The Mission of the International Federation of Accountants (IFAC) Is the Worldwide Development

References

IFAC
Financial and Management Accounting Committee / February 2003
QUALITY OF EARNINGS:
A Case Study Collection
Issued by the International
Federation of
Accountants /

The mission of the International Federation of Accountants (IFAC) is the worldwide development and enhancement of an accountancy profession with harmonized standards, able to provide services of consistently high quality in the public interest.

The Financial and Management Accounting Committee (FMAC) of IFAC welcomes any comments you may have on this booklet. Comments should be sent to:

Technical Manager, FMAC

International Federation of Accountants

535 Fifth Avenue, 26th Floor

New York, NY 10017-3610

USA

Fax: +1 212-286-9570

E-mail:

Copies of this Case Study Collection may be downloaded free of charge from the IFAC website at www.ifac.org. Hard copies may be purchased from IFAC through the bookstore on the website or by calling +1 212-286-9344.

Copyright © February 2003 by the International Federation of Accountants and the American Institute of Certified Public Accountants, Inc. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, method or device, electronic, mechanical, photocopying, recorded or otherwise, without the prior written permission of the International Federation of Accountants and the American Institute of Certified Public Accountants.

For information about the procedure for requesting permission to make copies of any part of this work, for commercial purposes, or for purposes other than classroom use, please call the AICPA Copyright Permissions Hotline on 201-938-3245.

ISBN: 1-931949-00-X

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Foreword

The Financial and Management Accounting Committee (FMAC) of the International Federation of Accountants (IFAC) explores emerging trends and seeks to represent contemporary best practice in the domain of accounting work concerned with the management of organizations. This is done primarily through a range of publications: annual theme booklets, an annual collection of articles of merit, research studies, International Management Accounting Practice Statements (IMAPS) and guides for practitioners. Periodically, a member body makes available its own work for distribution to a broader audience through FMAC in an effort to share that work. Such is the case with this collection of case studies on earnings quality.

“Earnings Quality” has been a subject of investigations by regulators in many countries, articles in most, if not all, business publications, and significant debate in recent years. It is a matter of importance in the financial reporting and regulatory communities, and it impacts the confidence of investors in global financial markets. For this reason, the American Institute of CPAs in the U.S. engaged authors and experts to assemble this collection of case studies, to put the reader in the seat of executives making decisions that could impact the future of their company, and their own and their employees’ livelihoods.

The concept of Quality Earnings goes back to preparers understanding the economic substance of a transaction, then reflecting it properly in the books and records of the company. However, this is not always easy, as accounting rules are not simply black and white, and the nature of transactions is ever more complex. This understanding can be improved when the chief financial officer (CFO), an expert in the management of process, technology and resources, is part of the decision-making process in a company and can help guide and shape decisions to make better sense within the context of the applicable accounting standards and regulatory reporting requirements.

Managing the business and its operations to achieve a desired outcome or hit a target is entirely appropriate, (the emphasis here is placed on managing the business); managing earnings as we all agree, is not an acceptable practice to hit earnings targets. This fact is critical to professional accountants in management throughout the globe, and especially to our brethren in the United States where the profession has been challenged by corporate scandals and government regulation. As practitioners in the global financial reporting community we must report high quality earnings and the necessary disclosures to enable the investing public to make better informed decisions.

One way to do this is through the creation of a robust performance measurement system incorporating both financial and non-financial measures that not only measure current positions but also are predictive of future conditions in the business. Knowing and understanding key metrics in a company can lead to better decision-making and reporting, and thus higher quality earnings. Having an effective early-warning system in place could obviate the need for managing earnings by giving more of an opportunity for managing operations.

We hope you use these cases as an education opportunity for yourself and for your colleagues. You may want to create an interactive discussion session by distributing the cases for discussion, and then introducing the expert commentary for review. If you learn something about earnings quality, and it sensitizes you to the importance of this topic to your company, and to the integrity of the broader financial markets, then we will have achieved our objective.

Bill Connell, FCMA / John F. Morrow, CPA
Chairman / AICPA Vice President
IFAC FMAC / The New Finance

Members of the 2002 Financial & Management Accounting Committee:

References

Santiago Lazzati, Argentina

David Jeffries, Australia

Gerhard Prachner, Austria

Raymond Darke, Canada

Patrick Rochet, France

Srinivasan Ramanathan, India

Ghasem Fakharian, Iran

Rodolfo Di Dato, Italy

Yeo Tek Ling, Malaysia

Peter Sampers, Netherlands

Muhammad Aslam, Pakistan

Zein El Abdin El Boraie Ahmed, Sudan

Recep Pekdemir, Turkey

William L. Brower, Jr., United States

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Table of Contents

The Experts 1

Cases: Index By Issue 4

Do the Right Thing 5

By Howard Fowler, MS, CPA, CFM, FHFMA

A Controller’s Challenge 15

By Timothy L. Riedinger, CPA

Accounting For Loan Losses at County National Bank 23

By Larry M. Prober, Ph.D., CPA

Accounting for In-Process R&D at Simpco Incorporated 32

By Larry M. Prober, Ph.D., CPA

Vision Technologies Incorporated: Issues in Revenue Recognition 41

By Larry M. Prober, Ph.D., CPA

Restructuring At Exozol? 51

By Larry M. Prober, Ph.D., CPA

Accounting Issues At National Technology Corporation 59

By Larry M. Prober, Ph.D., CPA

Is it Okay to Buy Earnings? 69

By Lorri Carpenter, CPA

A Troubled Acquisition for Websave 79

By a Fortune 100 Executive

Policy and Judgment—The X Systems Group 89

A Corporate Training Case Study

Inventory Valuation Issues at AKL 97

By Grace S. Morin, CPA

Accounting for a Windfall 105

By Grace S. Morin, CPA

The Aker Computer Company 111

By Russell F. Briner, CPA

Restatements at Vesania Networks 117

By Jim Moult

The Case of Barter Transactions and Revenue Recognition 127

By Chris Baker

References 137

References

The Experts

Quality of Earnings Expert / Case Commentaries /
Anwer S. Ahmed, Ph.D., is Associate Professor of Accounting at the School of Management, Syracuse University. He is the author of “Bank Loan Loss Provisions: A Reexamination of Capital Management, Earnings Management and Signaling Effects,” (with C. Takeda & S. Thomas), Journal of Accounting & Economics, August 2000. / Accounting For Loan Losses at County National Bank 23
Bob Stefanowski, CPA, CFE, M.B.A., is an adjunct professor at the Stern School of Business and holds an M.B.A. in Finance from Cornell University. / The Aker Computer Company 111
Restatements at Vesania Networks 117
Carol A. Purcell, CPA, is the Chief Financial Officer at the Roman Catholic Archdiocese of Newark (NJ). Carol spent 10 years at Coopers & Lybrand specializing in hospitals and not-for-profit organizations, in addition to having experiences in large commercial organizations. Following her years at Cooper & Lybrand, Carol was a senior financial executive at a major hospital corporation in Northern New Jersey, before taking her current position as CFO at the Roman Catholic Archdiocese of Newark. / Do the Right Thing 5
Restatements at Vesania Networks 117
Dan Hugo, CPA, is Director of External Reporting for EBay Inc. Ebay pioneered a Web-based community in which buyers and sellers are brought together. EBay also engages in the traditional auction business and in online payment processing. / Vision Technologies Incorporated: Issues in Revenue Recognition 41
A Troubled Acquisition for Websave 79
The Case of Barter Transactions and Revenue Recognition 127
Dan M. Guy, Ph.D., CPA, lives and practices in Santa Fe, New Mexico. Dan’s practice is limited to consulting services, including litigation involving accountant’s malpractice issues. His most recent book is Audit Committees: A Guide for Directors, Management, and Consultants (Aspen Law & Business). / A Controller’s Challenge 15
Is it Okay to Buy Earnings? 69
Inventory Valuation Issues at AKL 97
Accounting for a Windfall 105
Restatements at Vesania Networks 117
Grace Pownell, Ph.D., joined the Goizueta Business School Faculty, Emory University in the fall of 1993. She is the author of “How Frequently Do Managers Disclose Prospective Earnings Information?” The Journal of Financial Statement Analysis, Spring 1998. (Co-authors: C. Kile & G. Waymire). / A Controller’s Challenge 15
Accounting for In-Process R & D at Simpco Incorporated 32
Restructuring At Exozol? 51
Lota Zoth, CPA, was appointed Senior Vice President and Corporate Controller at PSINet Inc on August 7, 2000. PSINet Inc is a global facilities-based provider of Internet access services and related products to businesses. PSINet Inc. also provides Internet Protocol and network backbone services. Prior to joining PSINet, Ms. Zoth was Controller and Chief Accounting Officer for Sodexho Marriott Services, Inc. (NYSE: SDH). / Is it Okay to Buy Earnings? 69
A Troubled Acquisition for Websave 79
The Case of Barter Transactions and Revenue Recognition 127
Marshall Pitman, Ph.D., CPA, CMA, is Associate Professor of Accounting at The University of Texas in San Antonio. / The Aker Computer Company 111
Martin S. Fridson, CFA, is Chief High Yield Strategist and Managing Director at Merrill Lynch. Mr. Fridson is author of several books on Financial Statement Analysis. / Do the Right Thing 5
Accounting Issues At National Technology Corporation 59
Policy and Judgment—The X Systems Group 89
Maureen F. McNichols, Ph.D., CPA, is Marriner S. Eccles Professor of Public and Private Management, Stanford University. She is the author of “Does Meeting Expectations Matter: Evidence from Analysts’ Forecast Revisions and Share Prices,” (with R. Kasznik), Stanford University Graduate School of Business working paper, 2001. / Policy and Judgment—The X Systems Group 89
The Case of Barter Transactions and Revenue Recognition 127
Mike Cohen, CPA, is Director of Technical Services for the NJSCPA. He previously worked at Ernst & Young as a specialist in technical matters and before that he was a project manager with the FASB. / Accounting for In-Process R & D at Simpco Inc. 32
Restructuring At Exozol? 51
Nita Clyde, Ph.D., CPA, is a partner at Clyde Associates. Clyde Associates is a boutique consulting firm located in Dallas, TX where Nita specializes in accounting education with a particular emphasis on issues of professional ethics. She chairs the AICPA/NASBA Joint Committee on Continuing Professional Education Standards, as well as a Special Committee on Ethics in the CPA Profession. She is a past member of the AICPA Board of Directors, and is currently a member of its governing Council. Nita was a university professor for almost 20 years. / Accounting for In-Process R & D at Simpco Incorporated 59
Policy and Judgment—The X Systems Group 89
Inventory Valuation Issues at AKL 97
Accounting for a Windfall 105
Paul Bialek, CPA, is Chief Financial Officer and Senior Vice President, Finance and Operations of RealNetworks, Inc. RealNetworks is a provider of media delivery and digital distributions solutions designs for the internet. / A Controller’s Challenge 15
A Troubled Acquisition for Websave 79
The Case of Barter Transactions and Revenue Recognition 127
Paul Munter, Ph.D., CPA, is KPMG Peat Marwick Professor of Accounting at the University of Miami. He is editor-in-chief of The Journal of Corporate Accounting & Finance and the author of “Progress on Impairments and Business Combinations”, The Journal of Corporate Accounting & Finance, November/December 2000. / Vision Technologies Incorporated: Issues in Revenue Recognition 41
Accounting Issues At National Technology Corporation 59
Robert M. Tarola, CPA, is Chief Financial Officer and Senior Vice President of W.R. Grace & Co. / Do the Right Thing 5
Stephen J. Cosgrove is Vice President, Consumer Sector Finance, at Johnson and Johnson Inc. Johnson and Johnson is engaged in the manufacture and sale of a broad range of products in the health care field in many countries of the world. / Accounting for In-Process R & D at Simpco Incorporated 32
Restructuring At Exozol? 51
Stephen L. Key is the retired Executive Vice President and Chief Financial Officer of Textron Inc. He is a former Executive Vice President and Chief Financial Officer of ConAgra and a former managing partner of the Ernst and Young New York office. / Vision Technologies Incorporated: Issues in Revenue Recognition 41
Is it Okay to Buy Earnings? 69
Steven M. Mintz, Ph.D., is a leading expert in the field of professional ethics for CPAs. Dr. Mintz is Visiting Professor of Accounting at Chapman University. He is the author of more than twenty published papers in ethics and a casebook in accounting ethics. / Accounting For Loan Losses at County National Bank 23
Is it Okay to Buy Earnings? 69
Inventory Valuation Issues at AKL 97
Accounting for a Windfall 105
Steven Wallman, J.D., is founder and CEO of FOLIOfn founded in 1998. Using the FOLIOfn system, investors can purchase customized portfolios. He is a former commissioner of the U.S. Securities and Exchange Commission and a former partner, Covington and Burling. He is a non-resident senior fellow of economic study at Brookings. / Vision Technologies Incorporated: Issues in Revenue Recognition 41
Accounting Issues At National Technology Corporation 59
Policy and Judgment—The X Systems Group 89
William McLucas, J.D., is a Partner with Wilmer, Culter & Pickering. His practice focuses on securities enforcement, regulation and litigation matters. McLucas served as Director of Enforcement at the Securities and Exchange Commission for eight years. / Do the Right Thing 5
Accounting For Loan Losses at County National Bank 23

Cases: Index By Issue

Managers can use their knowledge about the business and its opportunities to select reporting methods and estimates that match the company’s business economics, potentially increasing the value of accounting as a form of communication. However management’s use of judgment also creates opportunities for earnings management in which managers choose reporting methods and estimates that do not adequately reflect their company’s underlying economics (Healy, Wahlen, Working paper, 1998).