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(EM) Earnings Management June 28, 2006. Group Members Alfred D’Souza Aman Gill Eric Lindsay Mary Guo Michael Flaman Ranbir Khangura Tammy Cheung.

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Presentation on theme: "(EM) Earnings Management June 28, 2006. Group Members Alfred D’Souza Aman Gill Eric Lindsay Mary Guo Michael Flaman Ranbir Khangura Tammy Cheung."— Presentation transcript:

1 (EM) Earnings Management June 28, 2006

2 Group Members Alfred D’Souza Aman Gill Eric Lindsay Mary Guo Michael Flaman Ranbir Khangura Tammy Cheung

3 What is Earnings Management? What motivates Earnings Management? Common Approaches Example – Krispy Kreme Consequences Agenda

4 What is Earnings Management? Healy and Wahlen, 1999 “Earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers.”

5 What is Earnings Management? Schipper (1989) “… a purposeful intervention in the external financial reporting process, with the intent of obtaining some private gain (as opposed to merely facilitating the neutral operation of the process”

6 Worldcom (1999 –2002) –$ 9 billion overstatement through release of improper reserves Xerox (1997 –2000) –$ 3 billion accelerated revenue recognition –$ 500 million though ‘cushion’ reserves –SEC levied $ 10 mm in fines –No admission of guilt Lucent Technologies, Cendant, MicroStrategy (2000) –Stock market lost 34 billion in three days EM – Recent Examples

7 “Conservative” Accounting “Aggressive” Accounting “Fraudulent” Accounting Aggressive recognition of provisions and reserves Overvaluation of R&D purchase acquisitions Overstate asset write-offs Understate provision for bad debts Drawing down provisions/reserves in an overly aggressive manner Recording sales before realizable; recording fictitious sales Backdating sales invoices Overstating inventory Within GAAP Violates GAAP Earnings Management Fraud vs. Earnings Management

8 Determined by motive. When is EM Fraudulent? EM and accrual methods are fraudulent under the following circumstances: – 1. When they are used to satisfy analysts’ expectations. –2. When they are used to realize bonuses. –3. When transactions are structured or carried out to alter financial reports. –4. Whenever they are used for reasons other than to provide accurate financial information to investors and stakeholders

9 Manipulate the company’s earnings so the figures match a pre-determined target Is Accrual Accounting a form of EM? Accrual accounting uses accrual, deferral, and allocation to reflect an entity’s performance during a period Managers use GAAP to make reporting decisions Enables its investors to assess the entity’s economic performance more accurately than from just cash flows

10 Qualitative vs Quantitative Earnings Size matters. Most investors look at cents per share when analyzing earnings Quality earnings have 3 basic qualities: –Repeatable –Controllable –Bankable

11 Repeatable In the 3rd quarter of 2001, Motorola posted earnings per share of 4 cents, beating analysts’ expectations, but the stock fell 15% soon after. – The reason? Sales had shrunk, and the economy was soft. Most of the earnings growth came by way of job cuts and the sale of investments

12 Controllable Some U.S companies with European subsidiaries are reporting earnings that are better than expected. – The Reason? The falling U.S dollar has improved earnings via the exchange rate. Inflation can also affect earnings through the prices of inputs and outputs.

13 Bankable In 2002, Circuit City’s stock price fell over 40% even though both sales and earnings showed sizable increases. – The Reason? The size of the company’s Accounts Receivable had more than doubled creating concerns around their collectibility

14 Why is EM not acceptable? Misallocation of Investment Resources Undue improvement in management credibility MD&A provides room to explain variance in performance Sign of Compromised Collusive Auditing

15 What is Earnings Management? What motivates Earnings Management? Common Approaches Example – Krispy Kreme Consequences Agenda

16 Why does EM occur? Three main reasons: Capital Market Expectations and Valuation (Earnings Shock) Contracting Motives Anti-trust and Government Regulations

17 Capital Market Motivations Sample motives: Short term stock price performance Valuation prior to management buyouts E.M. to meet the expectations of financial analysts

18 But… studies show investors “see through” such E.M. and instead rely on long term strategy when allocating resources Capital Market Motivations Sample methods: Income increasing depreciation methods and allowances in year prior to IPO Income smoothing

19 Earnings Shock Positive earnings surprises usually aren’t significantly rewarded by the market. Negative earnings surprises are penalized harshly The Reason Earnings targets are usually conservative. Every subsequent positive shock has less of an impact.

20 Earnings Shock cont’d… Positive earnings surprises tend to be more frequent than negative earnings surprises as companies try to ‘beat down’ expectations Interim Reports are not audited, thus creating more opportunity to manage earnings

21 But… Study showed only 5 of 22 firms delayed default through E.M. Contracting Motivations 1. Lending Contracts Managers manage earnings to ensure compliance with existing lending covenants (i.e. debt service coverage or debt equity ratios)

22 But… study shows personally motivated E.M. has little effect on asset allocation Contracting Motivations 1.Management Compensation Contracts Managers use judgment to increase earnings based bonus awards Managers manage earnings when job security is threatened

23 Strong evidence that E.M occurs when companies are on verge of violating regulatory provisions. Regulatory Motivations Industry Regulations Banks required to satisfy capital adequacy requirements Insurance companies must meet conditions for minimum financial health Utilities companies have been historically permitted to earn normal return on invested assets

24 Study: Companies being investigated for anti- trust violations report income decreasing accruals Regulatory Motivations Anti-Trust Regulations Companies on verge of investigation may manage earnings to appear less profitable

25 What is Earnings Management? What motivates Earnings Management? Common Approaches Example – Krispy Kreme Consequences Agenda

26 How are Earnings Managed? ‘Big Bath’ Restructuring Cookie Jar Reserve Accounting Premature Revenue Recognition –Camouflage of ‘Hold and Sale’ transactions –Transporter picks up risk of loss –Uncertainty at cut off date –Inflating standard orders Expected lives of long term assets Obligations for pension benefits Deferred Taxes

27 1)Tuck away- create the Cookie Jar 2)Dip into the Cookie Jar – reversal of accruals 3)Can’t manage growing market expectation 4)No real cash flow - Scraping the bottom Typical Stages of EM

28 How are Earnings Managed? Cont.. Deference of Asset Impairment FIFO vs LIFO methods of accounting (e.g.hyper inflationary countries) Accelerated Declining method of Amortization Working Capital Management – delayed shipments Timing of capital gains

29 Other Sophisticated methods Off Balance Sheet reporting in subsidiaries Synthetic Leases Pro-forma Estimates Inter-company transactions

30 Some Special Cases Banks – Loan Loss Reserves Insurance Companies – Claim Provisions Large Petrol Chemical Projects – Deferred Tax Allowances Business Combos – creative acquisition accounting Equity structuring to avoid / require consolidation

31 How auditors detect EM Cash flows that are not correlated with earnings Receivables that are not correlated with revenues Allowances for uncollectible accounts that are not correlated with receivables Reserves that are not correlated with revenue growth or balance sheet items Questionable acquisition reserves –restructuring charges or reserves set aside for disposals Earnings that consistently and precisely meet analysts’ expectations

32 S&P’s Core Earnings Metric Attempts to provide consistency and transparency related to earnings Created with the input of the investment community Clearly defines what can and cannot be included as Revenues and Expenses

33 What’s In  Employee stock option expenses  Restructuring charges  Pension fund costs  Purchased R&D expenses  Write-downs and depreciable operating assets What’s Out  Goodwill impairment  Gains/losses from asset sales  Pension gains  Litigation costs/proceeds  Unrealized gains from hedging activities S&P Core Earnings

34 Critique – S&P’s Core Earnings Can option expenses be fairly priced? –Black-Scholes produces highly subjective results; especially with volatile stocks Pension plan gains are excluded, but losses are included. –If returns are down in a given year, earnings will be penalized even if the plan is flush

35 What is Earnings Management? What motivates Earnings Management? Common Approaches Example – Krispy Kreme Consequences Agenda

36 Krispy Kreme - What Went Wrong?

37 Background Information KKD began in 1937 in the southeast U.S. Began going national in 1996, opening stores in Manhattan, L.A, Los Vegas Declared “Hottest Brand in the Land” by Fortune Magazine IPO took place in 2000

38 KKD: Initial Public Offering IPO in 2000, just after the tech bubble burst Investor’s were eager for a business they could understand Considered one of the best IPO’s of that year IPO price: $21…. by August 2003: $50 2004: $665.6 MM in sales, $94.7 MM in profit, 400 total stores (Australia, Canada, Korea)

39 KKD: Canadian Rights Owned by KremeKo Inc. under exclusive franchising and licensing arrangement (2000) KremeKo required to open 32 stores within 7 years ($US 40,000 pre store plus royalties)

40 What happened? May 2004: First ever missed quarter and first loss as a public company (CEO blames low carb diets) July 2004: SEC makes an informal inquiry into KKD buybacks of several franchises Stock price plunges, shareholders file suit Oct. 2004: SEC inquiry upgraded to “formal” KKD continued to add stores, though sales were falling Jan.2005: KKD decides to restate financials; CEO replaced by Stephen Cooper, who kept his other job as interim CEO of Enron.

41 Management’s decision to include ingredient and equipment sales does not accurately reflect overall health of company = E.M. How KKD Managed Earnings? Getting Greedy KKD required franchisee’s to buy equipment and ingredients at marked up prices 31% of 2003 came from selling ingredients and equipment KKD concentrated on growing parent company sales instead of franchisee profits

42 How KKD Managed Earnings? Synthetic Lease KKD financed a $35 MM mixing plant with an off-balance sheet synthetic lease Permissible only when lessee has no intention of acquiring leased property at term end “Mixing Plant” should be technically an asset to the company and should be recorded on balance sheet KKD scuttled this plan in Feb.2002 after Enron

43 How KKD Managed Earnings? Fudging the Numbers Oct. 2003: Company acquired seven Michigan based franchises for $32.1 MM Purchase price recorded as intangible asset (Reacquired Franchise Rights), which it did not amortize Purchase price was inflated so seller could make interest payments so vendor could pay interest for past due loans Interest was recorded as income

44 How KKD Managed Earnings? Additional Items KKD rolled store closing costs, consulting fees into intangible capital asset account KKD bought California based franchises at inflated prices which were owned by CEO’s ex-wife KKD bought Dallas based stores at inflated prices that were partly owned by former director and board member KKD employed 3 different CFO’s from 2000-2004

45 KKD’s Motives Extreme pressure to satisfy expectations of public market Personal benefit by paying excess amounts for franchises Company faced S.E.C. inquiries CFO’s jobs were not secure

46 What is Earnings Management? What motivates Earnings Management? Common Approaches Example – Krispy Kreme Consequences Agenda

47 Reaction from Stake Holders- Extreme Distrust Dump stock on news of Managed Earnings Increased reliance on non financial information –Investment bankers –Financial analysts –Bond Rating Agencies –Financial Press Class action suits – Nortel

48 Debatable Over Reactions Stop earnings guidance –Coca-Cola Reward share-holders with trustworthy book-keeping not earnings Class action suits against auditors

49 Reality The markets are still more reliant on earnings reports than on cash flows Management judgment better indicator of future earnings than fluctuating cash flows Almost every one does it in some way


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