1. Earnings Management Ch 16 Accounting Information for Decision Making Rick Hayes, Ph.D., CPA California State University L.A.

2. Earnings Management A conscious manipulation of accounting processes or numbers to make a company's operations or financial position look better in order to gain some benefit for themselves or to increase the stock price of the firm. represents active manipulation of or conscious choices in the accounting results that produce an altered perception of the performance of an entity

3. Incentives to Manipulate Earnings Budget versus actual Bonuses Influence Wall Street analysts Make stock options more valuable Comply with debt covenants

4. Manipulating Information Pro-forma earnings – SEC ruling have to show GAAP equally Selective release of information – Insider trading – Regulation Fair Disclosure (FD) should be released simultaneously to all groups

5. Revenue/Gain – Sales Returns and allowances Cost of Sales Depreciation/amortization Expense Net Income/loss Accounts Receivable Allowance for Bad Debt Inventory Allowance for Obsolete Inventory Investments Current Assets Fixed Assets Intangible assets Total Assets Accounts Payable Accrued Payables Warranty Liability Current Liabilities Retained Earnings Total Liabilities and Equity Expense

6. Flexibility of accounting principles Choices: –Inventory (LIFO, FIFO, Average Cost, Specific ID) –Depreciation (straight line, accelerated, time, salvage) –Expensing vs. Capitalizing (asset or expense?) –Allowance Accounts (uncollectable, obsolete

7. Asset impairments Restructuring costs Inventory write-downs Environmental liabilities Pension assumptions In-process R&D Percentage of completion contracts

8. Manipulating Revenue Most frequently used Keep books open past cut-off Bill and Hold Channel stuffing Not recording returns and allowances Incorrect percentage of completion in long term projects

9. Deferring Expenses Not recognize expenses in proper period (violating matching principle) Unrealistic estimates (allowance for uncollectable accounts, depreciation, warranty, obsolete inventory, etc.) Not writing down assets when they become impaired Capitalizing expenses

10. Off Balance Sheet Debt Transferring liabilities to Special Purpose Entities (SPEs) Transferring poor performing assets to SPEs Incorrectly guaranteeing debt of SPEs Improper leases

11. Income Smoothing Smooth earnings so that it always meets or exceeds analysts expectations Taking “big bath” in bad years Reversing special allowances (reorganization allowance) Creating the affect of no volatility in net income

12. Detecting Earnings Manipulation Change in ratios and trends Difference from industry data Reasonable testing – Revenue and Accounts receivable – Inventory and cost of sales – Bad debt, warranty and other allowances as a percentage of sales

13. Accounting Tricks - Examples Waste Management Inc. – Understated depreciation and capitalized interest improperly, failed to write down impaired assets. Total restatement $2 billion.

14. Waste Management Overstated Income

15. Accounting Tricks - Examples WorldCom – Recorded expenses as capital expenditures, double-booked revenues, booked revenues as cost reductions. Total restatement $4.6 billion

16. WorldCom – Reported vs. Restated EBITDA

17. Accounting Tricks - Examples Xerox – Recorded revenue on long-term leases of copiers prematurely. Total restatement $3 billion (but part of this increased later revenues).

18. Xerox – Reported and Restated Revenue

19. Accounting Tricks - Examples Adelphia – Hid billions in debt off-balance sheet in unconsolidated subsidiaries, diverted undetermined millions to the family stockholders, inflated subscriber numbers in press reports, overstated earnings.

20. Adelphia Debt Load $3.5 Billion $12.6 Billion ReportedActual

21. Accounting Tricks - Examples Sunbeam – Inflated revenues by channel stuffing and bill &hold. Reduced expenses by capitalizing advertising costs, reducing allowance for bad debts.

22. Sunbeam – Revenues and Net Income

23. Accounting Tricks - Examples Rite-Aid – Inflated revenues by recording vendor rebates that pertained to future purchases. Reduced expenses by capitalizing expenses, not recording certain expenses, failing to write off inventory shrinkage, understating depreciation.

24. Rite-Aid – Net Income Restatement

25. Accounting Tricks - Examples Enron - Hiding debt and losses in unconsolidated entities

26. Enron – Reported and Restated Net Income