FACTS OF CASE
The first issue involving Halliburton is the recognition of revenue from the disputed construction jobs. Before the accounting change, Halliburton would receive most of its revenue within one year. Until 1998, Halliburton would bid on construction projects under ‘cost-plus’ contracts. Under these conditions, the company was able to recover from customers the cost of a project plus a certain percentage profit from gas pipelines. In 1998, the company changed from the ‘cost-plus’ system to lump sum contracts. Because of the accounting change, Halliburton will keep claims for construction projects that run over budget on its books indefinitely, as long as they expect the customer to pay. In essence, Halliburton changed its accounting methods to reflect revenue from construction projects where it had incurred cost overruns before those additional costs were billed to customers. The reason for the SEC inquiry was to determine if the booking of revenue was accelerated improperly.
The other issue regarding this case was the non-disclosure of the accounting method change. Because the accounting change was made in 1998, the Notes to the Consolidated Financial Statements for the 1998 fiscal year should have contained a note referencing the change in accounting method. The accounting change was eventually disclosed to investors in the 1999 fiscal year Financial Statements. However, it was not until May 2002 that the SEC decided to look into the accounting change, its effect on the financial statements, and evidence of non-disclosure to investors.
RESOLUTION
According to GAAP, revenue may be recognized when it is realized and earned. By this definition, the changes made by Halliburton are acceptable. Before the accounting change, the recognition of the cost overruns would have been somewhat questionable because of the cost-plus considerations. However, the change in accounting method to lump sum or fixed price contracts set the amount of costs to the customer. The contract value would have been determined before work began based on a bidding process, and any costs over and above the stated contract value would be considered additional revenue that may be recognized. Halliburton did not break any accounting rules by making this change.
Whether their accounting change followed the conservatism convention is subject to debate. I believe, however, that the conservatism rule was not violated in this instance. Their revenues were not overstated, merely accelerated, as long as the client was indeed billed for the cost overruns. If it was determined, at a later point, that these cost overruns were never billed, a whole new set of accounting rules would have been broken.
Also, the question of materiality has been discussed in this case. Halliburton, of course, believes that the $100 million revenue they booked was not material. Considering their revenues when they did disclose the accounting change in 1999 was over $9 billion, it is tough to argue with their stance. Without knowing what their revenues were, $100 million would seem to be material. Regardless of conservatism and materiality, Halliburton did break an accounting rule – perhaps the most important rule of all when dealing with investors – proper disclosure of an accounting change.
Accounting changes affect the financial statements presented in the Annual Report. Investors use the Annual Report issued by a firm as an investment “Bible”. If the numbers shown in that report are accurate, the Annual Report will give the investor a window through which to view the company from a financial standpoint. Independent auditors are hired to evaluate the firm’s financial data and verify the accuracy of the financial statements. In addition, the auditors are hired to ensure full disclosure. In Halliburton’s case, the numbers were not accurate and full disclosure was not given. Given the auditors used by Halliburton, Arthur Andersen, this should not come as a surprise.
The policy regarding the accounting changes stems from the consistency and full disclosure conventions. The consistency convention holds that accounting procedures, once adopted by a company, must remain in use from one period to the next unless investors are informed of the change. If management decides that a certain procedure is not appropriate and should be changed, GAAP requires that the change be described in the notes to the financial statements along with a dollar effect on the Balance Sheet, Income Statement, and any other statement in the Annual Report. Full disclosure requires that financial statements and their footnotes present all information relevant to the investors’ understanding of the financial statements. In other words, accounting information should offer any explanation that is needed to keep the information from being misleading to the investor. This is not to say that every little minute detail of the financial statement should be included in the notes. The notes should aid understanding of the financial statements, not impede it. That said, the accounting change made by Halliburton should have been disclosed and its effect on the financial statements in 1998 should have been in the financial statement’s notes section.
CONCLUSION
If Halliburton would have disclosed the accounting method change, this case would not be subject to debate. The fact that they did not disclose the change leads me to believe that something else could have been going on. It is hard to for me to believe that the Andersen auditors could have missed the accounting change or forgot to have Halliburton include it in the notes section. Could the disclosure in 1999 try to cover something that could have been a bigger problem for Halliburton in the long run? The change seems perfectly sound financially and legally. I asked a question on page two and now three pages later, I am still not sure of the answer.
Why not disclose the change?