Financial Warnings
Misreported Assets and Liabilities
Overstated Assets
__________
Understated Liabilities
__________
Financial Warnings Checklist
Prof. Charles Mulford
Scheller College of Business
Georgia Institute of Technology
Atlanta, GA 30308
[email protected]
C. Mulford, Misreported Assets and Liabilities, page: 2
When Are Assets Overvalued?
Assets are probable future economic benefits owned or
controlled by an entity.
Assets are valued at cost, or the present value of the resources or
efforts expended in their acquisition.
Previous sections focused on assets subject to annual
amortization, especially
 Property, plant and equipment
 Intangible assets
 Other assets
Also, we looked at accounts receivable in reviewing premature
or fictitious revenue recognition.
This section looks at assets not subject to annual amortization,
especially


Inventory
 Write-downs when cost exceeds market
(replacement cost)
Investments
 Write-downs when cost exceeds market (quoted
price)
C. Mulford, Misreported Assets and Liabilities, page: 3
Defining assets in terms of future economic benefits implies that
balance sheet amounts reported for assets will be realizable.
In the absence of an expectation of realization, asset book values
should be written-down to realizable amounts.

Net realizable value (NRV) is the overriding criterion.

Assets should not be carried at amounts greater than
NRV
As noted earlier, when book value exceeds net realizable value,
an asset is value impaired, a writedown and accompanying
charge to income are needed.
C. Mulford, Misreported Assets and Liabilities, page: 4
Overstating Inventory
Convenient Fiction
Inventory Chicanery Tempts More Firms, Fools More Auditors
A quick Way to Pad Profits, It is Often Revealed Only When Concern Collapses
A Barrel Full of Sweepings
(Excerpts from WSJ Article)
"When companies are desperate to stay afloat, inventory fraud is the easiest way to
produce instant profits and dress up the balance sheet."
What it means:
Inventory overstatement increases current assets, reduces cost of sales, increases
net income, retained earnings and stockholders' equity.
How it's done:
To overstate inventory requires a simply journal entry,
Inventory↑
XXX
Cost of sales↓
XXX
"Since auditors observe only a statistical sample of inventory on hand, inventory
chicanery can go undetected."
"Inventory fraud has increased fourfold from five years ago."
"The recent rise in inventory fraud is one of the biggest single reasons for the
proliferation of accounting scandals."
C. Mulford, Misreported Assets and Liabilities, page: 5
WSJ Article Excerpts (cont'd)
"Shipments between plants were recorded as stocks located at both plants. Some
shipments never left the first plant, and documentation supposedly showing they
were being transferred to the second plant "appeared to be largely fictitious.'"
" . . . Deloitte sent "three to five auditors with three years or less experience to the
plants to check inventory. The faces kept changing and there was little continuity."
"Experts say many companies overvalue obsolete goods and supplies. Others
create phantom items in the warehouse to augment the assets needed as loan
collateral. Still others count inventory that they pretend they have ordered but that
will never arrive."
"As critics see it, unscrupulous managers can get auditors to swallow all kinds of
ruses. In one case, auditors permitted company officials to follow the auditors and
record where they were making test counts of inventory . . . Then the managers
simply falsified counts for inventory that wasn't being tested."
"In another case, the auditor spotted a barrel whose contents management had
valued at thousands of dollars. Actually, the barrel was filled with floor
sweepings. The auditor forced the company to subtract the false amount from
inventory . . . but it never occurred to the auditor that this was an egregious
example of intentional and pervasive fraud."
". . . the auditor test-counted two types of computer chips . . . The next day, the
acquired company's controller called the auditor and told him that 'an hour after
you left . . . more chips . . . arrived in a shipment . . .' But the auditor never
checked back to see if the new chips were for real."
C. Mulford, Misreported Assets and Liabilities, page: 6
WSJ Article Excerpts (cont'd)
"Overstatement of inventory need not be only of physical quantities. Failure to
write inventory down to market (replacement cost) can give the same financial
statement effect."
"But after Laribee filed for bankruptcy-court protection, a court-ordered
investigation by other accountants, attorneys and bankruptcy specialists showed
that much of Laribee's inventory didn't exist. Some was on the books at bloated
values. Certain wire-product stocks carried at $2.20 a pound were selling at only
$1.70 to $1.75 a pound."
C. Mulford, Misreported Assets and Liabilities, page: 7
While concern regarding fraudulent overstatement of inventory
is important, financial statement readers must also be alert to
unintentional (i.e., non-fraudulent) inventory overstatement.

Results in losses from inventory write-downs.
Inventory overstatement can result from:

Overstating inventory quantities

Failure to write inventory down to market (replacement
cost). Will inventory costs be realized?
Indications of inventory overstatement, whether from fraudulent
or non-fraudulent origins, will typically be found in two key
measures:

Cost of sales as a percent of sales

Inventory in days
Both measures should be compared:

With similar measures for competitors

With similar measures for the company in question for
earlier fiscal years and quarters
Before comparing amounts, ensure that the company in question
and comparison benchmark firms use the same inventory cost
flow assumptions (i.e., Lifo, Fifo, etc.)
C. Mulford, Misreported Assets and Liabilities, page: 8
On the Wild Side
Inventory Misstatements Can Entail Some of the More
Outlandish Reporting Violations
The Stuff that Movies are Made of
Bre-X Minerals, Ltd.
The company reported a significant gold find in the jungles of
Indonesia. A flurry of public announcements, including press
releases and television appearances, each pointing to increased
amounts of discovered gold reserves, created excitement and a
buying frenzy in the company's stock.
Heads turned and questions began to surface, however, when, at
the height of activity and excitement, the company's geologist
committed suicide by "jumping" from a company helicopter.
Ultimately it was determined the Bre-X personnel had "salted"
or added gold to, core test samples. In reality, the company
owned little if any gold.
International Nesmot Industrial Corp.
According to the SEC, the company engaged in "a deliberate
scheme to overstate the company's income and inflate its
reported assets by including in inventory fake gold materials . . "
Apparently, the company made up brass bars to look like gold
bars.
C. Mulford, Misreported Assets and Liabilities, page: 9
On the Wild Side (cont'd)
Centennial Technologies, Inc.
(From an SEC Enforcement Action)
The Company overstated its inventory values and levels in a variety of ways. It
falsified invoices to support inflated inventory pricing, manipulated inventory
counts, understated the cost of sales and included phony inventory.
For example, the company's former chief executive officer and its former chief
financial officer caused 27,000 PC cards to be manufactured.
Although these PC cards looked like the typical product that the company
manufactured, they consisted of outer metal casing only and had no inner circuitry.
These dummy PC cards were included in inventory and counted by the
independent auditors during the company's annual audit.
These empty cards constituted a material amount of the finished goods inventory,
overstating it by $8.8 million, or 78%.
The company also overstated the value of its fixed assets in several ways.
Nonexistent additions to fixed assets were made on the company's books and the
cost of bona fide fixed asset additions was padded to inflate their reported value.
These additions consisted primarily of small dollar amounts (less than $5,000)
which the former chief financial officer believed, based on his prior experience
working for the outside auditing firm, the auditors would not check.
Moreover, the company's books and records were adjusted to falsely increase the
reported value of fixed assets and certain inventory items were improperly
reclassified as fixed assets.
As of year-end, the company's fixed assets were overstated by $2.7 million, or
95%.
C. Mulford, Misreported Assets and Liabilities, page: 10
Class Exercise
Printed Circuits, Inc.
(Comptronix Corp.)
Printed Circuits, Inc (PC) provided contract manufacturing services to original
equipment manufacturers in the electronics industry. Between 2008 and 2012, the
company enjoyed a period of significant growth. During that period, sales grew to
$102.0 million from $14.3 million and net income increased to $5.1 million from
$200 thousand.
Soon after the 2012 results were reported, however, it was learned that much of the
company’s sales and earnings were totally fictitious. Several members of company
management had involved themselves in a spectacular fraud designed to create
nearly totally fictitious financial statements.
A Wall Street Journal article is excerpted below. The article describes in good
detail how the PC fraud was carried out. Following the article are selected financial
statistics for the company.
As noted in the article, some outsiders indicated that despite the fraud’s apparent
complexity, it was full of red flags.
Required:
Review the article excerpts and financial statistics. What red flags do you see?
What questions would you ask of management for clarification and understanding?
C. Mulford, Misreported Assets and Liabilities, page: 11
Printed Circuits, Inc. (cont'd)
Key points from the WSJ article . . .
"Company officials also acknowledged yesterday that they really couldn't say
when the fraud began, but confirmed that it stretched back to at least 2010, the year
the company went public."
" . . . the company sketched how the accounting maneuvers were carried out. The
goal was to increase gross profits and sales. To accomplish the former, according
to the company, the officers, usually on a monthly basis, inflated inventory and
decreased the cost of sales by equal amounts, thus exaggerating profits."
"Periodically during the year, a portion of the amounts improperly added to
inventory were shifted to the equipment line on the company's balance sheet,
according to PC -- apparently because it was easier to hide them there for a long
period. To document the apparent increase in the amount of equipment, fake
invoices for the purchase of equipment were prepared . . . "
"To increase sales, the executive recorded phony sales out of the company's
burgeoning - but bogus - inventory . . . As a complement to the phony sales, phony
accounts receivable were set up as well . . ."
"Finally, the officers had to show that the money owed for the fake sales - the
accounts receivable - was actually being paid. So . . . they wrote checks for
equipment that was never purchased and deposited it into the company's own bank
accounts."
"But PC couldn't fully explain how checks that were made out to equipment
suppliers and, according to the company, never endorsed, could have been
processed by Home Bank and then deposited in PC's own account. A
spokeswoman said the deposit mechanism has been 'used to accomplish a
legitimate business purpose' for customers that were also suppliers. Under the
unusual arrangement, if PC owed money to a company that was a supplier - but the
same company owed money to PC as a customer - the account was used to
reconcile the difference."
C. Mulford, Misreported Assets and Liabilities, page: 12
Printed Circuits, Inc. (cont'd)
Selected financial statistics . . .
Y/E ($ millions):
12/12
12/11
12/10
12/09
12/08
Sales:
$102.0
$70.2
$42.4
$29.3
$14.3
COS:
$85.4
$59.3
$36.7
$24.9
$12.2
Net income:
$5.1
$3.0
$1.5
$.9
$.2
Accts. receivable:
12.6
12.3
4.7
9.3
2.1
$28.5
$20.7
$7.5
$9.0
$3.7
55.2
35.9
23.5
9.5
5.8
8.5
8.4
3.4
7.3
1.1
83.7%
84.5%
86.6%
85.0%
85.3%
44.5
63.1
39.9
114.3
52.9
Inventory:
Fixed assets:
Accts. payable:
COS%:
Receivables
in days:
Industry:
Inventory
in days:
Industry:
Payables
in days:
47 - 87 days with a median of 74 days
120.1
125.7
73.6
110.6
109.2
76 - 114 days with a median of 101 days
35.8
51.0
33.4
105.5
32.5
Industry:
30 - 85 days with a median of 52 days
Sales / fixed assets
1.8
Industry:
4.7 - 25.9 with a median of 8
2.0
1.8
3.1
2.5
C. Mulford, Misreported Assets and Liabilities, page: 13
The Lifo Inventory Method
and the Lifo Reserve
Wyley Corp.
From the balance sheet and notes . . .
2015
Current Assets (in 000's):
Cash
Accounts receivable, net
Inventories
Other assets
Total current assets
$
42,299
68,080
46,109
20,623
177,111
2014
$
148,970
53,785
40,003
13,212
255,970
Inventories
Inventories are stated at cost or market, whichever is lower. Domestic book
inventories aggregating $35.4 and $27.4 million at April 30, 2015 and 2014,
respectively, are valued using the last-in, first-out (LIFO) method. All other
inventories are valued using the first-in, first-out method.
Inventories were as follows:
Dollars in thousands
Finished Goods
Work-in-Process
Paper, Cloth, and Other
LIFO Reserve
Total
2015
$40,370
3,537
5,241
49,148
(3,039)
$46,109
2014
$ 34,485
5,325
2,007
41,817
(1,814)
$ 40,003
The company uses the Lifo method of inventory for the majority of its
inventories. In valuing inventory at older costs, is typically lower than if
the Fifo alternative had been employed.
Lifo resulted in an inventory valuation that was $3,039,000 lower than if
current (Fifo) cost had been employed for all inventories. The lower
Lifo inventory valuation makes an inventory writedown to market less
likely than under Fifo.
C. Mulford, Misreported Assets and Liabilities, page: 14
Lifo and the Fourth Quarter Earnings Surprise
R.R. Donnelley & Sons Company
From a letter addressed to us from the Senior Vice President and Treasurer:
“All of our inventory accounts --paper, inks, work-in-process, supplies, etc.- are all maintained on a FIFO basis. When we review our operating results,
those results reflect FIFO accounting. In addition, we have a LIFO reserve
in our General Ledger. At the beginning of each year, we estimate what we
think the year-end reserve will be and then periodically provide a portion of
that charge during the year. For example, this year we are estimating that
the reserve at year-end will be $5 million higher than at the beginning of the
year. We therefore are providing, each quarter, $1.25 million of LIFO
provision (expense). This expense forms part of the cost of sales in our
public financial statements.”
The Lifo method is applied on an annual basis. That is, the Lifo reserve
adjustment is made at year-end, using actual price changes that occurred
during the year.
In adjusting the Lifo reserve for interim statements, companies must
estimate what the annual rate of inflation rate will be. Inaccurate
estimates are corrected in the fourth quarter.
Sometimes the fourth quarter adjustment results in a contraction in
earnings.
Other times it is a positive adjustment, as in the next example.
C. Mulford, Misreported Assets and Liabilities, page: 15
The Fourth Quarter Lifo Reserve Adjustment
Winn Dixie Stores
From the notes . . .
11. Quarterly Results of Operations (Unaudited)
The following is a summary of the unaudited quarterly results of operations for the year.
Quarters Ended (dollars in thousands)
Net sales
Gross profit on sales
Net earnings
Net LIFO charge (credit)
Sept. 18
(12 Weeks)
Jan. 8
(16 Weeks)
April 2
(12 Weeks)
June 25
(12 Weeks)
$ 2,985,702
$ 740,723
$
47,033
$
3,666
4,057,174
989,319
47,687
3,666
3,114,029
790,258
57,343
3,055
3,061,810
795,553
52,380
(8,763)
The fourth quarter results reflect a change from the estimate of inflation used in the calculation
of LIFO inventory to the actual rate experienced by the Company of 1.9% to 0.2%.
In this case, the fourth quarter received a boost to correct for
overestimates of inflation and cost of goods sold during the preceding
three quarters
C. Mulford, Misreported Assets and Liabilities, page: 16
Compiled Statements
and the Fourth Quarter Lifo Adjustment
Banker Testimonial:
A banker with customers in the lower end of the middle market and below reported
the case of a customer who disclosed much lower year-end earnings than expected
based upon the first three quarterly reports. The customer was on LIFO for annual
financial and tax purposes, but apparently reported on FIFO, or a comparable basis,
during the year. Only compiled statements were received by the bank. Due
apparently to significant price increases across the year, a sharp year-end increase
in the LIFO reserves and LIFO cost of sales was required. The account officer was
clearly surprised by this development.
In confirming whether Lifo is being applied during the year, check the
following:

Compare the cost of sales % for interim periods with
the annual amounts for prior years.

Check for a change in the Lifo reserve account
balance during interim period(s).

Caution is especially warranted during periods of high
inflation.
C. Mulford, Misreported Assets and Liabilities, page: 17
Case Assignment
Babson Tool Works
Babson Tool Works is a machine tool manufacturer. Specifically, the company
manufactures precision-machined screws primarily for heavy equipment
manufacturers. While there is a strong cyclical component to the company’s sales,
its business is not seasonal.
Babson has grown in recent years and has financed that growth with a credit line
secured by receivables and inventory and a term loan secured by certain property
and equipment.
Babson is new to your portfolio. In reviewing the company’s compiled financial
statements for the last several years, you noted that the former relationship
manager had been concerned about the company’s relatively low and declining
operating profit margin caused, among other reasons, by chronic increases in the
cost of raw materials and skilled manufacturing labor. In fact, after interest
expense, the company reported a loss in 2014 - the first loss on record. Moreover,
in prior years, 2014 included, the company had seldom been in full compliance
with its debt covenants. But since the bank had had a relationship with the
borrower for many years and because the violations had been “only minor”, they
had been waived.
In reviewing the file you note that in the past, only annual financial statements had
been made available by the borrower. Now, however, in an effort to persuade you
to increase the credit line to meet what has been termed “a short-term cash flow
need”, the borrower has provided you with interim statements for the nine-months
ended September, 2015.
In handing you the financials, the company president noted, "While we have been
in violation of some of our covenants in prior years, we're doing much better this
year." “We’ve also returned to profitability.”
C. Mulford, Misreported Assets and Liabilities, page: 18
Babson Tool Works (cont’d)
The company’s covenants are as follows:
 Current ratio of greater than 1.0
 Total liabilities to tangible net worth of less than 1.5
 Interest coverage (earnings before interest and taxes to interest) of greater
than 3.5
Required:
1. How is the company doing with respect to its loan covenants?
2. Are the financial statements for the period ended September 2015
misleading? What is causing that to happen?
3. Is the company really profitable in 2015? Are debt covenants being fulfilled
in 2015?
C. Mulford, Misreported Assets and Liabilities, page: 19
Mason and Platt
Certified Public Accountants
Cincinnati, Ohio
To the Board of Directors
Babson Tool Works, Inc.
Compilation Report
We have compiled the accompanying balance sheet of Babson Tool Works,
Inc. as of September 30, 2015 and December 31, 2014 and the related statements
of income for the nine months and year then ended in accordance with Statements
on Standards for Accounting and Review Services issued by the American Institute
of Certified Public Accountants.
A compilation is limited to presenting in the form of financial statements
information that is the representation of management. We have not audited or
reviewed the accompanying financial statements and, accordingly, do not express
an opinion or any other form of assurance on them.
Management has elected to omit substantially all of the disclosures and the
statement of cash flows required by generally accepted accounting principles. If
the omitted disclosures and the statement of cash flows were included, they might
influence the user's conclusions about the company's financial position, results of
operations, and cash flows. Accordingly, these financial statements are not
designed for those who are not informed about such matters.
Mason and Platt
December 5, 2015
C. Mulford, Misreported Assets and Liabilities, page: 20
Babson Tool Works, Inc.
Income Statement
Unaudited
For the 9 Months and Year Ended
September 30, 2015 and December 31, 2014
Net sales
Cost of sales
Gross profit
Selling, general and administrative expenses*
Interest expense
Other income
Income (loss) before income taxes
(Provision) benefit for income taxes
Net income (loss)
*Includes depreciation of $513 and $1,000.
2015
(9 Mos.)
2014
(1 Yr.)
$ 11,048
8,286
2,762
1,622
220
8
928
278
$ 650
$ 12,716
10,809
1,907
1,670
310
10
(63)
19
$ (44)
C. Mulford, Misreported Assets and Liabilities, page: 21
Babson Tool Works, Inc.
Balance Sheet (Unaudited)
As of September 30, 2015 and December 31, 2014
2015
ASSETS
Current assets:
Cash and equivalents
Accounts receivable
Inventory (Lifo method)
Prepaid expenses and other current assets
Total current assets
Property and equipment
Machinery and equipment
Furniture and fixtures
Accumulated depreciation
Net property and equipment
Other assets
Total assets
*No change in PPE cost in 2014.
2014
$ 158
1,452
2,160
92
3,862
$ 260
1,242
1,474
74
3,050
6,848
1,700
8,548
(3,248)
5,300
6,420
1,588
8,008 *
(2,562)
5,446
324
$ 9,486
96
$ 8,592
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable
1,138
Accrued expenses
448
Revolving credit agreement
1,544
Current maturities of long-term debt
236
Income taxes payable
94
Total current liabilities
3,460
1,150
446
1,100
210
74
2,980
Long-term debt less current maturities
2,124
2,360
100
900
2,902
3,902
$ 9,486
100
900
2,252
3,252
$ 8,592
Stockholders' equity:
Common stock
Additional paid-in capital
Retained earnings
Total stockholders' equity
Total liabilities and stockholders' equity
C. Mulford, Misreported Assets and Liabilities, page: 22
Lifo Liquidations
Class Exercise
Cross Co.
Cross Co. reported a lifo liquidation in its fiscal years ended December, 2015 and 2014. Excerpts
from the company’s financial statements are provided below.
Required:
Review the disclosures provided and identify 1) where in the financial statements the effects of
the lifo liquidation will be found and 2) the financial impact of that liquidation. 3) What
indicators of a lifo liquidation are apparent in the absence of the provided disclosures?
Consolidated Balance Sheets: December 31
Assets
Current Assets
Cash and cash equivalents
Short-term investments
Accounts receivable, net
Inventories:
Finished goods
Work in process
Raw materials
2015
2014
$ 52,822,365
18,311,963
36,960,352
$ 22,406,377
42,804,070
39,594,495
11,736,582
3,004,261
4,222,975
18,963,818
3,067,532
130,126,030
20,010,347
5,849,940
8,650,570
34,510,857
4,315,812
143,631,611
2015
2014
2013
$164,606,391
84,392,881
80,213,510
$187,129,510
99,087,116
88,042,394
$205,248,494
107,573,956
97,674,538
62,846,578
5,042,168
2,212,851
(2,516,161)
11,010,000
78,595,436
63,707,825
5,184,115
1,236,428
(3,197,899)
2,100,000
69,030,469
64,039,313
4,958,121
1,387,538
(4,674,570)
1,618,074
1,099,000
519,074
19,011,925
6,239,000
12,772,925
31,964,136
9,200,000
22,764,136
Other current assets
Total Current Assets
Consolidated Statements of Income
Year Ended December 31
Net sales
Cost of goods sold
Gross profit
Operating Expenses (Other Income)
Selling and general expenses
Service and distribution costs
Research and development expenses
Interest and other income
Restructuring charges-Note J
Income from Continuing Operations
Before Income Taxes
Provision for income taxes
Income from Continuing Operations
65,710,402
C. Mulford, Misreported Assets and Liabilities, page: 23
Inventories
Substantially all domestic inventories are priced at the lower of last-in, first-out cost or market.
The remaining inventories are priced at the lower of first-in, first-out cost or market.
Inventories Domestic inventories approximating $10,416,000 and $18,253,000 at December 31,
2015 and 2014, respectively, are priced at the lower of last-in, first-out (LIFO) cost or market.
The remaining inventories are priced at the lower of first-in, first-out cost or market. If the firstin, first-out method of inventory valuation had been used by the Company for those inventories
priced using the last-in, first-out method, inventories would have been approximately
$13,532,000 and $15,733,000 higher than reported at December 31, 2015 and 2014, respectively.
During 2015 and 2014, inventory quantities were reduced resulting in liquidations of LIFO
inventory quantities carried at lower costs prevailing in prior years as compared with the cost of
current purchases. The effect of these liquidations was to increase net income by approximately
$719,000 or $.04 per share and $1,563,000 or $.09 per share in 2015 and 2014, respectively. The
Company believes the LIFO method of inventory valuation ordinarily results in a more
appropriate matching of its revenues to their related costs since current costs are included in
costs of goods sold and distortions in reported income due to the effect of changing prices are
reduced.
C. Mulford, Misreported Assets and Liabilities, page: 24
Changing Inventory Mix
A Precursor of Falling Sales?
Topton Manufacturing
From the income statement . . .
Net sales
Cost of goods sold
Gross profit
2015
$4,650,925
3,234,370
1,416,555
2014
$5,048,997
3,215,216
1,833,781
2015
$ 35,091
181,388
955,499
$ 1,171,978
2014
$ 113,236
96,001
1,370,795
$1,580,032
2013
$5,325,942
3,381,964
1,943,978
From the notes . . .
Composition of inventories
Raw materials
Work in process
Finished goods
The company's sales through fiscal 2015 have been declining. A
manufacturer like Topton has greatest control over raw materials
inventory. That is, it is easier to shut the flow of inventory down at the
receiving dock than once it is placed in-process. Once in-process,
inventories are likely to be carried through to finished goods.
The significant drop in raw materials may indicate that management
anticipates continuing, perhaps even accelerating, sales declines.
As an update, for the first six months of the Company's fiscal 2016, sales
were down 49% when compared with 2015.
C. Mulford, Misreported Assets and Liabilities, page: 25
Inventory Theft and the Unexpected Inventory Writedown
Crown Crafts
From a company release . . .
Both fourth quarter and full year operating results were negatively impacted by an
unanticipated inventory write down of approximately $1.4 million at the company's
comforters and accessories facilities in Roxboro, N.C.
"The fourth quarter inventory write off in Roxboro reduced net earnings per share
by about $.10 for both the quarter and the full fiscal year," stated Michael H.
Bernstein, Crown Crafts' president and chief executive officer. "Our conclusion,
after reasonable investigation, is that a significant portion of the inventory shortage
is probably the result of theft.
"We have taken immediate action to improve our inventory handling procedures
and add to the security of our merchandise," Bernstein emphasized.
C. Mulford, Misreported Assets and Liabilities, page: 26
Crown Crafts (cont'd)
It is difficult to anticipate such an earnings surprise. Amounts
may accumulate over time and typically aren't large enough in
any one year to affect margins sufficiently to be noticeable.
Answers to a few questions may help.
What is the company's posture with respect to inventory
controls? Is the environment strict or somewhat lax?
What controls are in place to guard against theft? Do they
seem adequate?
When the physical inventory is taken, how does it compare
with perpetual records?



Are the amounts different by significant amounts?
Are differences always in the same direction?
Typically, are the books greater than the physical
count, necessitating a reduction in the book inventory?
 Are the books adjusted or are differences
dismissed as errors in taking the physical
inventory?
C. Mulford, Misreported Assets and Liabilities, page: 27
Investments
Rules for Investments in Debt and Equity Securities
Increase Volatility of Stockholders' Equity
Debt and equity securities held (including short-term and longterm) that are available for sale:





Most securities included in this caption
Excludes trading securities (e.g., trading portfolio of
banks where securities are held short-term for profit on
spread between bid and ask prices), nonmarketable
equity securities, and debt securities held to maturity
Carry at market value (even if above cost)
Price fluctuations (gains above cost and losses) taken
directly to stockholders' equity
Written down to market value with loss included in
earnings only if market value declines below cost and
the market value decline is non-temporary.
Trading securities:


Carry at market value.
Include gains and losses in earnings.
Nonmarketable equity securities:


Carry at cost.
Write-down to market value (estimate) only if decline
below cost is non-temporary, the loss is included in
earnings.
C. Mulford, Misreported Assets and Liabilities, page: 28
Debt securities held to maturity:

Carry at amortized cost

Write-down to market value only if decline below cost
is non-temporary, the loss is included in earnings.
Formerly, companies with large investment portolfios may have
had unrecognized market value appreciation.

An off-balance sheet asset and an equity cushion
This appreciation is now be recognized and added directly to
stockholders' equity.

Includes appreciation on debt securities that are
available for sale and marketable equity securities
That are available for sale.
The balance sheet is less conservative.
Future price
accordingly.
declines
will
reduce
stockholders'
equity
Because market prices can change rapidly, stockholders' equity
can now also rise and fall more quickly.
Stockholders' equity buoyed substantially by the appreciation of
securities available for sale can be wiped out suddenly.
C. Mulford, Misreported Assets and Liabilities, page: 29
A Major Balance Sheet Boost
SunTrust Banks
Excerpts from the Balance Sheet . . .
(Dollars in thousands)
As of December 31
Year 1
Year 2
Assets:
Trading assets
Securities available for sale
4,979,938
28,477,042
10,396,269
19,696,537
514,667
8,521,042
8,562,807
(1,055,136)
1,070,163
372,799
6,904,644
10,388,984
(1,368,450)
981,125
Shareholders’ Equity:
Common stock, $1.00 par value
Additional paid in capital
Retained earnings
Treasury stock, at cost
Accumulated other comprehensive income
From the notes to the financial statements:
Components of accumulated other comprehensive income:
Gain (loss) on available for sale securities
Other items (incl., pension plan and derivatives-related items)
Accumulated other comprehensive income
1,144,968
(74,805)
1,070,163
C. Mulford, Misreported Assets and Liabilities, page: 30
SunTrust Banks (cont’d)
From the notes . . .
Note 5 - Securities Available for Sale
Securities available for sale at December 31 were as follows:
(Dollars in thousands)
U.S. Treasury and federal agencies
U.S. states and political subdivisions
Residential mortgage-backed securities - agency
Residential mortgage-backed securities - private
Other debt securities
Common stock of The Coca-Cola Company
Other equity securities 1
Total securities available for sale
Amortized
Cost
$7,939,917
927,887
15,704,594
500,651
785,728
69
786,248
$26,645,094
Year 2
Unrealized
Unrealized
Gains
Losses
$13,423
$39,229
27,799
10,629
273,207
61,724
6,002
99,425
16,253
4,578
1,709,931
918
$2,047,533
$215,585
Fair
Value
$7,914,111
945,057
15,916,077
407,228
797,403
1,710,000
787,166
$28,477,042
C. Mulford, Misreported Assets and Liabilities, page: 31
What Are Debt Securities Worth?
Even debt securities held to maturity must be written down for
other than temporary declines in fair value.
Presidential Life
From the WSJ:
Presidential Life settles with SEC
after charges firm masked decline of junk bond portfolio
The SEC said Presidential Life ignored generally accounting standards requiring
companies to reduce, or "write down," on their balance sheets the value of
investment securities that have suffered "other than temporary declines."
Such declines in Presidential life's securities portfolio totaled $25 million, or about
37 percent of pretax income, the SEC said. Of that amount, $20.7 million was due
to declines I the value of Presidential Life's junk-bond holdings, it said.
The Company carried investments in such failed concerns as
Eastern Airlines, Inc. and Southland Corp.
The bankruptcies of these debt issuers was evidence that the fair
value of their debt securities had suffered an other-thantemporary decline.
Keep this case in mind when a company carries a large portfolio
of debt securities held to maturity. Is the securities' market
value less than cost? Will this value recover?
C. Mulford, Misreported Assets and Liabilities, page: 32
When Are Liabilities Undervalued?
Liabilities are probable future sacrifices of corporate resources or
services to settle present obligations.
For reporting purposes, liabilities are valued at the present value of the
resources or services to be provided.

Liabilities reported at lesser amounts are undervalued.
Most on-balance sheet liabilities are properly valued and, accordingly,
are not a potential future charges against earnings.

Notes payable

Bonds payable
Exception - long-term debt issued at rates significantly higher than
current levels.

Early retirement may involve a loss on early retirement.
C. Mulford, Misreported Assets and Liabilities, page: 33
Liabilities that are more likely to be undervalued and to result in future
earnings charges involve accounts payable, accrued expenses, and
commitments and contingencies.
Potential examples include:
Accounts payable - understatement is likely accompanied by an
understatement of inventory purchases and cost of goods sold.


Watch Cost of goods sold % and A/P days
Watch changes in inventory and accounts payable
Accrued liabilities - may involve under-accruals for such items as
wages, warranties, utilities, insurances, maintenance, payroll taxes, or
even sick pay and vacation pay.
Future earnings will be charged when the expense
accrual is increased or a related payment is made for an
item that has not been accrued.


Watch the trend in accrued expenses payable
 A declining trend indicates that payments exceed
expenses being accrued.

Watch selling, general and administrative expense as a
percentage of revenues.
 Declining % may mean increased efficiency, or, it
may mean expenses are not being accrued.
C. Mulford, Misreported Assets and Liabilities, page: 34

Caution:
 Even though accrued expense amounts may be
immaterial to the financial statements taken as a
whole. Underaccruals may still be material to net
income.
 The indicators tend to be volatile - making
interpretations difficult

An understanding of the company's business, the
accounts employed and their historical
relationships is useful.
 Amortization of prepaid expenses can also raise and
lower selling, general and administrative expenses
and can raise or lower selling, general and
administrative expense.
C. Mulford, Misreported Assets and Liabilities, page: 35
Accrued Expenses Payable
Note the decline in Accrued Warranty Liability Even as Sales Grow
Disk Drive Corp.
From the balance sheet . . .
Current liabilities:
Accounts payable
Current portion of long-term debt
Accrued compensation and related expenses
Accrued warranty expense
Other current liabilities
Total current liabilities
2015
2014
$37,160
946
2,820
1,374
4,386
$12,228
1,742
1,746
2,083
3,274
$46,686
$21,073
From the income statement . . .
Net sales
Cost of sales
Gross profit
Selling, general and administrative
Research and development
Total operating expenses
Income (loss) from operations
2015
2014
2013
$184,861
137,936
$113,951
111,445
$123,606
110,577
46,925
2,506
13,029
14,459
8,555
12,217
4,204
9,798
8,307
23,014
16,421
18,105
$ 23,911
$(13,915)
$(5,076)
C. Mulford, Misreported Assets and Liabilities, page: 36
Low Effective Tax Rate
Due to Net Operating Loss Carryforwards
Resource Engineering, Inc.
From the income statement . . .
Operating earnings
Interest income (expense), net
Earnings before income taxes
Income tax expense
Net earnings
2014
$ 226,110
(3,299)
222,811
-$ 222,81
2015
$ 765,804
6,875
772,679
208,000
$ 564,679
From the notes . . .
The effective rate for income tax expense (27%) for 2015 assumes full utilization
of the Company's remaining $366,000 net operating loss carryforward in the
current year.
While the effective rate was 0% in 2014 and increased to 27% in
2015, an increase to the 40% range should be expected for 2016.
C. Mulford, Misreported Assets and Liabilities, page: 37
Failure to Accrue a Contingent Liability
Lee Pharmaceuticals, Inc.
Failure to accrue a contingent liability that is both probable and subject
to reasonable estimation would result in the understatement of a liability
and the overstatement of net income and shareholders' equity.
As Reported in an SEC Enforcement Action:
Management at Lee Pharmaceuticals had become aware of high levels of
contamination in its soil and groundwater.
Consultants hired by the company confirmed the company's role in the
contamination.
Estimates of the cost to clean up the property that ranged from $465,200
to $700,000 were available to management.
Given the probable nature of the obligation for cleanup and the
availability of a reasonable estimate of the cost, the company should
have accrued a loss.
In accordance with GAAP, the amount accrued should have been the
lower amount of the estimated loss range.
Yet the company made no such loss accrual, significantly overstating its
financial results and position.
C. Mulford, Misreported Assets and Liabilities, page: 38
Restructuring Reserves
SEC Probe of Lucent Is Broader (Excerpts)
The Wall Street Journal
By Jonathan Weil
Reprinted with permission
THE SECURITIES AND EXCHANGE Commission's formal investigation into Lucent
Technologies Inc.'s accounting and financial-reporting practices is far broader than the company
has disclosed, according to people familiar with the probe, covering possible earnings
manipulations.
SEC investigators' concern is that Lucent may have improperly timed reversals of its
restructuring reserves into income in order to help the company beat Wall Street analysts'
quarterly earnings estimates, the people said. Lucent said in its financial statements that actual
costs under the restructuring plan were lower than originally forecast.
Across a four-year period, the company reversed $540 million of the $1.9 billion in reserves it
had set up with the restructuring charge, a longstanding point of criticism among some analysts.
During that time, Lucent reported 14 consecutive quarters during which it beat Wall Street
analysts' earnings expectations, according to Thomson First Call. But were it not for its reversals
of the $540 million, the company would have disappointed expectations for at least three
quarters, according to an analysis of Lucent's financial statements by Charles Mulford ,
accounting professor at Georgia Institute of Technology in Atlanta.
Mr. Mulford said Lucent's reserve reversals "appear to have served as an earnings support
mechanism from which the company metered out profits to boost corporate performance over a
four-year time frame." He said the pattern looks strikingly similar to that of other companies
already disciplined by the SEC for dipping into cookie-jar reserves, including Xerox.
One key distinction in the Xerox instance is that the SEC accused the company of not adequately
disclosing its reversals. Lucent's disclosure of its reserve reversals weighs in its favor, but, by
itself, doesn't mean that the maneuvers complied with prevailing accounting standards, according
to one person familiar with the Lucent probe.
Lucent denies that it manipulated earnings through its restructuring charge. The fact that "we
disclosed the existence of the reserve, and any adjustments we made to them over time,
disproves claims that there was some type of cookie-jar reserve to discreetly boost our earnings,"
Ms. Fitzgerald said. Many of Lucent's restructuring projects were complex, and some couldn't be
completed as expected, she said, adding that Lucent reviewed the reserves each quarter and made
appropriate adjustments.
C. Mulford, Misreported Assets and Liabilities, page: 39
Case Assignment
Haven's Building Supplies, Inc.
Haven's, a local, family-run company, sells building supplies to small contractors
and to the public. The company has operated profitably for over 25 years and has
built a substantial equity base. In recent years, however, Haven's has struggled as
“category killers” such as Home Depot have entered the local market. The
company's sales are down about 15% in the year ended January, 2016 from 2015.
Bob Haven, the company's founder is pleased that even with the decline in sales,
net income has been maintained at about equal with 2015. He attributes much of
his success to continued investment in the latest of equipment, including state-ofthe-art computer equipment and furniture and fixtures to keep his stores fresh and
appealing. In his view, these investments have kept sales from falling apart totally.
Also helping out was a concerted effort to reduce SG&A expenses.
As he hands you his latest compiled financial statements, he notes that overall,
2016 wasn’t bad, considering.
Required:
1. How has Haven’s been able to maintain net income in the face of declining
sales?
2. Make necessary assumptions to calculate a revised net income figure for the
year ended January 31, 2016 given the items identified in number 1 above.
3. In reviewing the company’s financial statements, what other warning signs
do you see?
C. Mulford, Misreported Assets and Liabilities, page: 40
Mary Martin
Certified Public Accountant
To the Board of Directors
Haven’s Building Supply, Inc.
Compilation Report
We have compiled the accompanying balance sheet of Haven’s Building
Supply, Inc. as of January 31, 2016 and 2015 and the related statements of income
for the years then ended in accordance with Statements on Standards for
Accounting and Review Services issued by the American Institute of Certified
Public Accountants.
A compilation is limited to presenting in the form of financial statements
information that is the representation of management. We have not audited or
reviewed the accompanying financial statements and, accordingly, do not express
an opinion or any other form of assurance on them.
Management has elected to omit substantially all of the disclosures and the
statement of cash flows required by generally accepted accounting principles. If
the omitted disclosures and the statement of cash flows were included, they might
influence the user's conclusions about the company's financial position, results of
operations, and cash flows. Accordingly, these financial statements are not
designed for those who are not informed about such matters.
Mary Martin
March 5, 2014
C. Mulford, Misreported Assets and Liabilities, page: 41
Haven’s Building Supplies, Inc.
Income Statement
Unaudited
For the Year Ended
January 31, 2016 and 2015
Net sales
Cost of sales
Gross profit
S. G. & A. (expenses)
Interest (expense)
Other income
Income before income taxes
(Provision) for income taxes
Net income
2016
2015
$ 7,344
5,450
1,894
(1,274)
(344)
51
327
(16)
$ 311
$ 8,640
6,221
2,419
(1,821)
(323)
42
317
(38)
$ 279
C. Mulford, Misreported Assets and Liabilities, page: 42
Haven’s Building Supplies, Inc.
Balance Sheet
Unaudited
As of January 31, 2016, 2015 and 2014
2016
2015
ASSETS
Current assets:
Cash and equivalents
Accounts receivable
Inventory
Prepaid expenses
Total current assets
Property and equipment
Warehouse and store equipment
Furniture and fixtures
Accumulated depreciation
Net property and equipment
Other assets
Total assets
$ 86
1,288
1,572
642
3,588
$ 241
1,372
1,568
428
3,609
$ 387
1,314
1,611
104
3,416
8,661
1,683
10,344
(5,167)
5,177
8,288
1,641
9,929
(4,372)
5,557
7,400
1,547
8,947
(3,578)
5,369
528
$ 9,293
451
$ 9,617
327
$ 9,112
$
$
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable
$ 627
Accrued expenses payable
217
Revolving credit agreement
1,502
Current maturities of long-term debt
357
Income taxes payable
18
Total current liabilities
2,621
Long-term debt less current maturities
Stockholders' equity:
Common stock
Additional paid-in capital
Retained earnings
Total stockholders' equity
Total liabilities and s/h equity
2014
595
423
1,450
347
20
2,835
501
408
1,173
335
24
2,441
2,503
2,431
2,349
100
900
3,169
4,169
$ 9,293
100
900
3,351
4,351
$ 9,617
100
900
3,322
4,322
$ 9,112
C. Mulford, Misreported Assets and Liabilities, page: 43
Hidden Obligations
Class Exercise
Personal Diagnostics and Bay Tact Corp.
Investment-related footnote disclosures for two companies are provided below.
Review these disclosures and prepare to comment on the risk, if any, you see to
each company’s earnings and financial position.
Personal Diagnostics
From the notes . . .
Concentration of Credit and Off-Balance-Sheet Risk The Company has open
future positions for silver and gold. The gains or losses are recognized in income
as they occur. The contract amounts, while appropriately not recorded in the
financial statements, reflect the extent of the Company's market risk which at yearend totaled $3,637,000.
Note: Personal Diagnostics is a precision-machining company specializing in
replacement human hips and joints. The company reports total assets and
stockholders' equity of $12.2 million and $8.7 million, respectively.
C. Mulford, Misreported Assets and Liabilities, page: 44
Bay Tact Corp.
(Amounts in dollars, not thousands)
Marketable Securities
Marketable securities consist of investments in equity stocks recorded at cost less
the amount due on margin. A comparison with market value is as follows:
Total
Less - amount due on margin
Net marketable securities
Cost
Market
Value
$ 186,838
98,583
$ 88,255
$ 198,985
98,583
$ 100,402
Note: Bay Tact is a financial publisher. The company reports total assets and
stockholders' equity of $356,112 and $142,679.
C. Mulford, Misreported Assets and Liabilities, page: 45
Off Balance Sheet Liabilities
Special Purpose Entities (SPEs)
Special Purpose Entity - an entity created by a sponsor to carry out a
specified purpose or activity, such as to consummate a specific
transaction or series of transactions with a narrowly defined purpose.
SPEs are typically established as financing mechanisms to allow
companies to execute certain transactions while keeping the majority of
the details and results off of the books.
By keeping incremental debt off of the books, a company may earn a
higher debt rating, and possibly, an overall lower cost of capital.
Example. A company wants to acquire land and construct a building for
its own use. An outright purchase with accompanying debt financing
would burden the balance sheet with debt.
The company sponsors creation of an SPE that borrows specifically to
acquire the land and construct the asset. The SPE leases the building
and land to the sponsoring company on an operating lease. The
sponsor's lease payments provide resources to the SPE to service its
debt.
C. Mulford, Misreported Assets and Liabilities, page: 46
Consolidation Rules for SPEs (now referred to as VIEs)
Off Balance Sheet Entities
Guidance from the FASB
Codification Topic 810 Consoldiations
Primary Beneficiary
The enterprise that consolidates a variable interest entity is referred to as the primary beneficiary
of the variable interest entity. The primary beneficiary absorbs a majority of the variable interest
entity’s expected losses, receives a majority of its expected residual returns, or both, as a result
of holding the variable interest(s).
Consolidation
Variable interest entities must be consolidated by their primary beneficiaries if the entities do not
effectively disperse risks among the parties involved. Primary beneficiaries of variable interest
entities are thus required to consolidate under the following conditions:
1. The equity investment at risk is not sufficient (less than 10% of total assets) to permit the
variable interest entity to finance its activities without additional subordinated financial
support from other parties, which is provided through other interests that will absorb
some or all of the expected losses of the entity.
2. The equity investors lack one or more of the following essential characteristics of a
controlling financial interest:
a. The direct or indirect ability to make decisions about the entity’s activities
through voting rights or similar rights.
b. The obligation to absorb the expected losses of the entity if they occur, which
makes it possible for the entity to finance its activities.
c. The right to receive the expected residual returns of the entity if they occur, which
is the compensation for the risk of absorbing the expected losses.
Valuation and financial reporting
Assets, liabilities, and noncontrolling interests of newly consolidated variable interest entities
generally will be initially measured at their fair values except for assets and liabilities
transferred to a variable interest entity by its primary beneficiary, which will continue to be
measured as if they had not been transferred.
Disclosure
The primary beneficiary of a variable interest entity is required to disclose:
1. The nature, purpose, size, and activities of the variable interest entity.
2. The carrying amount and classification of consolidated assets that are collateral for the
variable interest entity’s obligations.
3. Any lack of recourse by creditors (or beneficial interest holders) of a consolidated
variable interest entity to the general credit of the primary beneficiary.
C. Mulford, Misreported Assets and Liabilities, page: 47
Other Sources of Off-Balance Sheet Liabilities
Lehman Brothers
Accounting for Repurchase Agreements
A Repo or Repurchase/Resale Agreement is an agreement where securities,
typically treasury securities, are sold with a simultaneous agreement to repurchase,
across a short timeframe.
Seller or transferor receives cash and gives up securities
Buyer or transferee receives securities and pays cash
The transaction is a financing transaction, providing a cash infusion to the
transferor.
A standard Repo transaction is accounted for as a borrowing by the transferor:
Cash↑
100
Obligation to repurchase securities↑
100
The securities owned by the transferor remain on the balance sheet. Liabilities,
reflecting the repurchase obligation (to repay the borrowing), are increased.
Shareholders’ equity is not affected. Measures of financial leverage are increased.
Lehman, as transferor, structured its Repo transactions as so-called “105” Repos.
As such, the company transferred $105 in securities for $100 in cash received.
The over-collateralization permitted the company to account for its Repo
transactions as sales as opposed to borrowings.
SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities, stipulates that for a Repo to be accounted for as a
sale, the transferor must demonstrate that it has relinquished control to the
transferred securities.
To maintain effective control, the transferor must have both the contractual
right and obligation to reacquire the securities.
The transferor’s right to repurchase is not assured unless it is protected by
C. Mulford, Misreported Assets and Liabilities, page: 48
obtaining collateral sufficient to fund substantially all of the cost of purchasing
identical replacement securities during the term of the contract.
The thinking here is that by receiving cash of $100 for the transfer of securities
worth $105, Lehman does not have the collateral from the transaction to replace
the securities that have been transferred.
SFAS 140 indicates that when a Repo transaction entails a collateralization that
is more than 102%, the transaction fulfills the requirements for sale accounting.
Thus, it would appear that Lehman’s 105 Repos fulfill the requirements for sale
treatment.
But consider Lehman’s accounting for the transaction. They recorded an asset,
a derivative asset, for the $5 haircut taken in the transfer. Rather than
accounting for the transferred securities as an obligation, the securities asset is
reduced on the balance sheet.
Cash↑
Derivative asset↑
Treasury securities↓
100
5
105
According to Lehman, the $5 derivative asset represents “a receivable under a
derivative contract because we are required to repurchase under a forward
contract, $105 worth of securities for payment of only $100.”
Even Lehman’s own language suggests the transaction is a borrowing.
Would anyone reasonably expect that Lehman would not repurchase the
securities and realize the $5 derivative asset?
The company’s accounting appears to fulfill the letter of SFAS 140, but clearly
does not fulfill the substance or spirit of the standard.
Note how the above accounting serves to remove the treasury securities from
the balance sheet and does not increase liabilities. As such, leverage is reduced.
In a true sale, Lehman would give up the treasury securities for cash and walk
away. There would be no expected repurchase.
C. Mulford, Misreported Assets and Liabilities, page: 49
The net result would be a loss on the sale.
Cash↑
Loss on sale of treasury securities↑
Treasury securities↓
100
5
105
Lehman certainly did not want to record a loss on sale.
Lehman regularly increased its Repo transactions near the end of each reporting
period to lower evident financial leverage.
The company entered into as much as $51 billion in Repo transactions as of the
end of the May Quarter, 2008.
See balance sheet below. Had the company accounted for the Repo transactions as
repurchase agreements, assets and liabilities would be higher by $51 billion.
Shareholders’ equity would remain unchanged.
Total assets to shareholders’ equity would be increased from:
639.4 / 26.3 to 690.4 / 26.3,
Or, from:
24.3 to 26.3
C. Mulford, Misreported Assets and Liabilities, page: 50
LEHMAN BROTHERS HOLDINGS INC.
Consolidated Statement of Financial Condition
(Unaudited)
At
In millions
Assets
Cash and cash equivalents
Cash and securities segregated and on deposit for regulatory and other purposes
May 31, 2008
$
6,513
Nov 30, 2007
$
7,286
13,031
12,743
269,409
313,129
Securities purchased under agreements to resell
169,684
162,635
Securities borrowed
124,842
138,599
Brokers, dealers and clearing organizations
16,701
11,005
Customers
20,784
29,622
4,236
2,650
Property, equipment and leasehold improvements
(net of accumulated depreciation and amortization of
$ 2,697 in 2008 and $2,438 in 2007)
4,278
3,861
Other assets
5,853
5,406
Identifiable intangible assets and goodwill
(net of accumulated amortization of $ 361 in 2008 and $340 in 2007)
4,101
4,127
$639,432
$691,063
Financial instruments and other inventory positions owned
(includes $ 43,031 in 2008 and $63,499 in 2007 pledged as collateral)
Collateralized agreements:
Receivables:
Others
Total assets
See Notes to Consolidated Financial Statements.
C. Mulford, Misreported Assets and Liabilities, page: 51
LEHMAN BROTHERS HOLDINGS INC.
Consolidated Statement of Financial Condition—(Continued)
(Unaudited)
In millions, except share data
Liabilities and Stockholders’ Equity
Short-term borrowings and current portion of long-term borrowings
(including $9,354 in 2008 and $9,035 in 2007 at fair value)
Financial instruments and other inventory positions sold but not yet purchased
Collateralized financings:
Securities sold under agreements to repurchase
Securities loaned
Other secured borrowings
(including $13,617 in 2008 and $9,149 in 2007 at fair value)
Payables:
Brokers, dealers and clearing organizations
Customers
Accrued liabilities and other payables
Deposit liabilities at banks
(including $10,252 in 2008 and $15,986 in 2007 at fair value)
Long-term borrowings
(including $27,278 in 2008 and $27,204 in 2007 at fair value)
Total liabilities
Commitments and contingencies
Stockholders’ Equity
Preferred stock
Common stock, $0.10 par value:
Shares authorized: 1,200,000,000 in 2008 and 2007;
Shares issued: 612,948,910 in 2008 and 612,882,506 in 2007;
Shares outstanding: 552,704,921 in 2008 and 531,887,419 in 2007
Additional paid-in capital
Accumulated other comprehensive loss, net of tax
Retained earnings
Other stockholders’ equity, net
Common stock in treasury, at cost
(60,243,989 shares in 2008 and 80,995,087 shares in 2007)
Total common stockholders’ equity
Total stockholders’ equity
Total liabilities and stockholders’ equity
At
May 31, 2008 Nov 30, 2007
$ 35,302
141,507
$ 28,066
149,617
127,846
55,420
181,732
53,307
24,656
22,992
3,835
57,251
9,802
3,101
61,206
16,039
29,355
29,363
128,182
613,156
123,150
668,573
6,993
1,095
61
11,268
(359)
16,901
(3,666)
61
9,733
(310)
19,698
(2,263)
(4,922)
19,283
26,276
$639,432
(5,524)
21,395
22,490
$691,063
C. Mulford, Misreported Assets and Liabilities, page: 52
Off Balance Sheet Liabilities?
The Unusual Case of Bank of America
Average Assets are Consistently Higher than Quarter-end Assets
Required:
1. What does this finding imply about liabilities?
2. What could cause this result?
3. Why is this occurring?
Bank of America (in millions)
4Q 09
3Q 09
2Q 09
1Q 09
4Q 08
3Q 08
2Q 08
1Q 08
4Q 07
3Q 07
2Q 07
1Q 07
4Q 06
3Q 06
2Q 06
1Q 06
4Q 05
3Q 05
2Q 05
1Q 05
4Q 04
3Q 04
2Q 04
1Q 04
4Q 03
Avg assets
Q-end assets
2,421,531
2,390,676
2,420,317
2,519,134
1,948,854
1,905,691
1,754,613
1,764,927
1,742,467
1,580,565
1,561,649
1,521,418
1,495,150
1,497,987
1,456,004
1,416,373
1,305,057
1,294,754
1,277,478
1,200,859
1,152,524
1,096,653
1,094,427
833,161
---------
2,223,299
2,251,043
2,254,394
2,321,963
1,817,943
1,831,177
1,716,875
1,736,502
1,715,746
1,578,763
1,534,359
1,502,157
1,459,737
1,449,211
1,445,193
1,375,080
1,291,803
1,252,267
1,246,339
1,212,229
1,110,432
1,072,802
1,024,701
799,942
719,453
Avg minus
Q-end
198,232
139,632
165,923
197,171
130,911
74,514
37,738
28,425
26,721
1,802
27,290
19,261
35,413
48,776
10,811
41,293
13,254
42,487
31,139
-11,370
42,092
23,851
69,726
33,219
* B of A acquisition of Merrill Lynch closed 1/1/09
** B of A merger with FleetBoston closed 4/1/04
% of Q-end
8.9%
6.2%
7.4%
8.5%
7.2%
4.1%
2.2%
1.6%
1.6%
0.1%
1.8%
1.3%
2.4%
3.4%
0.7%
3.0%
1.0%
3.4%
2.5%
-0.9%
3.8%
2.2%
6.8%
4.2%
Avg minus
pvs Q-end
170,488
136,281
98,354
701,191*
117,677
188,816
18,111
49,181
163,704
46,206
59,492
61,681
45,939
52,794
80,924
124,570
52,790
48,415
65,249
90,427
79,722
71,952
294,485**
113,708
% of pvs Qend
7.6%
6.0%
4.2%
38.6%*
6.4%
11.0%
1.0%
2.9%
10.4%
3.0%
4.0%
4.2%
3.2%
3.7%
5.9%
9.6%
4.2%
3.9%
5.4%
8.1%
7.4%
7.0%
36.8%**
15.8%
C. Mulford, Misreported Assets and Liabilities, page: 53
Financial Warnings Checklist
Overstated Assets
Are assets being carried at a valuation that can be considered excessive?
Accounts receivable

Is the allowance for doubtful accounts sufficient to
cover future collection problems?
 Compute receivables in days for each of the last
four to six quarters.
 Is the trend steady, improving, or worsening?
 Is the overall level high when compared with
competitors or other firms in the industry?
 What amount of receivables are "at risk"?
 By what amount would the allowance for doubtful
accounts need to be increased (reducing accounts
receivable, net) such that receivables in days would be
more in line with prior years, competitors or the
industry?
(No. of days reduction needed x sales revenue per day).
 Have economic conditions for the company's
customers worsened recently?
 Are company sales declining?
 Other general economic reasons to expect
that customers are having difficulties?
 Are sales growing rapidly?
 Has the company changed its credit policy?
 Have payment terms been extended?
 Granting credit to less creditworthy customers?
C. Mulford, Misreported Assets and Liabilities, page: 54
Inventory
 Are inventories reported that do not exist?
 Are existing inventories carried at amounts greater
than replacement cost?
 Compute cost of sales as a percentage of sales revenue and
inventory in days for the last four to six quarters
 Is the trend steady, worsening, or improving?
 How do the statistics compare with
competitors' and other firms in the industry?
 Are same inventory cost flow assumptions used?
 Do on-going company events and fortunes suggest problems with
slackening demand for the company's products?
 Are sales declining?
 Have raw materials inventories declined
markedly as a percentage of total inventory?
 Does the company employ the Lifo inventory
method for at least a portion of its inventory?
 Are Lifo adjustments being made for interim periods?
 Has the Lifo reserve account remained
unchanged during interim periods?
 If the Lifo reserve account has been adjusted
during interim periods, does the estimate of
inflation used appear reasonable?
 How does cost of sales as a percent of sales
for interim periods compare with prior years'
annual results?
 What is the nature of the company's environment
with respect to inventory controls? Lax?
 Do controls to guard against theft seem adequate?
 When a physical inventory is taken, how does
the amount compare with perpetual records?
 Are differences significant and always in the same direction?
 Typically, are the books greater than the physical count,
necessitating a reduction in the book inventory?

Are the books adjusted or are differences dismissed as
errors in taking the physical inventory?
C. Mulford, Misreported Assets and Liabilities, page: 55

Special warning - be particularly alert for overvalued inventory in the
following situations:
 Company uses the Fifo inventory method
 Company's industry is experiencing price deflation (inventory
replacement costs will likely be declining)
 Company is in an industry that is experiencing rapid
Technological change (obsolescence may be a problem)
 Company has shown evidence in the past of
overvaluation of inventory.
 Is there an example of a prior year writedown of inventory
that became value impaired?
Investments
 For debt securities and marketable equity securities
that are available for sale (carried at market value),
has stockholders' equity been buoyed by substantial
write-ups to market value?
 For debt securities held until maturity (carried at
amortized cost) and non-marketable equity securities
(carried at cost), is there evidence of a nontemporary decline in market value?
 For equity securities accounted for under the equity
method, is there evidence of a non-temporary
decline in market value?
C. Mulford, Misreported Assets and Liabilities, page: 56
Understated Liabilities
Accounts payable

Compute accounts payable in days for each of the last four to six
quarters
 Is the trend steady, worsening, or improving?
 How does the statistic compare with competitors' and other firms
in the industry?
Notes and bonds payable
 Are coupon or stated interest rates significantly higher than the
current level of rates?
Accrued liabilities
 What is the trend in accrued liabilities?
 What is the trend in selling, general and administrative expense as a
percentage of sales revenue?
 What is the trend in accrued expenses in days?
Deferred tax liabilities and taxes payable
 Is the effective tax rate unsustainably low?
 Does the balance sheet disclose the existence of deferred tax items?
 Is there evidence in the footnotes of unrecognized net operating loss
carryforwards?
Commitments and contingencies



What unrecognized contingencies are noted in a careful reading of the
commitments and contingencies footnote?
Given an understanding of the company's business dealings, is there
reason to believe that an unrecognized contingent liability exists?
Does the company have a speculative investment position?
 Futures contracts
 Investments using margin debt
C. Mulford, Misreported Assets and Liabilities, page: 57
Other off-balance sheet liabilities


Does the company have outstanding synthetic leases?
 Future lease payment obligations will be disclosed as operating
lease commitments
 Are there other commitments, including residual value
guarantees, that exist beyond operating lease payments?
Does the company use special purpose entities (SPEs) as a source of
other off-balance sheet financing?
 What is the underlying business purpose of these entities?
 What are the underlying obligations of the entities?
 Has the reporting company guaranteed those obligations?
C. Mulford, Misreported Assets and Liabilities, page: 58