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Earnings Management

Earnings Management. What is earnings management?. Why do managers do it?. How do they do it?. How can we detect it?. What?. Aggressive Accounting Earnings Management Income Smoothing Fraudulent Reporting Creative Accounting. What?.

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Earnings Management

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  1. Earnings Management What is earnings management? Why do managers do it? How do they do it? How can we detect it?

  2. What? • Aggressive Accounting • Earnings Management • Income Smoothing • Fraudulent Reporting • Creative Accounting

  3. What? The active manipulation of accounting results for the purpose of creating an altered impression of performance. Managers choosing accounting policies so as to maximize their own utility and/or the market value of the firm.

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

  5. Waste ManagementOverstated Income

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

  7. WorldCom – Reported vs. Restated EBITDA

  8. How would you detect this type of fraud? • A decrease in the asset turnover ratio. A fictitious asset cannot produce revenue • PPE increases while revenue decreases • When an expense that is fixed remains constant as a percentage of sales, despite decreases in revenue • Possible from disclosures on significant accounting policies • Writing off previously capitalized cost

  9. Ratio Analysis 2nd Qt 2000 to 1st Qt 2002 Line costs/revenue 40.73% 38.49% 42.53% 42.26%41.83% 41.77% 42.09% 42.84% Asset Turnover 10.47% 10.16% 9.71% 9.76% 8.74% 8.55% 8.16% 7.82% Sales/PPE 59.2% 55.1% 47.4% 45.5% 44.1% 40.7% 35.6% 32.2%

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

  11. Xerox – Reported and Restated Revenue

  12. How would you detect? • Examine Days in receivables – if this increases because revenue is being recognized significantly earlier than it is collected. • The relationship between CFFO and revenue significantly decreases

  13. 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.

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

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

  16. Sunbeam – Revenues and Net Income

  17. Signals of this type of fraud • Days in Receivables increases • An increase in Gross Margin percentage • CFFO falls • Change to a more aggressive revenue recognition policy • Offers large discounts or other inducements to get orders • Revenue is recorded despite a right of return

  18. 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.

  19. Rite-Aid – Net Income Restatement

  20. Detecting overstated inventory • Not recording “shrinkage” of inventory • Recognizing rebates from vendors before Rite Aid actually sold the goods

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

  22. Enron – Reported and Restated Net Income

  23. Why? -- Share price effects -- Borrowing cost effects -- Bonus plan effects -- Political cost effects

  24. How? 1. Flexibilityof accounting principles 2. Choices, estimates, & judgments 3. Rule-based accounting loopholes

  25. How? 1. Flexibility of accounting principles What problems does choice create? • Choices: • Inventory • Depreciation • Expensing vs. Capitalizing • Software sales recognition Why do we allow choices?

  26. How? 2. Choices, Estimates, & Judgments • warranties • Depreciation • method • useful life • salvage value • Allowance accounts • bad debts • sales returns

  27. Choices etc., cont’d. • Asset and goodwill impairments • Restructuring costs • Inventory write-downs • Environmental liabilities • Pension assumptions • In-process R&D • Percentage of completion contracts

  28. How? 3. Rule-based versus principle-based accounting • What is principle-based accounting? • What are its advantages and disadvantages? • What is rule-based accounting? • What are its advantages and disadvantages? Sickening example – SPE’s

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