ACCOUNTING 742 Professor Brian Bushee The Wharton School of Business Intangibles and Reserves The Shaw Group SOLUTION Please refer to the attached Shaw Group case to answer the following questions. 1. What does the “Goodwill” from Shaw’s acquisitions represent (i. e. , what are some of the economic assets that comprise this account)? Which intangible assets and liabilities does Shaw amortize over time? Which intangibles, if any, are not amortized? Shaw defines Goodwill as the “excess of the purchase price of acquisitions over the fair value of the net assets acquired” (Note 1).

The net assets acquired include not only tangible assets and liabilities, such as accounts receivable and PP&E, but all separately identifiable and transferable intangible assets and liabilities. As indicated in Notes 1 and 4, these intangibles include “various licenses, patents, technology, and related processes;” customer relationships; contract asset and liability adjustments; and accrued contract loss reserves. Thus, Goodwill must include any intangibles that are not separately identifiable and transferable. These economic “assets” could include the value of human capital, growth opportunities, and expected synergies.

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Goodwill could also represent overpayment, as it is a plug between the purchase price and the fair value of all net assets acquired. Shaw amortizes technology intangibles over 15 years, patents over 10 years, and customer relationships over 10 years. Each of these intangibles is amortized on a straight-line basis. Contract assets and liabilities, as well as accrued contract losses, are amortized to contract costs over the lives of the contracts as work is performed on the contracts. Goodwill is no longer amortized (effective fiscal year 2002).

Instead, Shaw performs annual Goodwill impairment reviews by reporting unit based on “a fair value concept. ” 2. What do the Contract Liability Adjustments and Accrued Contract Loss Reserves represent? How does Shaw’s management estimate the fair value of these liabilities? At what point do these liabilities affect the income statement, and in which direction (increase or decrease)? Shaw performs work under a variety of contractual arrangements, including costreimbursable contracts (i. e. , Shaw can pass all costs along to the customer), fixed-price contracts (i. e. Shaw charges the customer a negotiated fixed price and bears the costs or benefits of any cost overruns or shortfalls), and incentive/penalty provisions (e. g. , extra costs or discounts for finishing projects by certain deadlines). The contracts generally run for two-to-four years. Intangibles and Reserves: The Shaw Group Solution Page 1 of 10 When Shaw makes an acquisition, they acquire a large number of contracts in progress and contract backlogs (i. e. , contracts where the work has not started yet). Because these contracts are separately identifiable and transferable, SFAS No. 41 requires that they be recognized as separate assets and liabilities, recorded at their fair value at the date of acquisition. Shaw values these contracts using “a market-based discounted cash flow approach. ” If the NPV of a contract is positive, it will be recorded as a contract asset adjustment. If the NPV is negative, it will be recorded as a liability adjustment. Note that these contract adjustments were created by two acquisitions. The August 2000 acquisition of Stone & Webster accounted for the additions to the reserve in 20001.

The May 2002 acquisition of the IT Group accounted for the additions in 2002 and thereafter. Also, note that there is some uncertainty as to the amounts of the contract adjustments at the time of acquisition because the acquired companies are in bankruptcy. Thus, Shaw makes adjustments to the contract adjustments accounts for up to a year (or more) after the acquisition. The offset to these adjustments is a change in Goodwill. Contract assets and liabilities are amortized to contract costs (i. e. , cost of revenues) over the estimated lives of the underlying contracts as work is completed.

The amortization of contract asset adjustments increases the cost of revenues. Because the “extra” profit of these contracts was recognized at acquisition, there must be a reduction in profits recognized at contract completion to avoid double counting. The amortization of contract liability adjustments (and accrued contract losses) reduces costs of revenues. Again, the “extra” losses of the contracts were recognized at acquisition, so cost of revenues is reduced to avoid double counting. 3. Using Exhibit 2, compute Shaw’s gross profit margin for each quarter between 2000: Q4 and 2003: Q4: a.

As reported Quarter Q4:00 Q1:01 Q2:01 Q3:01 Q4:01 Q1:02 Q2:02 Q3:02 Q4:02 Q1:03 Q2:03 Q3:03 Q4:03 Revenues 263. 8 418. 8 340. 3 394. 2 385. 7 453. 6 566. 2 902. 6 1248. 2 996. 9 720. 5 824. 0 765. 4 Cost of Revenues 212. 2 349. 1 282. 4 324. 7 313. 5 384. 8 492. 4 809. 3 1127. 9 903. 3 666. 9 738. 3 680. 0 Gross Profit 51. 6 69. 6 57. 9 69. 5 72. 3 68. 8 73. 8 93. 3 120. 3 93. 7 53. 5 85. 7 85. 4 Gross Profit Percentage 19. 6% 16. 6% 17. 0% 17. 6% 18. 7% 15. 2% 13. 0% 10. 3% 9. 6% 9. 4% 7. 4% 10. 4% 11. 2% Intangibles and Reserves: The Shaw Group Solution Page 2 of 10 b.

Assuming that Shaw had never recorded any Contract Liability Adjustments and Accrued Contract Loss Reserves Quarter Q4:00 Q1:01 Q2:01 Q3:01 Q4:01 Q1:02 Q2:02 Q3:02 Q4:02 Q1:03 Q2:03 Q3:03 Q4:03 Revenues 263. 8 418. 8 340. 3 394. 2 385. 7 453. 6 566. 2 902. 6 1248. 2 996. 9 720. 5 824. 0 765. 4 Gross Profit 51. 6 69. 6 57. 9 69. 5 72. 3 68. 8 73. 8 93. 3 120. 3 93. 7 53. 5 85. 7 85. 4 Gross Profit Pct 19. 6% 16. 6% 17. 0% 17. 6% 18. 7% 15. 2% 13. 0% 10. 3% 9. 6% 9. 4% 7. 4% 10. 4% 11. 2% Remove Utilization 13. 5 41. 4 26. 8 17. 7 13. 5 9. 3 6. 8 6. 5 14. 0 8. 2 10. 5 14. 6 13. Adj. Gross Profit 38. 1 28. 2 31. 1 51. 8 58. 8 59. 5 67. 0 86. 8 106. 3 85. 5 43. 0 71. 1 72. 1 Adj. Gross Profit Pct 14. 4% 6. 7% 9. 1% 13. 1% 15. 2% 13. 1% 11. 8% 9. 6% 8. 5% 8. 6% 6. 0% 8. 6% 9. 4% 4. Does the amount of utilization of reserves into Cost of Revenues across quarters seem reasonable? Why or why not? (Hint: compare trends in reserve utilization to trends in the other quarterly variables) In the Lehman Brothers’ analyst report, the following chart was used to demonstrate how Shaw’s earnings quality had dropped in recent quarters because of the reserve activity:

The key conclusion was that around 55% of EBIT for the last two quarters were due to reserve utilization, and that reserve utilization was significantly higher than it had been in recent quarters (except for Q4:2002). I constructed some figures to provide a more complete analysis of the situation. In the Figures page at the end, I plotted reserve utilization against sales, gross profit, and OIBD. In these graphs, I measured reserve utilization as a percentage of the total reserves available (beginning balance plus additions during the quarter).

This figure represents how much of the available reserves are being utilized during the quarter, Intangibles and Reserves: The Shaw Group Solution Page 3 of 10 which seems like the most reasonable measure. I also plotted the graphs using the level of utilization and the utilization divided by gross profit and the graphs looked similar, but I did not reproduce them to conserve space. First, the usage of the reserves should track somewhat with revenue, as the reserves are released into earnings as work is completed (i. e. , revenue is recognized) on the projects.

In Figure 1, I plot reserve utilization and sales. Instead of reserve utilization increasing with revenue growth, the two measures seem countercyclical. When revenue is growing substantially (Q4:01 – Q4:02), reserve utilization is declining. When revenues start falling in 2003, reserve utilization starts trending upward. Thus, this graph suggests that Shaw is using its reserves to counteract declines in revenue. Second, if Shaw is using the reserves to offset declines in unmanaged earnings, then we should see more reserve utilization when the adjusted gross profits and adjusted OIBD are low.

Adjusted gross profits and OIBD are computed by subtracting the reserve utilization from to the reported numbers; thus, the adjusted numbers represent what gross profit and OIBD would have been had Shaw not used any reserves. Figure 2 plots reserve utilization and adjusted gross profit. Again, the two trends are somewhat countercyclical, except that the most recent spike in reserve utilization matches a spike in adjusted gross profit. Figure 3 plots reserve utilization against adjusted OIBD.

Here again, reserve utilization appears to be highest when adjusted OIBD is low and vice versa (Q2:03 is an aberration because of a special item). These graphs, combined with the fact that Shaw consistently meets or beats earnings targets (Exhibit 1 of the case), suggests that Shaw is using the reserves to smooth earnings. However, before we dump the stock, let’s take a closer look at the timing of the reserve utilization vis-a-vis the timing of the additions to the reserves. Recall that the additions to the reserves came from two acquisitions: Stone & Webster (S&W) during 2000-2001 and IT Group (IT) during 2002-2003.

Most of the additions occurred at the time of the acquisitions, with some adjustments within the subsequent year when there was more certainty about the nature of the contracts assumed from the bankrupt targets. Recall also that contracts are typically 2-4 years in length in this industry, and that many acquired contracts are already in progress, so we should expect to see most of the reserve utilizations occur within the first two years or so of the acquisition. In the table below, I have reproduced the quarterly additions and utilizations of the reserves.

Then, I assume that all additions to the reserves before Q3:02 are due to S&W and all after due to IT. All utilizations before Q4:02 are due to S&W. Afterwards, 6. 0 of the utilization is devoted to S&W until used up; the rest are due to IT. I report the cumulative amounts of additions and utilizations and the percent of the total cumulative additions that have been used up by each quarter. I also represent these numbers in Figure 4. Intangibles and Reserves: The Shaw Group Solution Page 4 of 10 Quarter Q4:00 Q1:01 Q2:01 Q3:01 Q4:01 Q1:02 Q2:02 Q3:02 Q4:02 Q1:03 Q2:03 Q3:03 Q4:03

Quarterly Totals Reserve Reserve Additions Utilizations 120. 0 13. 5 7. 9 41. 4 43. 9 26. 8 -2. 5 17. 7 -5. 7 13. 5 0. 0 9. 3 0. 1 6. 8 30. 0 6. 5 36. 3 14. 0 -1. 6 8. 2 6. 4 10. 5 -0. 8 14. 6 4. 5 13. 3 S&W Acquisition Cumul. Cumul. Adds. Utils. Pct 120. 0 13. 5 11% 127. 9 54. 9 43% 171. 8 81. 7 48% 169. 3 99. 4 59% 163. 6 112. 9 69% 163. 6 122. 2 75% 163. 7 129 79% 163. 7 135. 5 83% 163. 7 141. 5 86% 163. 7 147. 5 90% 163. 7 153. 5 94% 163. 7 159. 5 97% 163. 7 163. 7 100% IT Group Acquisition Cumul. Cumul. Adds. Utils. Pct 30 66. 64. 7 71. 1 70. 3 74. 8 0 8. 0 10. 2 14. 7 23. 3 32. 4 0% 12% 16% 21% 33% 43% Figure 4 and the above table both suggest that the pattern of reserve utilization could be simply a timing effect. During 2002, when reserve utilization is shrinking, we see that one explanation is that most of the S&W reserves have been used up. Meanwhile, the spike in sales during 2002 is likely to be largely driven by the acquisition of IT in Q3:02. Reserve utilization begins to increase again late in 2003, about one year after the acquisition of IT.

This spike could simply be due to the acquired IT contracts being completed over this period. Thus, it is entirely possible that the seeming evidence of earnings management using the reserves is really legitimate matching of the contract adjustments to the completion of the contracts. 5. What are Shaw’s possible earnings management incentives in initially estimating the size of the Contract Liability Adjustments and Accrued Contract Loss Reserves? What are the risks, if any, of overestimating the amounts of the reserves? What are the risks, if any, of underestimating the amounts of the reserves?

The contract liability adjustments and contract loss reserves allow Shaw to reduce future cost of revenues without a great deal of transparency about what the appropriate time period should be for reversal of the reserves. When Shaw makes an acquisition, they can create these reserves without any impact on current expenses; the offset is higher Goodwill: Goodwill xxx Accrued Contract Losses xxx When Shaw completes a contract (or decides to manage earnings), they reverse the reserve into cost of revenues, increasing gross profits: Accrued Contract Losses Cost of revenues xxx xxx Intangibles and Reserves: The Shaw Group Solution Page 5 of 10

However, note that the contracts are expected to be unprofitable, which is why a liability was originally estimated and booked by Shaw. Thus, the reversal entry should cause a loss contract to show up as a “zero-margin” contract upon completion, as the original “loss” was booked at acquisition as higher Goodwill. The big risk of overstating the reserves is that it will overstate Goodwill. Shaw must do an impairment test of Goodwill each year. The higher the balance in Goodwill, the more likely that the impairment test will find that the value of Goodwill has been impaired. An impairment would lead to a one-time charge to write down Goodwill.

This write-down could be interpreted by the market as evidence that the acquisition was a failure. The big risk to understating the reserves is that it will reduce future profits as losses from unprofitable contracts hit earnings at the completion of the contract, rather than at acquisition. Thus, the market could see that margins have declined after the merger and attribute it to the failure of the acquisition, rather than a bad estimate of loss contracts at acquisition/ 6. Do you agree with the analyst at Lehman Brothers that Shaw’s use of its reserve accounts justifies a recommendation of “Underweight” (i. e. , Sell! )?

Why or why not? Any reasonable answer would be acceptable here, as the evidence of whether Shaw is manipulating or not is far from clear cut. Here is what has been happening. After the close of trading on June 10, 2004, the Shaw announced that it was the subject of an informal investigation by the SEC into the Company’s method of accounting for acquisitions. In response, the price of Shaw’s common stock fell 18% to $10. 05 when trading resumed on June 14, 2004. In July 2004, numerous investors initiated a class action lawsuit against Shaw, claiming the company and three top officers misled the investing public about its finances.

The lawsuit alleges that Shaw established excessive or “general” contract reserves in conjunction with two acquisitions and then tapped those “cookie jar” reserves to artificially boost its earnings when needed. Shaw allegedly took advantage of the “artificially inflated” stock price by offering $479 million in shares of Shaw common stock to the public, as well as millions of dollars of debt securities. Shaw management also took advantage of the inflated price by selling approximately 1. 94 million shares of Shaw common stock during the Class Period (2000-2004), for proceeds of roughly $80 million.

There has been no further news on the lawsuit or the SEC investigation. The SEC has not posted anything on its website about Shaw and the Stanford Securities Law Database does not indicate any further progress in the suit. Intangibles and Reserves: The Shaw Group Solution Page 6 of 10 Here is Shaw’s reserve utilization post-case. Initially, it seems like they have high reserve utilization when revenues and gross profits are low, and vice versa. But in 2005, their reserve utilization is steady and minimal. Quarter Q1:04 Q2:04 Q3:04 Q4:04 Q1:05 Q2:05 Q3:05 Q4:05 Q1:06 Revenues 649. 691. 2 917. 8 818. 8 828. 1 763. 4 907. 2 767. 2 1138. 0 Gross Profit 12. 7 60. 2 72. 5 74. 4 76. 4 69. 5 80. 8 65. 7 106. 0 Gross Profit Pct 2. 0% 8. 7% 7. 9% 9. 1% 9. 2% 9. 1% 8. 9% 8. 6% 9. 3% Remove Utilization 10. 9 16. 6 3. 9 1. 4 3. 0 3. 5 3. 2 3. 4 2. 0 Adj. Gross Profit 1. 8 43. 6 68. 6 73. 0 73. 4 66. 0 77. 6 62. 3 104. 0 Adj. Gross Profit Pct 0. 3% 6. 3% 7. 5% 8. 9% 8. 9% 8. 6% 8. 6% 8. 1% 9. 1% Here is Shaw’s cumulative reserve utilization post-case by acquisition. This chart (and graph) makes it look like they are using up the reserve as the contracts on IT close out.

Quarter Q4:03 Q1:04 Q2:04 Q3:04 Q4:04 Q1:05 Q2:05 Q3:05 Q4:05 Q1:06 Quarterly Totals Reserve Reserve Additions Utilizations 4. 5 13. 3 -0. 2 10. 9 12. 0 16. 6 0 3. 9 2. 7 1. 4 0 3. 1 0 3. 5 -0. 1 3. 2 0 3. 4 0 2. 0 S&W Acquisition Cumul. Cumul. Adds. Utils. Pct 163. 7 163. 7 100% IT Group Acquisition Cumul. Cumul. Adds. Utils. Pct 74. 8 32. 4 43% 74. 6 43. 3 58% 86. 6 59. 9 69% 86. 6 63. 8 74% 89. 3 65. 2 73% 89. 3 68. 3 76% 89. 3 71. 8 80% 89. 2 75. 0 84% 89. 2 78. 4 88% 89. 2 80. 4 90% Figure 4: Cumulative Additions and Utilizations by Acquisition 200. 0 180. 0 160. 0 140. 0 120. 0 100. 0 80. 60. 0 40. 0 20. 0 0. 0 $ 4: 00 1: 01 2: 01 3: 01 4: 01 1: 02 2: 02 3: 02 4: 02 1: 03 2: 03 3: 03 4: 03 1: 04 2: 04 3: 04 4: 04 1: 05 2: 05 3: 05 4: 05 Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Quarter S&W Add SW Util IT Add IT Util Intangibles and Reserves: The Shaw Group Solution Page 7 of 10 Q 1: 06 Here is the movement in Shaw’s (SGR) stock price since the time of the case. If you had purchased Shaw in October 2003, you would have profited nicely. Intangibles and Reserves: The Shaw Group Solution Page 8 of 10 Figures Figure 1: Reserve Utilization and Sales 1400. 0 40. 0% 1200. 0 35. 0% 1000. 25. 0% 800. 0 Sales 20. 0% 600. 0 15. 0% 400. 0 10. 0% 200. 0 5. 0% 0. 0 Q4:00 Q1:01 Q2:01 Q3:01 Q4:01 Q1:02 Q2:02 Quarter Sales Util/Total Res Q3:02 Q4:02 Q1:03 Q2:03 Q3:03 Q4:03 0. 0% Figure2: Reserve Utilization and Adjusted Gross Profit 120. 0 40. 0% 35. 0% 100. 0 30. 0% 80. 0 25. 0% Adj. GP 60. 0 20. 0% 15. 0% 40. 0 10. 0% 20. 0 5. 0% 0. 0 Q4:00 Q1:01 Q2:01 Q3:01 Q4:01 Q1:02 Q2:02 Quarter AGP Util/Total Res Q3:02 Q4:02 Q1:03 Q2:03 Q3:03 Q4:03 0. 0% Intangibles and Reserves: The Shaw Group Solution Page 9 of 10 Reserve Utilization/Total Reserves Reserve Utilization/Total Reserves 30. 0%

Figure 3: Reserve Utilization and Adjusted OIBD 60. 0 40. 0% 50. 0 35. 0% 40. 0 25. 0% Adj. OIBD 30. 0 20. 0% 20. 0 15. 0% 10. 0 10. 0% Q4:00 Q1:01 Q2:01 Q3:01 Q4:01 Q1:02 Q2:02 Q3:02 Q4:02 Q1:03 Q2:03 Q3:03 Q4:03 5. 0% (10. 0) Quarter AOIBD Util/Total Res 0. 0% Figure 4: Cumulative Additions and Utilizations by Acquisition 200. 0 180. 0 160. 0 140. 0 120. 0 100. 0 80. 0 60. 0 40. 0 20. 0 0. 0 Q4:00 Q1:01 Q2:01 Q3:01 Q4:01 Q1:02 Q2:02 Quarter S&W Add SW Util IT Add IT Util Q3:02 Q4:02 Q1:03 Q2:03 Q3:03 Q4:03 Intangibles and Reserves: The Shaw Group Solution $ Page 10 of 10 Reserve Utilization/Total Reserves 30. 0%