1 CHAPTER 6 Earnings Management

2 “Earnings Management” An expression referring to cases when management uses its reporting discretion to produce financial statements that place management’s performance in a particular light. Extreme forms of earnings management such as intentional misrepresentation constitute fraud. GAAP allows management much discretion which permits some limited management of earnings.

3 “Earnings Management” (continued) It is in management’s interest to long- term best interest to report truthfully and without Many managers choose accounting methods, make estimates, and structure transactions that report their performance in ways that further their personal interests. Educated users of financial reports watch for signs of earnings management so they can appropriately interpret the reported results.

4 Incentives to Manage Earnings Management’s performance is measured by the financial statements. Management’s compensation is often tied directly to reported profits, return on equity or stock prices.

5 Common Forms of Earnings Management Overstating operating performance. Taking a bath. Creating hidden reserves and smoothing performance. Off balance-sheet financing.

6 How Managers Use Accounting Judgments to Manage Earnings Materiality judgments. Recognition vs. disclosure judgments. Pro forma reporting. Classification judgments. Operating vs. non-operating. Liability or equity? Short-term or long-term.

7 Measurement Judgments Applying the matching principle. – Revenue recognition. – Matching expenses against revenues. – Inventory cost flow assumption (LIFO, FIFO, average) – Expense or capitalize? – Allocating capitalized costs to future periods.

8 Asset Valuation Choose to hold or sell securities classified as available for sale. Estimation of uncollectible accounts receivable. Application of lower-of-cost-or-market method to inventory. Estimation of asset impairment write- downs.

9 Liability Valuation Estimate accrued restructuring costs. Estimate other accrued costs (warranties, employee compensation, contingent liabilities, postretirement costs). Structuring lease transactions as operating leases. Use equity method to keep affiliate liabilities off the balance sheet.

10 “Real” Earnings Management Management of real business transactions as opposed to managing how transactions are accounted for. Some examples: - Cutting back or delaying research and development or advertising expenditures. - Delaying inventory purchases at year end. - Offering special incentives to increase sales or collections of receivables.

11 Global Perspective on Earnings Management Historically, earnings reports in Japan and much of Western Europe were very conservative. IFRS generally allows more management discretion than GAAP. Use if hidden reserves is widespread in some countries.

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