NEWSWIRE - Feburary 1, 1999

Topic: Financial Statement Analysis

Source: "Firms Say SEC Scrutiny Goes Too Far," by Elizabeth MacDonald, Wall Street Journal, Monday, February 1, 1999, page A2 and "High Tech Firms Are Upset Over SEC Crackdown", by Michael Schroder, Wall Street Journal, Monday, February 1, 1999, page B4.

Synopsis of Articles:

These two articles discuss how earnings should be derived and reported to the public on the firm's income statement and balance sheet. The SEC wants to make sure that reported earnings are not misleading the investing public. The affected corporations want to use accounting conventions to benefit current shareholders. The main issue is capitalization versus expensing. The first article describes management's ability to "store" expenses as reserve accounts on the balance sheet and then move them to the income statement in a possible effort to smooth earnings. The second article describes the practice of reporting "goodwill" as a single, current expense rather than an amortized capital cost. High tech firms are particularly concerned about this since many acquire smaller firms at prices in excess of their book value. The acquiring firms classify as much of this cost as possible as an R&D expense. The SEC believes that this practice may be misleading.

Questions:

1. Why is the Securities Exchange Commission (SEC) concerned about current practices regarding the determination of profits?

2. Explain how the establishment of "reserves" on the balance sheet could potentially allow a firm to manipulate after tax earnings on the income statement.

3. Given the choice, why would a firm report large acquisition costs as a one-time expense rather than reporting the value as an asset ("goodwill") and spreading its expense out over a number of years (by amortization)? How would this choice influence the firm's net profit margin and total asset turnover?

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