chapter 6 Earnings Management

Learning Objectives 1. Identify the factors that motivate earnings management. 2. List the common techniques used to manage earnings. Critically discuss whether a company should manage its earnings. Describe the common elements of an earnings management meltdown.

1. Motivation for Earning Management Forces pushing managers to manipulate results: 1. Meet internal targets. 2. Meet external expectations. 3. Provide income smoothing. 4. Provide window dressing for an IPO or a loan.

Motivation for Earning Management 1. Meet Internal Targets Internal earnings targets represent an important tool in motivating manager to increase sales efforts, control costs, and use resources more efficiently.

Motivation for Earning Management 1. Meet Internal Targets Performance There is a tendency for the person being evaluated to forget the economic factors underlying the measurement and instead focus on the measured number itself.

Motivation for Earning Management 2. Meet External Expectations Employees and customers want a company to do well so that it can survive for a long run and make good on its long-term pension and warranty obligations.

Motivation for Earning Management 2. Meet External Expectations Suppliers want assurance that they will receive payment and that the purchasing company will be a reliable purchaser for many years into the future.

Motivation for Earning Management 3. Provide Income Smoothing The practice of carefully timing the recognition of revenues and expenses to even out the reported earnings from year to year is called income smoothing.

Motivation for Earning Management 3. Provide Income Smoothing Annual Earnings Years

Motivation for Earning Management 4. Provide Window Dressing for an IPO or a Loan For companies entering a phase in which it is critical that reported earnings look good, such as just before making a large loan application or just before an IPO of stock, accounting assumptions can be stretched.

2. Earnings Management Techniques The Earnings Management Continuum Savvy transaction timing Aggressive accounting Deceptive accounting Strategic matching Change in methods or estimates with full disclosure Change in methods or estimates but with little or no disclosure General Electric Delta Airlines Xerox

Earnings Management Techniques The Earnings Management Continuum Fraudulent reporting Fraud Non-GAAP accounting Fictitious transactions Enron ZZZZ Best

Chairman Levitt’s Top Five Accounting Hocus-Pocus Items 1. Big bath charges 2. Creative acquisition accounting 3. Cookie jar reserves 4. Materiality 5. Revenue recognition Arthur Levitt Former SEC Chairman

1. Big Bath Charges Years Annual Earnings Company D recognized all of its bad news in one year—thus, took a “big bath” loss.

2. Creative Acquisition Accounting Allocating a large amount of a “basket purchase” to ongoing research and development, then expensing these costs immediately had the same effect as “big bath.” SFAS Nos. 141 and 142 gave extensive guidelines on how the purchase price of business acquisitions should be allocated. The SEC staff informed companies they would be skeptical of large amounts being allocated to R&D.

3. Cookie Jar Reserves Recognizing estimated expenses when revenue is high, so that less estimated expenses can be recognized when earnings are lower. Likewise, deferring revenue for “tougher times” is an example of building a cookie jar reserve. The SEC has issued SAB 101, identifying when it appropriate to defer revenue.

4. Materiality A change in one penny per share can cause a company to lose billions of dollars in market value. Chairman Levitt encouraged auditors to challenge questionable accounting practices involving materiality.

4. Materiality - Cont’d If the questionable practice allows the firm to meet analysts’ earnings expectations, the firm should be required either to change the data resulting from the questionable practice or to convince the auditor that it in accordance with GAAP. The SEC released SAB 99 that outlines a more comprehensive definition of materiality.

5. Revenue Recognition Firms eager to show operating results to lenders and potential investors, would like to report revenue when contracts are signed or partially complete rather than waiting until the promised product or service has been fully delivered. The SEC has released SAB 101 to more carefully identify the circumstances in which it is appropriate for a company to recognize revenue.

Pro Forma Earnings A pro forma earnings number is the regular GAAP earnings number with some revenues, expenses, gains, and losses excluded.

Pro Forma Earnings The concern with pro forma earnings is that companies can report pro forma earnings merely in an effort to make their results seem better than they actual were. Do the pro forma earnings numbers help financial statement users better understand a company,… …or are they a blatant attempt to cover up poor performance? That’s the key question.

Pro Forma Earnings In December 2001, the SEC encouraged companies to provide a reconciliation between GAAP and pro forma earnings…see page 330

3. Critically discuss whether a company should manage its earnings There is no true earnings figure However, If the intent in using earnings management techniques is to deceive, then most people would consider it wrong. However, it would not be wrong to convey financial which is useful to decision makers

4. Seven Elements of an Earnings Management Meltdown 1 Downturn in business 2 Pressure to meet expectations 3 Attempted accounting solutions 4 Auditor’s calculated risk 5 Insufficient user skepticism 6 Regulatory investigation 7 Massive loss of reputation