Financial Reporting and Analysis of Technology Firms

Technology Firms: 1

MGT 6028

Financial Reporting and Analysis of Technology Firms

Fall Semester, 2002

Instructor:Charles W. MulfordOffice:DCOM 406

Phone:404-894-4395

Email:

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

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.

Grade Determination

Test 1: Accounting for technology firms15%

Test 2: Cash flow construction and analysis25%

Test 3 (final exam): Financial Warnings35%

Group case 1 - company analysis, due Oct. 2810%

Group case 2 - financial warnings using CFI, due Dec. 410%

Classroom participation5%

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.

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.

Financial Reporting and Analysis of Technology Firms

Course Outline

SessionNotebook page

Mon. Aug. 19

Course Introduction

Identifying Technology FirmsTech 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.

SessionNotebook page

Issues of Accounting and Financial Reporting

Development stage enterprisesFinancial Reporting, pp. 1-10

Definition

Accounting and reporting requirements

A Development stage enterprise - Waverider Communications, Inc.

Accounting for research and development costsFinancial 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. 26

Issues 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 28

Issues 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.

SessionNotebook page

Accounting for computer software costsFinancial 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 recognitionFinancial 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 2Holiday

Wed. Sept 4

Issues 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 Block83

Teradyne, Inc.85

SessionNotebook page

In-class:

Compensation of PersonnelFinancial 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 assignmentsValuation notes

Wed. Sept. 16

Cash Flow ConstructionCash 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

SessionNotebook page

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. 18

Cash Flow AnalysisCash 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

SessionNotebook page

Wed. Sept. 23

Cash 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. 25

Cash 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. 30

Cash Flow Analysis (cont’d)

Pre-class assignment:

Problem:Liuski Corp - computer generated

cash flow statementCase section, back of notebook

Read:Share valuation lecture notesValuation notes

In-class:

Complete review of Environmental Services

Review Liuski Corp.

Share Valuation

Share valuation lecture and discussion of case assignmentsValuation notes

Wed. Oct. 2

Share Valuation

Pre-classRead share valuation lecture notes

Share valuation lecture and discussion of case assignmentsValuation notes

SessionNotebook page

Mon. Oct. 7

Share Valuation

Pre-classRead share valuation lecture notes

Share valuation lecture and discussion of case assignmentsValuation notes

Wed. Oct. 9

Share Valuation

Pre-class:Read share valuation lecture notes

Share valuation lecture and discussion of case assignmentsValuation 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. 23

Introduction to Financial Warnings

Pre-classRead chapters 1 and 2, The Financial Numbers Game

Complete: A Survey of Lenders - anticipating earnings surprises12

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 agenda16

Causative Factors for Earnings Surprises - Economic Fundamentals17

SessionNotebook page

Oct. 28

Introduction (cont'd)

Pre-classRead chapters 4 and 5, The Financial Numbers Game

Complete: Financial Numbers Game Questionnaire27

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

Flexibility in Financial Reporting27

Group Case Assignment 1 is due.

Oct. 30

Premature 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 recognition3

SEC requirements for revenue recognition4

Persuasive evidence of an arrangement4

Perceptive BioSystems - Consignments4

Digital Lightwave - No P.O.5

Delivery has occurred4

American Software - Shipment of user msanuals6

Cylink - Shipments to a warehouse7

Informix - Side letters8

Fixed or determinable fee9

Informix - Extended payment terms`9

Collectibility is probable10

Informix - Disregarding customer creditworthiness10

Change in revenue recognition practice to conform to new guidelines11

American Software - Recognition awaits shipment11

SessionNotebook page

Using accounts receivable to detect premature or fictitious revenue12

Knowledgeware - Buildup in accounts receivable12

Nov. 4

Premature or Fictitious Revenue (cont'd)

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

Global Resources30

Revenue recognition - premature or fictitious?18

Boston Scientific - Sales to nonexistent customers20

California Micro Devices - "What's Wevenue?"21

Mercury Finance - Revenues with the stroke of a pen22

Flight Transportation - Insufficient capacity23

Revenue recognition cover-up activities25

Special terminology - Premature or fictitious revenue34

Sunbeam - Bill and hold34

Bausch & Lomb - Channel stuffing35

Knowledgeware and others - Side letters36

Financial warnings checklist37

Nov. 6

Aggressive Cost Capitalization

Pre-classRead chapter 7, The Financial Numbers Game

Complete: Capitalized costs11

Complete: Cendant / CUC International - capitalized costs13

Complete: American Software - capitalizing software

development costs27

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 recognition4

O.I. Corporation - Warranty expense4

Top Air Manufacturing - Amortization of patents5

Dynatech - Improvements and R & D6

SessionNotebook page

Advertising expenditures - Can it be capitalized?7

CPI Corp. - Direct response advertising7

AOL - Direct response advertising8

 What is aggressive cost capitalization?12

How do I recognize aggressive cost capitalization?18

Pre-Paid Legal, Inc. - Capitalized sales commissions19

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 & D24

Capitalizing software development costs25

Microsoft - No capitalization25

System Software - capitalizing software development costs26

Nov. 11

Extended Amortization Periods

Pre-classComplete: Micron Technology - Average amortization period43

Complete: American Software - Software amortization period44

Guidelines for choosing an amortization period30

Bausch & Lomb - Depreciation policy31

Cordis Corp. - Depreciation policy31

U.S. Surgical - Depreciation policy31

Impact of amortization periods on pretax results32

U.S. Surgical - amortization periods32

Differences in the selection of amortization periods - capitalized software

development costs33  Bolt Beranek and Newman - Amortization period for software costs 33

Autodesk - Amortization period for software costs33

BMC Software - Amortization period for software costs33

Brazen steps taken to boost earnings through extended amortization34

Livent - Amortizing capitalized preproduction costs34

 What's an extended amortization period?35

Waste Management - Underdepreciation of fixed assets37

Snax, Inc. - Writedown of overvalued assets39

SessionNotebook page

Calculating the average amortization period for property, plant and equipment41

National Semiconductor - Average amortization period41

What's an appropriate amortization period for technology?43

New rules for goodwill45

American Standard Co. - Evaluating goodwill for impairment45

Financial warnings checklist46

Nov. 13

Using Operating Cash Flow to Detect Creative Accounting Practices

Pre-class:Read chapter 11, The Financial Numbers Game

Complete: Men's Wearhouse: Adjusting operating cash flow13

Complete: Helen of Troy: Adjusting operating cash flow16

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

Using operating cash flow2

Adjusted cash flow to income ratio (CFI)3

Creative cash flow reporting5

Purchases and sales of trading securities5

WHX Corp. - Trading securities6

Reclassifying outstanding checks as accounts payable8

Aviall - Reclassifying outstanding checks8

Operating cash flow from discontinued operations9

Cytrx Corp. - Discontinued operations10

Adjusting operating cash flow for nonrecurring and nonoperating items12

Microsoft Corp. - tax benefits of stock options18

Nov. 18

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

Pre-classComplete: Tyco International: Acquired operating cash flow19

Complete: Men's Wearhouse: Adjusting income23

Complete: Sunbeam Corp.: Using the CFI29

SessionNotebook page

Using the CFI Ratio24

Xerox Corp.: Using the CFI26

Enron Corp. - Using the CFI28

Financial Warnings Checklist32

Nov. 20

Misreported Assets and Liabilities

Pre-class:Read chapter 8, The Financial Numbers Game

Complete: Comptronix - a complex fraud27

Excessive Asset Valuation2

When are assets overvalued?2

Accounts receivable - NRV represents amounts expected to be collected4

Carco - Keep an eye on economic conditions4

Earthgrains - a bankrupt customer6

Home Nutritional Services - Comparing receivables in days with a competitor's8

Inventory - a convenient fiction10

Perry Drug Stores, Inc. - Inventory issues14