Assessing Accounting Quality: Analysis of

Expense Recognition Policies

Financial Statement Analysis

ACC 411
Winter 2017

Professor Charles E. Wasley

Simon School
University of Rochester
Professor Charles E. Wasley 1
 Learning Objectives

These lecture notes cover a variety of issues associated with firms expense recognition
practices.

The focus is on developing the analytical skills required to identify when expense recognition
polices may be being used to manage earnings, and also the skills to made adjustments to the
financial statements to undo such earnings management.

Our biggest concern is with how a firms current earnings may be managed upward and its
real operating performance misstated by managers strategic use of expense recognition
policies. Such strategies consist of (among other things) aggressive cost capitalization policies,
and the use of extended amortization periods.

Also of importance is how current and future earnings performance are affected by accelerated
expense recognition decisions such as taking a Big Bath.

As always, our focus is on quantifying the effect of such actions so that we can reassess the
firms real underlying economic performance.
Professor Charles E. Wasley 2
Incentives to Understate Expenses
(and as a Result Overstate Earnings)

What rewards did we raise when we

discussed earnings management and revenue
recognition policies?

The same rewards apply here.

Professor Charles E. Wasley 3

Flexibility Within GAAP on Expense
Recognition Matters: An Opportunity
to Manage Earnings?
Examples of expense recognition settings providing opportunities for
earnings management include:
1) Aggressive cost capitalization policies.
e.g., American Softwares accounting for software development costs (examined
below) and in the past, America On-Lines (AOLs) capitalization of membership
acquisition and product development costs.
2) Extended amortization periods (an example later in the notes).
e.g., The choice of depreciation/amortization periods for tangible/intangible assets.
3) Delayed expense recognition:
e.g., Reserve recognition for bad debts and warranties examined below for Telecom
Service Providers and avoiding inventory write-downs studied using Cisco Systems.
4) Accelerated expense recognition via the Big Bath and restructuring
charges.
Illustrated using Borden.

Professor Charles E. Wasley 4

Capitalizing versus Expensing Certain
Costs

Aggressive cost capitalization:

Capitalization of costs is permitted under GAAP if future periods are expected to benefit
from current expenditures.
Amounts capitalized are reported as assets and are amortized over future years.
e.g., Pre-opening costs of retailers (Bed, Bath and Beyond), costs to develop landfill space for
waste management firms (Waste Management), software development costs for software firms
(Microsoft and many others) and membership acquisition costs (AOL, Polymedica and CUC Intl).

Managements Role:
Deciding if future periods will benefit relies on managements judgment.
Different capitalization policies may be employed in what appear to be similar situations (i.e.,
firms).
Some firms take a conservative stance and expense amounts incurred. Others (more optimistic)
take a more aggressive stance and capitalize items expensed by others.
Why? To report higher income in the current period (versus reporting lower income in future
periods).
At a minimum, watch for capitalization policies that deviate from competitors.

Professor Charles E. Wasley 5

Aspects of a Firms Expense
Recognition Policy to Evaluate on a
Regular Basis
Is there evidence of aggressive cost capitalization?
What are the firms policies with respect to cost capitalization?
Is it capitalizing costs that competitors expense or does the firm expense more or

faster, taking a more conservative approach?

Has the firm shown evidence in the past of being aggressive in its capitalization

policies?
Is there an example of a prior-year write-down of capitalized costs that, in
hindsight, should not have been capitalized?

Is there evidence of extended amortization periods?

Has the firm selected extended amortization and depreciation periods for capitalized
costs?
How does the average amortization period for long-lived assets compare with

competitors?
Be especially alert for extended amortization periods in the following situations:
The firm is in an industry experiencing rapid technological change.
The firm has shown evidence in the past of employing extended amortization periods.
There is evidence of a prior-year write-down of assets that became value-impaired.
Professor Charles E. Wasley 6
Assessing Potential Earnings Management/
Misstated Performance: Expense
Recognition Policies and Reserve
Recognition Issues
Under GAAP, firms must estimate future uncollectible A/R and the
expected future costs of honoring warranties on products sold in the
current year.
So, even when revenue is recognized properly, earnings can still be boosted, at least
temporarily, by improperly valuing A/R and/or the liability for warranties.

Amounts for bad debts and warranties are expensed in the current period
to match them with the Sales they generated.

However, the required creation of such reserves provides a mechanism

for managers to manage earnings by simply manipulating the amount
recorded for the reserve.

Describe how easy it is for managers to manipulate bad debt expense

and warranty expense to manage earnings upward (or downward).
Professor Charles E. Wasley 7
Assessing Potential Earnings Management/
Misstated Performance: Expense
Recognition Policies and Reserve
Recognition for Bad Debts
If a firm wants to boost earnings (at least temporarily) it can do so
by minimizing the expense for doubtful accounts.

This, in turn, understates the allowance for doubtful accounts and

overstates A/R on the balance sheet.

Later (in subsequent years), when the allowance for doubtful

accounts proves inadequate to handle actual uncollectible
accounts, the earlier manipulation surfaces.

At that point in time, an additional provision or expense (i.e., a

loss) must be recorded to accommodate the additional
uncollectible accounts.
Professor Charles E. Wasley 8
Assessing Potential Earnings Management/
Misstated Performance: Expense Recognition
Policies and Reserve Recognition for Bad
Debts by Telecom Service Providers
To illustrate issues associated with the creation and potential
manipulation of bad debt reserves I will analyze Telecom
Service Providers.

The analysis focuses on the following firms: SBC

Communications (SBC), BellSouth (BLS), Verizon (V), Qwest
(Q), AT&T (T) and Sprint (FON).

Carefully study the information appearing on the following

slide before you proceed.

What observations can you make?

Professor Charles E. Wasley 9
Assessing Potential Earnings Management/
Misstated Performance: Expense Recognition
Policies and Reserve Recognition for Bad
Debts by Telecom Service Providers
TABLE 1: BAD DEBT VERSUS REVENUE, ANNUAL TREND (IN %

COMPANY 20x3 20x2 20x1 20x0

SBC 2.1% 3.3% 3.0% 1.7%
BLS 2.6% 3.8% 2.3% 1.4%
VZ 2.7% 4.3% 2.9% 2.2%
Q 2.1% 3.3% 3.7% 2.7%
T 2.1% 2.8% 2.1% 2.0%
FON 1.8% 4.0% 3.6% 2.7%
TABLE 2: ALLOWANCE FOR DOUBTFUL ACCOUNTS VERSUS GROSS A/R, ANNUAL

COMPANY 20x3 20x2 20x1 20x0

SBC 12.9% 14.3% 11.8% 9.1%
BLS 13.0% 10.3% 8.4% 6.8%
VZ 19.4% 18.2% 13.0% 10.0%
Q 13.2% 13.3% -- --
T 12.5% 11.2% 9.7% 11.2%
FON 8.8% 12.3% 11.3% 9.2%
Professor Charles E. Wasley 10
Assessing Potential Earnings Management/
Misstated Performance: Expense Recognition
Policies and Reserve Recognition for Bad
Debts by Telecom Service Providers
Table 1 observations:
Sprint (FON) had the greatest boost to earnings in 20x3 due to recording
significantly lower bad debt expense.
As a percentage of revenue, the table shows that Sprints bad debt expense
declined to 1.8% in 20x3 from 4.0% in 20x2.
In dollar terms, Sprint recorded $461 million of bad debt expense in 20x3
versus $1.1 billion in 20x2 (a year-over-year decline of 56%).
The remaining firms also had boosts to 20x3 earnings since their bad debt
expense declined relative to 20x2.

Table 2 observations:
A related measure is the allowance for doubtful accounts (ADA) as a percentage
of gross accounts receivable (GAR).
For Sprint, this measure again indicates a more aggressive approach as this ratio fell
to 8.8% at year-end 20x3 from 12.3% in the prior year (the lowest level in the past
four years).
In contrast to Sprint, SBC, BellSouth, Verizon and AT&T have seen their ADA rise over
the past few years as a percentage of GAR.
Professor Charles E. Wasley 11
Assessing Potential Earnings Management/
Misstated Performance: Expense Recognition
Settings and Delaying Inventory Write-Downs
or How to Detect Over-Valued Inventory

Inventory write-downs are routine.

As goods become obsolete a write-down against earnings is needed.
A conscious strategy of postponing a write-down (in the hopes that
things will get better) is a form of earnings management.

Careful, an inventory write-down is not prima facie evidence

inventory was consciously overvalued in prior periods.
It could be the result of unanticipated changes in the firms economic
environment.

Professor Charles E. Wasley 12

Assessing Potential Earnings Management/Misstated
Performance: Expense Recognition Settings and
Delaying Inventory Write-Downs or How to Detect
Over-Valued Inventory -- Cisco Systems
Consider the following example using Cisco.
As of late November 20x0, orders at the firm were growing at rates approaching 70% per
year.

In fact, the biggest problem the firm expected was having sufficient inventory to meet
demand. Accordingly, it took steps to increase its supply of parts by making commitments
to buy components months before they were expected to be needed.

In December 20x0, orders declined precipitously in a delayed reaction to the burst of the
Internet bubble. As a result, the firm found itself with more inventory than it needed,
forcing it to take a write-down of $2.5B in April 20x1.

While there may not have been a conscious effort to overvalue inventory at Cisco it is
worthwhile to look at select financial information and ratios to develop an appreciation for
what ratios might have provided an early warning of inventory problems, and more
importantly an impending inventory write-off.

Consider the data in the following table. What observations can you make?
Professor Charles E. Wasley 13
Assessing Potential Earnings Management/Misstated
Performance: Expense Recognition Settings and
Delaying Inventory Write-Downs or How to Detect
Over-Valued Inventory -- Cisco Systems
CISCO SYSTEMS INC
SELECTED ACCOUNTS BALANCES AND RATIOS
QUARTERS ENDING JANUARY 20x0, APRIL 20x0, JULY 20x0, OCTOBER 20x0 AND JANUARY 20x1
(THOUSANDS OF DOLLARS, EXCEPT DAYS AND PERCENTAGES)

Jan-x0 Apr-x0 Jul-x0 Oct-x0 Jan-x1 Apr-x1

SALES $4,350 $4,919 $5,782 $6,519 $6,748 $4,728
% INCREASE (DECREASE) FROM PRIOR YEAR 13.08% 17.54% 12.75% 3.51% -29.93%
COST OF GOODS SOLD $1,536 $1,748 $2,098 $2,378 $2,581 $4,400
INVENTORY $695 $878 $1,232 $1,956 $2,533 $1,913
% INCREASE (DECREASE) FROM PRIOR YEAR 26.33% 40.32% 58.77% 29.50% -24.48%
INVENTORY DAYS 41.3 45.8 53.6 75.1 89.6 39.7

INVENTORY DAYS IS CACLULATED AS (INV / COST OF GOODS PER DAY)

WHERE COST OF GOODS PER DAY IS CGS / 91.25
Professor Charles E. Wasley 14
Assessing Potential Earnings Management/Misstated
Performance: Expense Recognition Settings and
Delaying Inventory Write-Downs or How to Detect
Over-Valued Inventory -- Cisco Systems

Observations:
Inventory is growing much faster than revenue.
For every quarter examined, inventory increased more than 25% (increases of
40.3% and 58.8% in the quarters ending July 20x0 October 20x0).
Also, note the increase in Inventory days which stood at 89.6 in January 20x1.
Up from as little as 41.3 in January 20x0.
In one year the firms inventory had more than doubled!!

According to the firm, the inventory build-up was to ensure it would have
parts on hand to fill expected orders and not the result of slowing demand.
However, notice there is some evidence of slowing Sales growth in the January
20x1 quarter, as evidenced by the small increase in Sales of 3.5%.
Upshot of slowing Sales:
When expected orders did not materialize by April 20x1, the firm had to write-down
inventory.

Professor Charles E. Wasley 15

Assessing Potential Earnings Management/
Misstated Performance: Expense Recognition
Settings and Delaying Inventory Write-Downs
or How to Detect Over-Valued Inventory
Whether inventory is overvalued due to:
An overstated physical count.
An increase in value assigned to ending inventory.
Or a delayed write-down of obsolete goods.

The same steps can be used for detection.

Watch for:
Unexplained increases in inventory that are large relative to the increase
in Sales.
Inventory days increasing to levels higher than normal for the firm and
industry.
Inventory that is fictitiously increased will also result in unexpected
improvements in gross margin.
Professor Charles E. Wasley 16
Assessing Potential Earnings Management/
Misstated Performance: Expense Recognition
Polices -- The Big Bath
While our biggest concern is with how a firms current earnings may be managed upward
and its real operating performance misstated by managers strategic use of expense
recognition practices to increase earnings, also of importance is how current and future
earnings performance are affected by accelerated expense recognition decisions such as
taking a Big Bath.

In a bad year (when reporting a large loss is already assured), a firm may decide to write-
down assets in a wholesale fashion.

Since it is already a bad year if an even larger loss is reported, why would it matter? The
implicit view is there are no additional penalties for making the loss worse.

By writing down assets now, (i.e., taking a Big Bath) the balance sheet is made more
conservative, which means that there are likely to be fewer future expenses/ write-offs to
serve as a drag on future years earnings.

Expenses that are accelerated into the current period by taking a big bath are expenses
that dont have to be recorded in the future
Professor Charles E. Wasley 17
Assessing Potential Earnings Management/
Misstated Performance: Expense Recognition
Polices -- The Big Bath

Restructuring charges are taken in conjunction with a consolidation of operations

or disposition or abandonment of operations or assets.
They are likely to include write-downs of A/R and inventory, accruals of liabilities for exit
costs (e.g., lease terminations, plant closing costs, severance pay and retraining, etc.).

One concern with restructuring charges is that excessively large ones will be taken
in attempt to convert future operating expenses into current period charges.
Why? Because doing so provides a boost to future years earnings.
How? In the current year, take a restructuring charge that is really too large and then
in a later year reverse the excess back into income by reducing an operating expense
like SG&A. Doing so provides a boost to future years earnings.

Consider the information on the following slide related to restructuring charges

taken by Borden.

Professor Charles E. Wasley 18

Assessing Potential Earnings Management/
Misstated Performance: Expense Recognition
Polices -- The Big Bath

Borden is a consumer-products company (M denotes millions of $s)

a) In YYY2 Borden took a $642M restructuring charge and reported a loss of $439.6M.
b) In YYY3, under pressure from the SEC, Borden reversed $119.3M of the charge, increasing
YYY2 income and reducing YYY3 income.
c) In addition, Borden was required to reclassify $145.5M of the charges that were for
packaging modernization as ordinary operating expenses.
d) In the 4th quarter of YYY3 Borden took another restructuring charge of $637.4M for
estimated losses on the disposal of businesses (unrelated to the earlier charge).
e) Its YYY4 3rd quarter results included a $50M credit from having over-estimated the losses in
YYY3.
What are your thoughts on the actions taken by Borden and the SEC? Specifically,
consider the following questions:
1) What does the information in (b) tell you about the size of the restructuring charge in (a) and
what Bordens managers may have been attempting to accomplish?
2) What does the information in (c) tell you about the size of the restructuring charge in (a) and
what else Bordens managers may have been attempting to accomplish?
3) With regard to (d), what else would you like to know about YYY3?
4) What does the information in (e) tell you about the size of the restructuring charge in (d),
and what Bordens managers may have been attempting to accomplish?

Professor Charles E. Wasley 19

Assessing Potential Earnings Management/
Misstated Performance: Expense Recognition
Polices -- The Big Bath

Some thoughts on the questions:

1) Was the YYY2 charge too large and an attempt by Bordens managers to be able to
boost the income of a future year by reversing the excess back into income?
And to make it look like the firm was on the comeback trail?

2) Was the YYY2 charge an attempt by Bordens managers to convert ordinary

operating expenses into a portion of the restructuring charge so that they would be able
to boost the income of a future year by not having to record such expenses in that year?
And, again, to make it look like the firm was on the comeback trail?

3) What was the total loss reported for YYY3?

Youd like to know if the charge was part of a big bath. For example, was YYY3s income,
excluding the charge already a loss? If so, perhaps (at least) some of the charge was motivated
by a desire to take a big bath.
Note that taking a big bath in a given year makes it easier to report profits in future years.

4) It tells me the charge in YYY3 was too large and that $50M had to be reversed back
into income in YYY4.
When evaluating the firms YYY4 performance, Id look at income excluding the $50M in
income from the restructuring charge reversal.

Professor Charles E. Wasley 20

Assessing Potential Earnings Management/
Misstated Performance: Expense Recognition
Polices -- Extended Amortization Periods
GAAP provides little guidance as to the period over which to depreciate long-lived
assets or amortize intangible assets.
This provides managers with discretion over reported earnings.
The longer the depreciation/amortization period, the lower the annual expense, and the higher
pre-tax earnings. Current period earnings can be increased by selecting extended amortization
periods (i.e., by spreading costs over a longer period of time).

Managements Role:
Deciding how many future periods will benefit relies on managements judgment.
Different depreciation and amortization policies may be employed in what appear to be similar
situations (i.e., firms).
Some firms take a conservative stance and use short lives. Others (more optimistic) take a more
aggressive stance and use longer lives.
Why? To report higher income in the current period (versus reporting lower income in future
periods).
At a minimum, watch for depreciation and amortization policies that deviate from competitors.

Consider the following examples:

Note, all firms operate in the same industry.
Professor Charles E. Wasley 21
Assessing Potential Earnings Management/
Misstated Performance: Expense Recognition
Polices -- Extended Amortization Periods

Differences among firms depreciation periods are evident from the following three
medical supplies firms.

Centocor: Depreciation is provided using the straight-line method over useful lives
ranging from 3 to 31 years. Leasehold improvements are depreciated over the
applicable lease period or estimated useful lives, whichever is shorter

Cordis: Lives used to calculate depreciation on a straight-line basis are: Building

and improvements: 10-30 years. Leasehold improvements: 10-20 years.
Machinery and equipment: 3-10 years.

U.S. Surgical Corp: Depreciation is provided using the straight-line method over
the following useful lives. Buildings 40 years. Molds and dies: 5-7 years.
Machinery and equipment: 3-10 years. Leasehold improvements: 10-30 years.

Professor Charles E. Wasley 22

Assessing Potential Earnings Management/
Misstated Performance: Expense Recognition
Polices -- Extended Amortization Periods

The three firms use different periods to expense buildings,

equipment and other SIMILAR costs.
Centocor uses 31 years for buildings.
U.S. Surgical amortizes buildings over periods up to 40 years.
Cordis uses a period of 10-20 years for leasehold improvements,
while U.S. Surgical uses 10-30 years.

The choice of depreciation periods can have significant

effects on pre-tax earnings.

Consider, the PP&E balances for U.S. Surgical in the

following table.
Professor Charles E. Wasley 23
Assessing Potential Earnings Management/
Misstated Performance: Expense Recognition
Polices -- Extended Amortization Periods

Select Account Balances:

YYY2 YYY3
Land $ 18.6 $ 20.7
Buildings 150.3 163.4
Molds and dies 128.3 114.3
Machinery and
equipment 262.6 306.6
Leasehold Improvements 127.5 147.1
Total 687.3 752.1
(-) Acc. Deprec. 159.2 159.9
Total 528.1 592.2

Professor Charles E. Wasley 24

Assessing Potential Earnings Management/
Misstated Performance: Expense Recognition
Polices -- Extended Amortization Periods

Lets make some adjustments to improve

comparability:

Lets apply:
40 years (the stated useful life) to the average cost of buildings.
6 years (the firm uses 5-7 years) to the average cost of molds and dies.
6.5 years (3-10 years is used) and
20 years (10-30 years is used), respectively, to the average cost of
machinery and equipment and leasehold improvements.

Doing the math yields depreciation of $74,788,000 for YYY3.

As an exercise, check my calculation.
Professor Charles E. Wasley 25
Assessing Potential Earnings Management/
Misstated Performance: Expense Recognition
Polices -- Extended Amortization Periods

If the firm were to reduce its amortization period for:

Buildings to 30 years.
Molds and dies to 4 years.
Machinery and equipment and leasehold improvements to 4.5 years and
15 years, respectively.

A depreciation charge of $107,951,000 would result for YYY3.

As an exercise, check my calculation.

This revised depreciation charge (one based on depreciation periods

more consistent with competitors) yields a charge that is $33,163,000
higher.
Pre-tax earnings would be reduced accordingly, or in the case of U. S.
Surgical in YYY3, the pre-tax loss would be increased.
The $33,163,000 depreciation difference is 24% of the firm's reported
pre-tax loss of $137,400,000 for YYY3.
Professor Charles E. Wasley 26
Assessing Potential Earnings Management/
Misstated Performance: Expense Recognition
Polices -- Aggressive Cost Capitalization of
Software Development Costs
The costs to develop computer software are capitalized once
technological feasibility is reached. Prior to that, such costs are
expensed as R&D.

Clearly, management plays a huge role in deciding when

technological feasibility is reached and when capitalization can
begin.

One could argue management can raise or lower amounts

capitalized by choice, raising or lowering earnings in the process.

Consider the disclosure of software costs capitalized and expensed

by American Software. What observations can you make?
Professor Charles E. Wasley 27
Assessing Potential Earnings Management/
Misstated Performance: Expense Recognition
Polices -- Aggressive Cost Capitalization of
Software Development Costs
AMERICAN SOFTWARE INC
SOFTWARE DEVELOPMENT COSTS CAPITALIZED AND EXPENSED
YEARS ENDING APRIL 30, YYY1 - YYY3
(THOUSANDS OF DOLLARS, EXCEPT DAYS AND PERCENTAGES) YYY1 YYY2 YYY3

TOTAL CAPITALIZED COMPUTER SOFTWARE DEVELOPMENT COSTS $8,827 $10,902 $10,446

TOTAL RESEARCH AND DEVELOPMENT EXPENSE $12,112 $11,511 $9,675
TOTAL R&D AND CAPITALIZED COMPUTER SOFTWARE COSTS $20,939 $22,413 $20,121
COSTS CAPITALIZED AS A % OF TOTAL COSTS INCURRED 42.16% 48.64% 51.92%
TOTAL AMORTIZATION OF CAPITALIZED COMPUTER SOFTWARE COSTS $6,706 $6,104 $3,632
Professor Charles E. Wasley 28
Assessing
Observations:
Potential Earnings Management/
The % of software costs capitalized increased to 51.9% in YYY3 from 42.2% in YYY1.
Misstated Performance: Expense Recognition

Notice that the amount of software costs expensed (and reported as R&D in the table) declined from $12,112
in YYY1 to $9,675 in YYY3, even as total software costs remained relatively stable.

Polices

-- Aggressive Cost Capitalization of
In recent years the firm has increased the % of software costs capitalized.
At the same time, the amount of capitalized software costs amortized each year from YYY1 to YYY3

Software

Development
Clearly, the policy Costs
decreased from $6,706 to $6,104 and then on down to $3,632.
of capitalizing software costs boosted pretax earnings.
The amount is calculated by subtracting the amount amortized from the amount capitalized:
$2,121 ($8,827 $6,706), $4,798 ($10,902 $6,104) and $6,814 ($10,446 $3,632), in YYY1, YYY2,
AMERICAN SOFTWARE INC and YYY3.

SOFTWARE DEVELOPMENT COSTS CAPITALIZED AND EXPENSED

YEARS ENDING APRIL 30, YYY1 - YYY3
(THOUSANDS OF DOLLARS, EXCEPT DAYS AND PERCENTAGES) YYY1 YYY2 YYY3

TOTAL CAPITALIZED COMPUTER SOFTWARE DEVELOPMENT COSTS $8,827 $10,902 $10,446

TOTAL RESEARCH AND DEVELOPMENT EXPENSE $12,112 $11,511 $9,675
TOTAL R&D AND CAPITALIZED COMPUTER SOFTWARE COSTS $20,939 $22,413 $20,121
COSTS CAPITALIZED AS A % OF TOTAL COSTS INCURRED 42.16% 48.64% 51.92%
TOTAL AMORTIZATION OF CAPITALIZED COMPUTER SOFTWARE COSTS $6,706 $6,104 $3,632
Professor Charles E. Wasley 29
Summary

These lecture notes covered a variety of issues associated

with firms expense recognition policies.

The two primary objectives throughout have been:

1) To further develop your analytical skills to identify when expense
recognition polices may be being used to manage earnings, or
alternatively where expense recognition policies may, or may not, be
misstating a firms real underlying economic activities.
2) To appreciate how to adjust a firms financial statements to
undo/correct for such actions to better understand/assess the firms
real economic performance.

Professor Charles E. Wasley 30

Review Question #1

A former SEC Chairman refers to hidden reserves on the

balance sheet as cookie-jar reserves. These reserves are
built up in periods when earnings are strong and drawn
down to bolster earnings in periods when earnings are weak.

Reserves for (1) bad debts and (2) inventory, along with the
(3) large accruals associated with restructuring charges are,
transactions that sometimes yield hidden reserves. For each
of these transactions, explain when and how a hidden
reserve is created (part a) and for each of these transactions,
explain when and how a hidden reserve is drawn down to
boost earnings (part b).
Professor Charles E. Wasley 31
Review Question #1 Answer

a) A cookie-jar reserve is created in the reserve for bad

debts and obsolete inventory by overstating the expected
amount of future uncollectible A/R and inventory that is not
salable.
Overstating the amount of future loss creates hidden reserves in
certain liabilities.

b) In future periods, these overstated reserves can be used

to increase earnings.
For example, in a period of soft sales, net income can be increased
by making a smaller than necessary accrual for bad debts or obsolete
inventory. Some past accrual can even be reversed. Likewise, these
certain liabilities can be reversed or simply debited for certain
expenses rather than an expense account.
Professor Charles E. Wasley 32
Review Question #2

In the past decade, several large money center banks

recorded huge additions to their loan loss reserve.
For example, Citicorp recorded a one-time addition to its loan loss
reserve totaling about $3 billion.
These additions to loan loss reserves led to large net losses
for these banks.
While most analysts agreed additional reserves were warranted,
many speculated the banks recorded more than necessary.

a) Why might a bank choose to record more loan loss

reserve than necessary? b) Explain how overstated loan loss
reserves can be used to manage earnings in future years.

Professor Charles E. Wasley 33

Review Question #2 Answer

a) Overstated loan loss reserves can be used to manage

earnings in the future. As a result, banks often choose to
overstate future losses as part of a big bath accounting
strategy.

b) In future years, if net income is somewhat less than

expected, it can be increased by recognizing less loan loss
expense than usual. This is possible because the reserve
will still be adequately large since it was overstated in an
earlier year.

Professor Charles E. Wasley 34