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BUS 424 Chapter 7

Earnings management
Techniques used to “hype” a firms numbers
Fraud
Deception or misrepresentation that an individual or entity makes knowing that the misrepresentation could result in some unauthorized benefit to the individual or entity or some other party
Most common work factors pushing management to deceive:
Greed
Work pressures
Financial statement fraud usually occurs with…
Management’s knowledge and blessing

Opportunity exists because of management’s position within the organization

Typical methods to commit fraud:
Moving revenue to an earlier period

Delaying expense recognition to a later period

Common ways to manipulate revenue:
By recording it:
1. Before the product is delivered to the customer
2. Recording it before the sale is complete
3. Recording it at a time when the customer can still terminate the sale
Earnings Management
Occurs when companies artificially inflate (or deflate) their revenues or profits, or earnings per share (EPS) figures

An excessive zeal to project smoother earnings from year to year that casts a pall over the quality of the underlying numbers

Due to a “culture of gameship to exceed financial analyst expectations”

Earnings management asks…
“How can be best report desired results?” rather than “How can we best report economic reality?”

Pressure to make the numbers ? meeting or beating Wall Street projections

Representational Faithfulness
An important quality of useful information:
-To represent the transactions faithfully in the financial statements
-Should be based on economic substance (not the legal form)
Motivation for Earnings Management
1. Meeting or beating the Wall Street projections
2. Violating of debt covenants – managers don’t want to violate terms of a debt contract
3. Income smoothing
Low-low organizational fit
More likely to lead to unethical choices
Earnings management is detrimental to…
The long-term value of the firm and the capital market
Some earnings management techniques are…
***Perfectly acceptable under GAAP***

But not all of them are – legal penalties can result

Waste Management Fraud (1999)
Violated antifraud provisions in 1999

Made financial projections that were unreasonable due to significant adverse trends

Was planning to use earnings management to meet the projection

Income Smoothing
Income smoothing ? occurs through the use of accounting techniques to level out net income fluctuations throughout consecutive periods

Ideal pattern ? a steady increase each year
-Make it look like the company is growing
-Gives manager credit for positive results
-Increases stock price

Investors willing to pay premium for stocks with steady and predictable earnings streams

Use of “cookie jar” reserves

“Cookie Jar Reserves”
Set aside reserves in good years
Used to prop up earnings in bad years
HealthSouth case

Reserves of money used to smooth out income over time

Can be used to ‘increase’ the trend of earnings
Distort the financial statements

2 ways earnings management is accomplished:
1. Using aggressive accounting techniques such as capitalizing costs that should have been expensed (WorldCom)
2. Establishing/altering the elements of an estimate to achieve a desired goal (Waste Management)
Two categories of Earnings Management
1) Operating earnings management
Examples: deferring necessary expenditures to a subsequent year, offering unusually attractive terms to customers at the end of the year

2) Accounting earnings management
Examples: changing accounting methods, recording expenses in the wrong year, changing inventory valuation

Operating earnings management
Altering operating decisions to affect cash flows and net income
Accounting earnings management
Flexibility in accounting standards to alter earnings numbers
Problem with proving earnings management was an appropriate decision or an intent to deceive:
Managerial intent is unobservable

Rest’s model ? ethical intent is an essential ingredient in moral decisions

Acceptability of earnings management should be based on…
An ethical framework

Ex. Virtue ethics examines the reasons for actions taken by the decision maker as well as the action itself
-Does earnings management violate honesty?

One might be able to rationalize the ethics of earnings management from…
Act-utilitarian perspective

Decision made by weighing benefits to management and the company versus the costs of using potentially misleading information

Rule-utilitarianism is different for earnings management because…
States that earnings should never be manipulated for personal gain regardless of any utilitarian benefits
Needle’s Continuum
Illustrates a possible basis for judgments that vary in materiality and how an auditor might go about accepting management’s position on the issue
Corporate Ethical Values
The individual values of managers and both the formal and informal policies on the ethics of the organization

Tone at the Top ? ethics consideration by management

Accountants with high ethical values perceive earnings management as…
Unethical
Bruns and Merchant Survey
Managers disagreed on if earnings management is ethically acceptable

EM by operating decisions was found to be “more ethical” than manipulation by accounting methods

Sunbeam Fraud
Choosing to reduce income by increasing a reserve account with an offset that increases expenses

CEO Al Dunlap ordered accountants to create reserve account

Showing net loss works to advantage in the long run ? future periods would look like Sunbeam was ‘growing’

“Cookie jar effect” while portraying company as looking worse than it really is (used later as a big bath)

“Big Bath Accounting”
Use of cookie jar reserves to further increase losses in a down year and reserving it to look like income in subsequent years
Revenue Recognition Principle
Revenue should be recognized when the firm has delivered a product or has produced a substantial portion of it and the cash receipt is reasonably certain
Accruals and Earnings Management
Provide management with the opportunity to manage earnings through: ESTIMATIONS
-Aggressive estimations
-Conservative estimations

Waste Management Fraud

Types of Accruals
1) Discretionary accruals: items that management has full control over and is able to delay or eliminate
-Used in earnings management
-Because up to manager discretion
-Controllable estimations

2) Nondiscretionary accruals: items that are estimated based on changes in the economic performance of the firm, management has no control over them

What type of accruals is typically used in earnings management?
Discretionary
Materiality
The judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement

Information is material for securities fraud purposes if a reasonable investor would have deemed it as having meaningfully altered the total mix of information

Acceptability of earnings management requires…
A materiality perspective
SOX…
Increased demands on management to prevent and detect material control weaknesses
Section 302 of SOX
Companies are required to:
1. Review their disclosure controls and procedures quarterly
2. Identify all key control exceptions and determine which are internal deficiencies
3. Assess each deficiencies impact on the fair presentation of the financials
4. Identify and report significant control deficiencies/material weaknesses to the audit committee of the BOD and to the internal auditor
Operating Failure – Internal Control
An adequately designed control does not operate properly
3 components of audit risk
1) Inherent
2) Control
3) Detection
Inherent Audit Risk
The possibility that a material misstatement will occur within the reporting company’s accounting info system
Control Audit Risk
The possibility that a material misstatement that has occurred will not be detected on a timely basis by the company’s control system
Detection Audit Risk
The possibility that a material misstatement that has occurred will not be caught by the independent auditor’s testing
Risk of Material Misstatement
Inherent Risk + Control Risk
Gemstar Fraud
-Illustrates danger of using only a quantitative analysis to make materiality judgments
-Audit by KPMG ? auditors unreasonably relied on representations by Gemstar management
-Unreasonably determined that revenues were immaterial to Gemstar financial statements
-Considered only quantitative materiality factors ? failed to consider qualitative materiality
-Materially overstated revenues
Financial Statement Restatement
Occurs when a company, either voluntarily or under prompting by auditors/regulators, revises its public financial information that was previously reported

Increased during 2000-2006 period ? many companies disclosed accounting frauds

Gone down since 2006

The SEC requires companies to disclose within ___ business days a determination that a financial can no longer be relied on
4
Financial statements should only be amended if the error would be ___________ to investors making current investment decisions
Material
Restatements Due to Errors
Switching from non-GAAP to GAAP ? error correction that requires restated financials and disclosure to the SEC

Revenue recognition Reserves/allowances
Expense recognition Inventory
Misclassification Capital assets
Equity Other comprehensive income
Liabilities/contingencies

5 Earnings Management Techniques
1. Big Bath Charges
2. Creative acquisition accounting
3. Cookie-jar reserves
4. Materiality
5. Revenue Recognition
1. Big Bath Charges
When a company resorts to taking a one-time large restructuring charge/write-down as opposed to appropriately recording the losses over several fiscal years

-Sunbeam Fraud
-To avoid successive years of earnings decline

2. Creative Acquisition Accounting
When following a business acquisition, the acquirer allocates the bulk of the total purchase price to the acquiree’s in-process research and development as opposed to long-lived assets as mandated by GAAP

-Huge expense in year of acquisition
-Earnings in future years would not be so affected by the acquisition costs

3. Cookie-jar Reserves
Objective is to smooth out net income over time

1. A company with recorded revenues overstates its bad debt expense in a quarter/year to as to record little bad debt expense in future years when it expects to have below-average revenues (Lucent case)

2. A company understates revenues by inflating unearned revenues to pad revenue figures in future years if they fall below market expectations

4. Materiality
A gray area in accounting, subject to different interpretations

Questionable accounting practices with seemingly immaterial monetary effects in order to meet or beat analysts earnings expectations

***Misstatements should be considered material if it is likely the stock price would decline if it was corrected

5. Revenue Recognition
Some companies accelerate recording of revenues to help meet analyst earnings projections, increase year-end bonuses, improve share price, etc.

HealthSouth Fraud (contractual allowances)

Financial Shenanigans
Actions or omissions intended to hide or distort the real financial performance or financial condition of an entity
Financial Shenanigans: 2 basic strategies
1. Inflating current reported income ? inflate current income by inflating current revenues and gains or deflating expenses

2. Deflating current reporting income ? deflate current revenues by deflating revenues/gains or inflating expenses

7 common financial shenanigans
1. Recording Revenue Too Soon/Questionable Quality
2. Recording Bogus Revenue
3. Boosting Income with One-time Gains
4. Shifting Current Expenses to a Later/Earlier Period
5. Failing to Record/Improperly Reducing Liabilities
6. Shifting Current Revenue to a Later Period
7. Shifting Future Expenses to the Current Period as a “Special Charge”
Recording Revenue Too Soon/Questionable Quality
Most common financial shenanigan technique:
-Record revenue before earnings process has been completed or before the exchange has occurred
-Future services have yet to be provided
-Record before shipment is complete
-Customer not obligated to pay
(Xerox Case)
Recording Bogus Revenue
Fictitious revenue
Sales lack economic substance
Fake companies
(ZZZZ Best Case)
Boosting Income with One-time Gains
Gains from sale of assets classified in other ways when intent is to boost income
Boost profits by selling undervalued assets
Investment income/gains as part of revenue
(IBM Case)
Shifting Current Expenses to a Later/Earlier Period
Capitalizing a cost in the current period rather than expensing it
Reducing asset reserves/failing to write off impaired assets
(WorldCom Case)
Failing to Record/Improperly Reducing Liabilities
Liabilities are often used to manipulate earnings
Expenses are also understated ? overstates earnings
Releasing cookie-jar reserves into income
Recording revenue when future obligations remain
Failing to record expenses/liabilities when future obligations remain
Discretionary accruals
Shifting Current Revenue to a Later Period
Delay revenue when amount is high in a given year
“Rainy day” reserve for future years
Cookie-jar reserve with excess revenues to release back to income at later date
Using deferred revenue
(Microsoft Case)
Shifting Future Expenses to the Current Period as a “Special Charge”
Accelerate discretionary expenses (repairs and maintenance) into current period
If current revenue is high, can shift future expenses into current period
Smooths out net income
Xerox Case
-Accelerated 3M in equipment revenues –> financial shenanigan #1
-Fraudulent Lease Accounting:
Increased lease revenues at inception of the lease and reduced amount recognized over life of the lease
-No matching of revenue in period which:
Financing was provided
Copier supplies were provided
Repairs were made to lease equipment
-Cushion Reserves:
Reserves closed gap between actual results and earnings targets 1997-2000
-Sanctions by SEC on KPMG ? issued cease-and-desist order against KPMG
Lucent Technologies Case
-Lucent used software pool agreement transactions to manage earnings and smooth income over time
-BOD and audit committee not involved or turned away from obligations
-SEC complaint alleged that Lucent fraudulently and improperly recognized $1.148B of revenue during 2000
-Motivated by drive to realize revenue and meet sales targets
Enron Case
-Structuring financial transactions to keep debt off the books and report higher earnings
-Special-Purpose Entities:
CFO Andy Fastow created a number of ‘partnerships’
“Cactus” ventures took money from banks and gave it to energy producers in return for gas reserves ? gave producers $ and Enron gas over time
SPE enables Enron to keep debt off the books while benefiting from the transfer and use of cash borrowed by the SPE
**Did not initially violate GAAP** – but eventually negated conformity to GAAP with so many SPEs
Culture at Enron
During fraud, tension grew when employees started working ridiculous hours

Employee evaluation policy ? “rank and yank” firing people at the bottom 20%

Tool for managers to reward loyalists and punish dissenters ? cutthroat system

Top management was given large payouts, and the desire for more became a part of a culture for greed

Enron – Chewco
1997 ? Enron entered a number of partnerships to inflate earnings

BOD waived requirement for Fastow; could be involved with CHEWCO in order to meet accounting requirements by year end ? violated code of ethics

Chewco, Fastow’s involvement, the board approval, and a rapid approval process were all due to lack of internal controls

FASB Rules on SPEs
Establish mechanism to encourage companies to invest in needed assets while keeping the related debt off the books –> sometimes use is legitimate

Controls risk if project fails

“Creativity” of Fastow was to use this less-than-well-known technique to satisfy Enron’s unique needs

Reinterpretation of SPEs by FASB
FASB issued in 2003 a revision of its interpretation ? unconsolidated variable interest entities must be consolidated by primary beneficiaries if the entities do not effectively disperse risk among parties involved

No more percentage ownership test (3% Enron)

Dispersion of risk now determines that consolidation status

Enrons role in creation and passage of SOX
Enron case was direct cause of congressional passage of SOX
Effects:
1. Prohibiting the provision of internal audit services for audit clients (Andersen at Enron)
2. Requiring off-balance sheet financing activities to be disclosed in the notes of financial statements
3. Requiring related-party transactions be disclosed in the notes

Ken Lay and Jeff Skilling found guilty of fraud and conspiracy

A tone at the top can…
Create a culture of making deals regardless of risks
Internal controls at Enron were either ignored or overridden by management
Example: Andy Fastow and Chewco, waived ethics policy to allow Fastow to control Chewco while also serving as CFO
-***Conflict of interest***
Moral of the story on Enron Case:
Weak internal controls can lead to possible fraud

Ethical tone at the top helps to prevent fraud

Ethical slippery slope ? sets company on a dangerous course

Bottom line factor = greed of top management

Earnings Quality
Current earnings are considered to be high quality if they serve as a good guide to the long-run profits of the firm

CFOs believe earnings are high quality when they are sustainable and backed by actual cash flows

3 red flags CFOs say indicate earnings management:
1. Persistent deviations between earnings and underlying cash flows
2. Deviations from industry and other peer experience
3. Large and unexplained accruals and changes in accruals
Fraud results from a lack of…
Professional judgment
Financial reporting needs to focus more on…
Representational Faithfulness

Even faithful does not always mean 100% accurate

“Reliability”
A qualitative characteristic of useful information with representational faithfulness
5 types of financial statement fraud:
1. Fictitious sales
2. Improper expense recognition
3. Incorrect asset valuation
4. Hidden liabilities
5. Inadequate disclosures
A ___________ of public companies engage is some type of earnings management
vast majority
BOD should…
Focus on long-term strategic goals, and shield managers from short-term pressures
Some earnings management techniques are…
Acceptable under GAAP
Waste Management Fraud
Provided false earnings guidance

Substantial monetary penalties incurred

Executives also had illegal insider trading

Used aggressive estimates for accruals

McKee – Positive Light on EM
“Reasonable and legal management decision making and reporting intended to achieve stable and predictable financial results”

McKee’s explanation is merely a rationalization:
-Doesn’t hold true to virtues of honesty and dependability
-Ignores rights of creditors/investors to receive fair and accurate information
-Masks true performance

Audit committee members with less financial knowledge…
Are more likely to accept insufficient client explanations for poor accounting judgment
Case of Sunbeam Corporation
“Cookie Jar” reserves
Set aside amounts of revenue to be taken out to boost earnings when needed in future

“Big bath accounting”
Creates cookie jar effect while portraying the company as looking worse than it is
Dunlap thought he could do this and blame it on previous CEO

SAB 99…
Lists qualitative factors affecting materiality

Find it unacceptable to have exclusive use of percentage materiality criteria

Design Failure – Internal Controls
When management fails to establish sufficient internal controls
Vorhies 4 perspectives to help meet SOX Requirements:
1. The actual financial statement misstatement/error
2. An internal control deficiency due to failure in design or operation of a control
3. A large variance in an accounting estimate compared with the actual determined amount
4. Financial fraud by management or other employees to enhance in company’s reported financial position and operating results
Estimating financial events….
Is necessary as long as it is legal
Motivation for Xerox:
Polish its reputation on Wall Street

Boost stock price

Motivation for Lucent:
Drive to realize revenue
Meet internal sales targets
Obtain sales bonuses
Auditors for Xerox and Lucent
KPMG
Motivation for Enron:
Started because debt load was high and needed to finance borrowings that would not be shown on balance sheet

Needed long-term supply contracts, but these were not available in current market (too risky to invest)

Fastow’s Special-Purpose Entities
To entice producers to invest in Gas plan, Enron needed cash to offer up front

Began to create partnerships that took money from banks and gave it to producers in return for a portion of existing gas reserves

Enron created Chewco to…
Buy out its partner in another venture, JEDI:
-Virtually no outside ownership
-Managed by a protégé of Fastow, Michael Kopper
-Not permitted by Code of Ethics, but waived by Board
-Allowable through a lack of internal controls
Sherron Watkin’s Role (Enron)
Sharron Watkin’s letter to Ken Lay, former and now current CEO and chair of board of directors – company will “implode in a wave of accounting scandals”

Described in detail problems with Enron’s partnerships

Assigned to be investigated by Vinson & Elkins

Lawyers stated no reason for concern

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