Presentation on theme: "Earnings Management Ch 16 Accounting Information for Decision Making Rick Hayes, Ph.D., CPA California State University L.A."— Presentation transcript:
Earnings Management Ch 16 Accounting Information for Decision Making Rick Hayes, Ph.D., CPA California State University L.A.
Earnings Management A conscious manipulation of accounting processes or numbers to make a company's operations or financial position look better in order to gain some benefit for themselves or to increase the stock price of the firm. represents active manipulation of or conscious choices in the accounting results that produce an altered perception of the performance of an entity
Incentives to Manipulate Earnings Budget versus actual Bonuses Influence Wall Street analysts Make stock options more valuable Comply with debt covenants
Manipulating Information Pro-forma earnings – SEC ruling have to show GAAP equally Selective release of information – Insider trading – Regulation Fair Disclosure (FD) should be released simultaneously to all groups
Revenue/Gain – Sales Returns and allowances Cost of Sales Depreciation/amortization Expense Net Income/loss Accounts Receivable Allowance for Bad Debt Inventory Allowance for Obsolete Inventory Investments Current Assets Fixed Assets Intangible assets Total Assets Accounts Payable Accrued Payables Warranty Liability Current Liabilities Retained Earnings Total Liabilities and Equity Expense
Flexibility of accounting principles Choices: –Inventory (LIFO, FIFO, Average Cost, Specific ID) –Depreciation (straight line, accelerated, time, salvage) –Expensing vs. Capitalizing (asset or expense?) –Allowance Accounts (uncollectable, obsolete
Manipulating Revenue Most frequently used Keep books open past cut-off Bill and Hold Channel stuffing Not recording returns and allowances Incorrect percentage of completion in long term projects
Deferring Expenses Not recognize expenses in proper period (violating matching principle) Unrealistic estimates (allowance for uncollectable accounts, depreciation, warranty, obsolete inventory, etc.) Not writing down assets when they become impaired Capitalizing expenses
Off Balance Sheet Debt Transferring liabilities to Special Purpose Entities (SPEs) Transferring poor performing assets to SPEs Incorrectly guaranteeing debt of SPEs Improper leases
Income Smoothing Smooth earnings so that it always meets or exceeds analysts expectations Taking “big bath” in bad years Reversing special allowances (reorganization allowance) Creating the affect of no volatility in net income
Detecting Earnings Manipulation Change in ratios and trends Difference from industry data Reasonable testing – Revenue and Accounts receivable – Inventory and cost of sales – Bad debt, warranty and other allowances as a percentage of sales
Accounting Tricks - Examples Waste Management Inc. – Understated depreciation and capitalized interest improperly, failed to write down impaired assets. Total restatement $2 billion.
Accounting Tricks - Examples Adelphia – Hid billions in debt off-balance sheet in unconsolidated subsidiaries, diverted undetermined millions to the family stockholders, inflated subscriber numbers in press reports, overstated earnings.
Accounting Tricks - Examples Rite-Aid – Inflated revenues by recording vendor rebates that pertained to future purchases. Reduced expenses by capitalizing expenses, not recording certain expenses, failing to write off inventory shrinkage, understating depreciation.