How to engineer books explained easy

1. Financial Engineering
How to engineer books explained easy
FASB or IFRS regulation
This assignment will attempt to provide the background
of the financial engineering issues and will then explain
in easy terms how accounting books can be engineered
and improved to the advantage of shareholders and
investors
Financial Engineering 1st Assignment
Index
INTRODUCTION..............................................................................................................................................2
HOW DOES IT WORK?...................................................................................................................................2
EXAMPLE – GOODWILL AND OTHER INTANGIBLE ASSETS UNDER FASB 142.........................................3
FASB 142 DECISION TREE...........................................................................................................................5
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2. GOODWILL.....................................................................................................................................................6
HOW WE SHOULD VALUATE THESE ASSETS?...............................................................................................6
EXAMPLE – DEMONSTRATE EFFECT OF FAS 142 ON BALANCE SHEET....................................................7
BIBLIOGRAPHY..............................................................................................................................................9
How to engineer books explained easy
FASB or IFRS regulation
Introduction
The concept of financial engineering of the accounting books has been wrongly associated with cases of
non-ethical behavior and terms like “cooking the books” have been perceived with negativity. The
financial engineering techniques can actually save the corporations millions in profits and can also
improve the bottom line by paying attention to the actual rules we must follow.
The tax accounting rules are very different from the investing accounting rules because they have
different objectives. The tax authorities do not want the companies to behave unethically and show
lower earnings in the tax books than in the investor books. The tax authorities have different objectives
compared to the business owners and they incentivize the companies to spend in whatever the
government considers most important, therefore the bottom line earnings are almost always different
in both the books. The accounting rules can be subject to different interpretation. With time the law
clarifies those interpretations issuing new clarifications, updates and bulletins but again, these new laws
are also subject to additional interpretations. Eventually, all ends in a negotiation between interested
parties and the original rules are updated.
The job of the financial engineers of multinational corporations (MNC’s) is to understand the accounting
rules in every country that the company operates and engineer the structure of the statements using an
interpretation of the rules that is beneficial to the corporation. This structuring is completely fair and
legal. A candidate applying for the job of financial engineer is incentivized to show primarily his best
skills and capabilities, he is incentivized to apply the most convenient interpretation of the accounting
rules.
How does it work?
In the example we went through in the second lecture, we saw how the NPV of a truck could be stated
from $58,940 to $53,589 according to the interpretation and use of the rules. Here the objective was to
achieve the lowest NPV possible for the company according to the rules. Depending on the final
objective, a good financial engineer will try to present the figures in a way that maximizes the results.
Some of the techniques used by companies are:
• Off-balance sheet accounting, offshore partnerships and Special Purpose Vehicles (SPE’s)
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3. • Expenses delay
• Anticipated revenue booking
• Non-recurring expenses, etc.
Some authors (Penno, 2008) argue that all accounting rule systems are plagued by the problem of
vagueness, which implies that some very important decisions cannot be objectively described as "right"
or "wrong" and must be based on an authority's judgment. This problem becomes very acute when
accounting faces rapid technological changes or changes in the way that business is done. If the
environment were static, explicit rules could eventually be developed for each category, but dynamic
environments present new problems characterized by vagueness.
Example – Goodwill and Other Intangible Assets under FASB 142
We will now focus on one of the rule books of the FASB and will try to explain in easy term how to
engineer a statement to achieve a specific objective. Some industries where these rules play a major
role are the following:
• Business Services (for example, temporary help, advertising and consulting) where people are key
assets and much of the company value is likely to be intangible
• Consumer Goods where the Brand Value is critical and provides a premium advantage
• Pharmaceuticals where patents on R&D are the key assets to the company
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Prior to the adoption of FASB 142, it was difficult to estimate the life of a Goodwill asset, so it was
arbitrarily set at a maximum of 40 years and amortized over that period on the straight-line method. The
amortization appeared as an expense on the income statement. The manner in which Goodwill was
amortized was misleading as it was stated as an expense on the income statement and expenses are
normally not amortized. Those who evaluated company income statements showing amortization of
Goodwill often added the amount back to net income.
The FASB 142 issued in December 2001 changed some of the previous rules from the “APB Opinion 17”
book. The main difference is that some intangible assets can no longer be amortized and the reported
amounts did not decrease as before. However, impairment tests had to be implemented on such assets
and that increased the volatility of the earnings. Under FASB 142 goodwill and intangible assets that
have indefinite useful lives are not amortized but rather tested at least annually for impairment.
However intangible assets that have finite useful lives continued to be amortized over their useful lives,
but without the constraint of an arbitrary ceiling.
As an area to explore, it is mentioned in the FASB 142 that some entities capitalize costs incurred to
develop identifiable intangible assets, while others expense those costs as incurred. Some companies
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JOSEPH M. MODICA. (2003). Accounting and Reporting. Available:
http://www.cfma.org/pubs/docs/Modica%20J%20JULYAUG.pdf. Last accessed 22 Nov 2008.
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4. such as AOL use to capitalize expenses as costs of internally developing identifiable intangible assets and
eventually they were forced to stop doing so. Additionally, intangible assets can be either developed
internally or acquired from other businesses. In the last case, they should be recorded at their “fair”
value; that is the transaction cost. If such assets were acquired in a group, a portion of the cost should
be assigned to each individual asset based on its fair value; and if those assets were acquired with non-
cash, then a “reliable” measure should be recorded (FASB 141).
If an intangible asset is determined to have an indefinite useful life, it shall not be amortized until its
useful life is determined to be no longer indefinite. An intangible asset that is not subject to
amortization shall be tested for impairment annually or more frequently if events or changes in
circumstances indicate that the asset might be impaired (FASB 142).
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5. FASB 142 Decision tree
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6. Goodwill
The FASB agrees that acquired goodwill fits the definition of asset (Assets are probable future economic
benefits obtained or controlled by a particular entity as a result of past transactions or events).
According to FASB goodwill is defined the difference between the price paid for an entity and the price
amounts assigned to the assets of acquired entity and the liabilities taken by the acquiring company.
The FAS 142 statement discusses the most appropriate way of accounting for goodwill. The final
decision is to leave goodwill as non-amortized asset, but subject it to impairment tests (directed at
testing and recording the fair value of the asset). The immediate write-off was dismissed as incorrect
approach almost with no disputes. However, the decision on whether or not goodwill or part of it
should be amortized and over what period was a matter of discussion and several times Board reviewed
its decision regarding this issue. The initial decision that the Board took was finding a way to separate
goodwill into different elements (discernible elements approach) and amortize them depending on their
useful life, however this entailed too many complications and “grey areas”, so this approach was
dismissed as well.
The predicted problem with impairment tests is the internally generated goodwill that can replace the
acquired goodwill. However, current standards do not provide a way for accounting for the internally
generated goodwill. Since the synergies between the acquired entity and acquiring company are not
possible to record at the level of either, the Board introduced goodwill testing at the level of reporting
unit.
Reporting unit is a lowest level of entity that is a business and it can be seen as separated operating unit,
with separate internal reporting and physical presence. The defining or reporting unit is set in a way that
allows different organizations have reporting units at different levels, that best comply with the purpose
of goodwill accounting. Reporting units are assigned assets and liabilities only in the case when these
assets and liabilities are considered to define reporting unit’s fair value. Goodwill is allocated to
reporting units that are expected to get benefits from the acquisition’s synergies. Goodwill is to go
through impairment tests annually.
How we should valuate these assets?
Valuing intangible assets is one of the most common challenge faced by financial engineers and again,
according to their final objective (maximize or minimize its value) financial engineers tend to choose the
most convenient method. Intangibles can be for example patents and trademarks, copyrights, mailing
lists, exclusive contracts, royalty agreements, work-in-progress, proprietary designs and many others.
The actual value of anything, tangible or not, can be based on what someone else is willing to pay for it
(Kerr). The price paid for an asset has a great deal to do with who can put it to its highest and best use. If
we hold a license or copyright on a book that is not presently being distributed because you cannot
afford to do so, that right may still have great value to a larger company with more resources.
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7. Obviously the purchaser of intangible assets will be trying to calculate whether it is better to purchase
the complete asset (a mailing list for example) or to simply duplicate the work that went into making the
asset. Therefore, Replacement Cost is another method to estimate the hours and expense of replicating
the intangible asset. Once we estimated the replacement cost as new, (often the highest price we
should pay) we could offer the owner a fair. However there is no equivalent replacement value on many
assets such as copyrights and trademarks, and no open market to draw comparisons from. Thus, we are
left with a second and sometimes more accurate tool which is the Net Present Value (NPV) method.
Now the goal is to determine what would be the future cash flows over the projected economic life and
then derive the NPV of the asset today.
Example – Demonstrate effect of FAS 142 on Balance Sheet
The difference in accounting due to introduction of FAS 142 can be illustrated with the help of an
example below. Consider a fictitious company ABC which buys another company XYZ in 1998 with a
goodwill value of $ 250000.
1. In 1998, 1999 and 2000 the amortization value of Goodwill is $ 6250, based on straight line
depreciation for a period of 40 years
2. From 2001 onwards the accounting will be based on FAS 142. The fair value of goodwill as per
certified valuation analyst is estimated to be impaired by $ 20,000.
3. In 2002 the impaired value is estimated again but this year the Goodwill of the company has an
improved value. The value of the impairment remains the same for this year as the Goodwill
improvement values do not result in change in Goodwill value.
Assets
1998 1999 2000 2001 2002
Current Assets
Cash 30000 28000 32000 33000 10000
A/R 345200 321600 321400 321400 345100
Total Current Assets 375200 349600 353400 354400 355100
Fixed Assets 150000 150000 150000 150000 150000
Accumulated Depreciation (15000) (30000) (45000) (60000) (75000)
New Fixed Asset 135000 120000 105000 90000 75000
Intangible Assets
Goodwill 250000 250000 250000 250000 250000
Accumulated
amortization (6250) (12500) (18500) (18500) (18500)
Goodwill Impairment (20000) (20000)
New Intangible Assets 243750 237500 231500 211500 211500
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8. Total Assets 753950 707100 689900 655900 641600
Income Statement
1998 1999 2000 2001 2002
Gross Revenue 15100000 15200000 15300000 15210000 16100000
COGS 13400000 13500000 13600000 1351200 14000000
Gross Profit 1700000 1700000 1700000 13858800 2100000
Operating expense
Amortization(Goodwill) 6250 6250 6250 0 0
Impairment(Goodwill) 20000 0
Depreciation 15000 15000 15000 15000 15000
Other expense 1000000 1100000 1000000 1111000 1211000
Total Operating expense 1021250 1121250 1021250 1146000 1226000
Net Income 678750 578750 678750 12712800 874000
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9. Bibliography
McClure, Ben. Putting Management Under The Microscope. Available:
http://www.investopedia.com/articles/stocks/05/050205.asp Last accessed 17/11/2008.
Wayman, Rick. Cooking the Books 101. Available: http://www.investopedia.com/articles/analyst/071502.asp Last
accessed 17/11/2008.
Obringer, Lee Ann. How Cooking the Books Works. Available: http://money.howstuffworks.com/cooking-
books.htm Last accessed 17/11/2008.
Penno, Mark (Sept 2008). Rules and Accounting: Vagueness in Conceptual Frameworks. Available:
http://web.ebscohost.com/ehost/pdf?vid=1&hid=16&sid=bb08c0e8-5f90-459f-9136-8c557a31c8ee
%40sessionmgr8 Last accessed 17/11/2008.
IFRS / IAS 38 Summary. Available: http://www.iasb.org/IFRS+Summaries/IFRS+and+IAS+Summaries+English+2007/
Last accessed 17/11/2008.
Harper, David. Financial Statements: Conclusion. Available:
http://www.investopedia.com/university/financialstatements/financialstatements10.asp Last accessed
17/11/2008.
Financial Accounting Standards Board (December 2001). Statement of Financial Accounting Standards No.142
Goodwill and Other Intangible Asset. Available: http://www.fasb.org/pdf/aop_FAS142.pdf Last accessed
17/11/2008.
Financial Accounting Standards Board (June 2001). Statement of Financial Accounting Standards No. 141 Business
Combinations. Available: http://www.fasb.org/pdf/aop_FAS141.pdf Last accessed 17/11/2008.
Kerr, Stephen J. (NA). VALUING INTANGIBLE ASSETS & INTELLECTUAL PROPERTIES. Available:
http://www.bizmark.net/Articles/article37.htm Last accessed 17/11/2008.
Intangible Assets Valualtion LLC (December 2001). Implementing FAS 142: A Guide for Controllers, CFO’s and
Others in Financial Management With Specific Focus on Appraisals. Available:
http://www2.ifes.com.br/webifes/conhecimento/Files/ADMINISTRA%C7%C3O%20FINANCEIRA%20e
%20CUSTOS/Avalia%E7%E3o%20de%20Intang%EDveis%20e%20Marcas/Artigos%20Internacionais/Implementing
%20FAS%20142.pdf Last accessed 17/11/2008.
Financial Accounting Standards Board (NA). Concepts No. 6. Available: http://www.fasb.org/pdf/aop_CON6.pdf
Last accessed 17/11/2008.
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10. Bibliography
McClure, Ben. Putting Management Under The Microscope. Available:
http://www.investopedia.com/articles/stocks/05/050205.asp Last accessed 17/11/2008.
Wayman, Rick. Cooking the Books 101. Available: http://www.investopedia.com/articles/analyst/071502.asp Last
accessed 17/11/2008.
Obringer, Lee Ann. How Cooking the Books Works. Available: http://money.howstuffworks.com/cooking-
books.htm Last accessed 17/11/2008.
Penno, Mark (Sept 2008). Rules and Accounting: Vagueness in Conceptual Frameworks. Available:
http://web.ebscohost.com/ehost/pdf?vid=1&hid=16&sid=bb08c0e8-5f90-459f-9136-8c557a31c8ee
%40sessionmgr8 Last accessed 17/11/2008.
IFRS / IAS 38 Summary. Available: http://www.iasb.org/IFRS+Summaries/IFRS+and+IAS+Summaries+English+2007/
Last accessed 17/11/2008.
Harper, David. Financial Statements: Conclusion. Available:
http://www.investopedia.com/university/financialstatements/financialstatements10.asp Last accessed
17/11/2008.
Financial Accounting Standards Board (December 2001). Statement of Financial Accounting Standards No.142
Goodwill and Other Intangible Asset. Available: http://www.fasb.org/pdf/aop_FAS142.pdf Last accessed
17/11/2008.
Financial Accounting Standards Board (June 2001). Statement of Financial Accounting Standards No. 141 Business
Combinations. Available: http://www.fasb.org/pdf/aop_FAS141.pdf Last accessed 17/11/2008.
Kerr, Stephen J. (NA). VALUING INTANGIBLE ASSETS & INTELLECTUAL PROPERTIES. Available:
http://www.bizmark.net/Articles/article37.htm Last accessed 17/11/2008.
Intangible Assets Valualtion LLC (December 2001). Implementing FAS 142: A Guide for Controllers, CFO’s and
Others in Financial Management With Specific Focus on Appraisals. Available:
http://www2.ifes.com.br/webifes/conhecimento/Files/ADMINISTRA%C7%C3O%20FINANCEIRA%20e
%20CUSTOS/Avalia%E7%E3o%20de%20Intang%EDveis%20e%20Marcas/Artigos%20Internacionais/Implementing
%20FAS%20142.pdf Last accessed 17/11/2008.
Financial Accounting Standards Board (NA). Concepts No. 6. Available: http://www.fasb.org/pdf/aop_CON6.pdf
Last accessed 17/11/2008.
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