1 Min Guide for Cooking Accounting Funda.....

Every company, to a certain extent, games the numbers to achieve budget and get bonuses. It has been this way for a long time. But, two things make the here and now different for us. First, our money is the issue (history is always about other people's money). Second, these are BIG numbers.

Enron, Aldelphia and WorldCom, however, are extreme examples. They are the few bad apples that get all the headlines. I believe that people with better ethics run the majority of companies. They may bend the rules, but few take the process to the extremes of Enron or WorldCom. If this wasn't true, we'd all be investing in government bonds.

What can investors do to protect themselves? You need to learn some of the basic signs that will alert you about possible earnings manipulation. While the details are even hidden from the accountants, learning these signs will help make you a better investor.
Outlined below are some of the fundamental ways companies can create earnings:

Accelerating Revenues
1. One way to accelerate revenue is booking lump-sum payment as current sales when services will be provided over a number of years. For example, a software service provider receives up-front payment for four-year service contract but records the full payment as sales of only the period that the payment is received. The correct, more accurate way is to amortize the revenue over the life of the service contract.

2. A second tactic is call “loading the pipeline.” Here, a manufacturer makes a large shipment to a distributor at the end of a quarter and records the shipment as sales; however, the distributor has the right to return any unsold merchandise. Because the goods can be returned, and are not guaranteed as a sale, the manufacturer should keep the products classified as a type of inventory until the distributor has sold the product.

Delaying expenses
AOL got in trouble for this in the early 1990s when they capitalized the costs of making and distributing their CDs. AOL viewed this marketing campaign as a long-term investment and capitalized the expense. This transferred the costs from the income statement to the balance sheet where it was going to be expensed over a period of years. The more conservative (and appropriate) treatment is to expense the cost in the period the CDs were shipped.

Accelerating Expenses Preceding an Acquisition
This may sound a little counterintuitive, but bear with me. Before a merger is completed, the company that is being acquired will pay, possibly prepay, as many expenses as possible. Then, after the merger, the EPS growth rate of the combined entity will be easily boosted when compared to past quarters; furthermore, the company will have already booked the expense in the previous period.

“Non-recurring” Expenses
(An oxymoron if ever there was one.) These one-time charges, by accounting for extraordinary events, were meant to help us to better analyze ongoing operating results. It seems, however, that companies take one of these each year. Then a few quarters later, they “discover” they reserved too much and are able to put something back into income (see next item).

Other Income or Expense
This category can house a multitude of “sins.” Here companies book any “excess” reserves from prior charges (non-recurring or otherwise). This is also the place where companies can hide other expenses by netting them against other newfound income. Sources of other income include selling equipment or investments (a la Amazon.com).

Pension Plans
If a company has a defined benefit plan, it can use some special techniques to smooth earnings. During a bull market, the company can improve earnings by reducing its pension expense--or even record revenues--if the investments in the plan grow faster than the company's assumptions. During the late 1990s, this was done by a number of large firms, some of them blue chips.

Off-Balance-Sheet Items
A company can create separate legal entities that can “house” liabilities or incur expenses that the parent company does not want to have on their financial statements. Because the subsidiaries are separate legal entities, which are not wholly owned by the parent, they do not have to be recorded on the parent's financial statements and are thus “hidden” from investors.

Synthetic Leases
A synthetic lease can be used to keep the cost of new building from appearing on a company's balance sheet. The lease is a long-term (five to ten year) agreement under which a company will pay a fixed lease expense to be in a new headquarters. At the end of the lease, the company is obligated to buy the building, but because of the nature of the lease, this liability is not included on the balance sheet! (Who said accountants were boring and uncreative?) At the time the lease was made, the company may have been in fine financial shape and the economy may have been booming; however, the ability of the company to meet this huge obligation is hard to determine until shortly before maturity (one to two years).