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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