3 Earnings Management Operating & discretionary accounting methods to adjust earnings to a desired outcome; the incentives of management to modify earnings in their own best interests Earnings manipulation includes aggressive earnings management and fraud
4 Why Earnings Management? “It pays to do it, it’s easy to do,and it’s unlikely that you’ll get caught (Schilit) Opportunism: self-interest with guile— violating normal ethical boundaries for personal gain Executive incentives include bonuses and stock options
5 Incentives for F.S. Fraud Incentives to commit financial statement fraud are very strong. Investors want decreased risk and high returns. Risk is reduced when variability of earnings is decreased. Rewards are increased when income continuously improves. Which firm will have the higher stock price? Firm AFirm B
6 An Accepted Practice March 31, 1997 LEARN TO PLAY THE EARNINGS GAME (AND WALL STREET WILL LOVE YOU) “The pressure to report smooth, ever higher earnings has never been fiercer. You don't want to miss the consensus estimate by a penny--and you don't have to.” Fortune Magazine
7 An Accepted Practice “In January 1997, for the 41st time in the 42 quarters since it went public, Microsoft reported earnings that met or beat Wall Street estimates. General Electric, a company whose name invariably comes up when you ask Wall Streeters about earnings management, says it does what it does because the stock market demands it. "We think consistency of earnings and no surprises is very important for us," says Dennis Dammerman, the company's CFO. FORTUNE's 1997 Most Admired list, seven--Coca-Cola, Merck, Microsoft, Johnson & Johnson, Intel, Pfizer, and Procter & Gamble--have missed fewer than five quarters in the past five years”
9 The Corporate Governance Environment Corporate governance practices signal the potential for earnings management—permissive structures indicate that manipulation is more likely The board of directors sets overall policy & provided oversight for operating activities Historically, boards were composed mainly of owners, managers & other insiders It is now clear that a majority of independent board member is essential for effective oversight
10 Concerns with the Board of Directors Is the CEO also the chairman of the board? Evidence of CEO oversight abuse Are a majority of board members independent? What are the board committees & is there evidence that they’re active & effective Evaluate board compensation—is it based on performance & active participation
11 Concerns with Executive Compensation Evaluate the compensation committee for independence & competence Analyze the executive compensation (especially the CEO) by component: base pay, bonuses, stock options (& other forms of ownership- related compensation) & perks Is compensation based on performance? Evaluate based on earnings & stock price performance Particular concerns are for over-compensation of CEO for poor performance & impact of previous accounting-related abuses
12 Concerns with Auditing Evaluate the audit committee for independence, competence with financial information, how many times the committee meets & other evidence of diligence Review audit procurement practices, including the external auditor (usually a Big 4 firm), non-audit fees, the audit opinion & timeliness of reports
13 Stock Options Options grant the holder the right to purchase stock at a set price (exercise price) over some fixed time period, usually the closing price at the issue date Options are a one-directional participation in the success of the company—the employee benefits (will exercise the options) only if the stock price goes up. If the price goes down, there is no loss the the employee Ideally options give employees the incentives to behave as owners of the company
14 Alternative to Stock Options The use of stock options has been criticized since the recent scandals Many companies are moving to alternative methods of employee participation in ownership, including restricted stock, phantom stock & stock appreciation rights
15 Environment for Earnings Management Strong CEO with substantial perks Board made up primarily of insiders Poor board committee structure Audit problems Executive compensation problems Investment banking problems
16 Effects of Financial Statement Fraud Undermines the reliability, quality, transparency, and integrity of the financial reporting process Jeopardizes the integrity and objectivity of the auditing profession, especially auditors and auditing firms Diminishes the confidence of the capital markets, as well as market participants, in the reliability of financial information Makes the capital markets less efficient
17 Effects of Financial Statement Fraud Results in huge litigation costs Destroys careers of individuals involved in financial statement fraud. Causes bankruptcy or substantial economic losses by the company engaged in financial statement fraud
18 Effects of Financial Statement Fraud Causes devastation in the normal operations and performance of alleged companies Raises serious doubt about the efficacy of financial statement audits Erodes public confidence and trust in the accounting and auditing profession
20 Red Flags – Fictitious Revenues Rapid growth or unusual profitability, especially compared to that of other companies in the same industry Recurring negative cash flows from operations or an inability to generate cash flows from operations while reporting earnings and earnings growth Significant transactions with related parties or special purpose entities not in the ordinary course of business or where those entities are not audited or are audited by another firm
21 Red Flags – Fictitious Revenues Significant, unusual, or highly complex transactions, especially those close to period end that pose difficult “substance over form” questions Unusual growth in the number of days’ sales in receivables A significant volume of sales to entities whose substance and ownership is not known
22 Red Flags – Timing Differences Rapid growth or unusual profitability, especially compared to that of other companies in the same industry Recurring negative cash flows from operations or an inability to generate cash flows from operations while reporting earnings and earnings growth Significant, unusual, or highly complex transactions, especially those close to period end that pose difficult “substance over form” questions Unusual increase in gross margin or margin in excess of industry peers Unusual growth in the number of days’ sales in receivables Unusual decline in the number of days’ purchases in accounts payable
23 Red Flags – Concealed Liabilities Recurring negative cash flows from operations or an inability to generate cash flows from operations while reporting earnings and earnings growth Assets, liabilities, revenues, or expenses based on significant estimates that involve subjective judgments or uncertainties that are difficult to corroborate Non-financial management’s excessive participation in or preoccupation with the selection of accounting principles or the determination of significant estimates
24 Red Flags – Concealed Liabilities Unusual increase in gross margin or margin in excess of industry peers Allowances for sales returns, warranty claims, and so on that are shrinking in percentage terms or are otherwise out of line with industry peers Unusual reduction in the number of days’ purchases in accounts payable Reducing accounts payable while competitors are stretching out payments to vendors
25 Red Flags – Improper Asset Valuation Unusual growth in the number of days’ sales in receivables Unusual growth in the number of days’ purchases in inventory Allowances for bad debts, excess and obsolete inventory, and so on that are shrinking in percentage terms or are otherwise out of line with industry peers Unusual change in the relationship between fixed assets and depreciation Adding to assets while competitors are reducing capital tied up in assets
26 Red Flags – Improper Asset Valuation Recurring negative cash flows from operations or an inability to generate cash flows from operations while reporting earnings and earnings growth Significant declines in customer demand and increasing business failures in either the industry or overall economy Assets, liabilities, revenues, or expenses based on significant estimates that involve subjective judgments or uncertainties that are difficult to corroborate Non-financial management’s excessive participation in or preoccupation with the selection of accounting principles or the determination of significant estimates Unusual increase in gross margin or margin in excess of industry peers
27 Red Flags – Other Domination of management by a single person or small group (in a non-owner managed business) without compensating controls Ineffective board of directors or audit committee oversight over the financial reporting process and internal control Ineffective communication, implementation, support, or enforcement of the entity’s values or ethical standards by management or the communication of inappropriate values or ethical standards Rapid growth or unusual profitability, especially compared to that of other companies in the same industry
28 Red Flags – Other Significant, unusual, or highly complex transactions, especially those close to period end that pose difficult “substance over form” questions Significant related-party transactions not in the ordinary course of business or with related entities not audited or audited by another firm Significant bank accounts or subsidiary or branch operations in tax haven jurisdictions for which there appears to be no clear business justification Overly complex organizational structure involving unusual legal entities or managerial lines of authority
29 Red Flags – Other Recurring attempts by management to justify marginal or inappropriate accounting on the basis of materiality Formal or informal restrictions on the auditor that inappropriately limit access to people or information or the ability to communicate effectively with the board of directors or audit committee
30 Deterrence of Financial Statement Fraud Reduce pressures to commit financial statement fraud Reduce the opportunity to commit financial statement fraud Reduce rationalisation of financial statement fraud
31 Reduce Pressures to Commit Financial Statement Fraud Establish effective board oversight of the “tone at the top” created by management. Avoid setting unachievable financial goals. Avoid applying excessive pressure on employees to achieve goals. Change goals if changed market conditions require it Ensure compensation systems are fair and do not create too much incentive to commit fraud. Discourage excessive external expectations of future corporate performance. Remove operational obstacles blocking effective performance
32 Reduce the Opportunity to Commit Financial Statement Fraud Maintain accurate and complete internal accounting records. Carefully monitor the business transactions and interpersonal relationships of suppliers, buyers, purchasing agents, sales representatives, and others who interface in the transactions between financial units. Establish a physical security system to secure company assets, including finished goods, cash, capital equipment, tools, and other valuable items. Maintain accurate personnel records including background checks on new employees. Encourage strong supervisory and leadership relationships within groups to ensure enforcement of accounting procedures. Establish clear and uniform accounting procedures with no exception clauses.
33 Reduce rationalisation of Financial Statement Fraud Promote strong values, based on integrity, throughout the organization. Have policies that clearly define prohibited behaviour with respect to accounting and financial statement fraud. Provide regular training to all employees communicating prohibited behaviour.
34 Reduce rationalisation of Financial Statement Fraud Have confidential advice and reporting mechanisms to communicate inappropriate behaviour. Have senior executives communicate to employees that integrity takes priority and that goals must never be achieved through fraud. Ensure management practices what it preaches and sets an example by promoting honesty in the accounting area. The consequences of violating the rules and the punishment of violators should be clearly communicated
35 Corporate Governance The board of directors and the structure in place to oversee the management of an organisation Importance of outside, independent directors Key committees include the audit committee & compensation committee
36 Cultivating a Vigorous Whistleblower Program Encourage the development of a culture in which employees view whistleblowing as a valuable contribution to an attractive workplace of integrity and their own futures. Employees should not feel like “tittle-tatlers” or “sneaks” for communicating potential fraud. The automatic and direct submission to the audit committee, of all complaints involving senior management (without filtering by management or other entity personnel) is essential.
37 Developing a Broad Information and Feedback Network Develop an extensive information network including: Internal auditors Independent auditors Compensation committee Key employees Company lawyers HR director Compliance officer Risk management officers Divisional managers and controllers “Management by walking about” Consider meeting periodically with representatives from each of the groups to discuss matters affecting the financial reporting process.
38 Occupational Fraud Survey Association of Certified Fraud Examiners 2006
39 Survey The data strongly supported Sarbanes-Oxley’s requirement for audit committees to establish confidential reporting mechanisms. Occupational frauds in the study were much more likely to be detected by a tip than through other means such as internal audits, external audits, and internal controls. Among frauds committed by owners and executives, which tend to be the most costly, over half of all cases were identified by a tip. Confidential reporting mechanisms reduce fraud losses significantly. The median loss among organisations that had anonymous reporting mechanisms was $56,500. In organisations that did not have established reporting procedures, the median loss was more than twice as high.
40 Survey More effective internal controls are needed to detect fraud. Internal controls ranked fourth – behind By Accident – in terms of the number of frauds detected in the study. Furthermore, the frauds that were detected by internal controls tended to be relatively small, with a median loss of $40,000, which was by far the lowest of any detection method. More effective types of internal controls are needed to detect fraud, especially larger frauds that may involve senior personnel overriding or circumventing traditional internal controls.
45 Losses associated with owner/exec schemes tend to be larger than for any other group, yet these schemes are much less likely to be detected through normal audits or control functions. This highlights the importance of establishing anonymous reporting mechanisms, conducting anti-fraud training and fostering open channels of communication.
49 Limiting Fraud Losses Anonymous Fraud Hotlines The survey found that anonymous reporting mechanisms showed the greatest impact on fraud losses. organisations that did not have reporting mechanisms suffered median losses that were over twice as high as organisations where anonymous reporting mechanisms had been established.
50 Limiting Fraud Losses This was consistent with the data gathered showing that the most common way for frauds to be discovered is through tips. Obviously, hotlines and other reporting mechanisms are designed to facilitate tips on wrongdoing. The fact that tips were the most common means of detection, combined with the fact that organisations which had reporting mechanisms showed the greatest reduction in fraud losses, indicates that this is an extremely valuable anti-fraud resource, and gives further support to Sarbanes-Oxley’s mandate for confidential reporting mechanisms.
51 Limiting Fraud Losses Internal Audits About 57% of the victim organisations in the study had internal audit or internal fraud examination departments. These organisations suffered a median loss of $80,000, compared with the median loss of $130,000 in organisations where there was no internal audit department.
52 Limiting Fraud Losses The absence of a measurable impact as a result of external audits is consistent with the data gathered on fraud detection, which showed that external audits generally ranked low – behind By Accident – as a means of catching fraud.
53 Cultural Differences? “A Theory of Corporate Scandals: Why the U.S. and Europe Differ” (Coffee, 2005)
54 A Theory of Corporate Scandals Gatekeeper Failure Across Ownership Regimes Both ownership regimes – dispersed and concentrated – show evidence of gatekeeper failure. The U.S./U.K. system of dispersed ownership is vulnerable to gatekeepers not detecting inflated earnings Concentrated ownership systems fail to the extent that gatekeepers miss (or at least fail to report) the expropriation of private benefits. A key difference is that in dispersed ownership systems the villains are managers and the victims are shareholders In concentrated ownership systems the controlling shareholders overreach minority shareholders.
55 A Theory of Corporate Scandals As a result, controlling shareholders in Europe do not obsess over the day-to-day market price They rationally do not engage in tactics to prematurely recognise revenues to spike their stock price. Therefore lesser use of equity compensation and lesser interest in the short-term stock price Explain in part why there were less accounting irregularities in Europe than in the U.S. during the last few years
56 References Association of Certified Fraud Examiners (2006) Occupational Fraud Survey. Coffee, J. (2005) A Theory of Corporate Scandals: Why the US and Europe Differ, working paper Columbia Law School. Giroux, G (2004) Detecting Earnings Management, Wiley. Quffa, H.C. (2006) Financial Statement Fraud, http://www.passia.org/seminars/2006/FinancialSt atementFraud retrieved 20 th November 2007.