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Earning management: A Review of Selected cases, identified numerous…
Earning management: A Review of Selected cases
Introduction
Financial reporting define as "to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditor in making decision about providing resources to the entity "IASB"
The pathways commission on Accounting Higher education, which was established jointly by the AICPA & AAA created the Vision Model diagram -
to show the reality of "What is Accounting" to student in their first course in accounting
to show the "Reality of Accounting" to professional accountant making complex accounting judgement that effect and effected by economy activity and contribute to a prosperous society
"Public Perception of Accounting" shows professional accountants focus on recording financial transaction and preparing financial statement using black & white rules
Although financial statement audit provides confidence that those judgement are reasonable, there are many case the audit firms could not detect the material misstatement or fraud
Earnings management
Typically focus on the artificial increase or decrease of revenue, profit or earning per share figures through aggressive accounting tactics
Purposeful intervention in external financial reporting process - for private gain
Use of judgement in financial reporting and in structuring transaction to alter financial reports - either mislead stakeholders or to influence contractual outcome
An intentional structuring of reporting or production/investment decisions around the bottom line impact
Earning management occurs when managers use judgement in financial reporting - and seems to have short term benefits for management and boards of directors
CEO with equity holdings often influence short term financial results by pressuring CFOs to set aside their role as a watchdog of financial reporting quality
Independence director of firm exhibit earning management than independence director on the audit committees
Some of debt covenant required
Company sell its receivable without resource
Company sells its receivable with recourse
Company sells its receivable with a side agreement to buy them back within thirty days
Accounting decision to consider
Company records the sale of receivables with the resulting gain or loss
Company record the sale of receivables and makes an optimistic estimate of probability of resource
Company record the sale of receivables and makes a pessimistic estimate of probability of recourse
Company record the sale of receivables and indicates in footnote disclosures the requirement to re-buy
Company record the sale of receivables and does not indicate in the footnote disclosure the requirement to re-buy
Every item in financial statement is the result of the complex interaction of "business structuring decision" and "financial reporting decision"
Management can structure its decision to such a way as to determine subsequent GAAP treatment
Time transaction to result in favorable timing of revenue or expense recognition
Write contract ,such as for lease agreement and pension agreement
GAAP requires manager to make numerous financial reporting judgement that have an impact on reported earnings
Long term construction contracts require estimates of progress towards completion and cost to complete
Depreciation computation require estimates of useful life and salvage values
Account receivable must be stated at net realizable value
Cost must be classified as product cost or period cost
Gain on assets dispositions may be fully recognized in the period of sale
Software development companies must estimate the point at which technology feasibility is reach for software product capitalized software development cost after that point
Anticipated cost of satisfying warranty obligation must be accrued and match to revenues
Ordinary repairs are expenses as incurred while major repairs are capitalized
Inventories must be stated at the lower of cost or market
Some pf the earning management within reasonable bound can be beneficial for company and even value adding
Meet the external earnings expectation of analysis and others
Meet internally set financial targets or make the company look better
Conceal the company deteriorating financial condition
Increase the stock price
Bolster financial position for pending equity or debt financing
Increase management compensation through achievement of bonus target
Cover up assets misappropriated for personal gain
Overly aggressive earning management is a form of fraud and differ from reporting error
Improper revenue recognition
Overstatement of assets
Understatement of expense/libilities
Insider trading also cited
Disguised use of related transaction
Other miscellaneous technique
Earning management is sophisticated fraud that very difficult to trace by auditer
Auditor need to distinguish fraud from error by identifying the intention and earning figure that line between acceptable and unacceptable
Judgment, estimates and earning management
Should be made within framework of GAAP
Normal and everyday Accounting choice may either ethical or unethical depend on degree to which the choice is carried put
Expense estimation may be illegal if the estimated amount is extreme but perfectly ethical if it is reasonable
GAAP did not tells manager what is normal and what is extreme
Uncollectible account estimation decision
It is also clear the magnified effect of just one judgment
The difficulty of identifying earnings management
The common criticism of earning management is that it reduces transparency
Leading academics argue that both the level and patterns of earnings convey information and that even when earning management conceal information - it can still beneficial to shareholders
Different people know different information and nobody knows everything - an environment a manage earning stream can convey more information than an unmanaged earning stream
Common measure of a company success is earning per share - also common measure of executive performance compensation
Discretionary accruals to manipulate reported earning potential
Earning management can be very difficult to identify except in retrospect
Accruals is most powerful tools for earning management and be very difficult to analysis the decision on shapes of the earning
Supporting evidence
Alternative explanation
Subsequent research
Detail analysis of severe effect of sample selection in recent study - This study conclude that the shape of earning distribution is evidence of earning management
Simple explanation for the shape of the earning distribution that most cited as evidence of earning management - relation between earning and price
more sample support the main point of their paper, evidence beyond the mere shape of a distribution must be brought to bear before researchers can draw conclusion regarding the presence/absence of earning management
Selected earnings management case examples
The Microsoft case
Following an investigation it failed to recognize revenue as earn
Example of not all fraud is involve overstatements
With the idea of reversing that procedure to record the revenues in less profitable times
Not accurately report the income causing overstatement and understatement of income during financial periods
The Time Warner case
Analysis of sales returns & allowance & uncollectible account
Estimates represent about 30% of gross account receivable for both years
Management explain area of judgement effecting reported revenue net income are based analysis
Example of conservative to neutral earning management
The Southwest Airline case
Change the estimated lives of its airplane from 22 years to 27 years under reasoning that improved maintenance method
that change in accounting estimated not required a consistency disclosure in audit report
Example of acceptable neutral to aggressive earning management
AT&T Inc. and Verizon Communication cases
Market meltdown over crisis incurred very large loss on their income
Rather than recognized these losses on their income the companies amortize them over the future years according U.S standard
Companies are electing to change their accounting for pension funds to mark-to-market accounting
The effect of the changes the large losses in prior year and will never reflect in the current accounting years
Example of acceptable aggressive earning management
The Dell case
Accuse of misleading investors by using money the company received from chip maker Intel to pad its quarterly earning statement
Intel pay in advance in the form of rebate to ensure Dell will never take other chip
Dell relied on payment from Intel to meet or surpass Wall street's expectation
When Dell picked AMD as second supplier Intel cut the rebate and Dell's performance suffer
Example of disclosure accounting fraud
The Satyam Computer Services case
The chairman acknowledge his culpability in hiding news that he had inflated the amount of cash on balance sheet by nearly $1 billion incurred a liability $253 million
Case qualified as deceptive accounting - unethical and fraudulent
Earning management occurs on a continuum from savvy transaction timing, to aggressive accounting to decpetive accounting
Method called "cookie jar reserve" - estimated expenses in a year when revenue are high and fewer expenses are recognized in a quarter when earnings are lower
Another way is by defer revenue for tougher times
"the big bath" company accelerates expenses and losses in a year with already poor results so that future income looks better and smoother
Conclusion
Discuss the earnings management continuum of ethical financial reporting
Difficulty to identify cases if earning management & provide the major case
reform needed in defining the boundaries of acceptable accounting flexibility
Balance between principle based standards and rules based standard needs to be better understood
Better understanding of judgement and rules based standard can be seen deficient flexible to accommodate
identified numerous motivation for falsifying
Common financial fraud
SETUPATHY RATHA KRISHNAN
ARTICLE 6 : EARNINGS MANAGEMENT : A RIVIEW OF SELECTED CASES