Making(Up)Numbers 155(R&D) costs. Accounting rules require such R&D costs to be ex-
pense dwhen incurre d(rather than amortize d), an dso many buyers
allocate that excess as a one-time expense at the merger time even
when that allocation defies business reality.- Cookie jar reserves. This entails the overestimation or underesti-
mation of things such as sales returns by publishers, probable loan
losses of lending institutions, and warranty obligations for manu-
facturers. The incorrect estimation enables managers to adjust and
smooth out earnings as actual earnings vary from expecte dearn-
ings perio dto perio d. - It’s not material. The materiality principle requires the reporting
of items that are material an dallows the nonreporting of items
that are not. Materiality is not an absolute concept but entails
making judgments. A standard legal formulation for public cor-
porations under federal securities laws is whether an item would
be important to an investor in making an investment decision
about a security (the accounting rule similarly asks whether it
would influence a reasonable person’s judgment). Judgments con-
cerning materiality are often guided by rough rules of thumb. One
rule of thumb accountants and auditors often use in determining
materiality is whether a particular item entails more than, say, a
5% impact on a company’s earnings. But applying such a simple
rule coul dlea dto exclu ding things that are meaningful to a user
of the financial statements in a qualitative sense. - Wine before its time. This image of popping open a bottle of wine
before it matures reflects the premature recognition of revenue.
For instance, a toy manufacturer may tag goods in a warehouse as
“sold” even though they are not and may never be sold, or a dis-
tributor of cell phones may recor drevenue for merchan dise that
it shippe dan dreceive dpayment for but that is subject to free
return by the buyer for a perio dof, say, 90 days.
To address these manipulations, the SEC called for immediate
an dcoor dinate daction, seeking nothing less than a fun damental
change in American corporate culture. Levitt articulate da multifac-
ete dprogram, beginning with instructing the SEC staff to scrutinize
financials for abuses of restructuring accounting an daccruals for
losses an dreserves. He aske dthe American Institute of Certifie d
Public Accountants (AICPA) to clarify auditing rules concerning
purchase dR&D, large acquisition write-offs, an drevenue recogni-