Earnings Management Ch 16 Accounting Information for Decision Making

1. Earnings Management Ch 16 Accounting Information for Decision Making Rick Hayes, Ph.D., CPA California State University L.A.

2. 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

3. Incentives to Manipulate Earnings • Budget versus actual • Bonuses • Influence Wall Street analysts • Make stock options more valuable • Comply with debt covenants

4. 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

5. 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

6. 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

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

8. 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

9. 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

10. Off Balance Sheet Debt • Transferring liabilities to Special Purpose Entities (SPEs) • Transferring poor performing assets to SPEs • Incorrectly guaranteeing debt of SPEs • Improper leases

11. 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

12. 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

13. Accounting Tricks - Examples Waste Management Inc. – Understated depreciation and capitalized interest improperly, failed to write down impaired assets. Total restatement $2 billion.

14. Waste ManagementOverstated Income

15. Accounting Tricks - Examples WorldCom – Recorded expenses as capital expenditures, double-booked revenues, booked revenues as cost reductions. Total restatement $4.6 billion

16. WorldCom – Reported vs. Restated EBITDA

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

18. Xerox – Reported and Restated Revenue

19. 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.

20. Adelphia Debt Load $3.5 Billion $12.6 Billion Reported Actual

21. Accounting Tricks - Examples Sunbeam – Inflated revenues by channel stuffing and bill &hold. Reduced expenses by capitalizing advertising costs, reducing allowance for bad debts.

22. Sunbeam – Revenues and Net Income

23. 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.

24. Rite-Aid – Net Income Restatement

25. Accounting Tricks - Examples Enron - Hiding debt and losses in unconsolidated entities

26. Enron – Reported and Restated Net Income