Earnings Management: A Review of Selected Cases by Belverd E. Needles, Jr, Marian Powers, Y. Bora Senyigit.

Introduction

The past decade has been characterized as a period of financial crisis. A number of high-profile cases have highlighted the role of financial reporting and the issues surrounding earnings management. The flood of these so-called ‘accounting scandals’ and the alarming increase in accounting revisions and restatements has drawn the attention around the globe of accounting researchers and the popular press alike.

Questions need to discuss?

1) What is earnings management or mismanagement?

2) What is the role of judgment in ethical financial reporting?

3) What are the difficulties of identifying earnings management?

The Difficulty of Identifying Earnings Management

What is Accounting?

Reality of Accounting

Public Perception of Accounting

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Earnings Management

Judgment, Estimates and Earnings Management

Selected Earnings Management Case Examples

The Time Warner Case

Management ‘Earnings management’ typically focuses on the artificial increase (or decrease) of revenues, profits, or earnings per share figures through aggressive accounting tactics.

Healy and Wahlen (1999) more closely address this complexity by stating that earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of a company or to influence contractual outcomes that depend on reported accounting numbers.

Conclusion

It is clear from the extensive literature on earnings management and the experience of the past decade that reform is needed in defining the boundaries of acceptable accounting flexibility, and the balance between principles-based standards and rules-based standards needs to be better understood. The need for better understanding of judgment is reinforced by the efforts of the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) to bring U.S. GAAP and International Financial Reporting Standards (IFRS) closer together through more principle-based standards. The lack of decisive guidelines for principles-based standards may create inconsistencies in the application of standards across companies and countries.

•“Use of judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting judgments.”

•“An intentional structuring of reporting or production/investment decisions around the bottom line impact.”

•“Purposeful intervention in the external financial reporting process with the intent of obtaining some private gain.”

Earnings management seems to have short-term benefits for management and boards of directors. Turner and Vann (2010) have shown that “independent directors of firms that exhibit earnings management benefited significantly greater cumulative percentage increases in the market value of stock and stock options owned.

Business decisions to meet its debt covenant requirements:

• The company sells its receivables without recourse.

• The company sells its receivables with recourse.

• The company sells its receivables with a side agreement to buy them back within thirty days.

Accounting decisions:

• Records the sale of receivables with the resulting gain or loss.

• Records the sale of receivables and makes an optimistic estimate of the probability of recourse.

• Records the sale of receivables and makes a pessimistic estimate of the probability of recourse.

• Records the sale of receivables and indicates in the footnote disclosures the requirement to re-buy.

• Records the sale of receivables and does not indicate in the footnote disclosures the requirement to re-buy.

Management can structure its decisions to such a way as to determine subsequent GAAP treatment by

• Time transactions to result in favourable timing of revenue or expense recognition.

• Write contracts, such as for lease agreements and pension agreements.

GAAP requires managers to make numerous financial reporting judgments that have an impact on reported earnings:

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• Long-term construction contracts require estimates of progress toward completion and costs to complete. Managers could use optimistic estimates of progress toward completion to inflate earnings.

• Depreciation computations require estimates of useful lives and salvage values. Managers could use optimistic estimates of the life and salvage value of depreciable assets, reducing depreciation expense.

• Accounts receivable must be stated at net realizable value. Managers could use optimistic estimates of collectability to overstate earnings.

• Costs must be classified as product costs or period costs. By classifying some borderline costs as product rather than period costs, managers can reduce expenses during times of inventory growth.

• Gains on asset dispositions may be fully recognized in the period of sale. Managers could time the sale of appreciated assets such as marketable securities and fixed assets to bolster earnings.

• Software development companies must estimate the point at which technological feasibility is reached for software products and capitalize software development costs after that point. Managers could accelerate this date to avoid immediately expensing some software development costs.

• Anticipated costs of satisfying warranty obligations must be accrued and matched to revenues. By making optimistic estimates of product warranty costs, managers could reduce current expenses.

• Ordinary repairs are expensed as incurred, while major repairs are capitalized. By treating ordinary repairs as major repairs, managers could bolster current earnings.

• Inventories must be stated at the lower of cost or market. Managers could use optimistic market values, resulting in reduced inventory write-downs (Jackson and Pitman, 2001).

Committee of Sponsoring Organizations (COSO) identified numerous motivations for falsifying the financial reports (Beasley et al., 2010, p. 14), including to:

• Meet external earnings expectations of analysts and others.

• Meet internally set financial targets or make the company look better.

• Conceal the company’s deteriorating financial condition.

• Increase the stock price.

• Bolster financial position for pending equity or debt financing.

• Increase management compensation through achievement of bonus targets and through enhanced stock appreciation.

• Cover up assets misappropriated for personal gain.

COSO report also identified the most common financial fraud techniques among the 347 fraud companies to include (Beasley et al., 2010, p. 17):*

• Improper revenue recognition (recording fictitious revenues or recording revenues prematurely) 61%

• Overstatement of assets (excluding accounts receivable) 51%

• Understatement of expenses/liabilities 14%

• Insider trading also cited 24%

• Disguised use of related party transactions 18%

• Other miscellaneous techniques (acquisition, joint ventures, etc.) 20%

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Most people understand that GAAP are the set of rules, practices, and conventions that describe what is acceptable financial reporting for external stakeholders, but they may find it surprising that a single, normal, everyday accounting choice may be either ethical or unethical.

The difference between an ethical and an unethical accounting choice is often merely the degree to which the choice is carried out.

GAAP does not tell managers what specifically is normal and what is extreme. It is more like a speed limit sign that simply says, ‘Don’t Drive Too Fast!’

Since a company extends credit as an incentive for customers to buy, estimated losses from those who do not pay are considered a cost of the current period even though it will not be known until future periods, which customers will not pay, and what the amount of non-payment will be.

GAAP requires that an estimate of uncollectible accounts be recorded as an expense in the same fiscal year as the revenue from the product is recorded.

A company has operating income of $100,000 before the estimate of uncollectible accounts. Also, assume management estimates uncollectible accounts to be $6,000, or 2% of net sales of $300,000. However, the fact that uncollectible accounts will be $6,000 is not always so clear. Assume that for the past five years, average uncollectible accounts costs on the same level of sales have ranged from $4,000 to $8,000 (1.33% to 3.67% of net sales) with no specific pattern being apparent. A financial manager who wanted to report the highest possible current period income would be justified in using the $4,000 amount for the current year’s expense estimate even though $4,000 is the bottom of the historical range. That same manager might use $8,000 to be conservative in a year when the economy is weak.

The scenario would be crossing the ethical line to possible financial fraud even though GAAP does not draw a clear line of the ethical use of judgment or the unethical use. There is no ‘bright line’ in GAAP to tell managers what is and is not acceptable. It is also clear that while this illustration shows the magnified effect of just one judgment, we have seen earlier that management is presented with numerous structural and estimate decisions that can impact reported earnings.

A common criticism of earnings management is that it reduces transparency by obscuring the ‘true’ earnings of the company.

Arya, Glover, and Sunder (2003) state: “That earnings management reduces transparency is a simplistic idea. A fundamental feature of decentralization organizations is the dispersal of information across people. Different people know different things and nobody knows everything.

During years of high accruals, CEOs exercise unusually large numbers of options, and CEOs and other insiders sell large quantities of shares. It, nevertheless, is true that firms subject to fraud investigations are severely penalized when SEC investigations for fraud result (Christensen et al., 2010).

Earnings management can be difficult to identify except in retrospect. Durtschi and Easton state that in spite of the popularity of the notion that the shapes of the earnings distributions are evidence of earnings management, they cannot be relied.

Durtschi and Easton (2009) provided three sets of evidence that these discontinuities are likely caused by factors other than earnings management:

(1) Supporting evidence that this is so is sparse, perhaps even non-existent.

(2) Alternative explanations for the shapes of the distributions are often very evident.


• A simple explanation for the shape of the earnings distribution that is most often cited as evidence of earnings management; the relation between earnings and prices differs with the magnitude and the sign of earnings.

• Further examples that support the main point of their paper; evidence beyond the mere shape of a distribution must be brought to bear before researchers can draw conclusions regarding the presence/absence of earnings management.

• A detailed analysis of the severe effects of sample selection in a recent study; this study erroneously concludes that the shape of an earnings distribution is evidence of earnings management.

The Southwest Airlines Case

The Microsoft Case

AT&T Inc. and Verizon Communications Cases

The Dell Case

The Satyam Computer Services Case

The Securities and Exchange Commission accused Dell of misleading investors by using money the company received from the chip maker Intel to pad its quarterly earnings statements. Intel paid Dell in the form of rebates as part of an agreement to ensure that Dell would not use computer chips made by Advanced Micro Devices (AMD) in its personal computers and computer servers, according to the civil charges. “Dell was only able to meet Wall Street targets consistently during this period by breaking the rules.” Without the Intel payments, Dell would have missed the consensus estimate for earnings per share published by Wall Street analysts who followed the company in every quarter during its fiscal years from 2002 through 2006.


Microsoft failed to accurately report its financial results, causing overstatements of income in some quarters and understatements of income during other quarters. The SEC said that Microsoft enhanced its financial results by setting aside artificially large reserves to reduce revenues, with the idea of reversing that procedure to record the revenues in less profitable times.

Time Warner established reserves of $2,253 billion and $2,229 billion at December 31, 2009 and 2008, respectively. These estimates represent about 30 percent of gross accounts receivable in both years. Management explains that this is an “area of judgment affecting reported revenues and net income” and is based on analysis of “vendor sell-off of product, historical return trends, current economic conditions, and changes in customer demand”.

Estimated lives of its airplanes from 22 years to 27 years under the reasoning that improved maintenance methods enabled the company to get more useful years out of the aircraft. This change in accounting estimate, which does not require a consistency disclosure in the auditor’s report, had the effect of enabling southwest to continue to show year-to-year earnings growth.

Changing their accounting for pension plans in 2010 by shifting to market-to-market accounting. In the market meltdown from the financial crisis in 2008–2009, these companies incurred very large losses: $23 billion for AT&T and $12 billion for Verizon. Rather than recognize these losses on their income statements in 2008–2009 the companies elected in accordance with current U.S. standards to amortize them over future years (Rapoport 2011).

On the morning of Jan. 7, 2009, Ramalingam Raju, the chairman of troubled Indian IT outsourcing company Satyam Computer Services, sent a startling letter to his board and the Securities & Exchange Board of India. Raju acknowledged his culpability in hiding news that he had inflated the amount of cash on the balance sheet of India’s fourth-largest IT company by nearly $1 billion, incurred a liability of $253 million on funds arranged by him personally, and overstated Satyam’s September 2008 quarterly revenues by 76% and profits by 97%.