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