Earnings Management Ch 16 Accounting Information for Decision Making Rick Hayes, Ph.D., CPA...

Earnings Management Ch 16 Accounting Information for Decision Making

Rick Hayes, Ph.D., CPACalifornia State University L.A.

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

Incentives to Manipulate Earnings

• Budget versus actual• Bonuses• Influence Wall Street analysts• Make stock options more valuable• Comply with debt covenants

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

• 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

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

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

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

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

Off Balance Sheet Debt

• Transferring liabilities to Special Purpose Entities (SPEs)

• Transferring poor performing assets to SPEs• Incorrectly guaranteeing debt of SPEs• Improper leases

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

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

Accounting Tricks - Examples

Waste Management Inc.

– Understated depreciation and capitalized interest improperly, failed to write down impaired assets. Total restatement $2 billion.

Waste ManagementOverstated Income

-1000

100200300400500600700800900

92 93 94 95 96 97

Original

Restated

Accounting Tricks - Examples

WorldCom

– Recorded expenses as capital expenditures, double-booked revenues, booked revenues as cost reductions. Total restatement $4.6 billion

0

2000

4000

6000

8000

10000

12000

14000

1999 2000 2001 1st Qtr 2002

Year

EB

ITD

A (i

n m

illio

ns)

Reported EBITDA

Restated EBITDA

WorldCom – Reported vs. Restated EBITDA

Accounting Tricks - Examples

Xerox

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

Xerox – Reported and Restated Revenue

14,500

15,000

15,500

16,000

16,500

17,000

17,500

18,000

18,500

19,000

19,500

20,000

1997 1998 1999 2000 2001

Original

Restated

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.

Adelphia Debt Load

$3.5 Billion

$12.6 Billion

Reported Actual

Accounting Tricks - Examples

Sunbeam

– Inflated revenues by channel stuffing and bill &hold. Reduced expenses by capitalizing advertising costs, reducing allowance for bad debts.

Sunbeam – Revenues and Net Income

(400,000)

(200,000)

0

200,000

400,000

600,000

800,000

1,000,000

1,200,000

1,400,000

1996 1997

Reported Revenue

Actual Revenue

Reported NI

Actual NI

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.

Rite-Aid – Net Income Restatement

-50

0

50

100

150

200

250

1998 1999 1Q2000

Reported

Restated

Accounting Tricks - Examples

Enron

- Hiding debt and losses in unconsolidated entities

Enron – Reported and Restated Net Income

0

200

400

600

800

1000

1200

1997 1998 1999 2000 2001

Reported

Restated