30 The company’s earnings seemed to indicate that its strategy was working. The com- pany reported pretax operating profit of $17,186,000, $23,395,000, and $44,762,000 in 1996, 1997, and 1998, respectively. 28 The year 1999 was also proceeding particularly well, with pretax operating profit reported at $92,865,000 for the first nine months of that year. In early 2000, however, the company announced that it was restating its results for the last two quarters of 1998 and three quarters of 1999, wiping out $81,562,000 of pretax earnings for the two years. Operating profit for the year ended 1998 was restated to $6,492,000 from $44,762,000, and to $49,573,000 from $92,865,000 for the first nine months of 1999. The primary culprit was the company’s method of accounting for pro- motional expenses paid to retailers. The company’s revenue recognition practices and amounts recorded for cost of goods sold and brokerage and distribution expense were also part of the restatement, but to a much lesser extent. Food companies compensate retailers for shelf space and supermarket displays. Aurora was apparently recognizing promotion expense not at the time it shipped prod- uct to the food retailers but rather when the retailers later sold that product. As such, Aurora was postponing expense recognition. In its 1999 annual report, the company de- scribed the impact of its improper practices: Upon further investigation, it was determined that liabilities that existed for certain trade promotion and marketing activities and other expenses (primarily sales returns and al- lowances, distribution and consumer marketing) were not properly recognized as liabilities and that certain assets were overstated (primarily accounts receivable, inventories and fixed assets). In addition, certain activities were improperly recognized as sales. 29 Even after the elimination of significant amounts of the company’s operating profit for 1998 and 1999, the company announced that “Sales of the company’s premium branded food products remain strong.” Still, one must reconsider whether earlier assess- ments of earning power were not overly optimistic given recent disclosures of its ac- counting practices. The markets agreed. The company’s share price was bid down to a low of $3 in early 2000 from a high of near $20 in 1999. Special Case of Earnings Management Earnings management is a special form of the financial numbers game. With earnings management, the flexibility of GAAP is employed to guide reported earnings toward a predetermined target. Often that target is a sustained, long-term growth rate in earnings, absent the kinds of dips and peaks that might ordinarily be considered representative of normal economic processes. Storing Earnings for Future Years A company’s management might consider a compound growth rate of 15% in corporate earnings to be a worthy long-term target. In particularly good years, that management might use more conservative assumptions about the collectibility of accounts receivable, T HE F INANCIAL N UMBERS G AME 31 about expected future warranty claims, or about fixed asset useful lives and residual val- ues to increase expenses and “manage” earnings downward. More conservative revenue recognition practices also might be employed in order to defer more revenue and reduce current earnings. In the process, through this use of so-called cookie jar reserves, the company is able to store earnings for future, slower years when, without help, earnings may be projected to come in below the target rate of growth. In that slower year, the allowance for uncollectible accounts receivable or the liabil- ity for expected warranty claims might be reduced, or fixed asset useful lives might be extended, or residual values might be increased, in order to reduce expenses and increase earnings. Similarly, a reduction in deferred revenue would boost revenue and increase earnings. From the preceding examples, it can be seen readily why earnings management is also known as income or profit smoothing. It is because the practice of earnings management often is designed to produce a smoother earnings stream, one that suggests a lower level of earnings uncertainty and risk. Earnings at General Electric Co. (GE) have grown steadily for decades. So predictable are the company’s earnings that The Value Line Investment Survey, a respected analyst- report service, gives the company its highest ranking for earnings predictability, a score of 100. 30 Drawn on a page, a temporal line of the company’s annual earnings is remark- ably straight, inexorably upward. One would not expect such a smooth and growing earnings stream from a company whose business segments include such diverse and often cyclical products and services as aircraft engines, appliances, industrial lighting, locomotives, medical systems, and financial services. Certainly the diverse nature of the company’s product and service mix provides a diversification effect that yields a more stable earnings stream. Beyond its product and service diversification, however, the company has in the past demonstrated a willingness to take steps that appear to manage its earnings to a smoother series. Martin Sankey, an equity analyst, noted that GE is “certainly a relatively aggressive practitioner of earnings management.” 31 Some of the actions the company has taken include offsetting one-time gains on asset sales with restructuring charges and timing the sales of equity stakes to produce gains when needed. For example, in 1997 the company recorded a gain on its disposition of an investment in Lockheed Martin. The company described the transaction as follows: Included in the “Other items” caption is a gain of $1,538 million related to a tax-free exchange between GE and Lockheed Martin Corporation (Lockheed Martin) in the fourth quarter of 1997. In exchange for its investment in Lockheed Martin Series A preferred stock, GE acquired a Lockheed Martin subsidiary containing two businesses, an equity in- terest and cash to the extent necessary to equalize the value of the exchange, a portion of which was subsequently loaned to Lockheed Martin. 32 Without the nonrecurring gain from the tax-free exchange, pretax income for 1997 would have fallen 10.8% below that reported for 1996. With the gain, however, pretax income was up 3.5% in 1997 over 1996. Another step taken in 1997 was for the company to reduce its effective tax rate. It was reduced to 26.6% in 1997 from 32.6% in 1996. The How the Game Is Played 32 tax-free nature of the exchange with Lockheed Martin Corp. was a primary contributor to the decline in the effective tax rate. However, an item described only as “All other— net” also played a role. 33 Once the reduced effective tax rate was factored in, the com- pany’s net income increased 12.7% in 1997 from 1996—maintaining the company’s continued growth streak. Understandably, GE takes exception to the observation that it manages earnings. When asked whether steps taken by the company to offset one-time gains with one-time charges could be considered earnings management, Dennis Dammerman, GE’s chief financial officer, said, “I’ve never looked at it in that manner.” 34 In most instances, as with General Electric, earnings management is effected within the boundaries of GAAP. During good years, the companies involved employ more con- servative accounting practices and loosen them slightly during leaner times. The steps taken are within the limits of normal accounting judgment. Interestingly, during the good times, regulators may on occasion view the accounting practices employed as being too conservative. Consider, for example, SunTrust Banks, Inc. The company is known for its conserv- ative accounting practices, pristine balance sheet, and steady earnings growth, which in recent years has approximated 12.5% on a compound annual basis. 35 In 1998, at the request of the Securities and Exchange Commission, the company agreed to restate its results upward for the three years ended December 1996. The SEC had determined that the company’s allowance for loan losses was too conservative given its loan profile. As a result, the company restated its provision and related allowance for loan losses, reduc- ing them by a cumulative amount of $100 million and increasing cumulative pretax in- come by the same amount. In its 1998 annual report, the company provided the following disclosure of the restatement: In connection with the review by the Staff of the Securities and Exchange Commission of documents related to SunTrust’s acquisition of Crestar Financial Corporation and the Staff’s comments thereon, SunTrust lowered its provision for loan losses in 1996, 1995 and 1994 by $40 million, $35 million and $25 million, respectively. The effect of this action was to increase net income in these years by $24.4 million, $21.4 million and $15.3 million, respectively. As of December 31, 1997, the Allowance for Loan losses was decreased by a total of $100 million and shareholder’s equity was increased by a total of $61.1 million. 36 It is the exception, not the rule, where the SEC considers earnings to be reported too con- servatively. However, given its actions toward SunTrust, it is clear that it does happen. Sears Roebuck & Co. reported an increase in pretax income of 17.5% in 1995 and 21.8% in 1996, accompanied by an increase in the company’s share price. At least one analyst, however, did not consider the company’s improved fortunes to be real. David Poneman argued that the company had, in previous years, increased unduly its reserve for credit card losses. Now the company was able to use that balance sheet account to help absorb credit card losses while minimizing new charges to expense. As noted by Mr. Poneman, “Sears is using its superabundant balance sheet to smooth out its earn- ings the big addition to reserves ‘moved income out of 1992 and 1993 and into 1995 and 1996.’ ” 37 T HE F INANCIAL N UMBERS G AME 33 Big Bath More flagrant applications of earnings management stretch the boundaries of GAAP. For example, in a bad year a company may decide to write-down assets in a wholesale fash- ion. It is a bad year anyway. Earnings expectations have not been met. The implicit view is that there will be no additional penalties for making the year even worse. By writing down assets now, taking a “big bath,” as it is called—the balance sheet can be cleaned up and made particularly conservative. As such, there will be fewer expenses to serve as a drag on earnings in future years. For example, the large reserve for credit card losses carried on Sears’ balance sheet arose as part of a particularly large restructuring charge in the amount of $2.7 billion that the company took in 1992. That year the company reported a pretax operating loss of $4.3 billion. The restructuring charge, which helped set the stage for higher earnings in later years, was described as follows: The Merchandise Group recorded a pretax charge in the fourth quarter of 1992 of $2.65 bil- lion related to discontinuing its domestic catalog operations, offering a voluntary early re- tirement program to certain salaried associates, closing unprofitable retail department and specialty stores, streamlining or discontinuing various unprofitable merchandise lines and the writedown of underutilized assets to market value. Corporate also recorded a $24 mil- lion pretax charge related to offering termination and early retirement programs to certain associates. During the first quarter of 1992, the Merchandise Group recorded a $106 million pretax charge for severance costs related to cost reduction programs for commission sales and headquarters staff in domestic merchandising. 38 Special Charges Restructuring charges, even in the absence of a big bath, provide a convenient way to manage earnings. Analysts tend to focus on earnings excluding such charges. Thus, when used inappropriately, the charges can be used to absorb what might otherwise be considered operating expenses. That was the case at W.R. Grace & Co. In an adminis- trative and cease and desist proceeding against the company dated June 30, 1999, the SEC found that Grace, through members of its senior management, misled investors from 1991 to 1995. This was done, according to the SEC, through the use of excess re- serves that were not established or maintained in conformity with GAAP. The ultimate objective of the procedure was to bring the company’s earnings into line with previously set targets. 39 Special charges also are often taken in conjunction with corporate acquisitions. Busi- ness combinations are supposed to create certain synergies. As the thinking goes, it is these synergies, derived from combining such activities as production, distribution, and administration, that increase postcombination shareholder value. At the time of an ac- quisition, a combined entity often will record a special charge in order to effect the com- bination and begin to achieve the projected synergies. Included in the charge might be estimated severance costs, lease termination expenses, and losses associated with antic- ipated asset disposals. In recording estimated expenses at the time of the acquisition, liabilities or reserves are recorded against which actual future payments and realized How the Game Is Played 34 losses are charged. Investors tend to ignore these acquisition-related charges and focus instead on postcombination earnings. In an effort to foster higher future earnings, companies may use creative acquisition accounting and get aggressive in the size of their acquisition-related charges. By record- ing higher charges at the time of the business combination, future expenses can be reduced. Some companies may go even further and in future years charge operating expenses against their acquisition-related reserves. Such action is clearly beyond the boundaries of GAAP. Fine Host Corp., an operator of food concessions for companies, sports facilities, hospitals, and other institutional customers, gave an impression of higher postacquisition earnings by charging improper items against acquisition-related reserves. 40 This tech- nique was also used at CUC International, Inc., one of the predecessor companies of Cendant Corp. 41 Purchased In-Process Research and Development A common charge seen at the time of the combination of technology firms is a charge for purchased in-process research and development. As the name suggests, purchased in- process R&D is an unfinished R&D effort that is acquired from another firm. It might be an unfinished clinical study on the efficacy of a new drug or an unfinished prototype of a new electronics product. Under current generally accepted accounting principles, if the acquired R&D has an alternative future use beyond a current research and development project, the expended amount should be capitalized. Capitalization also would be appropriate for purchased in- process software development, a form of R&D, if the software project has reached tech- nological feasibility—in effect, when it has been shown that the software will meet its design specifications. However, if acquired in-process research and development can be used only in a current R&D project, or for software, if technological feasibility has not been reached, it should be expensed at the time of purchase. This accounting treatment is the same as the treatment afforded internal research and development. It is expensed as incurred. 42 When a technology firm is acquired, undoubtedly there is research and development that is being conducted. Accordingly, a portion of the price paid for the acquired firm is properly allocated to this in-process activity. Not knowing whether the acquired R&D will have alternative future uses, expensing currently the amount paid for it is proper. In an effort to stretch the rules, however, some companies will allocate an overly large amount of the purchase price to in-process R&D, permitting them to charge off a signif- icant amount of the purchase price at the time of acquisition. This accounting procedure enables them to minimize the portion of the purchase price that must be allocated to goodwill. Goodwill must be carried on the balance sheet and written down when evidence indicates its value is impaired, necessitating a change to earnings. The greater the portion of an acquisition price that can be allocated to in-process research and development, the smaller the amount attributed to goodwill, eliminating the risk of future charges to earn- ings. 43 Moreover, paying for research and development suggests more strategic opportu- nities and higher future returns than paying for goodwill. It just sounds better. T HE F INANCIAL N UMBERS G AME 35 One company that has used acquisitions as part of its growth strategy is Cisco Systems, Inc. Given that its acquisitions are of technology firms, it is common to see purchased in- process R&D reported on its income statement. For example, for its fiscal years ended July 1997, 1998, and 1999, the company reported purchased in-process R&D in the amounts of $508 million, $594 million, and $471 million, respectively. These were in addition to expenses reported for its own internal R&D of $702 million, $1,026 million, and $1,594 million, respectively, for that same three-year period. In its 1999 report, Cisco Systems described its accounting policy for purchased in-process R&D: The amounts allocated to purchased research and development were determined through established valuation techniques in the high-technology communications industry and were expensed upon acquisition because technology feasibility had not been established and no future alternative uses existed. 44 The policy gives a glimpse of the judgment that is involved in determining what por- tion of an acquisition price should be allocated to in-process R&D as opposed to other assets acquired, including goodwill. The significant portion of acquisition prices allocated to purchased in-process research and development by the company is made clear in Exhibit 2.3, taken from the company’s 1999 annual report. The exhibit shows for each acquisition completed during 1999, the total consideration paid and the portion of that consideration allocated to purchased in-process research and development. While not presented in the company’s display of its acquisitions, on aver- age, purchased in-process research and development comprised 63% of the total acqui- sition prices paid by the company during fiscal 1999. That is a significant portion of the price paid, though it is down from 86% in 1997 and 1998. Other companies reporting significant amounts of purchased in-process research and development include National Semiconductor Corp. and MCI WorldCom, Inc. In 1997 and 1998 National Semiconductor expensed $72.6 million and $102.9 million, respec- tively, in purchased in-process research and development. That was enough to push the company into reporting a pretax operating loss of $7.7 million and $146.9 million, in each of those two years, respectively. During 1998, WorldCom, Inc. paid approximately $40 billion for MCI Communica- tions Corp. The company had originally intended to allocate between $6 billion and $7 billion of the acquisition price to purchase in-process research and development. How- ever, the SEC convinced the company to reduce that amount. This statement was given in a filing made with the SEC in September 1998: MCI WorldCom has completed asset valuation studies of MCI’s tangible and identifiable intangible assets, including in-process research and development projects (“R&D”). The preliminary estimate of the one-time charge for purchased in-process R&D projects of MCI, was $6–$7 billion. The Securities and Exchange Commission (the “SEC”) recently issued new guidance to the AICPA SEC Regulations Committee with respect to allocations of in-process R&D. Consistent with this guidance, the final analysis reflects the views of the SEC in that the How the Game Is Played 36 value allocated to MCI’s in-process R&D considered factors such as status of completion, technological uncertainties, costs incurred and projected costs to complete. As a result of the preliminary allocation of the MCI purchase price, approximately $3.1 billion will be immediately expensed as in-process R&D and approximately $26 billion will be recorded as the excess of purchase price over the fair value of identifiable net assets, also known as goodwill, which will be amortized on a straight-line basis over 40 years. 45 Concern over potential abuse of the purchased in-process research and development caption led the SEC to become more diligent in investigating the accounting treatment afforded amounts paid in acquisitions. As a result, the agency convinced MCI World- Com to reduce the amount of the planned charge for purchased in-process research and development from $6 to $7 billion to $3.1 billion. The amount of the charge was still a sizable sum. Accounting Errors It is possible that there is no premeditated intent to mislead when financial statement amounts are reported outside the boundaries of GAAP. In the absence of intent, such misstated financial statement amounts are simply considered to be in error. When errors are discovered, adjustments to correct the financial statements call for restatements of prior-period amounts. For example, in 1998 Neoware Systems, Inc., announced that it was restating results for its first and second quarters, “revising them from profits to losses because of account- ing errors.” 46 Little in the way of detail was provided regarding the errors committed. However, because the errors were identified early, before year-end results had been pub- lished, corrections entailed restating prior-quarter results only. T HE F INANCIAL N UMBERS G AME Exhibit 2.3 Allocation of Acquisition Price to Purchased Research and Development: Cisco Systems, Inc., Year Ended July 31, 1999 (millions of dollars) Purchased Acquired Companies Consideration Date R&D Fiscal 1999 American Internet Corporation $ 58 Oct. 1998 $41 Summa Four, Inc. $129 Nov. 1998 $64 Clarity Wireless, Inc. $153 Nov. 1998 $94 Selsius Systems, Inc. $134 Nov. 1998 $92 PipeLinks, Inc. $118 Dec. 1998 $99 Amteva Technologies, Inc. $159 June 1999 $81 Source: Cisco Systems, Inc., annual report, July 1999, p. 42. 37 Bigger errors, extending over longer time periods, were committed at Micro Ware- house, Inc. In 1996 the company announced that “accounting errors make the company ‘likely to restate its financial results for 1994 and 1995.’ ” 47 Ultimately it was determined that the errors discovered were more pervasive and affected more years than originally thought. In its 1996 annual report, the company made this statement: In late September 1996, an internal review led to the discovery of certain errors in Micro Warehouse’s accounting records. A Task Force comprised of company representatives and members of its outside accounting firm, KPMG Peat Marwick LLP, was immediately organized to determine the extent, causes and implications of these errors and appropriate corrective action. Simultaneously, the Audit Committee of the Board of Directors engaged outside counsel and independent auditing advisors to examine these matters. Over the course of the next several months, the Task Force and Audit Committee ex- amined these issues in detail. Ultimately, the company determined that the errors primarily impacted accrued inventory liabilities and trade payables since 1992. Inaccuracies in these accounts totaled approximately $47.3 million before tax. The 1992 through 1995 restated financial statements reflect aggregate net pre-tax adjustments of $41.9 million, net of the recovery of $2.2 million of incentive bonus payments for 1995 made to certain senior ex- ecutives. The balance of $3.2 million in pre-tax adjustments were made to the company’s first quarter 1996 results and were reflected in its Form 10-Q for the third quarter ending September 30, 1996. 48 At Micro Warehouse, the identified errors entailed understated amounts for inventory purchases and accounts payable. As a result, cost of goods sold was understated and gross profit and operating profit were overstated for a cumulative amount of $47.3 mil- lion before tax for the period 1992 to 1996. While misstatements such as those reported by Neoware Systems and Micro Ware- house were the result of errors and were not deliberate, adjustments to correct the finan- cial statements still can have a material effect. Moreover, expectations about earning power, formulated on financial amounts that were reported in error, will be overly opti- mistic and will need to be adjusted downward. One final error example involves the financial statements of Union Carbide Corp. In 1999 the company stated that it had “miscalculated earlier earnings after employees made a bookkeeping error during the transition to a new accounting computer system.” 49 As a result of the error, first- and second-quarter earnings for 1999 had been understated by a cumulative amount of $13 million. In addition, the fourth-quarter’s earnings for 1998 had been understated by $2 million. Creative Classifications within the Financial Statements In some instances, the financial numbers game is played in the manner in which amounts are presented in financial statements themselves rather than in how transactions are recorded. Companies that seek to communicate higher earning power might classify a nonrecurring gain in such as way as to make it sound recurring. For example, a non- recurring gain on sale of land might be labeled “other revenue” and reported in the rev- enue section of the income statement. Similarly, an expense or loss, the occurrence of How the Game Is Played 38 which could reasonably be expected to recur, might be classified as nonrecurring, implying the amount should be discounted in assessing earning power. For its nine months ended September 1999, IBM reported a 53% increase in operating income on revenue growth of just 12%. To the casual observer, the results suggest the company was being very diligent in controlling expenses, helping to fuel its growth in operating income. Upon closer examination, it was learned that IBM netted $4 billion in gains from the sale of its Global Network to AT&T Corp. against its selling, general, and administrative expenses (SG&A). The reporting practice does not alter net income. How- ever, it may alter how readers of its financial statements perceive its business perfor- mance. By netting the nonrecurring gains against SG&A, which are recurring expenses, the impression is made that the recurring expenses are lower. As a result, operating in- come, which should be reported before nonrecurring gains, is higher. When asked about the practice, one analyst noted that IBM should be “roundly criticized for its policy of bundling one-time gains and other nonoperating activities into operating income.” 50 When First Union Corp. released results for its third quarter of 1999, the company was able to meet Wall Street’s forecasts. It was not until the company filed its financial statements for the quarter with the SEC that it became known that its quarterly results had been helped with a nonrecurring gain. As reported at the time and quoted earlier, “First Union Corp. managed to meet Wall Street’s forecasts for its third-quarter profit, in part because of a one-time gain the bank didn’t disclose in its initial report on the quar- terly results.” 51 In the absence of the one-time gain, the company’s earnings would have disappointed Wall Street, falling two cents per share short of analysts’ forecasts. In some instances, in an effort to communicate an enhanced ability to generate recur- ring cash flow, companies will get creative in the presentation of information on the cash flow statement. The idea here is to boost the amount of cash flow reported as being pro- vided by operating activities. As operating cash flow is increased, cash disbursements in the investing or financing section also might be raised, resulting in no change in total cash flow. For example, the classification of an investing item as an operating item, or vice versa, is one way to boost cash flow provided by operating activities without changing total cash flow. For its fiscal year ended February 2000, Helen of Troy, Ltd., reported the proceeds from sales of marketable securities, $21,530,000, as a component of cash pro- vided by operating activities. The item, which is more appropriately classified with in- vesting activities, was the primary factor behind the company’s growth in cash provided by operating activities to $28,630,000 in 2000 from $11,677,000 in 1999. As another example, when software development costs are expensed as incurred, the associated cash disbursement is reported in the operating section of the cash flow state- ment. However, when software development costs are capitalized, the cash disbursement typically is reported as an investing item. Thus, a company that capitalizes software development costs will report higher operating cash flow than a company that does not capitalize such costs. Often financial analysts, dismayed by the general misdeeds conducted in the mea- surement and reporting of earnings, will turn to cash flow for a truer picture of a com- pany’s performance. Unfortunately, even when total cash flow is not altered, operating T HE F INANCIAL N UMBERS G AME 39 cash flow, a key metric in the valuation models used by many analysts, still can be swayed in one direction or another. FRAUDULENT FINANCIAL REPORTING In the majority of cases in which the financial numbers game is played, accounting pol- icy choice and application simply fall within the range of flexibility inherent in GAAP. While the point can be argued, the manner in which accounting policies is employed is largely a function of management judgment. In most cases, this judgment results in the biasing of reported financial results and position in one direction or another. It is aggressive accounting. It presses the envelope of what is permitted under GAAP, although it remains within the GAAP boundaries. It is not fraudulent financial reporting. At some point, a line is crossed and the accounting practices being employed move beyond the boundaries of GAAP. Often this is known only in hindsight. Once the line is crossed, the financial statements that result are not considered to provide a fair presenta- tion of a subject company’s financial results and position. Adjustments become necessary. Fine Host Corp., mentioned earlier, had for years capitalized the costs incurred in ob- taining new food-service contracts. These capitalized amounts were reported as assets and amortized over time. In its 1996 annual report, the company described its account- ing policy for these contract rights: Contract Rights—Certain directly attributable costs, primarily direct payments to clients to acquire contracts and the cost of licenses and permits, incurred by the company in obtain- ing contracts with clients are recorded as contract rights and are amortized over the contract life of each such contract without consideration of future renewals. The costs of licenses and permits are amortized over the shorter of the related contract life or the term of the license or permit. 52 The company capitalized these costs as opposed to expensing them on the premise that the costs incurred would benefit future periods. As such, under the matching princi- ple, by amortizing the capitalized costs over those future periods, the company was properly matching the costs with the revenue they helped to generate. Such a practice does appear to fit within the flexibility offered by GAAP. In the beginning, the amounts involved were small. In 1994, according to its statement of cash flows, the company capitalized $234,000 in contract rights. Over time, however, the amounts involved increased substantially. In 1995 the company capitalized $3,446,000 in contract rights, and in 1996 $6,277,000 were capitalized. Had the company gone beyond the boundaries of generally accepted accounting prin- ciples? Certainly as of the date of its latest audited financial statements, 1996, it had not, because the company’s statements had been audited and the company’s auditors agreed with its reporting practices. However, the amounts involved continued to grow. For the nine months ended Sep- tember 1997, the company capitalized $13,798,000 in contract rights. By then the bal- ance in contract rights reported on the company’s balance sheet, including capitalized How the Game Is Played TEAMFLY Team-Fly ® TEAMFLY Team-Fly ® [...]... had not been released at the time of the discovery of the errors, corrections for the full year were handled as a current-year charge Exhibit 2. 5 summarizes the various adjustments needed to clean up after the financial numbers game As seen in the exhibit, the appropriate adjustment depends on whether a change in accounting estimate or principle is needed or whether prior-year financial statements are... term creative accounting practices implies something less egregious and troubling than fraudulent financial reporting, that is not the intent An encompassing term was needed to describe all such acts, whether ultimately determined to be fraudulent or not Creative accounting fits the bill The financial numbers game refers to the use of creative accounting practices to alter a financial statement reader’s... that financial statements conforming to standards set by the FASB will be presumed to have substantial authoritative support 51 THE FINANCIAL NUMBERS GAME Financial Numbers Game The use of creative accounting practices to alter a financial statement reader’s impression of a firm’s business performance Fraudulent Financial Reporting Intentional misstatements or omissions of amounts or disclosures in financial. .. Certainly it is a matter of the extent to which aggressive accounting policies have been employed and the supposed intent on the part of management However, even with these guidelines, 41 THE FINANCIAL NUMBERS GAME determining the point at which aggressive accounting practices become fraudulent is more art than science In the United States, public companies fall under the jurisdiction of the Securities and... to note that when the financial numbers game is played, whether through aggressive accounting practices within the boundaries of GAAP, through aggressive accounting practices beyond the boundaries of GAAP that are not determined to be fraudulent, as a result of errors, or through fraudulent financial reporting, reported financial results and position are potentially misleading The numbers have been... Accounting errors result in unintentional misstatements of financial statements 49 Team-Fly® THE FINANCIAL NUMBERS GAME SUMMARY This chapter summarizes how the financial numbers game is played Key points raised include the following: • The financial numbers game often is played by exploiting normal reporting flexibility within generally accepted accounting principles • Reporting flexibility exists and... GAAP, or beyond, by either the aggressive application of accounting prin44 How the Game Is Played ciples or, worse, through fraudulent financial reporting, one or more of several potential catalysts draw attention to the fact that the financial statements require adjustment The catalyst that ultimately results in adjustment depends on the size of the misstatement, whether the financial statements are... aggressive accounting, both within and beyond the boundaries of generally accepted accounting principles, is considered to be included within the collection of actions known here as creative accounting practices Also included are actions referred to as earnings management and income smoothing Fraudulent financial reporting is also part of the creative accounting label However, while the term creative accounting. .. superseded by SAS No 82, Consideration of Fraud in a Financial Statement Audit.76 In SAS 82, use of the term accounting irregularities is replaced with the term fraudulent financial reporting Today the two terms, accounting irregularities and fraudulent financial reporting, tend to be used interchangeably Occasionally the term accounting errors is used in conjunction with financial reporting Accounting errors... reported at $22 9.8 million, $330.0 million, and ( $21 7 .2) for 1995, 1996, and 1997, respectively, from amounts originally reported as $3 02. 8 million, $ 423 .6 million, and $55.4 million, respectively Certainly investors, including HFS, Inc., were misled by the accounting practices at CUC.69 CLEANING UP AFTER THE GAME At some point, after reported financial results and position have been pushed to the boundaries . acts, whether ultimately determined to be fraudulent or not. Creative accounting fits the bill. The financial numbers game refers to the use of creative accounting practices to alter a financial. note that when the financial numbers game is played, whether through aggressive accounting practices within the boundaries of GAAP, through ag- gressive accounting practices beyond the boundaries. up after the financial numbers game. As seen in the exhibit, the appropriate adjustment depends on whether a change in accounting estimate or principle is needed or whether prior-year financial statements