MACRO RESEARCH
Accounting & Tax Policy
Quantitative Research
Portfolio Strategy
March 21, 2014
ACCOUNTING TOP 10: COOKIE JAR RESERVES
•
This is our inaugural report on the Top 10 accounting items to watch for and how to spot
them. Over the coming weeks and months, we will publish a new topic each Friday. This
week, we examine the impact of liability reserves (a.k.a., “Cookie Jar” reserves) on the
balance sheet, earnings, and cash flow. Common reserves include bad debts, restructuring,
warranty, sales discounts, worker’s compensation, taxes, and legal. Our focus on reserves is
timely as the annual Form 10-K footnotes provide fresh detail on the composition and
changes in reserve accounts.
•
A careful review of reserve disclosures is warranted as companies have frequently used
reserves to manage earnings in what is known as “cookie jar” accounting. Mechanically, this
occurs when a company ‘reverses’ an accrued liability account or contra asset (e.g. bad debt
reserve) as a gain in earnings. It is largely unsustainable (reserve account may only decline to
$0) and, therefore, paints a misleading picture of company profitability.
•
Another variation of this is “big bath” accounting under which a company records a very large
charge in earnings by writing down assets and recording various reserves. If the charge is
excessive, in a subsequent period, GAAP requires the reserve to be reduced / eliminated and
companies have discretion in choosing when to reverse it as a gain in earnings. The large
write-down itself may boost future earnings through the elimination of costs that would have
been expensed in future periods.
•
In this report, we illustrate reserve reversals and under expensing using Harley Davidson and
Hewlett Packard’s 10-K disclosures.
Chris Senyek, CFA, CPA
(646) 845-0759
[email protected]
Adam Calingasan, CFA, CPA
(646) 845-0757
[email protected]
Clinton Chang, CFA, CPA
(646) 845-0756
[email protected]
Chip Miller, CFA, CPA
Natalie Capasso
(646) 845-0752
(646) 845-0753
[email protected] [email protected]
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disclosures.
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ACCOUNTING TOP 10: COOKIE JAR RESERVES
Since accounting is based on an accrual based system, GAAP’s matching principle requires an
expense to be recorded in the same period in which revenue is recognized. Quarterly and annual
reporting necessitates management estimates in the financial statements as there is imperfect
information existing on potential liabilities at the reporting date, but for which the exact amount is
unknown. While it’s generally clear when a sale has occurred, it is not as clear cut always on cost
estimates. This gives rise to management’s estimates of accounting for contingencies that existed at
the reporting date.
Loss contingencies are recorded on the balance sheet through a reserve liability. The general rules
for loss contingencies are found under GAAP in U.S. ASC 450-Contingencies and IAS 37 for
international companies. Supplemental accounting guidance/rules exist for certain specific situations.
A loss is recorded under U.S. GAAP when both probable and estimable even though there is still
uncertainty over the exact timing and amount of the loss. To that end, probable is construed by
accountants as having a 70% or greater odds of occurring. Under International Accounting standards,
the rules are looser and only generally require odds of greater than 50% of occurring (“more likely
than not”). This lower threshold for non-U.S. companies allows the creation of larger reserves, earlier,
and with more volatility than for U.S. companies. Reserves take many forms — restructuring,
warranty, bad debts, legal, tax, sales returns, onerous contracts — to name a few. Over the next few
pages, we discuss how to analyze reserves and spot potential unsustainable benefits to earnings and
cash flows.
When analyzing the use and potential abuse of reserves, we focus on 3 key points:
1) The Opportunity — What is the Level of Reserve Balances? The first item we analyze is how
many reserve accounts does the company maintain and how large are their balances?
Reserve liabilities are typically disclosed either in a separate schedule or listed as part of
current and/or long-term liabilities in the 10-K footnotes. Assessing the breadth and depth of
reserves allows us to evaluate if the company has the opportunity to use the “cookie jar” to
boost earnings. As one way to common size the reserve balances, we compare the reserve
balance to LTM revenue and to a related balance sheet driver if one exists (e.g., A/R).
2) Have There Been Reserve Reversals as Gains in Earnings? We suggest analyzing financial
disclosures to ensure a material amount of excess reserves were not reversed as a gain in
earnings. Typically, the easiest way to spot this is an analysis of a reserve roll-forward table (if
disclosed), reading the Management, Discussion and Analysis section, or a review of the
operating section of the cash flow statement (where the gain is shown as a reduction in cash
flow since it is non-cash). Keep in mind that GAAP actually requires a company to “release” a
reserve if it’s no longer necessary and, therefore, reserve reversals technically may be within
the confines of perfectly acceptable accounting. However, the reversal as a gain in earnings
(offsetting SG&A or cost of sales) is likely unsustainable and, therefore, should be removed
from earnings. The SEC now requires quarterly and annual detailed activity of restructuring
reserves, frequently presented in a reconciliation table as we illustrate later in this report.
3) Is the Company Under-Reserving To Boost Earnings?: Another trick to boost current period
earnings is to underestimate the current period additions to the reserve. For example, a
company might choose to under expense recurring costs, such as warranty or sales returns to
boost current period earnings. Since this account will need to be replenished in a future period,
the company may encounter higher costs in future years as a higher than normal expense
occurs to maintain the account.
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March 21, 2014
RESERVES REVERSALS: AN ILLUSTRATION
Below is Harley Davidson’s 10-K restructuring reserve table. We use this example to illustrate the
way to spot a reserve reversal. As we previously noted, not all companies will provide this level of
reserve detail, but GAAP requires a quarterly roll forward of a company’s restructuring reserves.
Since reserves are subject to considerable discretion by management, the accounting game is to
create a larger than necessary reserve (in a bad quarter/year or otherwise) and dip into the reserve
when business conditions change.
We analyze the reserve schedule for material reversals into earnings. This reserve account is
increased when a company records a restructuring reserve (“big bath accounting”) as shown by
“Restructuring expense” below. Next, when costs are actually incurred/paid, the reserve account is
reduced and this is shown in the “utilized” columns below. Generally, this is a cash cost unless it is
property that is dispensed with/written down (e.g., depreciation as shown below). Last and
importantly, there is a reduction in the reserve called “Non-cash reserve release”. A reduction in this
reserve due to excess is recorded as a gain in earnings (technically it offsets part of an expense
either in cost of sales or SG&A). In the example below for Harley Davidson, we circled the “reversals”.
During 2013, the company reversed $6.34 million as a gain in earnings. We also analyze the
schedule for any past patterns of reversals and the overall ending balance in thinking about the
potential future opportunity to use it as a way to manage earnings.
Harley Davidson: Restructuring Disclosure ($ in thousands)
2013
Kansas City
Balance, beginning of
period
Restructuring expense
Employee Severance
and Termination
Costs
$
2,259
New Castalloy
Other
$
—
—
Employee
Severance and
Termination
Costs
Total
$
2,259
—
$
—
9,306
Consolidated
Accelerated
Depreciation
$
1,480
—
Total
Other
$
Total
145
$ 9,451
2,093
1,709
5,282
5,282
—
—
(5,369 )
(6,659 )
(3,814 )
(3,814 )
(5,369 )
(6,338 )
$
11,710
Utilized - cash
(1,290 )
—
(1,290 )
(5,369 )
Utilized - non-cash
—
—
—
(969 )
—
(969 )
—
(2,093 )
(1,721 )
Non-cash reserve release
(5,369 )
—
—
Balance, end of period
$
—
$
—
$
—
$
48
$
—
$
133
$
181
$
181
Note: Per 2013 10-K.
Source: Wolfe Research Accounting & Tax Policy Research; Company filings.
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March 21, 2014
UNDER RESERVING IS OFTEN UNSUSTAINABLE
Under reserving is more subtle, but provides a similar boost to current period earnings. A company
might choose to under-accrue bad debt expense in the current period so as to increase earnings.
However, if such costs haven’t changed economically, the company will need to replenish the reserve
in the future through materially higher than expected costs. Since this account is very subjective, we
find it as a relatively stealth way for management to manipulate and/or use aggressive assumptions.
Irrespective of whether the disclosure is bad debt, warranty, or sales discounts, etc., we analyze it the
same way. To determine if the company is under reserving expenses, we compare the accruals for
additions to the account (the amount expensed in earnings) to the payments on a current year basis
and with a one year lag (current year expense to prior year payments). The reason we compare also
with a one year lag is that sometimes a company’s business operates with a lag and amounts
expensed in the prior year might not be paid or written-off until the following year. If a company has
been consistently expensing higher cost than payments, it may reflect a management tone of
conservatism. However, that does create a higher reserve that could be used to manage earnings in
the future. Even if costs incurred are similar to payments, we also check this schedule for large
adjustments to any pre-existing reserves (e.g., warranties) that signal prior period under-estimation.
As a third check, we assess and standardize the overall balance by comparing it to revenues. We
expect a fairly constant ratio (%) over time unless something significant has changed in the business.
Similar to the prior example, we review the footnotes/schedule for any reserve gains (reversals) that
increased EPS.
As an illustration, the next exhibit is HP’s bad debt reserve disclosure. By comparing the additions to
bad debt expense to the deductions, our analysis concludes that the company under expensed bad
debts by $75-$100 million in FY 2011/2010 as there was a reserve draw down. Further, when
comparing additions ($23m) to deductions ($106m) with a one year lag, we reach the same general
conclusion. Subsequently, during FY 2012, ‘additions’ were roughly the same amount as ‘deductions’
as we would expect to find. We also find no bad debt ‘releases’ or reserve reversals in analyzing the
schedule.
Hewlett Packard: Bad Debt Reserve
Note: Per 2012 10-K.
Source: Wolfe Research Accounting & Tax Policy Research; Company filings.
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March 21, 2014
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March 21, 2014