Look For
Violations
Be
Cautious
• Recent accounting scandals
highlighted importance of
banker’s confidence in the
accuracy and lack of distortion of
accounting data
• health of a bank’s loan portfolio
•
•
The legal and moral culpability of top-level
company managers (as well as auditors) is an
issue
Why do some companies distort accounting
numbers as well as engage in other actions
that damage the interests of company
stakeholders, such as stockholders, banks,
employees, and the community?
MANAGEMENT DECISION





Choosing accounting
policies
Changing accounting
policies
Deferring expenses
Income smoothing
Recognizing revenue
too soon
BANKER’S CONCERN

Too liberal

Unjustified

Profits are overstated

Profits are understated

Profits are overstated
Signs of Misleading Financial Statements
Affecting All Industries
MANAGEMENT DECISION

Expense is under
accrued

Expense is under
accrued

Expense is over
accrued
BANKER’S CONCERN

Profits are overstated
and Expenses are
understated

Profits overstated and
Liabilities understated

Profits understated and
Liabilities overstated
MANAGEMENT DECISION

Changing
discretionary cost

Low quality controls

Change in auditors on
a frequent basis
BANKER’S CONCERN
•
Manipulation profits
•
Risk of financial
statement manipulations
•
Risk of financial
statement manipulations

Cash
 A portion is restricted
 Currency uncertainty divisional levels

Receivables






Large overdue receivables
Large increase with sales flat
Overly dependent on one or two customers
Related-party Receivables
Slow Receivables turnover
Right of return exists

Uncollectibility of Receivables Warning Signs
 Large amount of overdue Receivables
 Large increase in Receivables with flat sales
 Exaggerated dependence on one or two
customers

Receivable Check List
 Watch and work the ACP
 Business dispute with customer

Receivable Check List
 Watch "channel stuffing"
 making last minute sales to distributor just
before quarters end.
 Change one bad asset for another
 Growth companies feel pressure to book sales no
matter to whom
 Concentration vs. diversification






Inadequate Salability of Inventory Warning
Signs
Change of corporate inventory valuation
methods
Increase in the number of LIFO pools
Inclusion of inflation profits in inventory
Large, unexplained increase in inventory
Inclusion of improper costs in inventory

High inventory of high tech products can be
disastrous because improved products hit the
market every 6 to 24 months

Who wants a Verizon cell phone six years old?

Watch Inventory turnover

Watch Faddish Inventory

Fixed Assets Warning Signs
 Old equipment and technology
 Cash flow signals
 High maintenance and repair expense
 Declining output level
 Inadequate depreciation charge

Investments Watch Realization
 Switching between current and noncurrent
categories
 Investments recorded in excess of costs
 Risky investments that must be written off





Overstatement of Intangibles Warning Signs
Slow amortization period
Lengthening amortization period
High ratio of intangibles to total assets and
capital
Large balance in goodwill even though profits
are weak




Liabilities Watch Understated
Amortize warranties quickly
Arbitrary adjustments
Smoothing

Equity
 Treasury Stock - large and frequent transactions
 Large and unreasonable dividends
 Unexpected and/or substantial reserves
 Worrisome negative cumulative translation
adjustments
•
Accounting Policy Task Force (IATA) (APTF) of the
International Air Transport Association (IATA) has issued a
number of Airline Accounting Guidelines and liaises with
standard setting bodies on issues for the industry.
•
•
•
Translation of Long Term Foreign Currency Borrowings
Frequent Flyer Program Accounting
Components of Fleet Acquisition Cost and Associated
Depreciation
Recognition of Revenue
Accounting for Maintenance Costs
Accounting for Leases of Aircraft Fleet Assets
Segmental Reporting
•
•
•
•
•
The mining industry includes thousands of
companies engaged in mining an array of products
including precious metals, base metals, coal,
uranium, and other industrial minerals
▫ Accounting for and Disclosure of Mineral Reserves
 How should the costs of acquiring mineral rights or
properties be accounted for given these acquisitions may
take the form of taking title to properties, obtaining mineral
and mining rights, leases, patents, etc.
 How should generally accepted principles for determination
of the impairment of such costs capitalized be determined?
 What financial information should be disclosed to investors
that will provide relevant, comparable and transparent
disclosures of mineral reserves?

Accounting for costs associated with
exploration and development activities
 Clarify that costs incurred in exploring for
minerals may not be capitalized.
 Provide definitions of exploration activities
(related costs are expensed) versus mine
development activities (related costs are
capitalized).
•
Accounting for development activities
performed contemporaneous to production
▫ Specify that costs incurred at an operating mine,
excluding costs included in inventory, should not
be deferred.
▫ Provide guidance as to when a mine is under
construction versus in production.
▫ Due to the nature of the business, specify which,
if any mine development costs incurred prior or
subsequent to commercial production
commencing, should be capitalized.

Accounting for operating activities
 Define when it would be appropriate for
inventories of precious and base metals
appropriately to be recorded at other than cost.
 Provide guidance about common revenue
recognition matters unique to the industry.
•
Cost and Equity Method
▫ Cost method
 The original investment is recorded at cost in an
investment account.
 Additions to the original investment also recorded at cost in the
investment account.
 Dividends received out of accumulated earnings prior to
acquisition are recorded as a return of investment. All other
dividends are recorded as dividend income.
 The recording of dividends as dividend income is the major
difference between the cost and the equity methods.

Cost and Equity Method
 Equity method
▪ This method is exactly the same as the cost method
except:
▪ Dividends received are credited to the investment account and
are not considered income
▪ The investor periodically records its share of the investor's net
income by a debit to the investment account and a credit to
income from subsidiary
INVESTMENT IN XEROX (10%)
Debit
Credit
Investment in $700,000
Nerox
Cash
COST METHOD
Record dividends
when declared
• No accounting
distortions
$700,000
Income of
investment is
ignored
Adjust investment
book value of value
depreciates
• No accounting
distortions
• No accounting
distortions
COST METHOD
 WHEN DIVIDENDS ARE DECLARED
THE CASH ACCOUNT RECORDS A
$36,000 INCREASE AND THE INCOME
STATEMENT RECORDS $36,000
DIVIDEND INCOME:
Debit
Cash
Dividend
Income
Credit
$36,000
Record dividends
Income of
investment is
ignored
• No accounting
distortions
• No accounting
distortions
$36,000
Adjust investment
book value of value
depreciates
• No accounting
distortions
INVESTMENT IN NEROX (25%)
Debit
Credit
Investment in $1,000,000
Nerox
Cash
EQUITY METHOD
Record pro rata
share of profits
• Likely accounting
distortions
$1,000,000
Record Dividends
Adjust investment
book value of value
depreciates
• No accounting
distortions
• No accounting
distortions
EQUITY METHOD
 ON DECEMBER 31, 2007, NEROX
RECORDS A PROFIT OF $1,000,000.
WE RECORD 25% OF THAT INCOME
INTO OUR FINANCIAL STATEMENT:
Debit
Investment In
Nerox
Equity Earnings
In
Unconsolidated
Subsidiary
Record Pro Rata
Share Of Nerox
Income
Credit
Record divicends
$250,000
$250,000
Adjust investment
book value of value
depreciates
• Likely accounting
distortions
• No accounting
distortions
• No accounting
distortions
EQUITY METHOD
 ON DECEMBER 31, 2007, NEROX
DECLARES A $100,000 DIVIDEND
SENDING A CHECK OF $25,000 TO
US, THE INVESTOR.
Debit
Cash
Investment In
Nerox
Record dividends
Credit
Record dividends
$25,000
• No accounting
distortions
• No accounting
distortions
$25,000
Adjust investment
book value of value
depreciates
• No accounting
distortions

Restructuring Charges; How and Why?

Gains and Losses on Sale of Businesses
 Tie into Gains/Losses on Sale of Equipment

Deferred Tax Credits

Amortization of Bond Premiums

Amortization of Bond Discounts







Risk of catastrophic losses
Direct and indirect guarantees
Financial instruments with off balance sheet
risk
Recourse obligations on Receivables or B/R's
sold
Securitization of assets
Futures contracts
Pensions







Risk of catastrophic losses
Direct and indirect guarantees
Financial instruments with off balance sheet
risk
Recourse obligations on Receivables or B/R's
sold
Securitization of assets
Futures contracts
Pensions