What Mattel’s Accounting Mistake Teaches Us About Material Weakness and Deferred Taxes

Who knew that Thomas the Tank Engine could stir up so many problems?

 

Mattel, the owner of the toy brand and PwC, Mattel’s external auditor, did not take proactive steps to correct an accounting error.

 

The company and the auditor have paid a heavy price.

 

This excellent article from the Wall Street Journal, “Mattel and PwC Obscured Accounting Issues, Former Executive Says”, lays out a great example to explain a material weakness, and how deferred taxes work.

 

The story begins when an error is discovered.

 

What is a Material Weakness?

 

Mattel is a public company, so it makes sense to refer to the Public Company Accounting Oversight Board (PCAOB). The Board was created after the Enron collapse, in an effort to improve the amount and timeliness of accounting disclosure.

 

Here’s how PCAOB defines a material weakness in Auditing Standard 5:

 

“A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis.”

 

Let’s break that down, starting with materiality.

 

Materiality

 

The term “material” refers to a dollar amount that is large enough to change the opinion of a financial statement reader. The level of materiality is a judgment call. A $5 error in a $2 million inventory balance isn’t material, but a $10,000 mistake is probably material.

 

Firms needs controls in place to prevent material errors.

 

Internal controls

 

A business needs controls in place over inventory, including physical inventory counts.

 

During the count, the internal auditors compare items in the detailed inventory listing to the physical items in the warehouse. This procedure is the strongest evidence that the inventory exists.

 

Companies also need to control how goods move in and out of the warehouse, so that accurate records are maintained.

 

If controls are weak, the company will not report the inventory balance accurately. A material weakness means that a firm’s accounting system does not produce reliable reporting.

 

Timing is particularly important.

 

Timely basis

 

When you find a material error, you need to disclose it and correct it right away.

 

But that’s potentially embarrassing- and may change how investors view your firm. Which brings us back to Mattel and PwC.

 

Why an Earnings Restatement is a Disaster

 

Here’s a quote from the article:

 

“The accounting problem was tied to Mattel’s ownership of Thomas & Friends, an animated children’s show about talking trains. The finance team discussed fixing the problem and restating earnings, with the expectation that Mattel would have to admit to shortcomings in its accounting and reporting procedures…”

 

Ouch.

 

Restating earnings is a PR problem, for two reasons:

 

• Analysts and investors will have less confidence in Mattel’s management
• PwC (the auditor’s) reputation will be damaged, as well as the firm’s reputation with the client (who they’ve audited for decades)

 

So, what did Mattel and PwC do?

 

“… senior finance executives and Mattel’s auditor, PricewaterhouseCoopers, decided to change the accounting treatment of the Thomas asset, effectively burying the problem, according to Mr. Whitaker and documents reviewed by The Wall Street Journal. The executives agreed not to tell Mattel’s then-chief executive or its board of directors, an internal investigation found.”

 

They buried the problem- so the public (and particularly investors) didn’t know about the mistake right away.

 

There was a great deal of fallout. The Mattel CFO left the firm, and the PwC partner was put on administrative leave and is expected to leave the audit firm.

 

Let’s shift gears and talk about intangible assets, and the accounting error itself.

 

Reviewing Intangible Assets

 

Intangible assets include patents, copyrights, and other assets that are not physical.

 

Goodwill is a common intangible asset category. If you pay more than the book value for a company, some of the purchase price may be posted to goodwill. This video explains accounting for goodwill.

 

Intangible assets are amortized, which reclassifies the asset balance into amortization expense over time. It’s similar to depreciation expense for physical assets.

 

When Mattel buys an intangible asset, the company has to review the asset for possible impairment.

 

Impairment

 

GAAP requires that intangible assets must be evaluated each year for impairment.

 

If the fair value of the intangible asset is less than the unamortized balance in the intangible asset account, the asset is impaired.

 

Here’s an example:

 

Let’s assume that you buy a copyright for a book that generates $100,000 in sales a year. Time goes by, and the annual revenue for the book declines to $30,000 a year. Obviously, the value of the copyright has declined.

 

But by how much?

 

Estimating the fair value of an intangible asset is a complicated issue. This blog post from the CFA Institute goes into detail on the valuation process, if you want to know more.

 

Writeoff

 

If an intangible asset is impaired, you must write off the impairment amount to expense.

 

That’s consistent with other areas of accounting. We never want an asset on the books to be overstated. If an asset is overvalued, we generally expense the overage amount.

 

Here’s the Mattel accounting issue:

 

“The accounting error was tied to a $562 million valuation allowance—a reserve for a potential loss in value—that Mattel created against its deferred tax assets in September 2017.”

 

Reserve for Potential Loss

 

Reserve accounts help a business comply with the principle of conservatism.

 

This principle states that, when in doubt, choose the accounting method that generates less net income.

 

So, if Mattel considered that an intangible asset may be worth less in the future, why not set aside some dollars now to address the issue?

 

That’s taking a conservative approach.

 

Banks use reserve for loan loss accounts to set money aside for potential loans that may not be paid back. In fact, the amount of a bank’s loan loss can be an area of dispute between bankers and their external auditors.

 

Let’s talk about deferred taxes.

 

Deferred Tax Asset

 

The concept of deferred taxes is one of the toughest topics in accounting. This video and the video here both explain the topic.

 

The journal entry for the Mattel error was a debit to Deferred Tax Asset and a credit to a Reserve for Loss account.

 

A deferred tax asset means that you have a tax expense in the future, which reduces your tax liability in the future.

 

Depreciation expense can be different between book (accounting records) and the tax return. These temporary differences create deferred tax assets.

 

Let’s say that you have $30,000 more in depreciation for taxes than book depreciation in 2021. Higher expenses means less net income- and a lower tax liability this year.

 

You would have a $30,000 deferred tax liability, meaning that you have a higher tax liability in future years.

 

So what, exactly, was the big problem with the Mattel accounting?

 

How Mattel Made a Mistake

 

“The allowance was reduced by $109 million, which came from deferred tax liabilities related to the company’s 2011 acquisition of HIT Entertainment Ltd., which included Thomas & Friends, Barney & Friends, and Bob the Builder. Reducing the allowance lowered Mattel’s loss for the quarter.

Soon after, the company did an internal review of its intangible assets. Finance executives discovered that because of the way the HIT liability had been categorized, it shouldn’t have been used to reduce Mattel’s loss …”

Mattel mixed apples and oranges.

The reserve for potential loss for “A” should not have been reduced by an event from acquisition “B”. Events A and B were not related to each other.

 

My next book, 25 Intermediate Accounting Spreadsheets (and How to Use Them) will be out in 2020. The format will include a written discussion of a spreadsheet, with spreadsheet images, and a related video.

 

To learn more and get sample chapters of the book, watch this video.

 

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Ken Boyd

Author: Cost Accounting for Dummies, Accounting All-In-One for Dummies, The CPA Exam for Dummies and 1,001 Accounting Questions for Dummies

(email) ken@stltest.net

(website and blog) https://www.accountingaccidentally.com/