mgt 6028 syllabus

MGT 6028Financial Reporting and Analysis of Technology Firms

Fall Semester, 2002

Instructor: Charles W. Mulford Office: DCOM 406Phone: 404-894-4395Email: [email protected]

Course Materials:

Course Textbook: The Financial Numbers Game: Detecting Creative Accounting Practices, by C. Mulford and E. Comiskey

Course Notebook: Financial Reporting and Analysis of Technology Firms, by Prof. C. Mulford.

Consists of the following parts:

Course Lecture Notes: Course Description Identifying Technology Firms Issues of Accounting and Financial Reporting for Technology Firms Cash Flow Construction and Analysis of Technology Firms Share Valuation Financial Warnings Introduction Premature or Fictitious Revenue Aggressive Cost Capitalization and Extended Amortization Periods Misreported Assets and Liabilities Managing Earnings Perceptions Using Operating Cash Flow to Detect Creative Accounting Practices

Course Supplemental Materials: Prior year exam with answer key Case Assignments Course Readings

Technology Firms: 2

Course Description

Financial Reporting and Analysis of Technology Firms focuses on financial reporting and analysis issues facing firms from a broad range of industries whose common bond is research and development of new technology, including the application of technology to new or enhanced products and services. The course is presented in three interrelated parts, each part seeks to fulfill one of three overall course objectives.

Part 1 clarifies the accounting and reporting standards that are particularly troublesome for technology firms. Standards that guide the reporting of activities of technology firms are sometimes arbitrary and are often misunderstood. For example, research and development is expensed as incurred unless aimed at the development of new software. Also, development stage enterprises are offered no special accounting guidelines from operating firms, though they do have special reporting requirements. Readers of the financial statements of technology firms must be aware of standards such as these to effectively understand the firms' underlying financial performance and position.

Part 2 is devoted to cash flow analysis. Technology firms in general are fast-growth entities. Many of these companies require external sources of cash to maintain their growth. Other firms, however, that are growing just as fast, are generators of cash and accumulate large amounts that can be used for new investment. Investment analysis is ultimately focused on a firm’s ability to generate cash. This section is attentive to analyzing the traits of companies that permit some to generate cash while others consume it. The objective is to determine if and when companies that consume cash will begin to generate surpluses, and whether companies that generate cash currently will continue to do so.

In Part 3 attention turns to identifying financial warnings, available in the financial statements and notes, that can be useful in anticipating future declines in corporate earnings and cash flow. Such earnings declines might be caused by operational difficulties or by the application of creative accounting practices. The circumstances surrounding these performance declines have many names, such as "Asset write-offs", "unrecorded liabilities", "restructuring charges", "accounting irregularities", "inflated profits", and "earnings restatements". Each of these circumstances is often unanticipated. The objective of this section is to prepare the financial-statement reader to better anticipate and avoid them.

Course Procedure

A blending of lecture and discussion will typify the class sessions. A consistently high level of preparation for class sessions will be essential in order to derive maximum benefit from the course.

Technology Firms: 3

Grade Determination

Test 1: Accounting for technology firms 15%Test 2: Cash flow construction and analysis 25%Test 3 (final exam): Financial Warnings 35%Group case 1 - company analysis, due Oct. 28 10%Group case 2 - financial warnings using CFI, due Dec. 4 10%Classroom participation 5%

At the start of the semester, the class will be divided into groups of four to five persons. These groups will work together on two group cases. The first group case entails an analysis of an individual company’s earnings and cash flow potential. Firms selected for analysis by each group must be from a chosen technology industry. Firms should be small (revenues of under $100 million), profitable, and expected to grow at a minimum of 15% compounded over the next five years.

Technology industries from which individual companies may be chosen are listed below. No more than two groups may select the same industry.

Aerospace

Biotechnology

Computers and peripherals

Computer Software and Services

Drug

Electronics

Medical Supplies

Precision Instrument

Semiconductor

Semiconductor Capital Equipment

Telecommunications Equipment

The second group case entails a search for warnings of creative accounting

practices and impending operational difficulties using the CFI ratio from

among five chosen companies within the selected industry.

Technology Firms: 4

Consistent with the college's honor code, students must do their own work on the exam. Group work should be done without the help of others outside the group.

For students with disabilities: to request classroom accommodations, contact the ADAPTS office: Assistant Dean/Coordinator for Students with Disabilities, Smithgall Student Serices Building, Suite 221, (404) 894-2564.

Technology Firms: 5

Financial Reporting and Analysis of Technology Firms

Course Outline

Session Notebook page

Mon. Aug. 19

Course Introduction

Identifying Technology Firms Tech Firm Intro pp. 1-10 Use of technology in providing goods and services

Not a good indicator Using financial statement characteristics to identify technology firms

Percentage of assets that are technology-based High level of research and development activity, patents are a minor portion of

total assets - Biogen Capitalized software development costs - Astea International, Inc.

Portion of employees engaged in scientific research activities Personnel mix - Groundwater Technology

Research and development expenditures as a percentage of revenues A workable approach for identifying technology firms Research and development expense as a percentage of revenues for eight

industry groups Three industries that do not meet this technology firm definition

Broadcasting, including cable television Environmental Telecommunications services, including cellular phones

Technology 80 - share valuation case assigned

Wed. Aug. 21

Pre-class readings: Readings section, back of notebook FAS 7: "Accounting and Reporting by Development Stage Enterprises" FAS 2: "Accounting for Research and Development Costs" FAS 68: "Research and Development Arrangements" Exp. Draft: Proposed Statement of Financial Accounting Standards: "Business

Combinations and Intangible Assets - Accounting for Goodwill"

Written assignment: R&D or What? 26

Group assignments made.

Technology Firms: 6


Issues of Accounting and Financial Reporting Development stage enterprises Financial Reporting, pp. 1-10

Definition Accounting and reporting requirements A Development stage enterprise - Waverider Communications, Inc.

Accounting for research and development costs Financial Reporting, pp. 11-23 Definition Examples Reporting guidelines

Costs incurred internally Purchased from others Research and development arrangements

What is research and development? - St. Jude Medical Purchased research and development

Cisco Systems, Inc. MCIWorldCom

Research and development arrangements Hi-Tech Pharmacol Co., Inc.

In-class exercise - R&D or what?

Mon. Aug. 26Issues of Accounting and Financial Reporting (cont’d)

Pre-class assignment: Technology 80. Case section, back of notebook

In-class: Technology 80 - what’s it worth? Discuss collecting industry data and provide guidance for group case.

Students should consider industries of interest and group membership

Wed. Aug 28Issues of Accounting and Financial Reporting (cont’d)

Pre-class readings: Readings section, back of notebook SOP 98-1: “Internally Developed Software” FAS 86: "Accounting for the Cost of Computer Software to be Sold, Leased, or

Otherwise Marketed" SOP 97-2: "Software Revenue Recognition" Article: "The Boundaries of Financial Reporting and How to Extend Them" by

Lev and Zarowin. Be prepared to discuss findings and implications.

Technology Firms: 7


Accounting for computer software costs Financial Reporting, pp. 24-37 Key issue - sufficiently similar to research and development? Software purchased or created for internal use Software purchased or created for sale or lease The life cycle of software development

Accounting for software development costs Importance of technological feasibility Accounting and disclosure requirements

Capitalized software development costs Astea International, Inc. American Software, Inc.

Accounting for software revenue recognition Financial Reporting, pp. 38-50 Statement of Position 97-2 Basic Principles

Computer Associates International Four requirements for recognition

Evidence of an arrangement Delivery Fixed or determinable fees Collectibility

Special situations Multiple elements

PCS Services

Contract accounting for software Example policies

Microsoft Corp. IBM Corp. Mustang Software American Software

Mon. Sept 2 Holiday

Wed. Sept 4Issues of Accounting and Financial Reporting (cont’d)Pre-class readings: Readings section, back of notebook

FAS 123: “Accounting for Stock-Based Compensation” APB 25: "Accounting for Stock Issued to Employees" FIN 28: "Accounting for Stock Appreciation Rights and Other Variable Stock

Option or Award Plans"Complete:

H&R Block 83 Teradyne, Inc. 85

Technology Firms: 8


In-class: Compensation of Personnel Financial Reporting, pp. 57-94 Characteristics of technology firms often limit cash compensation Alternatives employed

Stock options Stock appreciation rights Performance - type plans

Reporting guidelines for stock-based compensation plans Stock compensation plans

Qualified vs. nonqualified stock option plans Qualified and nonqualified plans - Autodesk Tax benefits from stock options

Microsoft Quigley Corp. I2 Technologies

In-class exercise - H&R Block In-class exercise - Teradyne, Inc.

Stock appreciation rights SFAS 123 - Accounting for stock-based compensation

Pro-forma disclosures - Autodesk

Wed. Sept. 9 Test 1: Accounting and reporting for technology firms

Mon. Sept. 11 Review Test 1 results

Share Valuation Share valuation lecture and discussion of case assignments Valuation notes

Wed. Sept. 16Cash Flow Construction Cash Flow Construction, pp. 1-51

Partitioning cash flows Arch Therapeutics:

Change in cash Balance sheet changes Indirect method Direct method

Storefront Furniture, Inc. Indirect and direct methods contrasted

Technology Firms: 9


The UCA format cash flow statement Barton Industries, Inc. - calculating net cash after operations

Problem: Forders, Inc. - calculating net cash after operations The UCA format cash flow statement

A statement format for cash flow analysis Column Casts - bank format cash flow

Highlighting differences among the indirect method, direct method and bank format statements of cash flow

Cash flow construction: A closer look at deriving the UCA format cash flow statement

Cash flow construction: A three step process

Mon. Sept. 18Cash Flow Analysis Cash Flow Analysis, pp. 1-53

Pre-class assignment: Problem: Hamilton Farms, Inc. - preparing a UCA format cash flow statement - cont’d.

In-class: Review Hamilton Farms, Inc. solution Using the analysis cash flow format to analyze cash flows

Five cases - same revenues, same net income, same net cash flow, very different conclusions

Some comments on the cash flow cases A sixth case

Cash Flow Analysis (cont’d)

Using ratios to analyze cash flows Growth Profitability

Cost of goods sold percentage Selling, general and administrative expense percentage

Operating efficiency Days receivables Days inventory Days payables

Technology Firms: 10


Wed. Sept. 23Cash Flow Analysis (cont’d)

Pre-class assignment: Problem: Jewel’s Jewelers. - preparing a UCA format cash flow statement (time permitting)

In-class: Using ratios to analyze cash flows (cont’d) Review Jewel’s Jewelers solution (time permitted) Industrial Services (exclude tax accounts)

Mon. Sept. 25Cash Flow Analysis (cont’d)

Pre-class assignment:Problem: Environmental Services (excluding tax accounts)

In-class: Complete review of Industrial Services Review Environmental Services

Wed. Sept. 30Cash Flow Analysis (cont’d)

Pre-class assignment:Problem: Liuski Corp - computer generated

cash flow statement Case section, back of notebook

Read: Share valuation lecture notes Valuation notes

In-class: Complete review of Environmental Services Review Liuski Corp.

Share Valuation Share valuation lecture and discussion of case assignments Valuation notes

Wed. Oct. 2Share ValuationPre-class Read share valuation lecture notes

Share valuation lecture and discussion of case assignments Valuation notes



Mon. Oct. 7Share ValuationPre-class Read share valuation lecture notes

Share valuation lecture and discussion of case assignmentsValuation notes

Wed. Oct. 9Share Valuation

Pre-class:Read share valuation lecture notes

Share valuation lecture and discussion of case assignments Valuation notes

Mon. Oct. 14 Fall Recess, No Class

Mon. Oct. 16 Test 2: Cash flow analysis and share valuation

Wed. Oct. 21 Review Test 2 results

Oct. 23Introduction to Financial Warnings

Pre-class Read chapters 1 and 2, The Financial Numbers GameComplete: A Survey of Lenders - anticipating earnings surprises 12

What's an earnings surprise? 2 The Topps Co. - Provision for obsolescence and returns MiniScribe - A massive fraud Chambers Development - Abandoning unorthodox accounting Home Nutritional Services - Changes in reimbursement patterns Crown Crafts - Inventory theft loss Presidential Life - Loss on investments Lucent Technologies - Premature revenue recognition Sunbeam Corp. - Premature revenue recognition California Micro Devices - Fictitious revenue Cascade International - Where's Our Chairman?

How do earnings surprises impact future cash flows? 10 Course agenda 16 Causative Factors for Earnings Surprises - Economic Fundamentals17



Oct. 28Introduction (cont'd)

Pre-classRead chapters 4 and 5, The Financial Numbers GameComplete: Financial Numbers Game Questionnaire 27

Causative Factors for Earnings Surprises - Economic Fundamentals (cont'd) 17

Flexibility in Financial Reporting 27

Group Case Assignment 1 is due.

Oct. 30Premature or Fictitious Revenue

Pre-classRead chapter 6, The Financial Numbers Game Complete: Trading Cards, Inc (Topps). 13

When should revenue be recognized? 2 Autodesk - Sales to distributors BMC Software - Licensing of software Computer Associates - Product license fees Group 1 Software - Licenses of software

Guidelines for revenue recognition 3 SEC requirements for revenue recognition 4

Persuasive evidence of an arrangement 4 Perceptive BioSystems - Consignments 4

Digital Lightwave - No P.O. 5

Delivery has occurred 4 American Software - Shipment of user msanuals 6 Cylink - Shipments to a warehouse 7 Informix - Side letters 8

Fixed or determinable fee 9 Informix - Extended payment terms` 9

Collectibility is probable 10 Informix - Disregarding customer creditworthiness 10


Change in revenue recognition practice to conform to new guidelines 11

American Software - Recognition awaits shipment 11



Using accounts receivable to detect premature or fictitious revenue12

Knowledgeware - Buildup in accounts receivable 12

Nov. 4Premature or Fictitious Revenue (cont'd)

Pre-class: Complete: Disk Drive Corp (Miniscribe). 26Global Resources 30

Revenue recognition - premature or fictitious? 18 Boston Scientific - Sales to nonexistent customers 20 California Micro Devices - "What's Wevenue?" 21 Mercury Finance - Revenues with the stroke of a pen 22 Flight Transportation - Insufficient capacity 23

Revenue recognition cover-up activities 25

Special terminology - Premature or fictitious revenue 34 Sunbeam - Bill and hold 34 Bausch & Lomb - Channel stuffing 35 Knowledgeware and others - Side letters 36

Financial warnings checklist 37

Nov. 6

Aggressive Cost Capitalization

Pre-classRead chapter 7, The Financial Numbers GameComplete: Capitalized costs 11Complete: Cendant / CUC International - capitalized costs 13Complete: American Software - capitalizing software

development costs 27

Expense or Capitalize? 2 The Good Guys - Store preopening costs Sun Television & Appliances - Store preopening costs Lechters - Store preopening costs Value Merchants - A company changes its policies

Guidelines for expense recognition 4 O.I. Corporation - Warranty expense 4 Top Air Manufacturing - Amortization of patents 5 Dynatech - Improvements and R & D 6



Advertising expenditures - Can it be capitalized? 7 CPI Corp. - Direct response advertising 7 AOL - Direct response advertising 8

What is aggressive cost capitalization? 12

How do I recognize aggressive cost capitalization? 18 Pre-Paid Legal, Inc. - Capitalized sales commissions 19 Medical Disposal Technologies - A host of capitalized costs 21

Chambers Development - In hindsight, capitalization was a mistake 22

Computer software development costs - a special form of R & D 24

Capitalizing software development costs 25 Microsoft - No capitalization 25 System Software - capitalizing software development costs 26

Nov. 11Extended Amortization Periods

Pre-classComplete: Micron Technology - Average amortization period 43Complete: American Software - Software amortization period 44

Guidelines for choosing an amortization period 30 Bausch & Lomb - Depreciation policy 31 Cordis Corp. - Depreciation policy 31 U.S. Surgical - Depreciation policy 31

Impact of amortization periods on pretax results 32 U.S. Surgical - amortization periods 32

Differences in the selection of amortization periods - capitalized software

development costs 33 Bolt Beranek and Newman - Amortization period for software

costs 33 Autodesk - Amortization period for software costs 33 BMC Software - Amortization period for software costs 33

Brazen steps taken to boost earnings through extended amortization 34

Livent - Amortizing capitalized preproduction costs 34


What's an extended amortization period? 35 Waste Management - Underdepreciation of fixed assets 37 Snax, Inc. - Writedown of overvalued assets 39



Calculating the average amortization period for property, plant and equipment 41

National Semiconductor - Average amortization period 41

What's an appropriate amortization period for technology? 43

New rules for goodwill 45 American Standard Co. - Evaluating goodwill for impairment 45


Nov. 13Using Operating Cash Flow to Detect Creative Accounting Practices

Pre-class: Read chapter 11, The Financial Numbers GameComplete: Men's Wearhouse: Adjusting operating cash flow 13Complete: Helen of Troy: Adjusting operating cash flow 16

Note: Group Case Assignment 2 is due Dec. 4.

Using operating cash flow 2 Adjusted cash flow to income ratio (CFI) 3

Creative cash flow reporting 5

Purchases and sales of trading securities 5 WHX Corp. - Trading securities 6

Reclassifying outstanding checks as accounts payable 8 Aviall - Reclassifying outstanding checks 8

Operating cash flow from discontinued operations 9 Cytrx Corp. - Discontinued operations 10

Adjusting operating cash flow for nonrecurring and nonoperating items 12

Microsoft Corp. - tax benefits of stock options 18

Nov. 18Using Operating Cash Flow to Detect Creative Accounting Practices (cont'd)

Pre-classComplete: Tyco International: Acquired operating cash flow 19Complete: Men's Wearhouse: Adjusting income 23Complete: Sunbeam Corp.: Using the CFI 29



Using the CFI Ratio 24 Xerox Corp.: Using the CFI 26 Enron Corp. - Using the CFI 28

Financial Warnings Checklist 32

Nov. 20Misreported Assets and Liabilities

Pre-class: Read chapter 8, The Financial Numbers GameComplete: Comptronix - a complex fraud 27

Excessive Asset Valuation 2 When are assets overvalued? 2

Accounts receivable - NRV represents amounts expected to be collected 4

Carco - Keep an eye on economic conditions 4 Earthgrains - a bankrupt customer 6 Home Nutritional Services - Comparing receivables in days with

a competitor's 8

Inventory - a convenient fiction 10 Perry Drug Stores, Inc. - Inventory issues 14 Leslie Fay - Inconsistencies between corporate performance and

publishedresults 17

On the wild side - inventory reporting violations 23 Bre-X Minerals - "salted" gold samples 23 Centennial Technologies - fake inventory 24 International Nesmot Industrial - brass bars painted to look like

gold 26

Nov. 25Misreported Assets and Liabilities (cont'd)

Pre-class Complete: Babson Tool Works - Lifo 34

The Lifo Reserve 30 John Wiley & Sons - Life reserve 30 R.R. Donnelley - Lifo and the fourth quarter earnings surprise 31 Winn Dixie Stores - The fourth quarter lifo reserve adjustment32


Compiled statements and the fourth quarter lifo adjustment 33

Lifo liquidations - a temporary earnings boost 39 Cross Co. - lifo liquidations 39



Other inventory issues 41 Topton Manufacturing - Changing inventory mix, a precursor of

falling sales? 41 Crown Crafts - Inventory theft and the unexpected inventory

writedown 42

Investments - available for sale, trading and held to maturity 44 SunTrust Banks - A major balance sheet boost to assets and

equity 46 Presidential Life - What are debt securities worth? 48 Johnson Scientific - Equity method accounting can postpone

recognitionof market value declines 49

Bion Environmental - Overvaluation of notes received for stock issued 50

Nov. 27 Work on group projects

Dec. 2Misreported Assets and Liabilities (cont'd)

Pre-class: Complete: Haven's Building Supplies61

Undervaluation of Liabilities 51 When are liabilities undervalued? 51 Accounts payable and accrued liabilities 52

Collins Industries - Understating accounts payable, overstating net income 54

Disk Drive Corp. - underaccrued warranty liability 57

Low effective tax rate 58 Resource Engineering - net operating loss carryforwards 58

Contingent liabilities 60 Lee Pharmaceuticals - failure to accrue for environmental

damage 60

Hidden obligations 65 Personal Diagnostics - open futures positions 65 Bay Tact Corp. - stocks on margin 65

Off balance sheet liabilities - commitments 67


Marriott - Loan guarantees 68

Off balance sheet liabilities - Special Purpose Entities (SPEs) 69 Enron Corp. - SPEs and the company's restatement 75

Off balance sheet liabilities - Synthetic leases 82 Lexicon Graphics - Synthetic leases and restricted cash 85 Cisco Systems - Synthetic leases and restricted cash 86




Dec. 4Managing Earnings Perceptions and Management Fraud

Pre-classRead chapters 9 and 10, The Financial Numbers GameComplete: Basic Industries: Change in accounting principle (Managing Earnings Perceptions section) 40

Complete: Elite Tennis, Inc. - using the checklist (Management Fraud section) 17

Group Case Assignment 2 is due.

Creative Statement Structure Basic income statement structure 3 Key elements of the income statement 4 Employing creativity in structuring the income statement 6

Advanced Environmental Recycling - fire gains 8 Advanced Lighting Technologies - Extraordinary item, early

retirement of debt 9 Exxon Corp. - Material nonextraordinary item 12 Herman Miller - Material charge for litigation and restructuring

is not extraordinary 13

Problematic classification of extraordinary items 14 Bio-Rad Laboratories - extraordinary item 14 Norwest bank - Treatment of fire-related gain, not extraordinary

15 Differing treatments for extraordinary items 16

Additional examples of income statement creativity 19 IBM - Netting gains against operating expenses 19 Sherwin-Williams Co. - Netting other income and expense 22 Archer Daniels Midland - Netting other income and expense 23 Coca-Cola - Gains on sales of bottlers 24 Positive labels for not-so-positive events 25 W.R. Grace - Including operating expenses in a restructuring

charge 27 Scientific Atlanta - New disclosure rules for restructuring charges

28 Use of materiality 29

Accounting Changes31


Changes in accounting principle 31 Ameridiscs - adoption of new accounting principle 32

Changes in accounting estimate 34 Blowout Entertainment - Changing the estimated useful lives

of videocassette tapes 35



What are discretionary accounting changes? 36

Smoothed Income43

What is income smoothing? 43 Allied Bancshares - a quote from the treasurer 43 Daimler-Benz (Germany) - Storing significant earnings for future

years

What's wrong with income smoothing? 46

Identifying income smoothing 47 GE - Unsustainable boost to earnings 48

The big bath 49


Management Fraud

Assessing the risk of management fraud 2 Survey of audit partners 5 Management fraud by industry 6 Management fraud by deceptive action 7 Level of client personnel involved in fraud


Three necessary ingredients for fraud 8 Conducive conditions 8 Motivation 10 Attitude 12

Motivation - A closer look at the incentives 14

Using the Financial Warnings Checklist 14 QZ Corp. - Example indicators 15 Puritan Technologies - Example indicators 21

The Auditor's Role in Fraud Detection 22

The auditor's responsibility to detect and report errors and irregularities 25


Implications for lenders and investors 26

Final Exam Date – Test 3 Financial Warnings

mgt 6028 syllabus

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