost $1,600…In 1992 Microsoft decided to get into the encyclopedia business…[creating] a CD with some multimedia bells and whistles and a user friendly front end and sold it to end users for $49.95…Britannica started to see its market erode…The company's first move was to offer on-line access to libraries at a subscription rate of $2,000 per year…Britannica continued to lose market share…In 1996 the company offered a CD version for $200…Britannica now sells a CD for $89.99 that has the same content as the thirty-two volume print version that recently sold for $1,600. Shapiro and Varian (1999, pp. 19–20) On November 14, 2002 the following links were provided at http://pages.stern.nyu.edu/~blev/intangibles.html  1. Announcement: Lev's Book: Intangibles-Management, Measurement and Reporting has been published by the Brookings Institution Press. Get your copy now at book stores and retailers. 2. Paper with Feng Gu: Intangible Assets, discussing Lev's methodology for measuring intangible assets. - intangible-assets.doc - intangibles-tables.ppt (Accompany Tables in Microsoft Powerpoint) 3. Paper with Feng Gu: Markets in Intangibles: Patent Licensing, - patent-licensing.doc (Microsoft Word) - patent-licensing-tables.doc (Microsoft Word) 4. April 16, 2001 - "Accounting Gets Radical" - Fortune 5. April 2001 - "Knowledge Capital Scoreboard: Treasures Revealed" - CFO online 6. May 10, 2001 - Interview with Baruch Lev - (in spanish) 7. May 14, 2001 - "How Do We Guage Value of New Web Technologies?" - Wall Street Journal 8. May 14, 2001 - "How do you value intangible assets?" - National Law Journal (No Online Version Available) 9. June 18, 2001 - "Taking Stock of a Company's Most Valuable Assets" - Business Week   There are all sorts of models for valuing an entire firm such that estimates of the value of unbooked items (goodwill) can be derived as the difference between the sum of the values of booked items and the entire value of the firm.  However, derivation of values of knowledge capital becomes confounded by the synergy effects.  The major problem is all valuation models is that they entail forecasting into the future based upon extrapolations from past history.  This is not always a bad thing when forecasting in relatively stable industries and economic conditions.  The problem in modern times is that there are very few stable industries and economic conditions.  Equity values and underlying values of intangibles are impacted by highly unstable shifts in investor confidence in equity markets, manipulations of accounting reports, terrorism, global crises such as the Asian debt crises, emergence of China in the world economy, and massive litigation unknowns such as lawsuits regarding mold in buildings.  Forecasting the future from the past is easy in most steady-state systems.  It is subject to enormous error in forecasting in systems that are far from being in steady states. The popular models for valuing entire firms include the following: Valuation based upon analyst forecasts.  These alternatives have the advantages of being rooted in data outside what is reported under GAAP in financial statements.  Analysts may meet with top management and consider intangibles.  But there are also drawbacks such as the following: The cart is in front of the horse.  When the purpose of accounting data is to help help investors and analysts set stock prices in securities markets, the forecasts of users (especially leading multiples) for valuation entails circular reasoning. The recent scandals involving security analysts of virtually all major investment firms and brokerages makes us tend to doubt the objectivity and ability of analysts to make forecasts that are not self-serving.  See http://www.trinity.edu/rjensen/fraud.htm#Cleland  Analyst forecasts tend to be highly subjective.  Comparing them may be like finding the mean between a banana and a lemon. Valuation using stock price multiples (usually limited to comparing firms in a given industry and adjusted for leverage).  Multiples can be based upon price forecasts (leading multiples) or past price trends (trailing multiples).  In either case, the valuations are suspect for the following reasons: The cart is in front of the horse.  When the purpose of the valuation exercise is to help help investors set stock prices in securities markets, the use of stock prices (especially leading multiples) for valuation entails circular reasoning. Use of the current prices of small numbers of shares traded is not the same as the per-share value of all the shares acquired in a single transaction.  This difference arises in part because acquiring control usually i s far more valuable than the sum of the shares at current trading values.  This difference arises in part because current share prices are subject to transient market price movements of shares of all traded companies, whereas the value of the firm in a business combination deal is much more stable.  For example, Microsoft share prices have declined about 40% between Year 2000 and Year 2002, but it is not at all clear that the value of the firm and/or its knowledge capital value has declined so steeply in the bear market of securities pricing in Year 2002. Present value valuation based upon forecasted dividends (usually including a forecasted dividend growth rate).  The problem with forecasted dividends is that firms have dividend policies that do not reflect future value.  For example, many firms do not pay dividends at all or their payout ratios are too small to be reflective of firm value.  There may be enormous dividends decades into the future, but these are too uncertain to be realistic for valuation purposes.  Another problem is that forecasted dividend models generally require the estimation of a "terminal value" of the firm, and this usually entails grasping for straws. Discounted abnormal earnings and returns valuation (including Edwards-Bell-Ohlson (EBO) and Steward's EVA Models) Abnormal earnings  and returns valuation models generally use forcasted after-tax operating profits discounted at the firm's current weighted average cost of capital.   There are variations of methods such as the abnormal returns method, the abnormal earnings method, and the free cash flow method of valuing returns to debt and equity.    One of the nicer summaries of the EBO versus EVA models can be found in "Measuring Wealth," by Charles Lee, CA Magazine, April 1996, pp. 32-37 --- http://www.cica.ca/cica/camagazine.nsf/e1996-Apr/TOC  The value of the firm depends on its ability to generate "abnormal earnings" above what can be earned in riskless or near-riskless investment alternatives.  There are immense problems in this valuation approach for the following reasons: Empirical studies both before and after the Enron scandal indicate that earnings management is systemic and pervasive such that managers can manipulate abnormal earnings valuations with their earnings management policies (that are generally secret). Earnings measures are subject to all the limitations of GAAP including the failure to expense employee stock options, inclusion of income on pension funds, write-off of R&D under FAS 2, and the expensing of expenditures for knowledge capital intended to benefit the future.  Actually, this problem is not as serious as it might seem at first blush since many of the accounting distortions wash themselves out over time if they are do to timing.  However, when the timing is long-term such as in the case of long-term R&D projects, distortions persist due to discounting.  For example, if a firm deducts $1 billion per year on a research project that may only start to pay off 15 or more years into the future, the conservatism badly distorts the discounted abnormal earnings and return valuation methods. Abnormal earnings and returns valuation models implicitly assume firms that carry massive amounts of excess cash, beyond what is needed for year-to-year operations, distribute the excess cash as dividends to owners.  This just is not the case in some firms like Microsoft that carry huge cash reserves.  As a result, abnormal earnings and returns valuation methods must take this into account since abnormal earnings do not accrue to free cash reserves. Real Options There are various valuation methods that are less widely used.  One of these is the Real Options approach that shows some promise even though it is still quite impractical.  See http://www.trinity.edu/rjensen/realopt.htm  Market Transaction On rare occasion, a portion of a company's knowledge capital is sold in market transactions that give clues about total value.  The sale of a portion of the SABRE system by American Airlines is an excellent example of a clue to the immense value of this   unbooked asset on the balance sheet..  The problem with this is that market price of a portion of the SABRE system ignores the synergy values of the remaining portion still owned by AMR. In the final analysis, the most practical approach to date is to attempt to forecast the revenues and/or cost savings attributable to major components of intellectual capital.   This is much easier in the case of software and systems such as the SABRE system than it is in components like human resources where total future benefits are virtually impossible to drill down to present values at particular points in time. The valuation of intangibles will probably always be subject to enormous margins of error and risk. One way to help financial statement users analyze intangibles would be to expand upon the interactive spreadsheet/database approach currently used by Microsoft Corporation for making forecasts.  Although this approach is not currently used by Microsoft for detailed analysis of intangibles, we can envision how knowledge capital components might be expanded upon in a way that financial statement users themselves can make assumptions and then analyze the aggregative impacts of those assumptions.  Click on the Following from http://www.microsoft.com/msft/  FY 2003 Microsoft "What-if?" (193 KB) Do your own forecasting for Microsoft’s FY 2003 income statements based on your assumptions with this Excel projection tool --- http://www.microsoft.com/msft/download/PivotTables/What_If.xls  Pivot tables might also be useful for slicing and dicing information about intangibles.  Although Microsoft does not employ this specifically for analysis of intangibles, the approach used at the following link might be extended for such purposes: Financial History PivotTable (122 KB) Allows you to view and analyze historical Microsoft financial data.  For example, you can look at income statement line items dating back to 1985 --- http://www.microsoft.com/msft/download/PivotTables/historypivot.xls  Click here to view references on intangibles  FAS 141 and the Question of Value By PricewaterhouseCoopers CFOdirect Network Newsdesk, January 16, 2003 --- http://www.cfodirect.com/cfopublic.nsf/vContentPrint/CA13B226B214A04085256CB000512D34?OpenDocument  Just as early reactions to FAS 142 seemed to have overlooked the complexities in reviewing and testing goodwill for impairment, so too have reactions to complying with the Financial Accounting Standards Board's Statement No. 141 – Business Combinations. Adopted and issued at the same time as Statement No. 142 in the summer of 2001, the headline news about FAS 141 was the elimination of the Pooling-of-Interest accounting method in mergers and acquisitions. Going forward from June 30, 2001, all acquisitions are to be accounted for using one method only – Purchase Accounting. This change is significant and one particular aspect of it – the identification and measurement of intangible assets outside of goodwill – seems to be somewhat under-appreciated. Stephen C. Gerard, Managing Director at Standard & Poor's Corporate Value Consulting, says that there is "general conceptual understanding of Statement 141 by corporate management and finance teams. But the real impact will not be felt until the next deal is done." And that deal in FAS 141 parlance will be a "purchase" since "poolings" are no longer recognized. Consistent M&A Accounting The FASB, in issuing Statement No. 141, concluded that "virtually all business combinations are acquisitions and, thus, all business combinations should be accounted for in the same way that other asset acquisitions are accounted for – based on the values exchanged." In defining how business combinations are to be accounted for, FAS 141 supersedes parts of APB Opinion No. 16. That Opinion allowed companies involved in a merger or acquisition to use either pooling-of-interest or purchase accounting. The choice hinged on whether the deal met 12 specified criteria. If so, pooling-of-interest was required. Over time, "pooling" became the accounting method of choice, especially in "mega-deal" transactions. That, in the words of the FASB, resulted in "…similar business combinations being accounted for using different methods that produced dramatically different financial statement results." FAS 141 seeks to level that playing field and improve M&A financial reporting by: Better reflecting the investment made in an acquired entity based on the values exchanged. Improving the comparability of reported financial information on an apples-to-apples basis. Providing more complete financial information about the assets acquired and liabilities assumed in business combinations. Requiring disclosure of information on the business strategy and reasons for the acquisition. When announcing FAS 141, the FASB wrote: "This Statement requires those (intangible assets) be recognized as assets apart from goodwill if they meet one of two criteria – the contractual-legal criterion or the separability criterion." Unchanged by the new rule are the fundamentals of purchase accounting and the purchase price allocation methodology for measuring goodwill: that is, goodwill represents the amount remaining after allocating the purchase price to the fair market values of the acquired assets, including recognized intangibles, and assumed liabilities at the date of the acquisition. "What has changed," says Steve Gerard, "is the rigor companies must apply in determining what assets to break out of goodwill and separately recognize and amortize." Thus, in an unheralded way, FAS 141 introduces a process of identifying and placing value on intangible assets that could prove to be a new experience for many in corporate finance, as well as a costly and time-consuming exercise. Nonetheless, an exercise critical to compliance with the new rule. Continued at  http://www.cfodirect.com/cfopublic.nsf/vContentPrint/CA13B226B214A04085256CB000512D34?OpenDocument     Intangibles:  An Accounting Paradox An Accounting Paradox If you are following the accounting saga following the implosion of Enron and Andersen, I strongly recommend the Summer 2002, Volume 21, Number 2 of the Journal of Accounting and Public Policy --- http://www.elsevier.nl/inca/publications/store/5/0/5/7/2/1/  Enron:  An Accounting Perspective Reforming corporate governance post Enron: Shareholders' Board of Trustees and the auditor 97 -- 103  A.R. Abdel-khalik Enron: what happened and what we can learn from it pp. 105 -- 127  G.J. Benston, A.L. Hartgraves Enron et al.--a comment pp.129 -- 130  J.S. Demski Where have all of Enron's intangibles gone? pp.131 -- 135  Baruch Lev Enron: sad but inevitable pp.137 -- 145  L. Revsine Regulatory competition for low cost-of-capital accounting rules pp.147 -- 149  S. Sunder Regular Paper How are loss contingency accruals affected by alternative reporting criteria and incentives? pp. 151 -- 167  V.B. Hoffman, J.M. Patton Question: Where were Enron's intangible assets?  In particular, what was its main intangible asset that has been overlooked in terms of accounting for intangibles?

The Controversy over Accounting for Securitizations and Loan Guarantees

Accounting for Loan Guarantees

FASB Issues Accounting Guidance to Improve Disclosure Requirements for Guarantees --- http://www.fasb.org/news/nr112502.shtml 

Accounting and Auditing Policy Committee Credit Reform Task Force --- http://www.fasab.gov/aapc/cdreform/98CR01Recpts.pdf 

The new FAS 146 Interpretation 46 deals with loan guarantees of Variable Interest (Special Purpose) Entities --- at: http://www.fasb.org/interp46.pdf.

From The Wall Street Journal Accounting Educators' Review on November 15, 2002

TITLE: H&R Block's Mortgage-Lending Business Could Be Taxing 
REPORTER: Joseph T. Hallinan 
DATE: Nov 12, 2002 
PAGE: C1 
LINK:  http://online.wsj.com/article/0,,SB103706997739674188.djm,00.html 
TOPICS: Accounting, Bad Debts, Cash Flow, Debt, Loan Loss Allowance, Securitization, Valuations

SUMMARY: H&R Block's pretax income from mortgage operations grew by 146% during the fiscal year ending April 30, 2002. However, the accounting treatment for the securitization of these mortgages is being questioned.

QUESTIONS: 
1.) Describe the accounting treatment used by H&R Block for the sale of mortgages. Why is this accounting treatment controversial?

2.) What alternative accounting methods are available to record H&R Block's sale of mortgages? Discuss the advantages and disadvantages of each accounting treatment. Which accounting method is most conservative?

3.) Why do companies, such as H&R Block, sell mortgages? Why does H&R Block retain the risks of non-payment? How could the sale be structured to transfer the risks of non-payment to the purchaser of the mortgages? How would this change the selling price of the mortgages? Support your answer.

4.) How do economic conditions change the expected losses that will result from non-payment? How does the credit worthiness of borrowers change the expected losses that will result from non-payment? Support your answers.

Reviewed By: Judy Beckman, University of Rhode Island 
Reviewed By: Benson Wier, Virginia Commonwealth University 
Reviewed By: Kimberly Dunn, Florida Atlantic University

"H&R Block Faces Issues With Mortgage Business," by Joseph T. Hallinan, The Wall Street Journal,  November 12, 2002, Page C1 ---- http://online.wsj.com/article/0,,SB103706997739674188.djm,00.html

Famous for its tax-preparation service, H&R Block Inc. last year prepared 16.9 million individual income-tax returns, or about 14% of all individual returns filed with the Internal Revenue Service.

But the fastest-growing money maker for the Kansas City, Mo., company these days is its mortgage business, which last year originated nearly $11.5 billion in loans. The business, which caters to poor credit risks, has been growing much faster than its U.S. tax business. In the fiscal year ended April 30, Block's pretax income from mortgage operations grew 146% over the year before. The tax business, while still the largest in the U.S., grew just 23%.

If those rates remain unchanged, the mortgage business will this year for the first time provide most of Block's pretax income. In the most-recent fiscal year, mortgage operations accounted for 47.3% of Block's pretax income.

As Block's mortgage business has soared, so has its stock price, topping $53 a share earlier this year from less than $15 two years ago, though it has dropped in recent months as investors have fretted about the cost of lawsuits in federal court in Chicago and state court in Texas on behalf of tax clients who received refund-anticipation loans. But now, some investors and analysts are raising questions about the foundation beneath Block's mortgage earnings. "The game is up if interest rates rise and shut off the refinancing boom," says Avalon Research Group Inc., of Boca Raton, Fla., which has a "sell" rating on Block's shares.

On Monday, the shares were up $1.53, or 4.8%, to $33.63 in 4 p.m. New York Stock Exchange composite trading -- a partial snapback from a $3.25, or 11%, drop on Friday in reaction to the litigation in Texas over fees H&R Block collected from customers in that state.

The company dismisses concerns about its mortgage results. "We think it's a great time for our business right now," says Robert Dubrish, president and CEO of Block's mortgage unit, Option One Mortgage Corp.

Much of Block's mortgage growth has come because the company uses a fairly common but controversial accounting treatment that allows it to accelerate revenue, and thus income. This treatment, known as gain-on-sale accounting, has come back to haunt other lenders, including Conseco Inc. and AmeriCredit Corp. At Block, gains from sales of mortgage loans accounted for 62% of revenue at the mortgage unit last year.

In essence, under gain-on-sale accounting, lenders post upfront the estimated profit from a securitization transaction, which is the sale to investors of a pool of loans. Specifically, the company selling the loans records profit for the excess of the sales price and the present value of the estimated interest income that is expected to be received on the loans above the amounts funded on the loans and the present value of the interest agreed to be paid to the buyers of the loan-backed securities.

But if the expected income stream is cut short -- say, because more borrowers refinance their loans than expected when the profit was calculated -- the company essentially has to reverse some of the gain, taking a charge.

That is what happened at Conseco. The Carmel, Ind., mobile-home lender was forced to take a $350 million charge in 1998 after many of its loans were paid off early. It stopped using gain-on-sale accounting the following year, saying that the "clear preference" of investors was traditional loan accounting. AmeriCredit in Fort Worth, Texas, which lends money to car buyers with poor credit histories, abandoned the practice in September in the midst of a meltdown of its stock price.

But Block says it faces nowhere near the downside faced by AmeriCredit and Conseco, which it says had different business models. Big Block holders seem to agree. "Block doesn't have anywhere near the scale of exposure [to gain on sale] that the other companies had," says Henry Berghoef, co-manager of the Oakmark Select mutual fund, which owns 7.7 million, or about 4.3%, of Block's shares.

Another potential problem for Block is the way it treats what is left after it sells its loans. The bits and pieces that it keeps are known as residual interests. Block securitizes most of these residual interests, allowing it to accelerate a significant portion of the cash flow it expects to receive rather than taking it over the life of the underlying loans. The fair value of these interests is calculated by Block considering a number of factors, such as expected losses on its loans. If Block guesses wrong, it could be forced to take a charge down the road.

Block says its assumptions underlying the valuation of these interests are appropriately conservative. It estimates lifetime losses on its loan pools at roughly 5%, which it says is one percentage point higher than the 4% turned in by its worst-performing pool of loans. (Comparable industry figures aren't available.) So Block says the odds of a write-up are much greater than those of a write-down and would, in a worst-case scenario that it terms "remote," probably not exceed $500 million. Block's net income for the fiscal year ended April 30 was $434.4 million, or $2.31 a share, on revenue of $3.32 billion.

Block spokeswoman Linda McDougall says gain-on-sale provides an "insignificant" part of the company's revenue. She notes that Option One, Block's mortgage unit, recently increased the value of its residual interest by $57 million. She also says that the company's underwriting standards are typical of lenders who deal with borrowers lacking pristine credit histories.

Bears contend that Block has limited experience in the mortgage business. It bought Option One in 1997, and Option One in Irvine, Calif., has itself been in business only since 1993. So its track record doesn't extend to the last recession of 1990 to 1991.

On top of that, Block lends to some of the least creditworthy people, known in the trade as "subprime" borrowers. There is no commonly accepted definition of what constitutes a subprime borrower. One shorthand measure is available from credit-reports firm Fair, Isaac & Co. It produces so-called FICO scores that range from 300 to 850, with 850 being perfect. Anything less than 660 is usually considered subprime. Securities and Exchange Commission documents filed by Block's mortgage unit show its borrowers typically score around 600. Moreover, according to the filings, hundreds of recent Block customers, representing about 4% of borrowers, have FICO scores of 500 or less, or no score at all. A score below 500 would place an applicant among the bottom 5% of all U.S. consumers scored by Fair Isaac.

Mr. Dubrish says Block stopped lending to people with FICO scores below 500 some two years ago and says he is puzzled as to why those with scores below 500 still appear in the company's loan pools.

Block says its loans typically don't meet the credit standards set by Fannie Mae or Freddie Mac, which are the lending industry's norms. Block's customers may qualify for loans even if they have experienced a bankruptcy in the previous 12 months, according to underwriting guidelines it lists in the SEC documents.

In many cases, according to Block's SEC filings, an applicant's income isn't verified but is instead taken as stated on the loan application. In other cases, an applicant with a poor credit rating may receive an upgraded rating, depending on factors including "pride of ownership." Most Block mortgages are for single-family detached homes, but Block also makes mobile-home loans, according to the filings.

"We are doing a lot to help people own houses who wouldn't have the chance to do it otherwise," Mr. Dubrish says. "We think we're doing something that's good for the economy and good for our borrowers."

A key figure in the mortgage business is the ratio of loan size to value of the property being mortgaged. Loans with LTV rates above 80% are thought to present a greater risk of loss. The LTV on many of Block's mortgages is just under 80%, according to the SEC filings. The value of these properties can be important if Block is forced to foreclose on the loans and resell the properties. Nationwide, roughly 4.17% of subprime mortgage loans are in foreclosure, according to LoanPerformance, a research firm in San Francisco. As of June 30, only 3.52% of Block's loans, on a dollar basis, were in foreclosure, even though its foreclosure ratio more than tripled between Dec. 31, 1999, and June 30.

The Controversy Over Pro Forma Reporting and HFV

Up Up and Away in My Beautiful Pro Forma

"Little Bitty Cisco," by Jesse Eisinger, The Wall Street Journal, November 6, 2003 --- http://online.wsj.com/article/0,,SB106806983279057200,00.html?mod=technology%255Ffeatured%255Fstories%255Fhs 

The way Wall Street eyes these things, including the liberal use of the words "pro forma," Cisco had an impressive fiscal first quarter.

Revenue came in better than expected and grew 5.3% compared with a year ago, topping expectations of a flat top-line thanks in part to spending from the federal government (see article). How impressive is this? Well, the country's economy grew at 7.2%, and business spending on equipment and software rose 15%. Microsoft had revenue growth of 6%, IBM 8.6%, and Dell is estimated to come in at 15% growth. So Cisco Systems, one of the big tech dogs, looks like the runt of that particular litter. Is networking a growth industry anymore, or is it doomed to be troubled by overcapacity and a lack of business demand? The next few quarters are crucial.

Earnings per share -- that is, pro forma earnings per share -- easily surpassed estimates, logging in at 17 cents a share, compared with the expectation of 15 cents a share and last year's 14 cents.

The company's shareholder equity fell in the quarter to $27.4 billion from $28 billion a year ago. Cash flow from operations fell to $973 million from $1.1 billion a year earlier. Cash on hand and investments fell from $20.7 billion to $19.7 billion, which is still mountainous but lower year-over-year, nevertheless.

Then there is the gross-margin story. Cisco has had Himalayan gross margins throughout the slowdown, because it was able to squeeze suppliers and find efficiencies. But now that revenue is finally increasing, gross margins fell. Product gross margins came in at 69%, down from 71% in the fourth quarter. Cisco is selling less profitable products, including some from its recent acquisition of Linksys. It also has outsourced much of its production. How much operating leverage does Cisco now have? That is the reason it sports its high valuation, after all.

Then there is the outlook. Deferred revenue and backlog were down. Cisco's book-to-bill ratio, a measure that reflects order momentum, was below one. When book-to-bill is below one, orders are lower than billings, suggesting a slowdown, not acceleration. True, Cisco put out a forecast for modestly higher revenue for the second quarter compared with the first. But some questions should linger.

Question:  How does former Enron CEO Jeff Skilling define HFV?
Home Video Uncovered by the Houston Chronicle, December 19, 2002
Skits for Enron ex-executive funny then, but full of irony now --- http://www.chron.com/cs/CDA/story.hts/metropolitan/1703624 
(The above link includes a "See it Now" link to download the video itself which played well for me.)

The tape, made for the January 1997 going-away party for former Enron President Rich Kinder, features nearly 30 minutes of absurd skits, songs and testimonials by company executives and prominent Houstonians. The collection is all meant in good fun, but some of the comments are ironic in the current climate of corporate scandal.

In one skit, former administrative executive Peggy Menchaca plays the part of Kinder as he receives a budget report from then-President Jeff Skilling, who plays himself, and financial planning executive Tod Lindholm. When the pretend Kinder expresses doubt that Skilling can pull off 600 percent revenue growth for the coming year, Skilling reveals how it will be done.

"We're going to move from mark-to-market accounting to something I call HFV, or hypothetical future value accounting," Skilling jokes as he reads from a script. "If we do that, we can add a kazillion dollars to the bottom line."

Richard Causey, the former chief accounting officer who was embroiled in many of the business deals named in the indictments of other Enron executives, makes an unfortunate joke later on the tape.

"I've been on the job for a week managing earnings, and it's easier than I thought it would be," Causey says, referring to a practice that is frowned upon by securities regulators. "I can't even count fast enough with the earnings rolling in."

Texas' political elite also take part in the tribute, with then-Gov. George W. Bush pleading with Kinder: "Don't leave Texas. You're too good a man."

Former President George Bush also offers a send-off to Kinder, thanking him for helping his son reach the Governor's Mansion.

"You have been fantastic to the Bush family," he says. "I don't think anybody did more than you did to support George."

"Bubble Redux," by Andrew Bary, Barron's, April 14, 2003, Page 17.

Amazon's valuation is the most egregious of the 'Net trio.  It trades for 80 times projected "pro forma" 2003 profit of 32 cents a share.  Amazon's pro forma definition of profit, moreover, is dubious because it excludes re-structuring charges and, more important, the restricted stock that Amazon now is issuing to employees in lieu of stock options.  Amazon's reported profit this year under generally accepted accounting principles (which include restricted-stock costs) could be just 10 cents to 15 cents a share, meaning that Amazon's true P/E arguably is closer to 200.

Yahoo, meanwhile, now commands 70 times estimated 2003 net of 35 cents a share, and eBay fetches 65 times projected 2003 net of $1.35 a share.

What's fair value?  By our calculations, Amazon is worth, at best, roughly 90% of its projected 2003 revenue of $4.6 billion. That translates into $10 a share, or $4.1 billion.  This estimate is charitable because the country's two most successful brick-and-mortar retailers, Wal-Mart Stores and Home Depot, also trade for about 90% of 2003 sales.

Yahoo ought to trade closer to 15.  That's a stiff 43 times projected 2003 earnings and gives the company credit for its strong balance sheet, featuring over $2 a share in cash and another $3 a share for its stake in Yahoo Japan, which has become that country's eBay.

Sure, eBay undoubtedly is the most successful Internet company and the only one that has lived up to the growth projections made during the Bubble.  As the dominant online marketplace in the U.S. and Europe, eBay saw its earnings surge to 87 cents a share last year from three cents in 1998, when it went public at a split-adjusted $3.00 a share.

Why would eBay be more fairly valued around 60, its price just several months ago?  At 60, eBay would trade at 44 times projected 2003 profit of $1.35 a share and 22 times an optimistic 2005 estimate of $2.75.  So confident are analysts about eBay's outlook that they're comfortable valuing the stock on a 2005 earnings estimate.

Fans of eBay believe its profit can rise at a 35% annual clip in the next five years, a difficult rate for any company to maintain, even one, such as eBay, with a "scalable" business model that allows it to easily accommodate more transactions while maintaining its enviable gross margins of 80%.  If the company earns $5 a share in 2007--nearly six times last year's profit--it would still trade at 18 times that very optimistic profit level.

Continued in the article.

The New York Yankees today released their 4th Quarter 2001 pro forma results. Although generally accepted scorekeeping principles (GASP) indicate that the Yankees lost Games 1 and 2 of the 2001 World Series, their pro forma figures show that these reported losses were the result of nonrecurring items, specifically extraordinary pitching performances by Arizona Diamondbacks personnel Kurt Schilling and Randy Johnson. Games 3 and 4 results, already indicating Yankee wins, were not restated on a pro forma basis.
Ed Scribner, New Mexico State

Until recently, pro forma reporting was seen as a useful tool that could help companies show performance when unusual circumstances might cloud the picture. Today it finds itself in bad odour. 
"Pro forma lingo Does the use of controversial non-GAAP reporting by some companies confuse or enlighten?," by Michael Lewis, CA Magazine, March 2002 --- http://www.cica.ca/cica/camagazine.nsf/e2002-mar/Features 

For fans of JDS Uniphase Corp., the fibre-optics manufacturer with headquarters in Ottawa and San Jose, Calif., the report for fiscal 2001 provided the icing on a very delicious cake: following an uninterrupted series of positive quarterly earnings results, the corporate giant announced it was set to deliver US$67 million in pro forma profit.

There was only one fly in the ointment. Like all such calculations, JDS's pro forma numbers were not prepared in accordance with generally accepted accounting principles (GAAP), and as such they excluded goodwill, merger-related and stock-option charges, and losses on investments. Once those items were added back into the accounting mix, JDS suddenly showed a staggering US$50.6 billion in red ink - a US corporate record. Even so, many investors remained loyal, placing their trust in the boom-market philosophy that views onetime charges as largely irrelevant. The mantra was simple - operating results rule.

"That was the view at the time," says Jim Hall, a Calgary portfolio manager with Mawer Canadian Equity Fund. "It just goes to show how wrong people can be."

Since then, of course, the spectacular flameout of Houston's Enron Corp. has done much to change that point of view (though it's not a pro forma issue). Once the world's largest energy trader, the company now holds the title for the largest bankruptcy case in US history. The Chapter 11 filing in December came after Enron had to restate US$586 million in earnings because of apparent accounting irregularities. In its submission, the company admitted it had hidden assets and related debt charges since 1997 in order to inflate consolidated earnings. Enron's auditor, accounting firm Arthur Andersen LLP, later acknowledged that it had made "an [honest] error in judgement" regarding Enron's financial statements.

While the Enron saga will continue in various courtrooms for many months to come, regulators on either side of the border have responded to the collapse with uncharacteristic swiftness. Both the Securities and Exchange Commission (SEC) in the United States and the Canadian Securities Administrators (CSA) issued new guidelines on financial reporting just a few weeks after the Enron bust. In each instance, investors were reminded to redirect their focus to financial statements prepared in accordance with GAAP, paying special attention to cash flow, liquidity and the intrinsic value of acquisitions. At the same time, issuers were warned to reduce their reliance on pro forma results and to explain to investors why they were not using GAAP in their reporting.

SEC chairman Harvey Pitt moved furthest and fastest. In mid-January he announced plans to establish a private watchdog to discipline accountants and review company audits. Working with the largest accounting firms and professional organizations such as the American Institute of Certified Public Accountants (AICPA), the SEC wants the new body to be able to punish accountants for incompetence and ethics violations. As Pitt emphasized, "The commission cannot, and in any event will not, tolerate this pattern of growing re-statements, audit failures, corporate failures and investor losses."

The sheer scale of the Enron debacle has brought pro forma accounting under public scrutiny as never before, and, observers say, will provide a powerful impetus for financial reporting reform. "This will send a message to companies and accountants to cut back on some of the games they've been playing," says former SEC general counsel Harvey Goldschmid.

Meanwhile, the CSA (the forum for the 13 securities regulators of Canada's provinces and territories) expressed its concern over the proliferation of non-standard measures, warning that they improve the appearance of a company's financial health, gloss over risks and make it exceedingly difficult for investors to compare issuers.

"Investors should be cautious when looking at non-GAAP measures," says John Carchrae, chair of the CSA Chief Accountants Committee, when the guidelines were released in January. "These measures present only part of the picture and may selectively omit certain expenses, resulting in a more positive portrayal of a company's performance."

As a result, Canadian issuers will now be expected to provide GAAP figures alongside non-standard earnings measures, explain how pro forma numbers are calculated, and detail why they exclude certain items required by GAAP. So far, the CSA has provided guidance rather than rules, but the committee cautions it could take regulatory action if issuers publish earnings reports deemed to be misleading to investors.

Carchrae, who is also chief accountant of the Ontario Securities Commission (OSC), believes "moral suasion" is a good place to start. Nonetheless, he adds, the OSC intends to track press releases, cross-reference them to statutory earnings filings and supplemental information on websites, and monitor continuous disclosure to ensure a company meets its requirements under the securities act.

Although pro forma reporting finds itself in bad odour, until recently it was regarded as a useful tool that could help companies show performance when unusual circumstances might cloud the picture. In cases involving a merger or acquisition, for example, where a company has made enormous expenditures that generate significant non-cash expenses on the income statement, pro forma can be used as a clarifying document, enabling investors to view economic performance outside of such onetime events. Over the years, however, the pro forma route has increasingly involved the selective use of press releases, websites, and other reports to put a favourable spin on earnings, often leading to a spike in the value of a firm's stock. Like management discussion and analysis, such communications are not within the ambit of GAAP, falling somewhere between the cracks of current accounting standards.

"Obviously, this issue is of concern to everyone who uses financial statements," says Paul Cherry, chairman of the Canadian Institute of Chartered Accountants' Accounting Standards Board. "Our worry as standard-setters is whether these non-GAAP, pro forma items confuse or enlighten."

Regulators and standard-setters have agonized over this issue ever since the reporting lexicon began to expand with the rise of the dot-com sector in the late 1990s, a sector with little in the way of earnings that concentrated on revenue growth as a more meaningful performance indicator. New measures, such as "run-through rates" or "burn rates," were deemed welcome additions to traditional methodology because they helped determine how much financing a technology company might require during its risky startup phase.

Critics, however, argued such terms were usurping easily understood language as part of a corporate scheme to hoodwink unwary investors. Important numbers were hidden or left out under a deluge of new and ever-more complex terminology. The new measurements, they warned, fell short of adequate financial disclosure.

An OSC report published in February 2001 appears to support these claims. According to the report, Canadian technology companies have not provided investors with adequate information about how they disclose revenue, a shortcoming that may require some of them to restate their financial results.

"Initial results of the review suggest a need for significant improvement in the nature and extent of disclosure," the report states, adding that the OSC wants more specific notes on accounting policy attached to financial statements. The report also observes that revenue is often recognized when goods are shipped, not when they are sold, despite the fact that the company may be exposed to returns.

David Wright, a software analyst at BMO Nesbitt Burns in Toronto, says dealing with how technology companies record revenue is a perennial issue. The issue has gained greater prominence with the rise of vendor financing, a practice whereby companies act as a bank to buyers, lending customers the cash to complete purchase orders. If the customer is unable to pay for the goods or services subsequent to signing the sales agreement, the seller's revenue can be drastically overstated.

But pro forma still has plenty of advocates - particularly when it comes to earnings before interest, taxes, depreciation and amortization (EBITDA). Such a measure, it is often argued, can provide a pure, meaningful and reliable diagnostic tool, albeit one that should be considered along with figures that accommodate charges to a balance sheet.

Ron Blunn, head of investor relations firm Blunn & Co. Inc. in Toronto and chairperson of the issues committee of the Canadian Investor Relations Institute, says adjusted earnings can serve a legitimate purpose and are particularly helpful to analysts and money managers who must gauge the financial well-being of technology startups.

The debate shows no signs of burning out anytime soon. On the one hand, the philosophy among Canadian and US standard-setters in recent years has appeared to favour removing constraints, rather than imposing them. New rules to apply to Canadian banks this year, for example, will no longer require the amortization of goodwill in earnings figures. On the other hand, it has become abundantly clear that companies will emphasize the reporting method that puts the best gloss on their operations. And while the use of pro forma accounting has remained most prevalent among technology companies, the movement to embrace more and varied language has spread to "old economy" companies such as Enron, gaining steam as the economy stumbled. Blunn theorizes the proliferation of nontraditional reporting and the increasing reliance on supplemental filings simply reflect the state of the North American economy.

Carchrae has a slightly different diagnosis. When asked why pro forma reporting has mushroomed in recent years, he points to investors' slavish devotion to business box scores - that is, a company's ability to meet sales and earnings expectations as set out by equity analysts. Since companies can be severely punished for falling short of the Street's consensus forecast, there is intense pressure, especially in a bear market, to conjure up earnings that appear to satisfy forecasts.

As a result, pro forma terminology has blossomed over the Canadian corporate landscape. Montreal-based telephone utility BCE Inc., for example, coined the term "cash baseline earnings" to describe its operating performance. Not to be outdone, Robert McFarlane, chief financial officer of Telus Corp., Canada's second-largest telecommunications company, cited a "revenue revision" and "EBITDA deficiency" to explain the drop in the Burnaby, BC-based phone service firm's "core baseline earnings" for its third quarter ended September 30, 2001. (According to company literature, core baseline earnings refers to common share income before discontinued operations, amortization of acquired intangible assets net of tax, restructuring and nonrecurring refinancing costs net of tax, revaluation of future tax assets and liabilities and goodwill amortization.)

Meanwhile, IBM Corp. spinoff Celestica Inc. of Toronto neglected to mention the elimination of more than 8,700 jobs from a global workforce of 30,000, alluding to the cuts in its fiscal 2001 third-quarter report through references to "realignment" charges during the period.

Many statements no longer use the term "profit" at all. And while statutory filings must present at least one version of earnings that conforms to GAAP, few rules have been set down by US or Canadian regulators to govern non-GAAP declarations. Accounting bodies in Canada and around the world are charged with policing their members and assuring statutory filings include income and revenue according to GAAP, using supportable interpretations. But pro forma numbers are typically distributed before a company's statutory filing is made.

"Not to pass the buck," says Cherry, "but how can we set standards for something that's not part of GAAP?" Still, Cherry admits the use of non-GAAP terminology has become so widespread that accounting authorities are being forced to take notice. "The matter is gaining some prominence," he says, "because some of the numbers are just so different."

Despite his reservations, Cherry acknowledges "the critical point is when information is released to the marketplace," which nowadays is almost always done via a press release. The duty to regulate such releases, he says, must rest with securities bodies - an opinion shared by Edmund Jenkins, chair of the Financial Accounting Standards Board (FASB) in the United States.

Many authorities view the issue as a matter of education, believing that a high degree of sophistication must now be expected from the retail investing community. Others say the spread of non-GAAP reporting methodology, left unchecked, could distort markets, undermine investor confidence in regulatory regimes and ultimately impede the flow of investment capital. But pro forma devotees insist that introducing tough new measures to govern reporting would do little to protect consumers and encourage retail investment. Instead, new regulations might work to impede growth and limit available, useful financial information.

Continued at http://www.cica.ca/cica/camagazine.nsf/e2002-mar/Features 

From The Wall Street Journal Accounting Educators's Review on October 18, 2002

TITLE: Motorola's Profit: 'Special' Again? 
REPORTER: Jesse Drucker 
DATE: Oct 15, 2002 
PAGE: C1 
LINK: http://online.wsj.com/article/0,,SB1034631975931460836.djm,00.html  
TOPICS: Special Items, Pro Forma Earnings, Accounting, Earning Announcements, Earnings Forecasts, Financial Analysis, Financial Statement Analysis, Net Income

SUMMARY: Motorola has announced both pro forma earnings and net income as determined by generally accepted accounting principles for 14 consecutive quarters. Ironically, pro forma earnings are always greater than net income calculated using generally accepted accounting principles

QUESTIONS: 
1.) Distinguish between a special item and an extraordinary item. How are each reported on the income statement?

2.) Distinguish between pro forma earnings and GAAP based earnings. What are the advantages and disadvantages of allowing companies to report multiple earnings numbers? What are the advantages and disadvantages of not allowing companies to report multiple earnings numbers?

3.) What items were reported as special by Motorola? Are these items special? Support your answer.

4.) Are you surprised that all the special items reduced earnings? What is the likelihood that there were positive nonrecurring items at Motorola? How are positive nonrecurring items reported?

Reviewed By: Judy Beckman, University of Rhode Island 
Reviewed By: Benson Wier, Virginia Commonwealth University 
Reviewed By: Kimberly Dunn, Florida Atlantic University

"Pro-Forma Earnings Reporting Persists," by Shaheen Pasha, Washington Post, August 16, 2002 --- http://www.washingtonpost.com/wp-dyn/articles/A25384-2002Aug16.html 

While many on Wall Street are calling for an end to pro forma financial reporting given widespread jitters over corporate clarity, it's clear from second-quarter reports that the accounting practice is a hard habit to break.

Publicly traded companies are required to report their results according to generally accepted accounting principles, or GAAP, under which all types of business expenses are deducted to arrive at the bottom line of a company's earnings report.

But an ever-increasing number of companies in recent years has taken to also reporting earnings on a pro forma – or "as if" – basis under which they exclude various costs. Companies defend the practice, saying the inclusion of one-time events don't accurately reflect true performance.

There is no universal agreement on which expenses should be omitted from pro forma results, but pro forma figures typically boost results.

Indeed, as the second-quarter reporting season dwindles down with more than 90 percent of the Standard & Poor's 500 companies having reported, only Yahoo Inc., Compuware Corp. and Xilinx Inc. made the switch to reporting earnings under GAAP, according to Thomson First Call.

While a number of S&P 500 companies, including Computer Associates International Inc. and Corning Inc., made the switch to GAAP in the first quarter, that still brings the number to 11 companies in total that have given up on pro forma over the last two quarters.

"It's disappointing that at this stage we haven't seen more companies make the switch to GAAP earnings from pro forma," said Chuck Hill, director of research at Thomson First Call.

Continued at http://www.washingtonpost.com/wp-dyn/articles/A25384-2002Aug16.html  

A new research report from Bear Stearns identifies the best earnings benchmarks by industry. GAAP earnings are cited as the best benchmarks for a few industries, but not many. The preferred benchmarks are generally pro forma earnings or pro forma earnings per share. http://www.accountingweb.com/item/91934 

AccountingWEB US - Oct-1-2002 -  A new research report from Bear Stearns identifies the best earnings benchmarks by industry. GAAP earnings (earnings prepared according to generally accepted accounting principles) are cited as the best benchmarks for a few industries, but not many. Most use pro forma earnings or pro forma earnings per share (EPS).

Examples of the most useful earnings benchmarks for just a few of the 50+ industries included in the report:

• Autos: Pro forma EPS
  
• Industrial manufacturing: Pro forma EPS shifting to GAAP EPS
  
• Trucking: Continuing EPS
  
• Lodging: Pro forma EPS, EBITDA and FFO
  
• Small & mid-cap biotechnology: Product-related events, Cash on hand, Cash burn rate
  
• Advertising & marketing services: Pro forma EPS, EBITDA, Free cash flow
  
• Business/professional services: Pro forma EPS, Cash EPS, EBITDA, Discounted free cash flow
  
• Wireless services: GAAP EPS, EBITDA

EBITDA=Earnings before interest, taxes, depreciation and amortization.
FFO=funds from operations.

The report also lists the most common adjustments made to arrive at pro forma earnings and tells whether securities analysts consider the adjustments valid. Patricia McConnell, senior managing director at Bear Stearns, explains, "Analysts rarely accept managements' suggested 'pro forma' adjustments without due consideration, and sometimes we reject them... We would not recommend using management's version of pro forma earnings without analysis and adjustment, but neither would we blindly advise using GAAP earnings without analysis and adjustment."

From The Wall Street Journal Accounting Educators' Review on July 27, 2002

TITLE: Merrill Changes Methods Analysts Use for Estimates 
REPORTER: Karen Talley DATE: Jul 24, 2002 
PAGE: C5 
LINK: http://online.wsj.com/article/0,,BT_CO_20020724_009399.djm,00.html  
TOPICS: Accounting, Earnings Forecasts, Financial Accounting, Financial Analysis, Financial Statement Analysis

SUMMARY: Merrill Lynch & Co. has reported that it will begin forecasting both GAAP based earnings estimates in addition to pro forma earnings measures. To accommodate Merrill Lynch & Co., Thomson First Call will collect and report GAAP estimates from other analysts.

QUESTIONS: 
1.) Compare and contrast GAAP earnings and pro forma earnings?

2.) Why do analyst forecast pro forma earnings? Will GAAP earnings forecasts provide more useful information than pro forma earnings forecasts? Support your answer.

3.) Discuss the advantages and disadvantages of analysts forecasting both pro forma and GAAP earnings. Should analysts continue to provide pro forma earnings forecasts? Should analysts also provide GAAP earnings forecasts? Support your answers.

Reviewed By: Judy Beckman, University of Rhode Island 
Reviewed By: Benson Wier, Virginia Commonwealth University 
Reviewed By: Kimberly Dunn, Florida Atlantic University

Readers might also want to go to http://www.npr.org/news/specials/enron/ 
(Includes an interview with Lynn Turner talking about pro forma reporting.)

Deferred Taxes Related to FAS123 Expense – Accounting and Administrative Issues on New Trends in Stock Compensation Accounting
PWC Insight on FAS 123  --- http://www.fei.org/download/HRInsight02_21.pdf 
A recent PWC HR Insight discusses the applicable rules and answers questions raised on accounting for income taxes related to FAS 123 expense (for both the pro forma disclosure and the recognized FAS 123 expense). Per PWC, the rules are complex and require that the tax benefits arising from stock options and other types of stock-based compensation be tracked on a grant-by-grant and country-by-country basis

Corporate America's New Math:  Investors Now Face Two Sets of Numbers In Figuring a Company's Bottom Line
By Justin Gillis
The Washington Post
Sunday, July 22, 2001; Page H01 
http://www.washingtonpost.com/wp-adv/archives/front.htm   

Cisco Systems Inc., a bellwether of the "new economy," prepared its books for the first three months of this year by slicing and dicing its financial results in the old ways mandated by the rules of Washington regulators and the accounting profession.

Result: a quarterly loss of $2.7 billion.

Cisco did more, though. It sliced and diced the same underlying numbers in ways preferred by Cisco, offering an alternative interpretation of its results to the investing public.

Result: a quarterly profit of $230 million.

That's an unusually large swing in a company's bottom line, but there's nothing unusual these days about the strategy Cisco employed. Across corporate America, companies are emphasizing something called "pro forma" earnings statements. Because there are no rules for how to prepare such statements, businesses have wide latitude to ignore various expenses in their pro forma results that have to be included under traditional accounting rules.

Most of the time, the new numbers make companies look better than they would under standard accounting, and some evidence suggests investors are using the massaged numbers more and more to decide what value to attach to stocks. The pro forma results are often strongly emphasized in news releases announcing a corporation's earnings; sometimes the results computed under traditional accounting techniques are not disclosed until weeks later, when the companies file the official results with the Securities and Exchange Commission, as required by law.

Cisco includes its results under both the pro forma and the traditional accounting methods in its news releases. People skeptical of the practice of using pro forma results worry that investors are being deceived. Karen Nelson, assistant professor of accounting at Stanford University, said some companies were "verging on fraudulent behavior" in their presentation of financial results.

Companies that use these techniques say they are trying to help investors by giving them numbers that more accurately reflect the core operations of their businesses, in part because they exclude unusual expenses. Cisco's technique "gives readers of financial statements a clearer picture of the results of Cisco's normal business activities," the company said in a statement issued in response to questions about its accounting.

Until recently, pro forma results had a well-understood and limited use. Most companies used pro forma accounting only to adjust previously reported financial statements so they could be directly compared with current results. This most frequently happened after a merger, when a company would adjust past results to reflect what they would have been had the merger been in effect earlier. Pro forma, Latin for "matter of form," refers to statements "where certain amounts are hypothetical," according to Barron's Dictionary of Finance and Investment Terms.

What's changed in recent years is that many companies now using the technique also apply it to the current quarter. They include some of the leading names of the Internet age, including Amazon.com Inc., Yahoo Inc. and JDS Uniphase Corp. These companies have received enthusiastic support from many Wall Street analysts for their use of pro forma results. The companies' arguments have also been bolstered by a broader attack on standard accounting launched by some academic researchers and accountants. They believe the nation's financial reporting system, rooted in the securities law reforms of the New Deal, is inadequate to modern needs. In testimony before Congress last year, Michael R. Young, a securities lawyer, called it a "creaky, sputtering, 1930s-vintage financial reporting system."

The dispute over earnings statements has grown in intensity during the recent economic slide. To skeptics, more and more companies appear to be coping with bad news on their financial statements by redefining the concept of earnings. SEC staffers are worried about the trend and are weighing a crackdown.

"People are using the pro forma earnings to present a tilted, biased picture to investors that I don't believe necessarily reflects the reality of what's going on with the business," said Lynn Turner, the SEC's chief accountant.

For the rest of the article (and it is a long article), go to 
http://www.washingtonpost.com/wp-adv/archives/front.htm 
The full article is salted with quotes from accounting professors and Bob Elliott (KMPG and Chairman of the AICPA)

The Future of Amazon.com:  Unlike Enron, Amazon.com seems to thrive without profits.  How long can it last?

"Economy, the Web and E-Commerce: Amazon.com." An Interview With Jeff Bezos CEO, Amazon.com, The Washington Post,  December 6, 2001 --- http://discuss.washingtonpost.com/zforum/01/washtech_bezos120601.htm 

Amazon.com is pinning its hopes on pro forma reporting to report the company's first profit in history.  But wait! Plans by U.S. regulators to crack down on "pro forma" abuses in accounting may take a toll on Internet firms, which like the financial reporting technique because it can make losses seem smaller than they really are.  

"When Pro Forma Is Bad Form," by Joanna Glasner, Wired News, December 6, 2001 --- http://www.wired.com/news/business/0,1367,48877,00.html 

As part of efforts to improve the clarity of information given to investors, the Securities and Exchange Commission warned this week that it will crack down on companies that use creative accounting methods to pump up poor earnings results.

In particular, the commission said it will focus on abuse of a popular form of financial reporting known as "pro forma" accounting, which allows companies to exclude certain expenses and gains from their earnings results. The SEC said the method "may not convey a true and accurate picture of a company's financial well-being."

Experts say the practice is especially common among Internet firms, which began issuing earnings press releases with pro forma numbers en masse during the stock market boom of the late 1990s. The list of new-economy companies using pro forma figures includes such prominent firms as Yahoo (YHOO), AOL Time Warner (AOL), CNET (CNET) and JDS Uniphase (JDSU).

Unprofitable firms are particularly avid users of pro forma numbers, said Brett Trueman, professor of accounting at the University of California at Berkeley's Haas School of Business.

"I can't say for sure why, but I can take a guess: They're losing big time, and they want to give investors the impression that the losses are not as great as they appear," he said.

Trueman said savvy investors tend to know that companies may have self-serving interests in mind when they release pro forma numbers. Experienced traders often put greater credence in numbers compiled according to generally accepted accounting principles (GAAP), which firms are required to release alongside any pro forma numbers.

A mounting concern, however, is the fact that many companies rely almost solely on pro forma numbers in projections for future performance.

Perhaps the best-known proponent of pro forma is the perennially unprofitable Amazon.com, which has a history of guiding investor expectations using an accounting system that excludes charges for stock compensation, restructuring or the declining value of past acquisitions.

Invariably, the pro forma numbers are better than the GAAP ones. In its most recent quarter, for example, Amazon (AMZN) reported a pro forma loss of $58 million. When measured according to GAAP, Amazon's net loss nearly tripled to $170 million.

Things are apt to get even stranger in the last quarter of the year, when Amazon said it plans to deliver its first-ever pro forma operating profit. By regular accounting standards, the company will still be losing money.

Those results might not sit too well with the folks at the SEC, however.

In its statements this week, the SEC noted that although there's nothing inherently illegal about providing pro forma numbers, figures should not be presented in a deliberately misleading manner. Regulators may have been talking directly to Amazon in one paragraph of their warning, which said:

"Investors are likely to be deceived if a company uses a pro forma presentation to recast a loss as if it were a profit."

Neither Amazon nor AOL Time Warner returned phone calls inquiring if they planned to make changes to their pro forma accounting methods in light of the SEC's recent statements.

According to Trueman, few members of the financial community would advocate getting rid of pro forma numbers altogether.

Even the SEC said that pro forma numbers, when used appropriately, can provide investors with a great deal of useful information that might not be included with GAAP results. When presented correctly, pro forma numbers can offer insights into the performance of the core business, by excluding one-time events that can skew quarterly results.

Rather than ditching pro forma, industry groups like Financial Executives International and the National Investor Relations Institute say a better plan is to set uniform guidelines for how to present the numbers. They have issued a set of recommendations, such as making sure companies don't arbitrarily change what's included in pro forma results from quarter to quarter.

Certainly some consistency would make it easier for folks who try to track this stuff, said Joe Cooper, research analyst at First Call, which compiles analyst projections of earnings.

The boom in pro forma reporting has created quite a bit of extra work for First Call, Cooper said, because it has to figure out which companies and analysts are using pro forma numbers and how they're using them.

But the extra work of compiling pro forma numbers doesn't necessarily result in greater financial transparency for investors, Cooper said.

"In days past, before it was abused, it was a way to give an honest apples-to-apples comparison," he said. "Now, it is being used as a way to continually put their company in a good light."

See also:
SEC Fires Warning Shot Over Tech Statements
Earnings Downplay Stock Losses
Change at the Top for AOL
Where's the Money?, Huh?
There's no biz like E-Biz

The bellwether Internet firm says it will stop reporting earnings in pro forma, a controversial accounting method popular in the technology sector --- http://www.wired.com/news/business/0,1367,51721,00.html 

"Yahoo Gives Pro Forma the Boot." By Joanna Glasner, Wired News, April 11, 2002 --- 

Following the release of its first-quarter results on Wednesday, Yahoo (YHOO) said it will stop reporting earnings using pro forma, a controversial accounting method popular among Internet and technology firms.

Instead, the company said it plans to release all results according to generally accepted accounting principles, or GAAP. Executives said the shift would provide a clearer picture of the Yahoo's financial performance.

"We do not believe the pro forma presentation continues to provide a useful purpose," said Sue Decker, Yahoo's chief financial officer. In the past, the company has used pro forma accounting as a way to separate one-time expenses -- such as the costs of closing a unit or acquiring another firm -- from costs stemming from its core business.

Decker attributed the decision in part to new rules adopted by the U.S. Financial Accounting Standards Board that take effect this year. The new rules require companies to report the amount they overpaid for acquisitions as an upfront charge.

Accounting experts, however, said the rule change was probably not the only reason for Yahoo to drop pro forma. The accounting practice, popularized by technology firms in the late 1990s, has come under fire from regulators in recent months who say some firms have used nonstandard metrics to mask poor financial performance.

The U.S. Securities and Exchange Commission warned in December that it will crack down on companies that use creative accounting methods to pump up poor earnings results.

In particular, the commission said it will focus on abuses of pro forma accounting, which allows companies to exclude certain expenses and gains from their earnings results. The SEC said the method "may not convey a true and accurate picture of a company's financial well-being."

Experts say use of pro forma is especially common among Internet firms. In addition to Yahoo, the list of prominent Internet and technology firms employing pro forma includes AOL Time Warner (AOL), Cnet (CNET) and JDS Uniphase (JDSU).

Although pro forma accounting can be useful in helping to predict a company's future performance, investors have grown increasingly suspicious of the metric following the bursting of the technology stock bubble, said Sam Norwood, a partner at Tatum CFO Partners.

"Once the concept of pro forma became accepted, there were in some cases abuses," Norwood said. "There was a tendency for management to exclude the negative events and to not necessarily exclude the positive events.'

Brett Trueman, an accounting professor at the University of California at Berkeley's Haas School of Business, said he wouldn't be surprised if other firms follow Yahoo's lead in dropping pro forma.

Continued at  http://www.wired.com/news/business/0,1367,51721,00.html 

Bob Jensen's threads on pro forma reporting can be found at the following site:

http://www.trinity.edu/rjensen/roi.htm 

Triple Bottom Reporting

While some in the profession may question the long-term viability of audit-only accounting firms, proposed guidelines issued recently by the Global Reporting Initiative may help make the vision more feasible. The GRI's guidelines for "triple-bottom- line reporting" would broaden financial reporting into a three- dimensional model for economic, social and environmental reporting. http://www.accountingweb.com/item/78245 

While some in the profession may question the long-term viability of audit-only accounting firms, proposed guidelines issued recently by the Global Reporting Initiative (GRI) may help make the vision more feasible. The GRI's guidelines for "triple-bottom-line reporting" would broaden financial reporting into a three-dimensional model for economic, social and environmental reporting. Each dimension of the model would contain information that is valuable to stakeholders and could be independently verified.

Numbers, Ratios and Explanations

Despite the convenient shorthand reference to bottom lines, many of the GRI indicators are multi-faceted, consisting of tables, ratios and qualitative descriptions of policies, procedures, and systems. Below are examples of indicators within each of the three dimensions:

Economic performance indicators. Geographic breakdown of key markets, percent of contracts paid in accordance with agreed terms, and description of the organization's indirect economic impacts.

Environmental performance indicators. Breakdown of energy sources used, (e.g., for electricity and heat), total water usage, breakdown of waste by type and destination, list of penalties paid for non-compliance with environmental laws and regulations, and description of policies and procedures to minimize adverse environmental impacts.

Social performance indicators. Total workforce including temporary workers, percentage of employees represented by trade unions, schedule of average hours of training per year per employee for all major categories of employee, male/female ratios in upper management positions, and descriptions of policies and procedures to address such issues as human rights, product information and labeling, customer privacy, and political lobbying and contributions. The GRI was formed in 1997 by a partnership of the United Nations Environment Program (UNEP) and the Coalition for Environmentally Responsible Economies (CERES). Several hundred organizations have participated in working groups to help form the guidelines for triple-bottom-line reporting. These organizations include corporations, accounting firms, investors, labor organizations and other stakeholders.

The Controversy Over Fair Value (Mark-to-Market) Financial Reporting

Forwarded on May 11, 2003 by Patrick E Charles [charlesp@CWDOM.DM] 

Mark-to-market rule should be written off

Richard A. Werner Special to The Daily Yomiuri

Yomiuri

Since 1996, comprehensive accounting reforms have been gradually introduced in Japan. Since fiscal 2000, the valuation of investment securities owned by firms has been based on their market value at book-closing. Since fiscal 2001, securities held on a long-term basis also have been subjected to the mark-to-market rule. Now, the Liberal Democratic Party is calling for the suspension of the newly introduced rule to mark investments to market, as well as for a delay in the introduction of a new rule that requires fixed assets to be valued at their market value.

The proponents of so-called global standards are up in arms at this latest intervention by the LDP. If marking assets to market is delayed, they argue, the nation will lag behind in the globalization of accounting standards. Moreover, they argue that corporate accounts must be as transparent as possible, and therefore should be marked to market as often and as radically as possible. On the other hand, opponents of the mark-to-market rule argue that the recent slump in the stock market, which has reached a 21-year low, can at least partly be blamed on the new accounting rules.

What are we to make of this debate? Let us consider the facts. Most leading industrialized countries, such as Britain, France and Germany, so far have not introduced mark-to-market rules. Indeed, the vast majority of countries currently do not use them.

Nevertheless, there is enormous political pressure to utilize mark-to-market accounting, and many countries plan to introduce the standard in 2005 or thereafter.

Japan decided to adopt the new standard ahead of everyone else, based on the advice given by a few accountants--an industry that benefits from the revision of accounting standards as any rule change guarantees years of demand for their consulting services.

However, so far there has not been a broad public debate about the overall benefits and disadvantages of the new standard. The LDP has raised the important point that such accounting changes might have unintended negative consequences for the macroeconomy.

Let us first reflect on the microeconomic rationale supporting mark-to-market rules. They are said to render company accounts more transparent by calculating corporate balance sheets using the values that markets happen to indicate on the day of book- closing. Since book-closing occurs only once, twice or, at best, four times a year, any sudden or temporary move of markets on these days--easily possible in these times of extraordinary market volatility--will distort accounts rather than rendering them more transparent.

Second, it is not clear that marking assets to market reflects the way companies look at their assets. While they know that market values are highly volatile, there is one piece of information about corporate assets that have an undisputed meaning for

firms: the price at which they were actually bought.

The purchase price matters as it reflects actual transactions and economic activity. Marking to market, on the other hand, means valuing assets at values at which they were never transacted. The company has neither paid nor received this theoretical money in exchange for the assets. This market value is hence a purely fictitious value. Instead of increasing transparency, we end up increasing the part of the accounts that is fiction.

While the history of marking to market is brief, we do have some track record from the United States, which introduced mark-to-market accounting in the 1990s.

Did the introduction increase accounting transparency? The U.S. Financial Accounting Standards Board last November concluded that the new rule of marking to market allowed Enron Energy Services Inc. to book profits from long-term energy contracts immediately rather than when the money was actually received.

This enabled Enron executives to create the illusion of a profitable business unit despite the fact that the truth was far from it. Thanks to mark-to-market accounting, Enron's retail division managed to hide significant losses and book billions of dollars in profits based on inflated predictions of future energy prices. Enron's executives received millions of dollars in bonuses when the energy contracts were signed.

The U.S. Financial Accounting Standards Board task force recognized the problems and has hence recommended the mark-to-market accounting rule be scrapped. Since this year, U.S. energy companies will only be able to report profits as income actually is received.

Marking to market thus creates the illusion that theoretical market values can actually be realized. We must not forget that market values are merely the values derived on the basis of a certain number of transactions during the day in case.

Strictly speaking, it is a false assumption to extend the same values to any number of assets that were not actually transacted at that value on that day.

When a certain number of the 225 stocks constituting the Nikkei Stock Average are traded at a certain price, this does not say anything about the price that all stocks that have been issued by these 225 companies would have traded on that day.

As market participants know well, the volume of transactions is an important indicator of how representative stock prices can be considered during any given day. If the index falls 1 percent on little volume, this is quickly discounted by many observers as it means that only a tiny fraction of shares were actually traded. If the market falls 1 percent on record volume, then this may be a better proxy of the majority of stock prices on that day.

The values at which U.S. corporations were marked to market at the end of December 1999, at the peak of a speculative bubble, did little to increase transparency. If all companies had indeed sold their assets on that day, surely this would have severely depressed asset prices.

Consider this: If your neighbor decides to sell his house for half price, how would you feel if the bank that gave you a mortgage argued that, according to the mark-to- market rule, it now also must halve the value of your house--and, as a result, they regret to inform you that you are bankrupt.

We discussed the case of traded securities. But in many cases a market for the assets on a company's books does not actually exist. In this case, accountants use so-called net present value calculations to estimate a theoretical value. This means even greater fiction because the theoretical value depends crucially on assumptions made about interest rates, economic growth, asset markets and so on.

Given the dismal track record of forecasters in this area, it is astonishing to find that serious accountants wish corporate accounts to be based on them.

There are significant macroeconomic costs involved with mark-to-market accounting. As all companies will soon be forced to recalculate their balance sheets more frequently, the state of financial markets on the calculation day will determine whether they are still "sound," or in accounting terms, "bankrupt." While book value accounting tends to reduce volatility in markets to some extent, the new rule can only increase it. The implications are especially far-reaching in the banking sector since banks are not ordinary businesses, but fulfill the public function of creating and providing the money supply on which economic growth depends.

U.S. experts warned years ago that the introduction of marking to market could create a credit crunch. As banks will be forced to set aside larger loan-loss reserves to cover loans that may have declined in value on the day of marking, bank earnings could be reduced. Banks might thus shy away from making loans to small or midsize firms under the new rules, where a risk premium exists and hence the likelihood of marking losses is larger. As a result, banks would have a disincentive to lend to small firms. Yet, for all we know, the small firm loans may yet be repaid in full.

If banks buy a 10-year Japanese government bond with the intention to hold it until maturity, and the economy recovers, thus pushing down bond prices significantly, the market value of the government bonds will decline. Banks would thus be forced to book substantial losses on their bond holdings despite the fact that, by holding until maturity, they would never actually have suffered any losses. Japanese banks currently have vast holdings of government bonds. The change in accounting rules likely will increase problems in the banking sector. As banks reduce lending, economic growth will fall, thereby depressing asset prices, after which accountants will quickly try to mark down everyone's books.

Of course, in good times, the opposite may occur, as we saw in the case of Enron. During upturns, marking to market may boost accounting figures beyond the actual state of reality. This also will boost banks' accounts (similar to the Bank for International Settlements rules announced in 1988), thus encouraging excessive lending. This in turn will fuel an economic boom, which will further raise the accounting values of assets.

Thus does it make sense to mark everything to fictitious market values? We can conclude that marking to market has enough problems on the micro level to negate any potential benefits. On the macro level, the disadvantages will be far larger as asset price volatility will rise, business cycles will be exacerbated and economic activity will be destabilized.

The world economy has done well for several centuries without this new rule. There is no evidence that it will improve anything. To the contrary, it is likely to prove harmful. The LDP must be lauded for its attempt to stop the introduction of these new accounting rules.

Werner is an assistant professor of economics at Sophia University and chief economist at Tokyo-based investment adviser Profit Research Center Ltd.

Measuring the Business Value of Stakeholder Relationships – all about social capital and how high-trust relationships affect the bottom line. Plus a new measurement tool for benchmarking the quality of stakeholder relationships --- www.cim.sfu.ca/newsletter 

Trust, shared values and strong relationships aren't typical financial indicators but perhaps they should be. A joint study by CIM and the Schulich School of Business is examining the link between high trust stakeholder relationships and business value creation. The study is sponsored by the Canadian Institute of Chartered Accountants (CICA).

The research team is looking at how social capital can be applied to business. The aim of this project is to better understand corporate social capital, measure the quality of relationships, and provide the business community with ways to improve those relationships and in turn improve their bottom line.

Because stakeholder relationships all have common features, direct comparisons of the quality of relationships can be made across diverse stakeholder groups, companies and industries.

Social capital is “the stock of active connections among people; the trust, mutual understanding, and shared values and behaviors that bind the members of human networks and communities and make cooperative action possible” (Cohen and Prusak, 2000).

So far the research suggests that trust, a cooperative spirit and shared understanding between a company and its stakeholders creates greater coherence of action, better knowledge sharing, lower transaction costs, lower turnover rates and organizational stability. In the bigger picture, social capital appears to minimize shareholder risk, promote innovation, enhance reputation and deepen brand loyalty.

Preliminary results show that high levels of social capital in a relationship can build upon themselves. For example, as a company builds reputation among its peers for fair dealing and reliability in keeping promises, that reputation itself becomes a prized asset useful for sustaining its current alliances and forming future ones.

The first phase of the research is now complete and the study moves into its second phase involving detailed case studies with six companies that have earned a competitive business advantage through their stakeholder relationships. Click here for a full report

Bob Jensen's discussion of valuation and aggregation issues can be found at http://www.trinity.edu/rjensen/FraudConclusion.htm 

The FASB has released Statement No. 148. 

FAS 148 improves disclosures for stock-based compensation and provides alternative transition methods for companies that switch to the fair value method of accounting for stock options --- http://www.fasb.org/news/nr123102.shtml 
The transition guidance and annual disclosure provisions of Statement 148 are effective for fiscal years ending after December 15, 2002, with earlier application permitted in certain circumstances.  .  Fair value accounting is still optional (until the FASB finally makes up its mind on stock options.)

FASB Amends Transition Guidance for Stock Options and Provides Improved Disclosures

Norwalk, CT, December 31, 2002—The FASB has published Statement No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure, which amends FASB Statement No. 123, Accounting for Stock-Based Compensation. In response to a growing number of companies announcing plans to record expenses for the fair value of stock options, Statement 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, Statement 148 amends the disclosure requirements of Statement 123 to require more prominent and more frequent disclosures in financial statements about the effects of stock-based compensation.

Under the provisions of Statement 123, companies that adopted the preferable, fair value based method were required to apply that method prospectively for new stock option awards. This contributed to a “ramp-up” effect on stock-based compensation expense in the first few years following adoption, which caused concern for companies and investors because of the lack of consistency in reported results. To address that concern, Statement 148 provides two additional methods of transition that reflect an entity’s full complement of stock-based compensation expense immediately upon adoption, thereby eliminating the ramp-up effect.

Statement 148 also improves the clarity and prominence of disclosures about the pro forma effects of using the fair value based method of accounting for stock-based compensation for all companies—regardless of the accounting method used—by requiring that the data be presented more prominently and in a more user-friendly format in the footnotes to the financial statements. In addition, the Statement improves the timeliness of those disclosures by requiring that this information be included in interim as well as annual financial statements. In the past, companies were required to make pro forma disclosures only in annual financial statements.

The transition guidance and annual disclosure provisions of Statement 148 are effective for fiscal years ending after December 15, 2002, with earlier application permitted in certain circumstances. The interim disclosure provisions are effective for financial reports containing financial statements for interim periods beginning after December 15, 2002.

As previously reported, the FASB has solicited comments from its constituents relating to the accounting for stock-based compensation, including valuation of stock options, as part of its recently issued Invitation to Comment, Accounting for Stock-Based Compensation: A Comparison of FASB Statement No. 123, Accounting for Stock-Based Compensation, and Its Related Interpretations, and IASB Proposed IFRS, Share-based Payment. That Invitation to Comment explains the similarities of and differences between the proposed guidance on accounting for stock-based compensation included in the International Accounting Standards Board’s (IASB’s) recently issued exposure draft and the FASB’s guidance under Statement 123.

After considering the responses to the Invitation to Comment, the Board plans to make a decision in the latter part of the first quarter of 2003 about whether it should undertake a more comprehensive reconsideration of the accounting for stock options. As part of that process, the Board may revisit its 1995 decision permitting companies to disclose the pro forma effects of the fair value based method rather than requiring all companies to recognize the fair value of employee stock options as an expense in the income statement. Under the provisions of Statement 123 that remain unaffected by Statement 148, companies may either recognize expenses on a fair value based method in the income statement or disclose the pro forma effects of that method in the footnotes to the financial statements.

Copies of Statement 148 may be obtained by contacting the FASB’s Order Department at 800-748-0659 or by placing an order at the FASB’s website at www.fasb.org .

From The Wall Street Journal Accounting Educators' Reviews on June 20, 2002

TITLE: And, Now the Question is: Where's the Next Enron? 
REPORTER: Cassell Bryan-Low and Ken Brown 
DATE: Jun 18, 2002 PAGE: C1 LINK: http://online.wsj.com/article/0,,SB1024356537931110920.djm,00.html  
TOPICS: off balance sheet financing, Related-party transactions, loan guarantees, Accounting, Fair Value Accounting, Financial Accounting Standards Board, Regulation, Securities and Exchange Commission

SUMMARY: In the wake of the Enron accounting debacle, investors are concerned that another Enron-like situation could occur. The article describes steps taken to improve the quality of financial reporting.

QUESTIONS: 

1.) Why is it important that investors and other financial statement users have confidence in financial reporting?

2.) What is a related-party transaction? What accounting issues are associated with related-party transactions? What changes in disclosing and accounting for related party transactions are proposed? Discuss the strengths and weaknesses of the proposed changes.

3.) What is off-balance sheet financing? How was Enron able to avoid reporting liabilities on its balance sheet? What changes concerning special-purpose entities are proposed? Will the proposed changes prevent future Enron-like situations? Support your answer.

4.) When are companies required to report loan guarantees as liabilities? What changes are proposed? Do you agree with the proposed changes? Support your answer.

5.) What is mark to market accounting? How did mark to market accounting contribute to the Enron debacle? Discuss the advantages and disadvantages of proposed changes related to mark to market accounting.

6.) What are pro forma earnings? How can pro forma earnings be used to mislead investors? What changes in the presentation of pro forma earnings are proposed? Will the proposed changes protect investors?

Reviewed By: Judy Beckman, University of Rhode Island 
Reviewed By: Benson Wier, Virginia Commonwealth University 
Reviewed By: Kimberly Dunn, Florida Atlantic University

Controversies over revenue reporting are discussed at http://www.trinity.edu/rjensen/ecommerce/eitf01.htm 

From the Free Wall Street Journal Educators' Reviews for December 6, 2001 

TITLE: Audits of Arthur Andersen Become Further Focus of Investigation
SEC REPORTER: Jonathan Weil
DATE: Nov 30, 2001 PAGE: A3 LINK:
     http://interactive.wsj.com/archive/retrieve.cgi?id=SB1007059096430725120.djm 
TOPICS: Advanced Financial Accounting, Auditing

SUMMARY: This article focuses on the issues facing Arthur Andersen now that their work on the Enron audit has become the subject of an SEC investigation. The on-line version of the article provides three questions that are attributed to "some accounting professors." The questions in this review expand on those three provided in the article.

QUESTIONS:
1.) The first question the SEC might ask of Enron's auditors is "were financial statement disclosures regarding Enron's transactions too opaque to understand?" Are financial statement disclosures required to be understandable? To whom? Who is responsible for ensuring a certain level of understandability?

2.) Another question that the SEC could consider is whether Andersen auditors were aware that certain off-balance-sheet partnerships should have been consolidated into Enron's balance sheet, as they were in the company's recent restatement. How could the auditors have been "unaware" that certain entities should have been consolidated? What is the SEC's concern with whether or not the auditors were aware of the need for consolidation?

3.) A third question that the SEC could ask is, "Did Andersen auditors knowingly sign off on some 'immaterial' accounting violations, ignoring that they collectively distorted Enron's results?" Again, what is the SEC's concern with whether Andersen was aware of the collective impact of the accounting errors? Should Andersen have been aware of the collective amount of impact of these errors? What steps would you suggest in order to assess this issue?

4.) The article finishes with a discussion of expected Congressional hearings into Enron's accounting practices and into the accounting and auditing standards setting process in general. What concern is there that the FASB "has been working on a project for more than a decade to tighten the rules governing when companies must consolidate certain off-balance sheet 'special purpose entities'"?

5.) In general, how stringent are accounting and auditing requirements in the U.S. relative to other countries' standards? Are accounting standards in other countries set in the same way as in the U.S.? If not, who establishes standards? What incentives would the U.S. Congress have to establish a law-based system if they become convinced that our private sector standards setting practices are inadequate? Are you concerned about having accounting and reporting standards established by law?

6.) The article describes revenue recognition practices at Enron that were based on "noncash unrealized gains." What standard allows, even requires, this practice? Why does the author state, "to date, the accounting standards board has given energy traders almost boundless latitude to value their energy contracts as they see fit"?

Reviewed By: Judy Beckman, University of Rhode Island
Reviewed By: Benson Wier, Virginia Commonwealth University
Reviewed By: Kimberly Dunn, Florida Atlantic University

CPA2Biz Unveils Business Valuation Resource Center --- http://www.smartpros.com/x31976.xml 

The BV Center will include resources and information from the American Institute of Certified Public Accountants (AICPA) and industry experts on various factors affecting the value of a business or a transaction, such as mergers and acquisitions; economic damages due to a patent infringement or breaches of contract; bankruptcy or a reorganization; or fraud due to anti-trust actions or embezzlement. The BV Center will provide a comprehensive combination of solutions that meet the professional needs of CPAs practicing business valuation, including those who have achieved the AICPA's Accredited in Business Valuation credential. The BV Center will also provide networking communities for BV practitioners as well as a public forum for discussion of business valuation trends, developments and issues.

"Tremendous growth in the BV discipline, coupled with a dynamic group of factors affecting business valuation, means that CPAs need a consistent, timely and relevant vehicle through which BV-related information can be disseminated to them," said Erik Asgeirsson, Vice President of Product Management at CPA2Biz. "The BV Center on CPA2Biz will provide them with AICPA books, practice aids, newsletters and software, along with industry expert literature and complementary third-party products and solutions. Because the issues associated with valuation impact CPAs in both public and private sectors -- auditors, tax practitioners, personal financial planners as well as BV specialists -- the BV Center will have a powerful horizontal impact on the profession."

"I think that CPAs who practice in business valuation ought to go to the BV Center for information and tools that are timely, relevant and easy to obtain," said Thomas Hilton, CPA/ABV, Chairman of the AICPA Business Valuation Subcommittee. "The BV Center is a source CPAs can use to offer their clients a higher level of service, as well as to connect with other CPAs who provide valuation services."

The CPA2Biz Website is at www.cpa2biz.com/ 

Selected References on Accounting for Intangibles 
(most of which were published after the above paper was written)

BARUCH LEV'S NEW BOOK Brookings Institution Press has just issued Baruch's new book, Intangibles: Management, Measurement and Reporting. Regardless of the "dot com" collapse, this subject continues to be high on the corporate executive's agenda. Baruch foresees increasing attention being paid to intangibles by both managers and investors. He feels there is an urgent need to improve both the management reporting and external disclosure about intellectual capital. He proposes that we seriously consider revamping our accounting model and significantly broaden the recognition of intangible assets on the balance sheet. The book can be ordered at https://www.brookings.edu/press/books/intangibles_book.htm 

Professor Lev's free documents on this topic can be downloaded from  http://www.stern.nyu.edu/~blev/newnew.html 

FASB REPORT - BUSINESS AND FINANCIAL REPORTING, CHALLENGES FROM THE NEW ECONOMY NO. 219-A April 2001 Author: Wayne S. Upton, Jr. Source: Financial Accounting Standards Board --- http://accounting.rutgers.edu/raw/fasb/new_economy.html 
Upton's book challenges Lev's contention that the existing standards are enormously inadequate for the "New Economy."

The Garten SEC Report: A press release and an executive summary are available at http://www.mba.yale.edu  
The Garten SEC Report supports Lev's contention that the existing standards are enormously inadequate for the "New Economy."
(You can request a copy of the full report using an email address provided at the above URL)

Trinity University students may access this report at J:\courses\acct5341\readings\sec\garten.doc 

FEI BUSINESS COMBINATIONS VIDEO PROGRAM http://www.fei.org/confsem/bizcombo2k2/agenda.cfm 

American Accounting Association (AAA) members may view a replay of a day-long webcast on accounting for business combinations and intangible valuations (SFAS 141 and 142) at half the price that will be charged to other non-FEI members ($149 versus $299). The FEI hopes to use funds generated from AAA members to help the FEI assume sponsorship of a Corporate Accounting Policy Seminar.

The webcast encompassed five presentations by experts with question-and-answer periods: (1) Overview of SFAS 141/142, by G. Michael Crooch, FASB Board Member; (2) Recognition and Measurement of Intangibles, by Tony Aarron of E&Y Valuation Services and Steve Gerard of Standard and Poors's, (3) Impact on Doing Deals: Structure, Pricing and Process, by Raymond Beier of PWC and Elmer Huh, Morgan Stanley Dean Witter, (4) Testing for Goodwill Impairment, by Mitch Danaher of GE, and (5) Transition Issues and Financial Statement Disclosures, by Julie A. Erhardt of Arthur Andersen's Professional Standards Group.

As an example (Digital Island Inc.) of the impact of FAS 142 on impairment testing for goodwill, please print the following document: http://www.edgar-online.com/brand/businessweek/glimpse/glimpse.pl?symbol=ISLD 

Amortization of intangible assets. Amortization expense increased to $153.7 million for the nine months ended June 30, 2001 from $106.4 million for the nine months ended June 30, 2000. This increase was primarily due to a full period

of amortization of the goodwill and intangibles related to the acquisitions of Sandpiper, Live On Line and SoftAware, which were completed in December 1999, January 2000 and September 2000, respectively. This increase was offset by a decrease in the current quarter's amortization as a direct result of a $1.0 billion impairment charge on goodwill and intangible assets in the quarter ended March 31, 2001. Amortization of intangible assets is expected to decrease in future periods due to this impairment charge.

Impairment of Goodwill and Intangible Assets. Impairment of goodwill and intangible assets was recorded in the amount of $1,039.2 million. The impairment charge was based on management performing an impairment assessment of the goodwill and identifiable intangible assets recorded upon the acquisitions of Sandpiper, Live On Line and SoftAware, which were completed during the year ended September 30, 2000. The assessment was performed primarily due to the significant decline in stock price since the date the shares issued in each acquisition were valued. As a result of this review, management recorded the impairment charge to reduce goodwill and acquisition-related intangible assets. The charge was determined as the excess of the carrying value of the assets over the related estimated discounted cash flows.

Forwarded by Storhaug [storhaug@BTIGATE.COM] 

To follow up on this list's earlier brief discussion on FASB 141 & 142, below is a bookmark to a site "CFO.COM" which has an excellent compendium of articles and links, all of which help you evaluate these new FASB's.

http://www.cfo.com/fasbguide 

"The Goodwill Games How to Tackle FASB's New Merger Rules," by Craig Schneider, CFO.com --- http://www.cfo.com/fasbguide 

The thrill of victory and the agony of defeat. Chances are senior financial executives will experience a similar range of emotions while wrestling with the Financial Accounting Standards Board's new rules for business combinations, goodwill, and intangibles. Use CFO.com's special report for tips on tackling the impairment test, avoiding Securities & Exchange Commission inquiries, finding valuation experts, and much more. While accounting is not yet an Olympic sport, with the right training, you'll take home the gold. We welcome your questions and comments. E-mail craigschneider@cfo.com.
Take Your First Steps
	How to Survive the SEC's Second Guessing New rules for recording goodwill and intangibles may inadvertently produce more restatements. Cramming for the Final Get up to speed on the latest accounting rule changes for treating goodwill and intangibles. Pool's Closed FASB's new merger-accounting rules have already won some fans among deal makers. (CFO Magazine) Intangibles Revealed Once you identify them, how much will the fair value assessments cost? Four Ways to Say Goodbye to Goodwill Amortization Expert tips for tackling the impairment test.

 

Congratulations to Baruch Lev from NYU --- http://www.stern.nyu.edu/~blev/main.html 

Baruch's picture adorns the cover of Financial Executive, March/April 2002 --- http://www.fei.org/magazine/marapr-2002.cfm 

The cover story entitled "Rethinking Accounting:  Intangibles at a Crossroads:  What Next?" on pp. 34-39 --- http://www.fei.org/magazine/articles/3-4-2002_CoverStory.cfm 
The concluding passage is quoted below:

The Inertness and Commoditization of Intangibles 

Intangibles are inert - by themselves, they neither create value nor generate growth. In fact, without efficient support and enhancement systems, the value of intangibles dissipates much quicker than that of physical assets. Some examples of inertness: uHighly qualified scientists at Merck, Pfizer, or Ely Lilly (human capital intangibles) are unlikely to generate consistently winning products without innovative processes for drug research, such as the "scientific method," based on the biochemical roots of the target diseases, according to Rebecca Henderson, a specialist on scientific drug research, in Industrial and Corporate Change. Even exceptional scientists using the traditional "random search" methods for drug development will hit on winners only randomly, writes Henderson.

uA large patent portfolio at DuPont or Dow Chemical (intellectual property) is by itself of little value without a comprehensive decision support system that periodically inventories all patents, slates them by intended use (internal or collaborative development, licensing out or abandonment) and systematically searches and analyzes the patent universe to determine whether the company's technology is state-of-the-art and competitive.

uA rich customer database (customer intangibles) at Amazon.com or Circuit City will not generate value without efficient, user-friendly distribution channels and highly trained and motivated sales forces.

Worse than just inert, intangibles are very susceptible to value dissipation (quick amortization) - much more so than other assets. Patents that are not constantly defended against infringement will quickly lose value due to "invention around" them. Highly trained employees will defect to competitors without adequate compensation systems and attractive workplace conditions. Valuable brands may quickly deteriorate to mere "names" when the firm - such as a Xerox, Yahoo! or Polaroid - loses its competitive advantage. The absence of active markets for most intangibles (with certain patents and trademark exceptions) strips them of value on a stand-alone basis.

Witness the billions of dollars of intangibles (R&D, customer capital, trained employees) lost at all the defunct dot-coms, or at Enron, or at AOL Time Warner Co., which in January 2002 announced a whopping write-off of $40-60 billion - mostly from intangibles.

Intangibles are not only inert, they are also, by and large, commodities in the current economy, meaning that most business enterprises have equal access to them. Baxter and Johnson & Johnson, along with the major biotech companies, have similar access to the best and brightest of pharmaceutical researchers (human capital); every retailer can acquire the state-of-the-art supply chains and distribution channel technologies capable of creating supplier and customer-related intangibles (such as mining customer information); most companies can license-in patents or acquire R&D capabilities via corporate acquisitions; and brands are frequently traded. The sad reality about commodities is that they fail to create considerable value. Since competitors have equal access to such assets, at best, they return the cost of capital (zero value added).

The inertness and commoditization of most intangibles have important implications for the intangibles movement. They imply that corporate value creation depends critically on the organizational infrastructure of the enterprise - on the business processes and systems that transform "lifeless things," tangible and intangible, to bundles of assets generating cash flows and conferring competitive positions. Such organizational infrastructure, when operating effectively, is the major intangible of the firm. It is, by definition, noncommoditized, since it has to fit the specific mission, culture, and environment of the enterprise. Thus, by its idiosyncratic nature, organizational infrastructure is the major intangible of the enterprise.

Focusing the Intangibles Efforts 

Following Phase I of the intangibles work, which was primarily directed at documentation and awareness-creation, it's now time to focus on organizational infrastructure, the intangible that counts most and about which we know least. It's the engine for creating value from other assets. Like breaking the genetic code, an understanding of the "enterprise code" - the organizational blueprints, processes and recipes - will enable us to address fundamental questions of concern to managers and investors, such as those raised above in relation to H-P/Compaq and Enron.

Organizational Infrastructure By Example: A company's organizational infrastructure is an amalgam of systems, processes and business practices (its operating procedures, recipes) aimed at streamlining operations toward achieving the company's objectives. Following is a concrete example of a business process, part of the organizational infrastructure, which was substantially modified and thereby created considerable value. This was adopted from "Turnaround," Business 2.0, January 2002.

Nissan Motor Co. Ltd., Japan's third-largest automaker and a perennial loser and debt-ridden producer of lackluster cars, received in March 1999 a new major shareholder, Renault, and a new CEO, Carlos Ghosn, both imported from France. Ghosn moved quickly to transform Nissan into a viable competitor, and indeed, in the fiscal year ending March 2001, the company reported a profit of $2.7 billion, the largest in its 68-year history.

How was this miracle performed? Primarily by cost-cutting, achieved by a drastic change in the procurement process. Here briefly, is the old process: Nissan's buyers were locked into ordering from keiretsu partners, suppliers in which Nissan owned stock. The guaranteed stream of Nissan orders insulated those suppliers from competition. Suppliers can't specialize and can't sell excess capacity elsewhere. Each supplier was assigned a shukotan, Nissan-speak for a relationship manager. It was the shukotan who would negotiate price discounts - but favors got in the way.

Here, in brief, is the new procurement process, as drastically changed by Ghosn: Ghosn gave Itaru Koeda, the purchasing chief, authority to place orders without regard to keiretsu relationships - and, more important, insisted that he use it. Then, a Renault executive and Koeda dumped the shukotan system, instead assigning buyers responsibility by model and part. They formed a sourcing committee to review vendor price quotes on a global basis. "This is the best change in our process," Koeda says. "Suppliers are specializing in what they do best, making them more efficient."

The results? An 18 percent drop in purchasing costs, which was the major contributor to Nissan's transformation from a loss to a profit. Ghosn's next major set of tasks: To change the car design process in order to enhance the top line, sales; to rid Nissan of the myriad design committees and hierarchies that stifle and slow innovation; and to institute an efficient, effective innovative process.

Baruch's cover story is accompanied by "Fixing Financial Reporting:  Financial Statement Overhaul," by  Robert A Howell, pp. 40-42 --- http://www.fei.org/magazine/articles/3-4-2002_Howell_CoverStory.cfm 

Financial reporting is broken and has to be fixed - and fast! If it isn't, we will continue to see more cases such as Xerox, Lucent, Cisco Systems, Yahoo! and Enron. Xerox's market value is down 90 percent, or $40 billion, in the past two years. In the same period other market losses include; Lucent, down more than $200 billion; Cisco Systems, off more than $400 billion; Yahoo!, more than $100 billion; and Enron, down more than $60 billion in the largest bankruptcy of all time.

Some argue that these are extreme examples of "irrational exubuerance." Some in the accounting profession say that such cases represent a small percentage of the aggregate number of statements audited - some 15,000 public company registrants. Perhaps. But a financial reporting framework that permits these companies to suggest that they are doing well, and, by implication, to justify market valuations which, subsequently, cost investors trillions in the aggregate, is unconscionable.

Financial reporting, especially in the U. S., with its very public capital markets, has reached the point where "accrual-based" earnings are almost meaningless. Reported earnings are driven as much by "earnings expectations" as they are by real business performance. Balance sheets fail to reflect the major drivers of future value creation - the research and product, process and software development that fuel high technology companies, and the brand value of leading consumer product companies. And, cash flow statements are such a hodge-podge of operating, investing and financing activities that they obfuscate, rather than illuminate, business cash flow performance.

The FASB, in its Concept No. 1, states, "financial reporting should provide information that is useful to present and potential investors and creditors and other users in making rational investment, credit and similar decisions." This is simply not so.

The primary financial statements - income statement, balance sheet and cash flow statement - which derive their foundation from an industrial age model, need major redesign if they are to serve as the starting point for meaningful financial analysis, interpretation and decision-making in today's knowledge-based and value-driven economy. Without significant redesign, ad hoc definitions such as pro forma earnings, returns and cash flows will continue to proliferate. So will significant reporting "surprises!"

Starting Point: Market Value Creation
The objective of a business is to increase real shareholder value - what Warren E. Buffett would call the "intrinsic value" of the firm. It's a very basic idea: Investors get "returns" from dividends and realized market appreciation. Both investments and returns are measured in cash terms, so individuals and investors invest cash in securities with the objective of realizing returns that meet or exceed their criteria. If their judgments are too high, and that later becomes clear, the market value of the firm will drop. If judgments are too low and cash flows turn out to be stronger, market values increase.

From a managerial viewpoint, the objective of increasing shareholder (market) value really means increasing the net present value (NPV) of the future stream of cash flows. Note, "cash flows," not "profits." Cash is real; profits are anything, within reason, that management wants them to be. If revenues are recognized early - or overstated - and expenses are deferred or, in some cases, accelerated to "clear the decks" for future periods, resulting earnings may show a nice trend, but do not really reflect economic performance.

There are only three ways management may increase the real market, or "intrinsic," value of a firm. First, increase the amount of cash flows expected at any point in time. Second, accelerate cash flows; given the time value of money, cash received earlier has a higher present value. Third, if a firm is able to lower the discount rate that it applies to its cash flows - which it frequently can - it can raise its NPV.

Given that cash flows drive market value, financial statements should put much more emphasis on cash flows. The statement of cash flows now prescribed by the accounting community and presented by management is not easily related to value creation. Derived from the income statement and balance sheet, it's effectively a reconciliation statement for the change in the balance of the cash account. A major overhaul of the cash flow statement would directly relate to market valuations.

Cash Earnings and Free Cash Flows
Managers and investors should focus on "cash earnings" and the reinvestments that are made into the business in the form of "working capital" and "fixed and other (including intangible) investments." The net amount of these cash flows represent the business's "free cash flows."

With negative cash flows - frequently the case for young startups and high-growth companies - a business must raise more capital in the form of debt or equity. The sooner it gets its free cash flows positive, the sooner it'll begin to create value for shareholders. Positive free cash flows provide resources to pay interest and pay down debt, to return cash to shareholders (through stock repurchases or dividends) or to invest in new business areas.

The traditional cash flow statement purportedly distinguishes between operating, investing and financing cash flows, and has as its "bottom line" the change in cash and cash equivalents. In fact, the operating cash flows include the results of selling activities, investing in working capital and interest expense, a financing activity. Investing cash flows include capital expenditures, acquisitions, disposals of assets and the purchase and sale of financial assets. Financing cash flows consist of what's left over.

Indeed, the bottom-line change in cash is not a useful number, other than to demonstrate that it may be reconciled with the change in the cash account. If one wants a positive change in cash, simply borrow more. These free cash flows ultimately drive market value, and should be the focus of managers and investors alike.

Replacing Income With Cash Earnings
The traditional "profit and loss," or "income," statement needs modification in three ways, two of which are touched on above, along with a name-change, to "Operating Statement." That would suggest a representation of the business' current operations, without the emphasis on accrual-based profits.

Interest expense (income) should be eliminated from the statement, as it represents a financing cost rather than an operating cost. A number of companies do this internally to determine "net operating profit after taxes" (NOPAT). Also, NOPAT needs to be adjusted for the various non-cash items, such as depreciation, amortization, gains and losses on the sale of assets, tax-timing differences and restructuring charges - which affect income but not cash flows. The resultant "cash earnings" better represents the current economic performance of a business than accrual income and, very importantly, is much less susceptible to manipulation.

A third adjustment is the order in which the classes of expenses are displayed. Traditional income statements report cost of goods sold or product costs first, frequently focus on product gross margins, and then deduct, as a group, other expenses such as technical, selling and administrative expenses. This order made sense in the industrial age when product costs dominated. It does not for many of today's high-tech or consumer product companies. It would be more useful for companies to report expenses in an order that reflects the flow of the business activities. One logical order that builds on the concept of a business' value chain, is to categorize costs into development costs, product (service) conversion costs, sales and customer support costs and administrative costs.

Reinvesting in the Business
For most companies - especially those with significant investments that are being depreciated or amortized - cash earnings will be significantly higher than NOPAT. Unfortunately, cash earnings are not free cash flows because most businesses have to reinvest in working capital, property, plant and equipment and intangible assets, just to sustain - let alone increase - their productive capabilities.

As a business grows in sales volume, assuming that it offers credit to its customers who pay with the same frequency, accounts receivable will increase proportionately. As sales volumes increase, so, too, will product costs, inventories and accounts payable balances. Working capital - principally receivables, inventories, and payables - will tend to increase proportionately with sales growth, and will require cash to finance it. The degree to which it grows is a function of receivables terms and collection practices, inventory management and payables practices.

Companies such as Dell Computer Corp. collect payments up front, turn inventories in a few days and pay their vendors when due. The net effect is that as Dell grows it actually throws off cash, rather than requiring it to support increases in working capital. Most companies are not as efficient; the amount of cash needed to support increases in working capital can be as much as 20-25 percent of any sales increase. The degree to which working capital increases as sales increase is an important performance metric. Lower is better, which absolutely flies in the face of such traditional measures of liquidity as "working capital" and "quick" ratios, for which higher has been considered better.

Balance sheets ought to reflect investments that represent future value. What drives value for many businesses in today's knowledge-based economy - pharmaceuticals, high technology, software and brand-driven consumer product companies - is the investments in R&D, product, process and software development, brand equity and the continued training and development of the work force. Yet, based on generally accepted accounting principles (GAAP) accounting, these "investments" in the future are not reflected on balance sheets, but, rather, expensed in the period in which they are incurred.

A frequent argument for "expensing" is the unclear nature of the investments' future value. Apparently, investors believe otherwise, evidenced by the ratio of market values to book values having exploded in the past 25 years. In 1978, the average book-to-market ratio was around 80 percent; today it is around 25 percent. In the early 1970s, when accounting policies were established for R&D, product lines were narrower and life cycles longer, resulting in R&D being a much less significant element of cost. Expensing was less relevant. Now, with intangible assets having become so central and significant, expensing - rather than capitalizing and amortizing them over time - results in an absolute breakdown of the principle of "matching," which is at the heart of accrual accounting. The world of business has changed; accounting practices must also change.

Financial Statement Overhaul
Financial statements need marked overhaul to be useful for analysis and decision-making in today's knowledge-driven and shareholder value-creation environment. The proposed changes fall into three categories:

First - Move to a much more explicit shareholder (market) value creation and cash orientation, and away from accrual accounting profits and return on investment calculations predicated on today's accounting policies. Start with a shareholder perspective for cash flows, then reconstruct the statement of cash flows to clearly provide the free cash flows that the business' operations are generating. Cash earnings and reinvestments in the business comprise free cash flows.

Second - Expand the definition of investments to include intangibles, which should be capitalized as assets and amortized according to some thoughtful rules. This will better reflect investments that have potential future value.

Third - Change the title to "operating statement" and other "housekeeping" of financial statements, to include categorizing costs in a more logical "value chain" sequence and aggregating all financial transactions, such as interest and the purchase and sale of securities, as financing activities.

Value creation is ultimately measured in the marketplace, so it stands to reason that if a firm's market value increases consistently, over time, and can be supported by improvements in its cash generation performance, real value is being created. For this to happen, the place to start is by fixing the financial statements. 

Bob Jensen's threads on accounting theory are at http://www.trinity.edu/rjensen/theory.htm 

The Shareholder Action On-Line Handbook (1993) (history, finance, investing, law)--- http://www.ethics.fsnet.co.uk/0home.htm 

These Web pages are the on-line version of The Shareholder Action Handbook, first published in paperback 1993 by New Consumer. The Handbook aims to give practical advice to individuals about how they may use shares to make companies more accountable. The need for such a guide is now stronger than ever. Public concern in Britain about the accountability of company directors has risen to the extent that the subject makes regular appearances in debates in the House of Commons. While there are many obstacles to taking shareholder action, shareholders can do much to alter the course of corporate behaviour. Indeed, since the original version of the guide appeared there have been a number of successful shareholder action campaigns. However, there is considerable need both for new legislation to make it easier for shareholders to hold companies to account, and for the large institutional shareholders who own much of global industry to take their responsibilities as shareholders rather more seriously.

Online Resources for Business Valuations

Looking for information on valuing your business? Look no further. Or look way further, depending on your point of view. Here is a Web site, produced by Professor William C. Weaver, that provides numerous links to online business valuation resources all assembled in one easy-to-use location. http://www.accountingweb.com/item/56244 

Business Valuation Links --- http://www.bus.ucf.edu/weaver/links/bvlinks.htm 

Business Valuation References --- http://www.bus.ucf.edu/weaver/ 

Understanding the Issues

From The Wall Street Journal's Accounting Educator Reviews on January 22, 2002

TITLE: Deciphering the Black Box 
REPORTER: Steve Liesman 
DATE: Jan 23, 2002 PAGE: C1 LINK: http://interactive.wsj.com/archive/retrieve.cgi?id=SB1011739030177303200.djm  TOPICS: Accounting, Accounting Theory, Creative Accounting, Disclosure, Disclosure Requirements, Earnings Management, Financial Analysis, Financial Statement Analysis, Fraudulent Financial Reporting, Regulation, Securities and Exchange Commission

SUMMARY: The article discusses several factors that have led to financial reporting that is complex and difficult to understand. Related articles provide specific examples of complicated and questionable financial reporting practices.

QUESTIONS: 
1.) What economic factors have led to the complexity of financial reporting? Have accounting standard setters kept pace with the changing economic conditions? Support your answer.

2.) What determines a company's cost of capital? What is the relation between the quantity and quality of financial information disclosed by a company and its cost of capital? Why are companies reluctant to disclose financial information?

3.) Explain the difference between earnings management and fraudulent financial reporting? Is either earnings management or fraudulent financial reporting illegal? Is either unethical? Could earnings management ever improve the usefulness of financial reporting? Explain.

4.) Discuss the advantages and disadvantages of allowing discretion in financial reporting.

5.) Refer to related articles. Briefly discuss the major accounting or economic situation that has caused complexity in the financial reporting of each of these companies. What can be done to make the financial reporting more useful?

SMALL GROUP ASSIGNMENT: How much discretion should Generally Accepted Accounting Principles allow in financial reporting? Support your position.

Reviewed By: Judy Beckman, University of Rhode Island 
Reviewed By: Benson Wier, Virginia Commonwealth University 
Reviewed By: Kimberly Dunn, Florida Atlantic University

--- RELATED ARTICLES --- 

TITLE: GE: Some Seek More Light on the Finances 
REPORTER: Rachel Emma Silverman and Ken Brown 
PAGE: C1 ISSUE: Jan 23, 2002 
LINK: http://interactive.wsj.com/archive/retrieve.cgi?id=SB1011744147673133760.djm 

TITLE: AIG: A Complex Industry, A Very Complex Company 
REPORTER: Christopher Oster and Ken Brown 
PAGE: C16 ISSUE: Jan 23, 2002 
LINK: http://interactive.wsj.com/archive/retrieve.cgi?id=SB1011740010747146240.djm 

TITLE: Williams: Enron's Game, But Played with Caution 
REPORTER: Chip Cummins 
PAGE: C16 ISSUE: Jan 23, 2002 
LINK: http://interactive.wsj.com/archive/retrieve.cgi?id=SB1011739185631601680.djm 

TITLE: IBM: 'Other Income' Can Mean Other Opinions 
REPORTER: William Bulkeley 
PAGE: C16 ISSUE: Jan 23, 2002 
LINK: http://interactive.wsj.com/archive/retrieve.cgi?id=SB1011744634389346680.djm 

TITLE: Coca-Cola: Real Thing Can Be Hard to Measure 
REPORTER: Betsy McKay 
PAGE: C16 ISSUE: Jan 23, 2002 
LINK: http://interactive.wsj.com/archive/retrieve.cgi?id=SB1011739618177530480.djm 

Bob Jensen's threads on accounting and securities fraud are at http://www.trinity.edu/rjensen/fraud.htm 

Stock Option Valuation Research Database

From Syllabus News on December 13, 2002

Wharton School Offers Stock Data Via the Web

The University of Pennsylvania's Wharton business school is offering financial analysts access to historical information on stock options over the Internet. The data, supplied by research firm OptionMetrics's Ivy database, covers information on all U.S. listed index and equity options from January1996. The Ivy database adds to the 1.5 terabyte storehouse of financial information from a range of providers now available through Wharton Research Data Services (WRDS). The university said that by making data from the Center for Research in Security Prices, Standard & Poor's COMPUSTAT, the Federal Deposit Insurance Corporation, the New York Stock Exchange, and other data vendors accessible from a simple Web-based interface, WRDS hopes to become the preferred source among university scholars for data covering global financial markets.

Note from Jensen:  the Wharton Research Data Services (WRDS) home page is at http://www.wharton.upenn.edu/research/wrds.html 

Wharton Research Data Services, a revolutionary Internet-based research data service developed and marketed by the Wharton School, has become the standard for large-scale academic data research, providing instant web access to financial and business datasets for almost all top-tier business schools (including 23 of the top 25 schools as ranked by Business Week magazine).

Subscribers to Wharton Research Data Services (WRDS) gain instant access to the broadest array of business and economic data now available from a single source on the Web. From anywhere and at any time, WRDS functions as an application service provider (ASP) to deliver information drawn from 1.2 terabytes of comprehensive financial, accounting, management, marketing, banking and insurance data.

Launched in July 1997, the unique data service's client list of over 60 institutions now includes Stanford University, Harvard University, Columbia University, Yale University, Northwestern University, London Business School, INSEAD, University of Chicago, Massachusetts Institute of Technology and dozens of other institutions. Subscribers to WRDS need only PCs or even less-expensive Web terminals to endow their units with supercomputer capabilities and tap a massive, constantly updated source of data. Users click on the WRDS database and interactively select data to extract. The requested information is instantly returned to the web browser, ready to be pasted into a spreadsheet or any other application for analysis.

To learn more about WRDS or to get licensing information, contact: Nicole Carvalho, Marketing Director Wharton Research Data Services 400 Steinberg Hall-Dietrich Hall 3620 Locust Walk Philadelphia, PA 19104-6302

1-877-GET-WRDS (1-877-438-9737)

Knowledge@Wharton is a free source of research reports and other materials in accounting, finance, and business research --- http://knowledge.wharton.upenn.edu/ 

Forwarded by Robert B Walker [walkerrb@ACTRIX.CO.NZ] 

FASB Understanding the Issues: Vol 4 Series 1 --- 

I refer to the monograph on credit standing & liability measurement written by Crooch & Upton. --- http://accounting.rutgers.edu/raw/fasb/statusreport_articles/vol4_series1.html  

The article seems to suggest you wish to have feedback on this and other matters. Accordingly, I send my thoughts on this matter.

I would begin by observing that I think Concepts Statement 7 is inconsistent with the earlier 1996 study from which it was derived. I found that study utterly persuasive so I do not now find CS-7 persuasive. In moments of cynicism, I think that Mr Upton’s apparent epiphany is related more to the politics of accountancy than to its conceptual purity.

By this I mean that the measurement of liabilities at risk free interest rate rather than at a rate reflecting credit standing would be so anathema to the generality of accountants that it is futile to suggest it. Indeed the Crooch & Upton begin by stating a basic premise of axiomatic significance to their case – no gain or loss should arise when engaging in simple borrowing. The idea that no sooner one entered a loan agreement than a loss would arise (because it would invariably be a loss) would have most accountants in a state of high dudgeon.

The issue then is one of gain or loss. But then that is only if you perceive the world from an income orientation perspective. I don’t, primarily because of the influence of the conceptual framework. This is reinforced by my work as a liquidator of companies. I see the world purely from a balance sheet perspective and one subject to realisable value at that. In other words, I see the utility of accounting only in terms of solvency determination with all that entails in regard to the going concern assumption.

Unlike the United States, in the jurisdiction in which I live accounting has been rendered central to creditor protection in our corporate law. Central to this law, in turn, is the conceptual framework (at least in my view and to test the hypothesis I have a case before the courts now). I am then caused considerable misgiving as the final consequence of FASB’s view is the effective emasculation of our law built, essentially, on American conceptual development.

The ultimate consequence of what FASB propose is that as a company slides toward insolvency its liability value declines, the value of its net worth increases. Presumably as it has no credit standing at all because it is insolvent, it has no liabilities. This may be practically true when the creditors miss out but in my jurisdiction at least it is not legally true because those responsible for the creditors loss are held accountable, the impediments of the legal system notwithstanding.

I note that Crooch & Upton make reference in a footnote to the theory of Robert Merton in which it is implied that the residual assets are able to be ‘put’ to satisfy the claims of creditors. That may be true in an economist’s fantasy but it is not true in law, a rather more important arena.

I say perceiving a decline in the value of a liability is considerably more counter-intuitive than the problem of accelerating the recognition of cost of debt. This is a mere triviality by comparison. After all the same amount of charge is recognised over time. The advantage of accelerating loss is that it causes an entity to be more inhibited in its distribution policy as it has less equity to draw upon. That is to the advantage of creditors.

It seems to me that there needs to be an objective value at which to determine the value of a liability, this being central to the ability to liquidate. Mr Upton in his 1996 study demonstrates that such a value will represent the price the debtor has to pay to have the liability taken away. That price will be determined by the seller providing sufficient resources to the buyer to ensure that the buyer will avoid any risk. The resources would need to be enough to acquire a risk free asset with the same maturity profile as the liability.

The effect of perceiving the ‘price’ of a liability in this way is to necessitate that it is discounted at a risk free rate.

I note that the only way to make CS-7 coherent is to assume that such transfers of assets are always made between parties of the same credit standing. This pertains to one of the major practical difficulties of reflecting credit standing in accounting measurement – that is knowing what it is. It may be easily determined in the publicly listed world in which Crooch & Upton inhabit. It is not in the small, closely held corporate world in which I operate. For accounting to have long term validity it must be applicable in all circumstances.

I think it fair to note that there is another dimension to this that tends to undermine what I believe. I have a theoretical notion that the world upon consolidation nets to nil. That is to say, my financial asset and your financial liability must have the same value in our respective records. Call this a principle of reciprocity.

Theoretically, so far as I understand it a lender will discount the face value of a zero discount bond at the risk free rate after having adjusted for the probability of receiving nothing at all. The effect of doing that is, at the inception of an advance, to carry the value of the asset at the cash value paid at that time. If the application of the principle of reciprocity was applied when the liability was revalued in the books of the debtor, the creditor would take up a gain that denied any risk existed.

I find this inconvenient as it causes me to abandon a notion in which I fundamentally believe. I will just have to suffer cognitive dissonance, won’t I? But then one should not underestimate the psychology that underlies accounting, particularly in the face of the paradoxes it is capable of generating.

Also see other articles on related topics at  http://accounting.rutgers.edu/raw/fasb/statusreport_articles/ 

• New—Credit Standing and Liability Measurement
  June 2001–Volume 4, Series 1
  [Download–6 pages]

   

• New—Measuring Fair Value
  June 2001–Volume 3, Series 1
  [Download–6 pages]

   

• The Case for Initially Measuring Liabilities at Fair Value
  May 2001–Volume 2, Series 1
  [Download–4 pages]
  
  
• Expected Cash Flows
  May 2001–Volume 1, Series 1
  [Download–6 pages]

 

Baruch Lev has a very good site on accounting for intangibles at http://www.stern.nyu.edu/~blev/intangibles.html 

Also note Wayne Upton's Special Report for the FASB at http://accounting.rutgers.edu/raw/fasb/new_economy.html 

E-COMMERCE AND AUDITING FAIR VALUES SUBJECTS OF NEW INTERNATIONAL GUIDANCE The International Federation of Accountants (IFAC) invites comments on two new exposure drafts (EDs): Auditing Fair Value Measurements and Disclosures and Electronic Commerce: Using the Internet or Other Public Networks - Effect on the Audit of Financial Statements. Comments on both EDs, developed by IFAC's International Auditing Practices Committee (IAPC), are due by January 15, 2002. See http://accountingeducation.com/news/news2213.html  

The IFAC link is at http://www.ifac.org/Guidance/EXD-Download.tmpl?PubID=1003772692151 

The purpose of this International Standard on Auditing (ISA) is to establish standards and provide guidance on auditing fair value measurements and disclosures contained in financial statements. In particular, this ISA addresses audit considerations relating to the valuation, measurement, presentation and disclosure for material assets, liabilities and specific components of equity presented or disclosed at fair value in financial statements. Fair value measurements of assets, liabilities and components of equity may arise from both the initial recording of transactions and later changes in value.

 

Download "Auditing Fair Value Measurements And Disclosures" in MS Word format. File Size: 123 Kbytes Download "Auditing Fair Value Measurements And Disclosures" in Adobe Acrobat format. File Size: 209 Kbytes

Bob Jensen's threads on the Enron scandal are at http://www.trinity.edu/rjensen/fraud.htm

Standard & Poor's Redefines Core Earnings

Bob Jensen's Overview --- Go to  http://www.trinity.edu/rjensen//theory/00overview/CoreEarnings.htm