Foreword

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About the Experts

Foreword

"Earnings Quality" has been a subject of SEC investigations, 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 our financial markets. Considering that the U.S. controls 40% of the world's capital markets, and you get an appreciation for the global economic impact that shaken investor confidence could have. For this reason, we have 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 employee's livelihoods.

The concept of Quality of 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 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 GAAP 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. The AICPA will continue to provide guidance and education to ensure that our members and others in the financial reporting community 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 of 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.

John F. Morrow, CPA

AICPA Vice President

The New Finance

June 2001

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Download PDF files of the Casebook in its entirety or section-by-section:

1. Foreword and Table of Contents

2. The Experts and Cases: Index by Issue

3. Do the Right Thing

Chief Executive Dr. Ronald Weaver is facing shrinking demand for services at Union Hospital. His executives are giving him conflicting opinions about how to solve the hospital's immediate cash flow problems. Examine the facts presented for Union Hospital and determine the course of action you believe Dr. Weaver should follow.

4. A Controller's Challenge

Controller Jim Woodruff is under pressure to accelerate profits at Advanced Parts Manufacturing. Examine the facts presented for this case and determine the course of action you believe Jim Woodruff should follow.

5. Accounting for Loan Losses at County National Bank

Jane Bellows, controller at County National Bank, is debating whether the current year's loan loss estimates are justified. Trying to meet her professional obligations and the bank's goals are not easy when accounting and regulatory objectives differ. Examine the facts presented for County National Bank and determine the course of action you believe she should follow.

6. Accounting for In-Process R & D at Simpco Incorporated

Acquisitions at Simpco Incorporated have been instrumental in helping to develop and exploit new technologies. In these acquisitions the accounting for purchased research has usually meant large write-offs to in-process research and development. The following case highlights the accounting rules for this treatment and the issues involved in determining their application. It addresses the impact on the company's income statement and the perceptions of its significance as Kathy Oberlin, Simpco's controller, considers the underlying nature of this charge and its importance to the company's reported income.

7. Vision Technologies Incorporated: Issues in Revenue Recognition

Vision Technologies Incorporated illustrates the significance of revenue recognition in the reported income of a growing business. It shows how the development of a new product platform can affect which revenue realization criteria management uses in recognizing sales. It also addresses the considerations that management faces in employing generally accepted accounting principles and the external pressures inherent in these decisions. Study the problems encountered by Tim Archer, chief financial officer, as he collides with chairman Gene Denton over the recognition of product and support revenue of the company's product lines. Decide for yourself whether a change in revenue realization policy is needed for the company's new product line. Determine if Tim Archer's concerns about auditor independence are justified.

8. Restructuring At Exozol?

Restructuring at Exozol? addresses how restructuring charges can affect financial reports, and the influences of corporate management in the accounting for these costs. It highlights major points, from internal controls for adopting a restructuring plan to developing cost estimates and the year-to-year accounting for these items. The case illustrates some of the major corporate restructuring issues the Securities and Exchange Commission has addressed in its quest to reduce earnings management. Follow James Linwood as he uncovers several potential problems in his investigation of restructuring at the company.

9. Accounting Issues At National Technology Corporation

Jim Woods, controller of National Technology Corporation, a leading technology company, defends his company's recent changes in pension plan assumptions as appropriate and realistic. Nevertheless, he realizes that pension plans are long-term commitments and that short-term economic conditions will always differ to some degree from the long-term assumptions selected. Thus, he has second thoughts about his company's continuous attempts to adjust assumptions in calculating pension expense. His concerns are heightened by the impact of recent changes in the company's reported income and the criticism of some members of the investment community. Read the following case facts and determine if criticisms of the company's accounting are justified. Does Jim Woods have reason to be concerned?

10. Is It Okay to Buy Earnings?

Rising Star, an online discount retailer, has achieved success in a competitive market. To sustain that success, the company has made a series of strategic acquisitions. Now chief executive officer Jed Parker is faced with the possibility of accounting problems surrounding some of these deals—and the value of the deals themselves is even being called into question. Examine the facts presented for Rising Star and determine the course of action you believe Mr. Parker should follow.

11. A Troubled Acquisition for Websave

Chief financial officer Shirley McGuire must offer advice on the accounting for an acquisition that has not met her company's expectations. Evaluate each of the accounting options to improve the results of IVI and the accounting justifications for the positions taken. What hurdles would Websave face in attempting to apply pooling accounting to this transaction?

12. Policy and Judgment—The X Systems Group

A controller enjoys the team spirit and success of a dynamic corporate division, until the numbers stop adding up. Examine the facts presented for X Systems Group and determine the course of action you believe should be taken.

13. Inventory Valuation Issues at AKL

Matt, the new controller of a promising manufacturing company, is troubled by the inventory valuation practices he finds. Examine the facts for AKL and determine the course of action you believe should be taken.

14. Accounting for a Windfall

The president of Progressive Geriatric Equipment Design is pressuring controller Pierre Michaud to include a recent windfall from life insurance proceeds in the division's operating income. Examine the facts and determine the course of action you believe should be taken.

15. The Aker Computer Company

Aker Computer Company, which has been a successful business, is now facing mounting losses, and some of its accounting choices have been called into question. Read the following case facts and determine if criticisms of the company's accounting are justified. Does Michelle Sanders have reason to be concerned?

16. Restatements at Vesania Networks

Lynn Holland, the new chief financial officer of Vesania Networks, quickly realizes the company's accounting practices reflect a desire to please Wall Street analysts. Examine the facts and determine the course of action you believe should be taken.

17. The Case of Barter Transactions and Revenue Recognition

eCrawler.com is entering the home stretch on the road to its initial public offering. Dreams are soon to be realized. Two significant deals are closing that, taken together, should drive eCrawler through a successful public financing. But upon closer review in light of recent Securities and Exchange Commission and Emerging Issues Task Force barter revenue interpretations, the two defining agreements may not afford recognition of the anticipated revenue. Without the momentum generated from this revenue, the entire IPO could sink. What should eCrawler.com do? Examine the facts and determine the course of action you believe should be taken.

18. References

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Quality of Earnings Experts

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.

Bob Stefanowski, CPA, CFE, MBA, is an adjunct professor at the Stern School of Business and holds a MBA in Finance from Cornell University.

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.

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.

Dan M. Guy, PhD, 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).

Grace Pownell, PhD, 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).

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).

Marshall Pitman, PhD, CPA, CMA, is Associate Professor of Accounting at The University of Texas in San Antonio.

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.

Maureen F. McNichols, PhD, 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.

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.

Nita Clyde, PhD, 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.

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.

Paul Munter, PhD, 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.

Robert M. Tarola, CPA, is Chief Financial Officer and Senior Vice President of W.R. Grace & Co.

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.

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.

Steven M. Mintz, PhD, 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.

Steven Wallman, JD, 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.

William McLucas, JD, 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.