Proceedings of ASBBS

Volume 16 Number 1

IMPROPER CAPITALIZATION AND THE MANAGEMENT OF EARNINGS

Ryerson, Frank E. III Macon State College
frank.ryerson@maconstate.edu

ABSTRACT The economic crisis of 2008 will likely lead to public demands for increased regulation of market participants and for increased transparency in financial reporting. While it is appropriate for the public, and its institutions, to focus on these recent financial market abuses, it is also important not to lose sight of previously identified and ongoing schemes used to perpetrate fraud in the financial markets. The results of a SEC study of its own enforcement actions, covering the period July 31, 1997 to July 30. 2002, found that the most common type of abuse during this period was that of earnings manipulation or inappropriate earnings management. While the study found that improper revenue recognition led to the largest number of enforcement actions, there were also numerous enforcement matters involving improper expense recognition. These included improper capitalization or deferral of expenses, improper use of reserves, and other misstatements. The purpose of this paper is to provide evidence on this other, less common, approach to earnings management, the misstatement of expenses. In particular, the paper reports on the improper capitalization of expenses as a means to manipulate earnings. In order to provide evidence on the ways companies have improperly capitalized expenses to manipulate their reported income, the author chose to review the SECs Accounting and Auditing Enforcement Releases (AAERs) issued over the last seven years. A total of 16 AAERs citing improper capitalization were identified. These were examined to determine the specific reason(s) capitalization was deemed inappropriate. THE NATURE OF EARNINGS MANAGEMENT In 2000, the Panel on Audit Effectiveness stated that the term earnings management covers a wide variety of legitimate and illegitimate actions by management that affect an entitys earnings. In the broadest sense, almost all of managements decisions have a potential impact on earnings and, therefore could be said to constitute earnings management. However, in the more general case, earnings management is normally interpreted as those actions taken by management to either smooth earnings over two or more interim or annual accounting periods or to achieve a designated earnings level. In its attempts to manage earnings to achieve either one or both of these goals, managers can choose from a continuum of activities which range from complete legitimacy at one end to fraud at the other. Even in circumstances where the earnings management activity is deemed legitimate, its use may call into question the quality of the reported earnings for the period. Given the wide array of options normally available to managers to help them achieve certain earnings objectives, what distinguishes, for the accountant or auditor, the legitimate ones from those that lead to a misstatement of earnings? The answer to that question lies in the acceptability of the accounting policy under Generally Accepted Accounting Principles (GAAP). When managers implement legitimate earnings management techniques, there may be concern over the quality of the companys earnings, but not over whether the financial statements are presented fairly, in all material respects, in conformity with GAAP.

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Proceedings of ASBBS

Volume 16 Number 1

On the other hand, if the activities undertaken violate GAAP and lead to a misstatement of earnings, the auditors should follow the guidance set forth in Statement on Auditing Standards (SAS) No. 99: Consideration of Fraud in a Financial Statement Audit to determine if the misstatement is due to an error or due to fraud. SAS No.99 distinguishes fraud from an error on the basis of whether the underlying action that results in a misstatement of the financial statements is intentional or unintentional. If the misstatements are deemed intentional and, thus fraudulent, the auditor should consider whether they are due to fraudulent financial reporting or to the misappropriation of assets. With respect to fraudulent financial reporting, SAS No. 99 states that it involves intentional misstatements or omissions of amounts or disclosures in financial statements designed to deceive financial statement users where the effect causes the financial statements not to be presented in conformity with GAAP. SAS No. 99 goes on to state that the misappropriation of assets involves the theft of an entitys assets where the effect of the theft causes the financial statements not to be presented, in all material respects, in conformity with GAAP. Since the purpose of this paper it to provide evidence on earnings management through the improper capitalization of expenses, the focus of the research was on those activities that violate GAAP and can be classified as either errors or fraud. EXPENSE RECOGNITION CRITERIA Before presenting the nature of the misstatements,, a brief review of existing criteria for expense recognition is appropriate. In Statement of Financial Accounting Concepts No. 6 Elements of Financial Statements, expenses are defined as outflows or using up of assets or incurrence of liabilities (or a combination of both) from delivering or producing goods, rendering services, or carrying out other activities that constitute the entitys ongoing major or central operations. Although this definition seems straightforward and to the point, its interpretation in practice can be difficult. The problem of expense recognition is as complex as that of revenue recognition. From a conceptual perspective, anytime a cost is incurred, an asset is acquired and an expense should be recognized only when the economic benefits of the asset have expired. The problem of expense recognition thus lies in determining when the economic benefit of a cost has expired. The Financial Accounting Standards Board (FASB) provides some guidance in this area in Statement of Financial Accounting Concepts No. 5, (CON 5), Recognition and Measurement in Financial Statements of Business Enterprises. Paragraph 85 states guidance for recognition of expenses and losses is intended to recognize consumption (using up) of economic benefits or occurrence or discovery of loss of future economic benefits during a period. Expensesare generally recognized when an entitys economic benefits are used up in delivering or producing goods, rendering services or other activities that constitute its ongoing or central operations or when previously recognized assets are expected to provide reduced or no further benefits. CON 5 provides additional guidance by stating that the consumption of economic benefits during a period may be recognized either directly or by relating it to revenues recognized during the period. For those costs which can be rationally linked to revenues, the matching principle dictates they be expensed with revenues they helped to generate. For example, recording the cost of goods sold with the associated sales revenue. For other costs for which no rational association with revenue exists, some other approach must be used. In these situations it is common to use an indirect form of matching where it is necessary to associate costs with a particular period. Long-term assets are the most common example of these types of costs which are allocated (depreciated) to periods expected to be benefited by their use. Finally, there are other costs, called period costs, which are expensed simultaneously with their incurrence. This approach is preferred when no future benefit from the

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Volume 16 Number 1

incurrence of the cost is discernible. This would be the case with most selling and administrative costs. In summary, costs incurred should be analyzed to determine if a relationship exists with revenue. If so, the matching principle should be used. If no such relationship is found, the cost, if expected to provide benefits to current and future periods, should be expensed on some systematic and rational basis. If neither of these two methods is deemed appropriate, the cost should be expensed entirely in the period incurred. Based on these guidelines for expense recognition, improper capitalization of expenses could result from one or both of the following: (1) failure to match expenses with their revenues and capitalizing them instead; (2) capitalizing period costs when those costs should be expensed in the period of incurrence. The next section of this paper presents the results of the investigation into the management of earnings through the improper capitalization of expenses. EVIDENCE ON IMPROPER CAPITALIZATION To provide evidence on the manipulation of earnings through the improper capitalization of expenses, the author examined Accounting and Auditing Enforcement Releases (AAERs) issued by the Securities and Exchange Commission (SEC) over the period December, 2001 to September, 2008. This review identified a total of sixteen AAERs that cited the improper capitalization of expenses. While an in-depth reporting and analysis of these AAERs is beyond the scope of this paper, this section does identify the AAERs and the specific reason(s) that capitalization was deemed inappropriate. AAER No. 1481- This Release was issued in December of 2001 and concerns the Fine Host Corporations extensive financial fraud that predated, by several years, its June 1996 initial public offering and continued through the third quarter of the fiscal year ended December 31, 1997. The fraud involved, as its primary mechanism, the improper capitalization of millions of dollars in Company expenses as assets. Fine Host is a provider of food and beverage concession, catering, and other services to facilities in the United States. While it was a private company, it was Fine Hosts accounting practice to aggregate certain costs associated with the pursuit of contracts in an acquisition costs account. When a contract was signed, the costs attributed to it were then transferred to a contract rights account and were treated as capitalized costs to be amortized over the life of the contract. This is allowed under GAAP only to the extent these costs were directly related to the acquisition of assets with future economic benefit. Fine Host, however, routinely and improperly allocated a pool of general and administrative (G&A) expenses to the contract rights account without any documentary support for this practice, rather than properly recognizing these G&A costs as period expenses. The amount of improper capitalization in the period preceding its IPO was material. In 1994 it amounted to $2,458,000, approximately 75% of pretax income. For 1995, it was $4,284,000, an amount approximating 113% of pretax income for the year. In fiscal year 1996, following the IPO, Fine Host continued its improper capitalization of period expenses but began to shift some of this cost from the contract rights account to the fixture and equipment account. In 1996 the contract rights account totaled $12.2 million and the fixture and equipment account was increased by $16.5 million. By the fall of 1997, amortization of the contract rights balance was eating into reported earnings and Fine Host was having trouble in meeting analysts expectations. Alerted to the questionable accounting practices by a member of management, the companys independent directors initiated an internal investigation. In February of 1998, Fine Host announced that it had overstated its pretax income by $28 million for fiscal years 1992 through 1996 and by $21 million in the first three quarters of 1997. In Fine Hosts

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restatement, eighteen categories of material accounting errors were identified, with improperly capitalized contract rights of $21.7 million being the largest. AAER No. 1721- SmarTalk, the company cited in this Release, was charged with filing materially false and misleading financial statements with the SEC from the third quarter of 1997 through the second quarter of 1998. Issued in February of 2003, the Release reported that SmarTalk was found to have falsely reported net income of $478,000 for the third quarter of 1997, when, in fact, the company had losses for that period. The primary source of the overstated income was the improper capitalization of ordinary operating expenses. These included such items as executive travel and entertainment costs, employee relocation expenses, consulting and legal fees, and telephone expenses and totaled to $1.1 million in the third quarter of 1997. Instead of being expensed, these costs were added to prepaid expenses, an asset on the balance sheet. Thus, instead of expensing these costs, SmarTalk created a fictitious asset. This allowed them to falsely report the $478,000 in third quarter net income instead of the correct loss of $622,000. AAER No. 1762- Issued in April of 2003, this Release reports on the improper accounting done by Chancellor Corporation in connection with the acquisition of a subsidiary. The Commission found that Chancellor improperly recorded $3.3 million in consulting fees payable to Vestex Capital Corporation (Vestex) as part of the cost of the acquisition of the subsidiary rather than as an expense. If Chancellor had recorded the fee as an expense, it would have reported a net loss of $2.45 million for 1998. By capitalizing the fee, the company was able to report a net gain of $850,000. The reason for disallowing Chancellors treatment of the costs was due to the fact that Vestex was a firm wholly owned by Chancellors CEO. Under GAAP, fees payable to employees or to entities controlled or owned by employees are considered internal costs and must be expensed. Interestingly, the fees were found to have been paid for services that were never rendered. In other words, a baseless payment was improperly capitalized rather than expensed. AAER No. 1966-This AAER, issued in March of 2004, relates to the multi-billion dollar fraud committed by WorldCom, Inc. From approximately September 2000 through June of 2002, WorldCom engaged in a scheme that fraudulently concealed its true operational and financial results. This fraud was carried out, in large part, by understating line cost expenses and treating them as assets on the balance sheet. These line costs were the largest single expense item on WorldComs income statement. A major component of these line costs were the fees paid to third-party telecommunications carriers under long term lease agreements for rights of access to their telecommunications networks. These agreements required WorldCom to pay the fees whether or not they used all of the leased capacity. Under GAAP, WorldCom was required to expense its line costs in the period incurred because they represented cash outflows from ongoing operations with no anticipation that they would benefit future periods. However, in 2001, WorldCom improperly removed approximately $3 billion in its line cost expenses from its income statement, improperly and fraudulently characterizing these expenditures as assets on its balance sheet. This improper accounting was accomplished by making manual journal entries to line cost and Property, Plant and Equipment accounts. AAER No. 2008-Issued in May of 2004, this Release involves The Warnaco Group, Inc. and its materially misleading fiscal 1998 Form 10-K annual report. The Form 10-K contained a material $145 million restatement of the prior three years financial results, which decreased net income over that period by a total of $104.8 million. The Commission found the annual report to be misleading because Warnaco lied about the reason for the restatement. Warnaco stated that the restatement was due to the write-off of previously-deferred start-up related costs identified in connection with the Companys adoption of a new accounting pronouncement. In reality, the restatement was due to a material inventory overstatement caused by a faulty cost accounting

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Volume 16 Number 1

system operated at one of the Companys largest divisions. In this division, the defective cost accounting system omitted certain cost data and improperly capitalized other costs. They used a standard costing system that was so deficient that the standards no longer approximated the divisions actual product costs. The resulting variances were significant in amount and were, in accordance with GAAP, allocated between the cost of goods sold account and the appropriate inventory accounts. This was done in an attempt to approximate actual product costs. However, the method used to prorate the variances was found to be deficient and resulted in too much of the variance amounts being capitalized in inventory. This was the real reason for the inventory being overstated by $145 million. It was not due to improperly recorded start-up related costs as reported by Warnaco. In short, Warnaco had to restate its financial statements because it failed to properly match expenses with revenues i.e.; cost of goods sold with sales. The Commission also determined that the costs that were improperly allocated were also overstated in amount due to the improper capitalization of certain costs as product costs rather than period costs. AAER No. 2027-Del Global Technologies Corp., Inc. is the subject of this Release, issued in June of 2004. Del was charged with materially overstating its reported revenues and making numerous material misrepresentations in Commission filings and in press releases. In addition to improper revenue recognition, Del was accused of improperly accounting for obsolete inventory at full value, overstating work in process values, and improperly characterizing certain ordinary expenses as capital expenditures. These actions violated GAAP and resulted in the overstatement of Dels reported pretax income by at least $3.7 million (110%) in 1997, $5.2 million (161%) in 1998 and $7.9 million (466%) in fiscal year 1999. AAER No. 2053-In July of 2004 the Commission found that Sport-Haley, a Denver, Colorado company, filed quarterly and annual reports that misrepresented its financial condition and results of operations during 1998 and 1999 fiscal years. Among the findings reported in the Release was one that cited the company for the improper capitalization of period costs. The commissioners found that Sport-Haley materially understated expenses related to product design, tradeshows, logo disks, property taxes and advertising by deferring these costs as prepaid assets and fixed assets. This caused the company to overstate its income by $164,000 in 1998 and by $159,000 in 1999 in its Form 10-K filings. AAER No. 2127-Issued in October of 2004, this release relates to Quest Communications International Inc. and charged the company with securities fraud and other violations of federal securities laws. The complaint alleged that, between 1992 and 2002, Quest fraudulently recognized over $3.8 billion in revenue and excluded $231 million in expenses as part of a multifaceted fraudulent scheme to meet optimistic and unsupportable revenue and earnings projections. Among the numerous violations cited by the Commission was one relating to the improper capitalization of $200 million in expenses associated with the companys design centers. AAER No. 2202-Issued in March of 2005, this enforcement action reports on TALX Corporation and the reasons why its fiscal year 2001 financial statements were judged to be materially misstated. As a consequence of these misstatements, TALX overstated its 2001 income by approximately $2.1 million, or 65%. TALXs violations included the fraudulent capitalization of costs related to a patent infringement claim. In early 2001, TALX entered into a license agreement with the patent holder relating to the claim. TALXs payment included an amount for claimed past use of the patented technology, which according to GAAP, should have been expensed immediately. TALX, however, capitalized the payment and, thereby overstated its income by $1.6 million, or 49%, in fiscal year 2001.

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Volume 16 Number 1

AAER No. 2251-Release No. 2251 was issued in June of 2005 and reports on the Commissions complaint that, in 2001 and 2002, Huntington Bancshares, Inc. reported inflated earnings in its financial statements, enabling Huntington to meet or exceed Wall Street analysts earnings per share (EPS) expectations and internal EPS targets that determined bonuses for senior management. These misstatements were deemed to be qualitatively material and included the improper capitalization of commission expenses and deferral of pension costs that were required to be recognized in the period incurred. Without these misstatements, Huntingtons EPS would have fallen short of analysts expectations and senior management bonuses would have been eliminated or reduced. AAER No. 2392-Issued in March of 2006, this Release deals with Aerosonic, an airplane instrument manufacturer. The company was accused with recording fictitious revenue through a number of accounting schemes in violation of GAAP. This began in 1999 and continued through 2002. In addition to misstating revenues, Aerosonic also initiated inventory schemes to overstate its inventory and understate expenses. Among the accounting manipulations uncovered was one in which labor and overhead costs were improperly capitalized as part of inventory cost. From 1999 through 2003, the cumulative overstatement of inventory, and corresponding understatement of expenses, totaled nearly $6.7 million. AAER No. 2393-The subject of this AAER, issued in March of 2006, was Winners Internet Network, Inc. Winners was charged with overstating its assets in 1997, 1998, and 1999. In 1997 and 1998 it materially overstated its software assets by between $75,000 and $300,000 by improperly capitalizing purported software costs in the software asset account. In 1999, Winners financial statements materially overstated its software asset by nearly $421,000, by improperly capitalizing operating expenses in the software asset account. This resulted in an overstatement of total assets by 416%. AAER No. 2643-Release No. 2643 was issued in July of 2007 in the matter of OM Group, Inc., a company engaged in the production and marketing of value-added, metal-based specialty chemicals and related materials. The OM Group, through its CFO and Controller, engaged in accounting fraud by recording and directing numerous adjustments to the consolidated financials (top-side adjustments), which were wholly unsupported and often duplicative of entries already recorded at the operating unit level. Many of these were done with the intent to manage earnings and achieve results that were closer to the OM Groups annual plan. One of the improper accounting practices carried out during this period (1999 through 2002) was the over capitalizing of overhead costs. This was accomplished by making top-side adjustments to capitalize additional overhead costs related to certain of its operating units. These adjustments were wrong because they were duplicative of amounts already recorded at the operating unit level. AAER No. 2765-Released in January of 2008, this AAER involves BUCA, Inc., a Minneapolisbased Italian restaurant company. The Commission found that two officers of the company, in order to meet analysts earnings expectations, designed and executed a scheme to inflate BUCAs income by taking ordinary period expenses and treating them as capital expenditures. Beginning in 2000, these officers would preliminarily assess BUCAs financials at the close of each quarter and then determine how much income they needed to find. They utilized a number of different ways to decrease expenses through improper capitalization. One of these involved capitalizing at least $713,000 in expenses incurred in connection with an elaborate bill-back arrangement. This entailed arranging with certain vendors to have them ostensibly fund BUCAs annual conference for its store managers. The selected vendors would make contributions to the cost of the conference with the understanding that they would bill these amounts back to BUCA in subsequent inflated invoices. BUCA focused this scheme on vendors that provided goods and

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services that, normally, could be capitalized. BUCA, in turn, would record the inflated invoices as capital expenditures. BUCA also improperly capitalized at least $4.67 million in repair and maintenance expenses, as well as general and administrative expenses. At one point, they began capitalizing most repair and maintenance invoices if they exceeded $1,000. Later they even set up a capitalization account for invoices under $1,000 and allowed accounting employees to put small invoices into the account, regardless of whether the invoice represented a capital expenditure or not. They also implemented schemes that capitalized employee salaries and costs of office space that were not legitimate capital costs. When BUCA eventually restated its financial statements for the 2000 to 2003 fiscal years and for the first three quarters of 2004, they disclosed that the improper capitalization of expenses had overstated its pretax income by approximately $11.9 million. AAER No. 2878-This Release was issued in September of 2008. This SEC enforcement action was based upon fraudulent misstatements in the financial statements of the American Italian Pasta Company (AIPC) from fiscal year 2002 through the second quarter of fiscal year 2004. Among the various fraudulent accounting actions taken by AIPC were several schemes in which the company improperly capitalized period expenses to increase reported income. In one scheme, the company improperly capitalized approximately $10 million of current period costs to manufacturing related assets. During the same time period the company improperly reduced current expenses by capitalizing nearly $4.5 million of them as Management Information Systems related assets. AAER No. 2882-The last AAER reviewed for this study was issued in September, 2008. The Release addresses improper accounting practices within the Insurance Services division of The BISYS Group, Inc., a leading provider of financial products and support services. The improper accounting occurred from July, 2000 through December, 2003. One of the problem areas related to the acquisition of another insurance company (Ascensus) in July of 2000. In June of 2001, nearly a year later, BISYS became aware that a vendor (Quotesmith) claimed that it was owed money by Ascensus. BISYS reached an agreement with Quotesmith and paid them $551,000. Most of the $551,000 pertained to policies placed after the Ascensus acquisition and accordingly should have been recorded as an expense of BISYS. BISYS, however, arranged to capitalize this cost as goodwill from the acquisition of Ascensus. The purported rationale being that a liability for these payments should have been recorded on the acquisition date. In addition, BISYS inflated the amount by $256,000, an amount that had already been booked and paid by Ascensus prior to the acquisition. Ultimately, BISYS restated all but $89,000 of the $807,000 based on its conclusion that only that amount had been paid by BISYS and pertained to the period before acquisition. SUMMARY AND CONCLUSIONS A total of sixteen AAERs were reviewed for this study, covering the period from December of 2001 to September 0f 2008. In each instance the SEC found that the companies involved had filed materially false and misleading financial statements with the Commission. While many of the Releases cited the subject company with multiple violations of GAAP, they all involved, at a minimum, the improper capitalization of expenses. The annual dollar amount of improper capitalization ranged from a low of $159,000 to an amount of nearly $3 billion. One possible explanation for improper capitalization of period costs found in this study could be the difficulty accountants face in determining if actual future economic benefits are derived from certain types of expenditures. The FASB recognized that fact in CON No. 5, paragraphs 172 to 177. In paragraph 175 the FASB state that uncertainty about business and economic

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outcomes often clouds whether or not particular items that might be assets have the capacity to provide future economic benefits to the entity, sometimes precluding their recognition as assets. The uncertainty is not about managements intention to increase future economic benefits through the expenditure, but about whether they have succeeded and, if so, to what extent. More specifically, paragraph 176 mentions that if research or development activities or advertising results in acquiring or increasing future economic benefit, those future economic benefits should be treated as an asset. The practical problem is whether future economic benefit has been derived and, if so, how much. The problem is further complicated because the benefits may be realized far in the future, if at all. Given the uncertainty surrounding these types of expenditures, it is not surprising to find that the SEC, given its reliance on GAAP, has determined that most of these should be expensed in the period incurred. These types of misstatements of expenses may be difficult to classify as either an error or as fraud, given the legitimate uncertainty surrounding the intention of management in recording these as assets. The auditor should have much less difficulty, if any, in concluding that the omission of entries or the makings of false entries constitute fraud. Of the sixteen Accounting and Auditing Enforcement Releases examined for this study, only a couple cited this second, more obvious, example of fraud as the reason the financial statements involved were deemed to be materially misleading. In the other instances, the financial statements were judged to be materially misleading due to the improper capitalization of expenses. In these cases, the Commission found that the accountants involved either knew, or should have known, that the expenses they capitalized should have been expensed in the period incurred. Because of this, the Commission viewed these errors to be intentional in nature, and in accordance with SAS No. 99, to be fraudulent. Why did the companies cited in these AAERs improperly capitalize expenses and file materially misstated financial statements? The overwhelming reason was to manage their earnings in such a way as to meet or exceed external analysts expectations and/or internal budgetary targets. As long as managers and accountants believe that that the smoothing of earnings and achievement of a designated level of earnings will reflect favorably on their company and their careers, they will continue in their efforts to do so. As noted at the beginning of this paper, there are many legitimate, if not always wise, ways to manage a companys earnings. If, however, these are not sufficient to accomplish the desired outcome, there will be pressure to manage through illegitimate actions. This paper has provided evidence that these illegitimate approaches to earnings management are not uncommon. REFERENCES American Institute of Certified Public Accountants (2002). Statement on Auditing Standards No. 99: Consideration of Fraud in a Financial Statement Audit, New York: AICPA Financial Accounting Standards Board (1984). FASB Concepts Statement No. 5, Recognition and Measurement in Financial Statements of Business Enterprises, Original Pronouncements, Vol. 2. Financial Accounting Standards Board (1985). FASB Concepts Statement No. 6, Elements of Financial Statements ,Original Pronouncements, Vol. 2. Public Oversight Board (2000). Report and Recommendations of the Panel on Audit Effectiveness, Stamford, CT: Public Oversight Board. Securities and Exchange Commission, SEC Enforcement Division, http://www.sec.gov/ enforce.htm

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