Earnings Management Ch 16 Accounting Information for Decision Making

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Earnings Management Ch 16 Accounting Information
for Decision Making

• Rick Hayes, Ph.D., CPA
• California State University L.A.

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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

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Incentives to Manipulate Earnings

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

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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

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• Accounts Receivable
• Allowance for Bad Debt
• Inventory
• Allowance for Obsolete Inventory
• Investments
• Current Assets
• Fixed Assets
• Intangible assets
• Total Assets

• Revenue/Gain
• Sales Returns and allowances
• Cost of Sales
• Depreciation/amortization
• Expense
• Net Income/loss

• Expense

• Accounts Payable
• Accrued Payables
• Warranty Liability
• Current Liabilities
• Retained Earnings
• Total Liabilities and Equity

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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

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

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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

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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

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Off Balance Sheet Debt

• Transferring liabilities to Special Purpose
  Entities (SPEs)
• Transferring poor performing assets to SPEs
• Incorrectly guaranteeing debt of SPEs
• Improper leases

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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

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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

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Accounting Tricks - Examples
Waste Management Inc.
Understated depreciation and capitalized
interest improperly, failed to write down
impaired assets. Total restatement 2 billion.
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Waste ManagementOverstated Income
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Accounting Tricks - Examples
WorldCom
Recorded expenses as capital expenditures,
double-booked revenues, booked revenues as cost
reductions. Total restatement 4.6 billion
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WorldCom Reported vs. Restated EBITDA
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Accounting Tricks - Examples
Xerox
Recorded revenue on long-term leases of copiers
prematurely. Total restatement 3 billion (but
part of this increased later revenues).
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Xerox Reported and Restated Revenue
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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.
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Adelphia Debt Load

3.5 Billion
12.6 Billion
Reported
Actual
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Accounting Tricks - Examples
Sunbeam
Inflated revenues by channel stuffing and bill
hold. Reduced expenses by capitalizing
advertising costs, reducing allowance for bad
debts.
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Sunbeam Revenues and Net Income
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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.
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Rite-Aid Net Income Restatement
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Accounting Tricks - Examples
Enron
- Hiding debt and losses in unconsolidated
entities
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Enron Reported and Restated Net Income