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Earnings Management What is earnings management? Why do managers do it? How do they do it? How can we detect it?

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Presentation on theme: "Earnings Management What is earnings management? Why do managers do it? How do they do it? How can we detect it?"— Presentation transcript:

1 Earnings Management What is earnings management? Why do managers do it? How do they do it? How can we detect it?

2 What? Aggressive Accounting Earnings Management Income Smoothing Fraudulent Reporting Creative Accounting

3 What? The active manipulation of accounting results for the purpose of creating an altered impression of performance. Managers choosing accounting policies so as to maximize their own utility and/or the market value of the firm.

4 Accounting Tricks - Examples Waste Management Inc. – Understated depreciation and capitalized interest improperly, failed to write down impaired assets. Total restatement $2 billion.

5 Waste Management Overstated Income

6 Accounting Tricks - Examples WorldCom – Recorded expenses as capital expenditures, double- booked revenues, booked revenues as cost reductions. Total restatement $4.6 billion

7 WorldCom – Reported vs. Restated EBITDA

8 How would you detect this type of fraud? A decrease in the asset turnover ratio. A fictitious asset cannot produce revenue PPE increases while revenue decreases When an expense that is fixed remains constant as a percentage of sales, despite decreases in revenue Possible from disclosures on significant accounting policies Writing off previously capitalized cost

9 Ratio Analysis 2 nd Qt 2000 to 1 st Qt 2002 Line costs/revenue 40.73% 38.49% 42.53% 42.26% 41.83% 41.77% 42.09% 42.84% Asset Turnover 10.47% 10.16% 9.71% 9.76% 8.74% 8.55% 8.16% 7.82% Sales/PPE 59.2% 55.1% 47.4% 45.5% 44.1% 40.7% 35.6% 32.2%

10 Accounting Tricks - Examples Xerox – Recorded revenue on long-term leases of copiers prematurely. Total restatement $3 billion (but part of this increased later revenues).

11 Xerox – Reported and Restated Revenue

12 How would you detect? Examine Days in receivables – if this increases because revenue is being recognized significantly earlier than it is collected. The relationship between CFFO and revenue significantly decreases

13 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.

14 Adelphia Debt Load $3.5 Billion $12.6 Billion ReportedActual

15 Accounting Tricks - Examples Sunbeam – Inflated revenues by channel stuffing and bill &hold. Reduced expenses by capitalizing advertising costs, reducing allowance for bad debts.

16 Sunbeam – Revenues and Net Income

17 Signals of this type of fraud Days in Receivables increases An increase in Gross Margin percentage CFFO falls Change to a more aggressive revenue recognition policy Offers large discounts or other inducements to get orders Revenue is recorded despite a right of return

18 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.

19 Rite-Aid – Net Income Restatement

20 Detecting overstated inventory Not recording “shrinkage” of inventory Recognizing rebates from vendors before Rite Aid actually sold the goods

21 Accounting Tricks - Examples Enron - Hiding debt and losses in unconsolidated entities

22 Enron – Reported and Restated Net Income

23 Why? -- Share price effects -- Borrowing cost effects -- Bonus plan effects -- Political cost effects

24 How? 1. Flexibility of accounting principles 2. Choices, estimates, & judgments 3. Rule-based accounting loopholes

25 How? 1. Flexibility of accounting principles What problems does choice create? Choices: –Inventory –Depreciation –Expensing vs. Capitalizing –Software sales recognition Why do we allow choices?

26 –warranties How? 2. Choices, Estimates, & Judgments Depreciation –method –useful life –salvage value Allowance accounts –bad debts –sales returns

27 Choices etc., cont’d. Asset and goodwill impairments Restructuring costs Inventory write-downs Environmental liabilities Pension assumptions In-process R&D Percentage of completion contracts

28 What is principle-based accounting? –What are its advantages and disadvantages? How? 3. Rule-based versus principle-based accounting What is rule-based accounting? –What are its advantages and disadvantages? Sickening example – SPE’s

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