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Expense Recognition Red Flags: Reserve Accounts and Write-Offs 2.5
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From the course by University of Pennsylvania
Accounting Analytics
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From the lesson
Earnings Management
This week we are going to examine "earnings management", which is the practice of trying to intentionally bias financial statements to look better than they really should look. Beginning with an overview of earnings management, we’ll cover means, motive, and opportunity: how managers actually make their earnings look better, their incentives for manipulating earnings, and how they get away with it. Then, we will investigate red flags for two different forms of revenue manipulation. Manipulating earnings through aggressive revenue recognition practices is the most common reason that companies get in trouble with government regulators for their accounting practices. Next, we will discuss red flags for manipulating earnings through aggressive expense recognition practices, which is the second most common reason that companies get in trouble for their accounting practices. By the end of this module, you’ll know how to spot earnings management and get a more accurate picture of earnings, so that you’ll be able to catch some bad guys in finance reporting!
Meet the Instructors
Brian J BusheeThe Geoffrey T. Boisi Professor
Accounting
Christopher D. IttnerEY Professor of Accounting
Accounting
Hello, I'm professor Brian Bushee.
Welcome back.
In this video, we're gonna wrap up our look at expense manipulations
by checking out reserve accounts and write-downs.
To find these manipulations,
we're gonna have to dive into the footnotes to get the information.
You're not gonna find this information generally on the balance sheet or
the income statement.
But hey, it's fun to dive into the footnotes, so let's get started.
>> What is a footnote disclosure?
Do we also have to look at headnotes and handnotes?
>> No, you do not have to look at headnotes or
handnotes, only the footnotes.
The footnotes are the part of the annual report that come right after
the financial statements.
Here, let me show you an example.
So right after you've finished seeing all of the finance statements,
the footnotes start.
The footnotes provide all of the policies
that the company used to do the accounting, and then
all sorts of additional information that doesn't fit on the financial statements.
A lot of this information is textual.
It's paragraphs.
But then a lot of it is also tables and additional numbers,
breaking down numbers that you can't see on the financial statements.
And as you can see, these notes go on and on and on and on and on and on and
on and on and on.
100 pages, 200 pages,
an extensive amount of information that follows the financial statements.
This is the part of the report that we're going to dig into
to find a lot of the information we need for these types of expense manipulations.
The first type of expense manipulation we'll look at involves reserve accounts.
So companies have to make assumptions each period for
certain expenses that are associated with revenue activities.
For example, the rules require that expected future losses due to
customer defaults, so a customer owes you money but doesn't pay you.
And expected future losses due to warranty claims, so you promise to fix
a defective product and so you have to pay cash in the future to fix it.
Those both have to be recognized at the time sales are made.
And so we create expenses called the provision for
doubtful accounts and warranty expense.
These expenses require reserve accounts on the balance sheet to bridge
the gap between when we recognize the expense at the time sales are made, and
the future cash flows, or I guess, in the case of doubtful accounts,
the lack of future cash flows.
And so we have on the asset side an allowance for
doubtful accounts, on the liability side, a warranty liability.
Companies can adjust the assumptions for
these reserve accounts at the end of the period to manipulate earnings.
So what we're going to look at is the ratio of the allowance for
doubtful accounts to gross accounts receivable.
That'll give us an estimate of the percent of total receivables that will not be
collected in the future.
We'll also look at the ratio of warranty expense to revenues,
which gives us an estimate of the percent of current sales
that will result in future warranty claims.
And if we see, for example, a big drop in this estimated percentage of
un-collectible receivables, it could be indicative that the company has
slashed this percentage in order to boost their earnings during the period.
>> So, any drop in the uncollectible percentage is manipulation?
Maybe the company just did a better job with credit checks on its customers.
>> No, you're right.
A change in the percentage of expected uncollectible accounts could
be due to legitimate changes in the business.
If you see one of these big changes, you wanna ask yourself,
did the manager have strong incentives to manipulate earnings this period or not.
You also wanna look at the magnitude of the estimated effect.
So if change in this rate reduced the expense by 300,000, but the company beat
its earnings target by 5 million, then it probably wasn't this change that was
helping the earnings management, and they may have done it for legitimate reasons.
So identifying a big change in this percentage
is the start of your investigation, it's not the end.
It's not conclusive proof that the company manipulated their earnings.
The second type of expense manipulation we're gonna look at is delaying
write-downs.
Companies are required to account for
non-financial assets at something called lower-of-cost-or-market, or LCM.
Examples of non-financial assets would be inventory, property,
plant, equipment, intangible assets.
Basically any asset that's not denominated in a dollar amount or a currency amount.
If the current fair value of the asset is greater than its book value, and by book
value, I mean the value on the financial statements, you don't do anything.
And I use the term fair value,
what that means is it's the market value of the asset today.
In other words, how much it would cost to buy the asset in the market or
it's an estimate of market value if there is no market.
And that's why we've changed to calling it fair value instead of market value because
we need to come up with a value even if there's no traded market for the asset.
But we still call it lower of cost or market for
some reason, it should be lower of cost or fair value.
Anyway, if the current fair value of the asset is below book value,
below the value on the finance statements,
then you have to write down the book value to the current fair value.
This decision rule is based on a fair value using undiscounted cash flows, but
the write down is based on discounted cash flows.
>> I don't even know what question to ask.
>> Then I guess I don't know what question to answer.
Yeah, I understand that this is really technical, and
I could spend an entire video just diving into these impairment rules,
these rules on when you write down assets.
But the only point I wanna make for
now is that there's a lot of discretion in these rules.
And so that even if a manager thought that an asset was impaired, that its value had
dropped below its fair value, it can still find ways to delay that write down for
a quarter or two in order to protect its earnings this period.
So companies could delay these write-downs by using their judgement and
estimates to say that the current fair value has not dropped below book value and
thus manipulate their earnings by avoiding recognizing the write-down expense.
So we'll try to spot this by looking at days inventory or days finished goods.
If that starts to increase dramatically,
it could be the company is avoiding a write-down.
We'll also look at the ratio of revenue to whatever non-financial asset we're
interested in, be it Property Plant Equipment, Goodwill or Intangible Assets.
So let's practice applying these red flags with a case.
So we're going to look at the case of Dogamer Enterprises.
Dogamer develops and manufactures video games for dogs.
As you know,
dogs cannot play traditional video games due to their lack of opposable thumbs.
So they can't hold the controllers.
Dogamer developed a gaming unit with eye scan technology
that lets dogs play by moving their eyes to different parts of the screen.
And that's how they can control the action in the video game.
The company went IPO in 2003 and grew rapidly.
Then in 2012, the American Veterinary Medical Association issued
research on the dangers of screen time for dogs, and
they recommended no more than two hours of screen time per week for dogs.
Well, sales of Dogamer products started to suffer as a result of this warning.
The company posted a net loss of 145 million in 2013 and 89 million in 2014.
They needed an emergency bridge loan of $30 million in early 2015 to stay afloat.
And the auditor gave the company a going concern opinion in 2014.
>> What is a going concern opinion?
>> A going concern opinion is a situation where the auditor gives an opinion to
indicate that the company may go bankrupt within the next year.
The auditor has to do that because the financial statements includes all of these
long term estimates, like you depreciate a building over 25 years.
Or you may spread unearned revenue over three years.
But if you thought the company was gonna go bankrupt within a year.
Then those finance statements are wrong.
You should actually have things at liquidation value.
So the going concern opinion is the auditor's way to say.
You can trust these statements if you think the companies can continue as
a functioning, healthy going concern.
But we have reservations that the company's able to do that.
And so you have to treat these statements with caution.
Because you may wanna think about looking at it as a bankruptcy within the next
year or so.
So in the midst of this crisis in their business,
Dogamer implemented a turn-around plan late in 2014.
They changed their top management.
They brought in some people that were experienced in turning
around distressed companies.
They did a lot of cost-cutting actions.
Things like employee layoffs, closing facilities, delaying capital expenditures.
They also signed a strategic alliance with Shibatendo of Japan
to try to boost sales in Asia.
Shibatendo was a traditional, non-electronic dog toy gaming company,
which would now carry dogamers electronic games.
And the good news was that in Asia they were not as familiar with
this screen time research.
The strategy was a great success.
Sales turned around and were up 4% in 2015.
The company had net income of $13 million and
the auditor removed the going concern opinion.
So now the future looks bright for Dogamer.
Based on the turnaround, the company was able to sign deals to be the exclusive
provider of dog gaming products in the Big W retail chain in Australia, and
the warehouse retail chain in New Zealand.
And they also signed a contract with the government of Switzerland to develop and
sell to them St. Bernard training simulation games.
So things have really turned around at the company.
So now let's bring up this spreadsheet.
Where I've got all of doggamers financial statements.
So I took their 2015 and
2014 results, which were reported in their most recent finance statements.
And then I added in columns for 2013 and 2012 from prior financial statements.
What we can see is their total assets trending down.
In the way the years are, you have to read right to left here.
So, as the crisis is going on, they're getting smaller,
but then their size stabilizes in 2015.
We can see their sales drop dramatically between 2013 and 2014.
And then we see the 4% increase into 2015.
The two net losses in 2013 and
2014 turns into a net profit, net income in 2015.
And their cash from operations rebounded and became positive in 2015.
The first item I want to focus on to look for potential expense manipulation,
is this accounts receivable net.
Now, what doggamer does is they give us the allowance for
outflow accounts right here in the balance sheet.
Some companies don't do that.
In which case, you'd have to look in a footnote.
But since it's on the balance sheet we can go ahead and use these numbers.
So go over to the accounts receivable allowance tab.
I've repeated the line from the balance sheet.
The calculation we're going to do is we're going to start with
net accounts receivable, add the allowance for uncollectibles, or allowance for
doubtful accounts to get something called gross accounts receivable.
Gross accounts receivable is the total amount that customers owe us.
The allowance is the amount of that total we expect to not collect.
So net accounts receivable is the amount that we expect to collect from customers.
So that's the number that goes on the balance sheet.
But what we're interested in is the ratio of how much we expect to not collect,
the allowance.
Divided by the total that's owed us.
And we can see if we do that ratio in 2012, we come up with 3%.
So 3% of our gross accounts receivable we expect to never collect.
That percent stays steady around 3% through 2012, 2013,
2014 and then plummets to 1.7% in 2015.
So in 2015, DogGamers is expecting to collect a lot more of their
receivables because their allowance is a midge smaller percentage of their gross.
What we can do is actually quantify how much this would have helped their net
income during the period.
So what we can do is say what if we took their gross accounts receivable at the end
of 2015.
And multiply it by the rate they used in 2014.
We would come up with an allowance of $4,210.
So in other words, if they had carried that 3.15% over as the percentage in 2015,
their allowance would have 4,210.
The actual allowance was 2,272,
which means that their allowance was almost two million lower.
Due to the drop in percentage,
which means that their expense was also two million lower.
So it saved them two million in expense by reducing this percentage.
Next I wanna take a look at warranty expense.
So if we go back to the balance sheet and look at liabilities.
There's no liabilities listed for warranty liabilities.
That's because they're included as part of these accrued liabilities.
So we're gonna have to look at the footnote to get the information.
So let me bring up their footnote.
So you can see what it looks like.
As you can see, it gives you a description of what the warranties are.
Then it gives you the balance at the beginning of the year.
The provisions are the new warranty expense.
So those are the estimates of how much of current sales will result
in warranty claims so it adds to the liability, utilizations.
That's the cash paid for fixing warranty claims.
So that reduces the liability.
Then we get the balance at December 31.
So now let me go back to the spreadsheet.
So you can see I brought in that information here.
I also added another year from a prior financial statement, 2013.
So we can look at a trend.
I also brought in net sales since we're going to use this to come up
with a percent of warranty expense.
So that line shows up here.
We're gonna take warranty expense as a percent of sales.
So we've got the provision or expense divided by net sales.
We find that in 2013,
DogGamer had 1% of their sales that they estimated as warranty expense.
That percent stayed around 1% in 2014 and
then plummeted to .73% in 2015.
We can also look at the warranty claims, the cash claims as a percent of sales.
And we can see that that rate has been steady and
actually increasing a little bit over time.
So this drop in warranty expense to sales does not seem to be justified by
fewer warranty claims.
Which makes it a potential manipulation.
So we can do the same calculation we did before.
Where we take net sales in 2015, times the warranty expense to sales ratio in 2014.
To come up with what the expense in 2015 would have been
had they not dropped the rate from 1% to 0.7%.
So their expense would have been $54.63.
We can compare that to their actual expense in 2015.
And see that they saved two million of expenses by
reducing this warranty rate in 2015.
Now I want to go back to the balance sheet and take a look at inventories
to see if I can find some evidence of delayed write-downs.
So I've got an inventory tab.
Bring in inventories from the balance sheet.
Cost of sales, I can get days inventory ratio.
And I see that there's not much going on between 2014 and 2015.
However, there is a footnote that provides more information on inventory.
And let me bring up that footnote now.
So if you look at the footnote,
you can see it breaks down inventory into raw materials.
Those are all of the supplies and components and
basic parts that the company will use to make gaming systems.
Work in process,
which is the cost of the gaming systems that are in the process of being built.
And finished goods which is the cost of gaming systems that are complete and
just sitting in a warehouse waiting to be sold.
So now let's go back to the spreadsheet.
As you can see, I brought in that information.
I brought in also the prior two years from another footnote.
Now we can calculate Days Raw Materials, Days Work in Progress,
Days Finished Goods, which is just the average inventory level for
each component compared to cost of sales or cost of goods sold.
So we see for Days Raw Material, there was a big drop in the number of days in 2015.
Also, for Days Work in Process, there's a big downward trend with a drop in 2015.
That indicates that the company is scaling back production.
They're holding less raw materials in the warehouse, and
they're not building as many gaming systems.
If we look at Days Finished Goods, it was holding steady at 57,
then it jumped to almost 65 days in 2015.
That means that the finished gaming systems are staying in
the warehouse longer before they're being sold.
This could be the delayed write downs,
where these are gaming systems that have become obsolete.
They can't sell them, they should write them down, but
instead they're just holding them longer.
Again, we can estimate how much they may have benefited from this.
So what we need to do is figure out what would finished goods have been
had they maintained their Days Finished Goods at 57.
This is complicated because there's an average balance of inventory.
So the calculations get a little tricky.
First we have to figure out the Average Finished Goods at the 2014 days level.
So what we do is we take the days of 57,
divide by 365, take it times cost of sales for 2015.
That's what Average Finished Goods should have been.
Then what we can do is figure out what finished goods at the end
of 2015 should be based on that average.
So basically it's what number average between 39,109 and
39,120 gives you finished goods, and it's 39,130, so that's
what their finished goods should've been, if Days Finished Goods stayed the same.
Instead, it was 49,355, and what that means is they
potentially saved $10 million in expenses by not writing down their
finished goods that are potentially obsolete and are not selling.
The last place I'd wanna look for delayed write downs would be in property plant
equipment, capitalized product costs, and goodwill.
I didn't find anything, but I did find something interesting in digging through
some of the ratios we saw last video.
I'm not gonna go through these calculations now in the interest of time.
You can look at them on your own later, but the years amortization for
the capitalized product cost shot way up in 2015, so
they're amortizing over more years.
And for property plant equipment, the years of amortization or
depreciation also shot up in 2015.
And so
I decided to go to the footnote to see if I could find an explanation for this.
Here is the capitalized product cost footnote.
Again, in the interest of time I'm not gonna read it to you, but It's available
on the course platform if you wanna download it and read it at your leisure.
The key part of this footnote is the last sentence, where they say that in 2015,
the company determined it was appropriate to extend the amortization period for
content cost, resulting in a decrease in cost of sales of $3.8 million.
So that's $3.8 million expense they saved by increasing the amortization period.
Here's the PP&E footnote, same thing, you can look at it on your own.
The key sentence is the last sentence.
During 2015, the company completed an assessment of its capital investment plans
and determined the useful life of its computers should be extended by two years,
resulting in a decrease in selling general administrative expense of $3.6 million.
So more expense that's saved by increasing the amortization lives.
The last tab of the spreadsheet summarizes everything that we've looked at.
So you can see in this first row, the two losses in 2013 and 2014, and
then they have a profit in 2015.
But then if we pull out the benefits due to the reduction in
the AR allowance ratio, the reduction in the warranty rate,
the delayed inventory write-off, they would have actually had a loss.
Then if we pull out the benefits due to increasing the useful lives of
the capitalized costs in the computers, they would have had a even bigger loss.
Now it's not as big of a loss as they had the prior two years, but
it's still a loss.
And so by these five changes, Dogamer was able to turn a third consecutive
year of losses into a nice turnaround where they were profitable in 2015,
showing that their turnaround strategy is really [COUGH] [COUGH] working.
>> Honey, can y’all tell me whether this is good or bad?
Seems bad because they manipulated their earnings.
However, they saved the business.
>> Yes, they even tricked some new customers into doing business with them!
>> This is a good example of why I teach accounting and not ethics.
So it's tricky to decide whether this is good or bad.
I mean at some level it is bad that the managers are trying
to mislead outsiders to think the company is healthier than it is.
On the other hand, by doing so, they're saving the company, they're saving their
employees' jobs, they're saving all the investment of their investors.
And certainly for those people, this is good.
So I'm not gonna get in to good or bad, because it's very, very tricky.
Instead, I wanna give you the tools to spot potential manipulations.
And then you can use your own moral compass to decide
whether the manipulations were good or bad.
That wraps up our week-long look at revenue and
expense manipulations in order to try to manipulate your net income.
As I've mentioned, these revenue and expense manipulations are the most common
reason that companies get in trouble with the SEC, cuz there's a lot of discretion
in when you can recognize revenue and when you can recognize the expense.
So if you're looking at a company, you have some suspicions about the earnings
management incentives, these are good red flags to check out
as a first pass in whether there might be some manipulation going on.
Hope you enjoyed the week, and I look forward to seeing you again soon.
>> See you next video.
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