Last month, the federal Securities and Exchange Commission charged Lucent Technologies, the Murray Hill, N.J.-based AT&T spinoff, with “fraudulently and improperly” recognizing some $1.148 billion of revenues and $470 million in pre-tax income during its fiscal year 2000. While Lucent and three of the company’s former employees agreed to settle the case without admitting or denying the allegations, as part of the settlement the telecommunications company agreed to pay a $25 million penalty for its “lack of cooperation.”
In these post-Enron times, regulators in the U.S. are holding companies to tougher financial reporting standards. With that in mind, what can companies learn from the situation that got Lucent in trouble with the SEC? Wharton accounting professors and other experts explain that the SEC’s action against Lucent and other companies shows that it is crucial for corporate accountants to pay close attention to issues such as the proper way to recognize revenues and calculate expenses. Unless this is done right, it could not only attract unwelcome regulatory attention but also potentially undermine relations with investors and partners.
Lucent’s apparent transgression — which was originally brought to the SEC’s attention by the company itself — turned on the question of when a sale can be properly “booked,” or recognized, on the company’s financial statements. While Generally Accepted Accounting Principles (GAAP) offer some leeway, a problem may arise if a firm tries to inflate its bottom line by moving revenues that are properly associated with a certain period into an earlier one. The SEC’s complaint alleged that in an attempt to “realize revenue, meet internal sales targets and/or obtain sales bonuses,” Lucent officers, executives and employees improperly granted and in some cases failed to disclose various side agreements, credits and other incentives to induce Lucent’s customers to buy the company’s products. Further, said the SEC, Lucent violated GAAP by recognizing revenues on these transactions where it could not be recognized under the rules; and by recording the revenues earlier than permitted under GAAP.
Lucent spokesman Bill Price says that while the company accepts responsibility for certain issues, it would not issue any comments beyond those contained in a December 2000 press release. In that document, Lucent noted that among other issues, there had been misleading documentation and incomplete communication between a sales team and the financial organization with respect to offering a customer credits in connection with a software license and that revenue had been recognized from the sale of a system that had been incompletely shipped. “Throughout the review, we believe we have taken an appropriate, conservative posture in every case,” said then-Chairman and CEO Henry Schacht. “I am confident in the remedies and controls we have put in place as we move forward.”
It is also important to note that the SEC did not blame Lucent’s accounting processes or procedures as much as executives and managers who violated them. According to the SEC, “In carrying out their fraudulent conduct, according to the complaint, these Lucent officers, executives and employees violated and circumvented Lucent’s internal accounting controls, falsified documents, hid side agreements with customers, failed to inform personnel in Lucent’s corporate finance and accounting structure of the existence of the extra-contractual commitments or, in some instances, took steps to affirmatively mislead them.”
The Numbers Game
In a famous 1998 speech titled The Numbers Game, former SEC Chairman Arthur Levitt used an Epicurean analogy to describe the practice of improperly booking revenues. “Think about a bottle of wine,” he said. “You wouldn’t pop the cork on that bottle before it was ready. But some companies are doing this with their revenue – recognizing it before a sale is complete, before the product is delivered to a customer, or at a time when the customer still has options to terminate, void or delay the sale.”
Today, Levitt’s analogy is still valid, say Wharton professors. “Companies cannot book revenue until it is both realizable and earned,” according to Brian J. Bushee, a professor of accounting at Wharton. “The term ‘realizable’ means that the company either gets paid in cash or bills the company with the reasonable expectation that it will get paid a fixed amount by the due date. The term ‘earned’ means the company has provided the goods or services.”
As an example, Bushee notes that if a company agreed to paint a house, it would need to issue a bill for a fixed price to which both parties had agreed, and it actually had to paint the house before recording the revenue associated with the transaction. “What Lucent basically did was to both record revenue before it ‘painted the house’ or even settled on which house to paint,’ and before it figured out what the price of the job would be,” he explains. “In one of the transactions cited by the SEC, Lucent billed Winstar [Winstar Communications, a unit of IDT Corp.] $135 million for the sale of software and recorded the revenue. The revenue was definitely realizable because Winstar was billed and was deemed likely to pay. However, the SEC found that part of the revenue was not earned.” The $135 million included a $35 million credit toward unspecified future software purchases and a $45 million credit toward a future purchase of a new network. “Neither of these goods or services were delivered by Lucent prior to the end of 2000, and there was not even a schedule for when they would be delivered,” he relates. “As a result, Lucent had not earned the revenue and should not have recorded it. To make sure the auditors would not find this, some Lucent executives falsified documents.”
Lucent, of course, is far from the only firm to be accused of distorting its sales. In one famous case, the SEC alleged that Sunbeam Corporation engaged in “accounting fraud by improperly recognizing bill-and-hold and contingency sale transactions.” Specifically, the Commission accused Sunbeam of giving financial incentives to its customers to write purchase orders before they needed the goods, offered to hold the product until delivery was requested and typically covered related costs. And just before the close of a quarter, according to the SEC, Sunbeam allegedly booked revenue and income from purported sales to wholesalers that incurred no expenses, accepted no ownership risks, and had the right to return unsold products.
The company eventually agreed to a cease-and-desist order, but it did not have to pay any fines, although its ex-Chairman and CEO Al Dunlap agreed to pay a $500,000 fine and was permanently barred as officer or director of a public company. However, he neither admitted nor denied the wrongdoing for which he was charged.
Catherine M. Schrand, a professor of accounting at Wharton, says the “basic story” at Sunbeam was similar to what happened at Lucent. “Sunbeam forced retail customers like Home Depot to buy gas barbecue grills before the Dec. 31 year end so that Sunbeam could recognize revenue. Of course, Home Depot didn’t really want gas grills in December, but Sunbeam had to meet certain conditions related to delivery in order to recognize the revenue,” she details. “They made various agreements with the retailers so that they could deliver the grills and meet the GAAP criteria for recognizing revenue. This is called channel stuffing, and it’s a timing thing. If all the grills are sold in December, then Sunbeam will have lower sales in March than they would have had if they had not recorded the sales in December.”
It appears that a significant number of companies try to dress up their results by playing around with revenue and expense recognition, based on the SEC’s Report Pursuant to Section 704 of the Sarbanes-Oxley Act of 2002. Released in January 2003 and covering the period from July 31, 1997 though July 30, 2002, it reviewed the Commission’s enforcement actions that arose from improper issuer financial reporting, fraud, audit failure, or auditor independence violations.
The SEC brought the greatest number of actions in the area of improper revenue recognition. Of a total of 227 investigations in the period, which led to 515 enforcement actions, 126 involved such conduct as fraudulent reporting of fictitious sales, improper timing of revenue recognition, and improper valuation of revenue. Further, 101 investigations, or “enforcement matters,” involved improper expense recognition, including improper capitalization or deferral of expenses, improper use of reserves, and other understatement of expenses. Additionally, 23 enforcement matters involved improper accounting for business combinations, while 137 enforcement matters involved such accounting and reporting issues as inadequate Management’s Discussion and Analysis disclosure and improper use of off-balance sheet arrangements (Because most of the 227 investigations involved more than one type of improper conduct, the SEC has noted it would not be meaningful to aggregate the number of cases).
Focusing on the issue of improper expense recognition, Wharton’s Bushee explains the opportunity for this kind of “massaging” stems from the accrual method of accounting, which is generally used by publicly held companies, and which reports income when earned and expenses when incurred, as opposed to cash basis accounting, which reports income when received and expenses when paid. “Expenses on the income statement do not always have to occur at the same time cash is paid,” he says. “This allows managers to exercise judgment on when to record (or not record) expenses.”
In general, notes Bushee, the accrual method makes a net income number more useful than cash flow, but it is also open to abuse. “For example, if a company paid $10 million in cash to produce inventory at the end of 2003 and sold it all for $15 million in 2004, it would have $10 million negative cash flow in 2003 and $15 million positive cash flow in 2004,” he explains. “In contrast, accounting allows the company to ‘store up’ the cost of the inventory as an asset until the product is sold. Thus, the expense for the cost of sales will be matched to the sales, and the user of the financial statements will get the more accurate picture that the company made $5 million profit in 2004.”
Unfortunately, managers sometimes abuse their judgment when it comes to recording expenses, which are the portion of costs incurred in the current period.
“The first way is to delay recording expenses even though the rules [i.e., GAAP] suggest that expenses should be recorded immediately when cash is paid,” he notes. For example, assume that a company buys a car for $25,000, and it has a five-year useful life. “The company would create an asset of $25,000 and reduce it by $5,000 per year, recording each $5,000 reduction as an expense. Thus, the initial cost of the car is ‘depreciated’ through expenses evenly over five years.”
Despite that, accounting rules state that if the company spends cash to perform routine maintenance necessary to make the car last five years (changing the oil, for example), that cash must be recorded as an expense immediately. However, if the company spends cash to perform a “capital improvement” that extends the life or value of the car (like putting in a more powerful engine which will extend the car’s useful life), that cash can be added to the asset and depreciated over a number of future years.
“An issue arises if a company treats repair expenditures as capital improvements, which will enable it to increase net income this year, although it will have lower net income in the future,” says Bushee. “This is basically what WorldCom did with its ‘line costs.’ It took $9 billion of cash expenditures that should have be expensed immediately and instead added them to an asset, so the costs could be expensed over a number of future years.”
He notes that another problem can arise when managers have to estimate an expense now to reflect expected future cash payments. “In the long run, total expenses have to equal total cash outflows, but managers can manipulate the timing of when expenses are recognized,” says Bushee. “Managers can either underestimate the expense now and record more expense when cash is paid in the future, or overestimate the expense now and record less expense when cash is paid in the future.”
As an example of an underestimated expense, Bushee points to a company that is required to record a charge for expected future warranty costs at the time it sells a covered product, even though the cash to satisfy the warranty will not be paid until a subsequent period. “If a manager underestimates the expected warranty costs, the company will record less expense this year but more in the future,” he says. “A manager who wants to boost earnings this year would adopt this approach.”
As for overestimating a current expense, Bushee notes that companies are required to immediately record an expense for all costs associated with a restructuring at the time a restructuring plan is developed. “Many of these expenses reflect expected future cash costs, including severance payments,” he says. “If the company overestimates the amount of future cash payments, it will take a larger-than-needed restructuring charge. However, this does not matter because the market often ignores these charges as ‘one-time items.’ Then, in future years, the cash actually paid is less than originally expected and the company records a gain, or negative expense, to correct the prior over-expensing. This example is often called the “cookie jar” reserve as it allows a manager to boost future earnings sometime in the future by just reaching into the cookie jar to record a gain.
Business Combinations and Other Abuses
Fortunately for investors and others, the occurrence of one of the top abuses cited in the SEC report — manipulating earnings through improperly accounting for business combinations — has been dampened thanks to a pair of regulations issued in June 2001 by the Financial Accounting Standards Board (FASB): Statement No. 141, Business Combinations, and Statement No. 142, Goodwill and Other Intangible Assets.
“As a result of FAS 141 and 142, managers no longer have the same incentives to engage in these actions anymore,” notes Bushee. “The short version of what was happening is the following. When a company makes an acquisition, it almost always pays more than the fair value of the acquired firm’s net assets. This is because the accounting system does not record intangibles such as human capital, expected growth opportunities, and synergies, which the acquiring company has to pay for nonetheless. This difference between the price of the acquisition and the fair value of the acquired firm’s net assets is called goodwill.
“Before the FASB rules changed goodwill, it was generally recorded as an asset and was expensed against earnings over a 40-year period. But to avoid recognizing a reduction to net income over such a long time, some managers tried to do one of three things.
“First, they would try to use the ‘pooling of interests’ method instead of the ‘purchase’ method,” relates Bushee. “Unlike the purchase method, there is no goodwill recorded under the pooling method. Although FASB had 12 restrictive criteria that had to be met to use the pooling method, companies would cheat to comply with these restrictions.”
As a second method, even if a company had to record goodwill, managers would try to overstate the fair value of the assets on the acquired firm’s balance sheet in order to make the goodwill, and therefore future reductions in earnings, as small as possible. Finally, notes Bushee, if a company had to record goodwill, it would try to expense as much of it as possible in the first year to reduce the future drag on earnings.
“The company would call it a ‘one-time charge’ and most analysts would ignore it,” he says. “But since FASB eliminated the pooling method, everyone has to record goodwill, which eliminates the first problem. In conjunction, it no longer requires goodwill to be charged to earnings every year. Instead, it can remain as an asset indefinitely as long as its value does not decline. If it does decline, companies have to take a one-time charge to reduce it. This change has largely eliminated the second and third problems, although managers may still want to limit the size of the goodwill asset somewhat to reduce the potential size of future write-downs.”
Greed and Hubris
Greed, fear and the relatively low chances of getting caught are the primary drivers behind corporate misreporting, suggests Howard Schilit, the founder of the Center for Financial Research & Analysis in Rockville, MD. “Public companies are run by competitive, successful leaders who are not used to losing,” he says. “So if Wall Street expects a particular quarter’s earnings to be $1 a share, and a customer suddenly defers an order worth three cents a share, a CEO may have the mindset to exploit accounting’s flexibility to make the numbers anyway.”
In addition to accelerating the recognition of revenue, he says depreciation and amortization schedules may be modified, or bad debt and other reserves can be adjusted. “The changes are relatively easy to accomplish, and management may be able to justify them to auditors, regulators and others,” Schilit says. “The solution isn’t just higher penalties and more enforcement. Instead, human behavior will only change when the system of rewards and punishments changes.” He suggests, for example, that the “incredible wealth” offered by stock options tempts managers to beat Wall Street estimates. “If the ‘cops’ aren’t looking closely enough, then the urge to produce great numbers may drive CEOs to go beyond acceptable limits,” Schilit says. “When they do it once, it’s difficult to avoid doing it again.”
For CEOs who want to avoid falling into such traps, a good rule of thumb may be to accept the reality that when market conditions are bad, a company may have a poor quarter or two, rather than trying to disguise that reality through accounting tricks. It may simply be a matter of pursuing a moderate rather than aggressive path to growth. Says John Percival, adjunct professor of finance at Wharton: “It sounds like Lucent may have chosen a more reasonable path to profitable growth, but I would imagine that some of their reduced enthusiasm for growth at any cost is simply a reflection of the recently depressed state of the global telecommunications industry. It’s not necessarily a change in management philosophy.”