COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Earnings Management Chapter 6 S t I c e | S t I c e | S k o u s e n Intermediate Accounting 16E Prepared by: Sarita Sheth | Santa Monica College

Learning Objectives 1.Identify the factors that motivate earnings management. 2.List the common techniques used to manage earnings. 3.Critically discuss whether a company should manage its earnings. 4.Describe the common elements of an earnings management meltdown. 5.Explain how good accounting standards and ethical behavior by accountants lower the cost of obtaining capital.

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.

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

Creative Acquisition Accounting 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.

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.

Materiality A change in one penny per share can cause a company to lose billions of dollars in market value. If a questionable practice helps a firm meet analysts’ expectations, the firm should be required to change the data or to convince the auditor that they comply with GAAP. The SEC released SAB 99, a more comprehensive definition of materiality.

Revenue Recognition Firms 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 Pro forma earnings is derived from the regular GAAP earnings number with some revenues, expenses, gains, and losses excluded. 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.

Cost of Capital Cost of capital- the cost a company bears to obtain external financing. Cost of debt financing- the after-tax interest cost for borrowing money. Cost of equity financing- expected return (both as dividends and an increase in market value) necessary to entice investors to provide equity capital Cost of capital is important because it determines what long-term projects are profitable to undertake.

Role of Accounting Standards The FASB and AICPA help lower the U.S. cost of capital by promulgating uniform recognition and disclosure standards for companies. The SEC’s “primary mission…is to protect investors and maintain the integrity of the securities markets.” IASB plays an important role in improving the credibility of international financial reporting.