Author Archives: Youngmi Chung

June 2002, Microsoft settled with the Securities and Exchange Commission regarding allegations of misstating its financial statements by managing earnings, according to the Wall Street Journal.  In this settlement, Microsoft neither denied nor admitted to any wrong doings but agreed to abide by the S.E.C. rules going forward; and the company did not face any fines.  The S.E.C. investigation, which started in 1999, was focused on the company’s reserve practices during fiscal year 1994 to 1998 that may have materially  misrepresented its earnings, the so-called “cookie jar” accounting.

“Cookie jar” accounting is a non-GAAP accounting method which allows management to manipulate the company’s bottom line to smooth out the earnings from period to period by using reserves.  Although there are strict guidelines for when and how to recognize revenues, there are also flexibilities to the rules that the managers can manipulate in order to maintain smoother earnings trend.  Specifically for Microsoft, setting higher reserves for returned software or bad debt accounts during well performing quarter (understating earnings) and then reversing the reserves during an underperforming quarter (overstating earnings) can result in a smoother upward trend of earnings.

Moreover, due to Microsoft’s multifaceted nature of licensing agreements, revenues from these licensing business are deferred to match the life time of the agreements.  Since Microsoft had billions of dollars of unearned revenue in its liabilities accounts, the company can understate or overstate its revenues if revenue recognition methods used are not compliant to GAAP.

These types of illegal accounting practices are usually serious violations which can result in large fines and other disciplinary measures for fraud.  However, the S.E.C. did not allege fraud for Microsoft because, unlike other cases, the company had understated its earnings.  Additionally, the investigation was unable to find any evidence of intent to reverse the reserves to overstate its earnings.  One example of a company charged with fraud under the same “cookie jar” accounting method is Xerox.  In 2002, Xerox was fined $10 million and revised its financial statements back to 1997.  The S.E.C. charged Xerox of setting high reserves during better performance years and then reversed the reserves to overstate its earnings during lower performance years which artificially inflated its revenues by $2 billion since 1997.

These types of violations of accounting rules will always be difficult to identify because the estimates of, say, bad debt or returned merchandise, are, to a large extent, subjective judgment calls by the management.  Thinking about accounting in this way makes accounting much more complex than just a quantitative study of transactions as would a beginning student of Accounting may have supposed.