Free Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, 3rd Edition by Howard Schilit, Jeremy Perler

accounting is typically used for long-term construction or production contracts. Under percentage-of-completion accounting, the amount of revenue recognized in a given period is determined by the percentage of the total contract that was completed during the period. To calculate revenue, companies first determine the amount of costs they incurred under the contract as a percentage of the estimated total costs to be incurred over the entire life of the contract. Then, this percentage is applied to the total revenue expected to be recognized under the contract, as illustrated here.
 

     
    Even when it is appropriate for companies to use percentage-of-completion accounting, incorrect estimates and bad luck can lead to inflated revenue and earnings. That’s what happened at defense contractor Raytheon Company. Raytheon recorded revenue for several years based on estimates of costs and expected unit sales. When it became clear that the revenue from the contract would materially lag behind the original estimates, Raytheon announced that the previously reported revenue was too high, and it was forced to take a one-time charge.
     
Potential Problems in Using Percentage-of-Completion Accounting
• Companies may use percentage-of-completion accounting when it is not appropriate.
• Companies may make aggressive assumptions to accelerate revenue.
• Revenues may be inflated simply because honest estimates are off the mark.
     
    Recording Revenue from Assets Leased to Customers
     
    Lease accounting is another topic that, like percentage-of-completion accounting, relies heavily on management’s estimates. Investors must monitor these inputs, since management might begin using unreasonably optimistic projections. In the case of Xerox Corporation, management inflated revenue and earnings by billions of dollars using lease accounting tricks, some of which are discussed in this section. When the shenanigans finally caught up with Xerox, the company restated equipment revenue by $6.4 billion and pretax earnings by $1.4 billion.
     
Accounting Capsule: Capital Leases
 
Certain equipment leases should be treated in a fashion similar to the treatment for an outright sale. These are called capital leases . At the inception of the lease, the seller (called a lessor) recognizes as revenue a large portion of the present value of future lease payments. Estimates such as the discount rate, residual value, length of the contract, and other lease terms dictate the timing of revenue recognition over the course of the lease.
 
For example, the discount rate is used to calculate the current value of future lease payments, adjusted for the time value of money. This present value is recognized as revenue immediately, and the remainder of the payments is recorded as interest income over the lease term. A higher discount rate yields a lower present value for revenue recorded, while a lower discount rate yields a higher present value. By choosing an inappropriately low discount rate, management could aggressively accelerate the recognition of revenue.
     
    Watch for Companies That Select Inappropriately Low Discount Rates. Xerox selected unrealistically low discount rates, which allowed it to record more of the lease payments as up-front revenue. For example, in the late 1990s, it assumed discount rates ranging from 6 to 8 percent on many Brazilian leases, even though the average local borrowing rates regularly exceeded 20 percent. The SEC contended that had Xerox used a discount rate more in line with the market, revenue on Brazilian leases would have been $757 million lower during the period 1997 to 2000.
     
    Be Aware When Companies Alter the Terms of Existing Lease Arrangements. Xerox also allegedly accelerated revenue by incorrectly accounting for price increases and lease extensions imposed on existing lease customers. Accounting rules state that companies should recognize the impact of these changes over the lease term. However, Xerox was