Earnings Management: Practice and Pitfalls Philip Livingston President and CEO Financial Executives International

What is Earnings Management? The process of establishing stakeholder expectations and achieving the result through legitimate and/or illegitimate methods

Why Are We Talking About It?  Illegitimate methods CLOUD financial reporting transparency  Contrary to unbiased reporting  Result is low quality earnings even if the target is reached.  U.S. capital markets placed a premium on predictability  SEC action in 1998

Legitimate Earnings Management  Planning discretionary spending Marketing and advertising Research and development Employee meetings, T&E

Legitimate Earnings Management  Special Quarter-End Sales Price reductions Sales force incentives Quantity/truckload offers to customers  Shipments Hold or Push Daily management of revenue Add warehouse workers Schedule factory and warehouse overtime

Legitimate Earnings Management  Instituting a hiring freeze, temporarily avoiding: Hiring expense Non-essential salary expense Benefit costs

Top Problem Area  Revenue accounting manipulation Side deals by salespeople that are undisclosed to accounting – allowances, deductions and credits. Shipments to distributors or intermediaries associated with great uncertainty of sale. Premature recording when right of return exists Payment contingencies tied to other events Invoices that are inconsistent with underlying transactions

“Managing the Bottom Line” Past Accounting Practices Merger and Acquisition Reserve Abuses  Setting up reserves to cover future operating costs of an acquired company  Providing rich reserves that allow for future adjustments that favorably impact earnings  Writing-off excessive “in-process R&D” to avoid future amortization charges

“Managing the Bottom Line” Past Accounting Practices Restructuring Reserve Abuses  Providing general restructuring reserves subject to subsequent adjustment  Reserving for exit costs that will benefit future periods (employee moving and training)  Including in the restructure charge the cost of assets already impaired

“Managing the Bottom Line” Past Accounting Practices Materiality Abuses  Exclusive reliance on “rule of thumb” criteria (e.g. 5% of earnings) for determining materiality  Intentional failure to record items deemed “immaterial” per these criteria  Improperly Aggregating and Netting unrecorded adjustments

Judgment Areas Subject to Abuse  Adjusting Reserves and Accruals on a Quarterly Basis Those that require considerable judgment: Inventory obsolesce and valuation Sales returns and allowances Accruals for professional fees Accrued marketing costs Warranty claim reserves Reserves for self-insured benefits

Judgment Areas Subject to Abuse  Adjusting Reserves and Accruals on a Quarterly Basis Those that require considerable judgment: Bad debt allowance Inventory overhead absorption rates Tax rate Prepaid expenses

SEC Actions: SAB #99 Materiality  Requires consideration of QUALITATIVE factors, not just quantitative “Is it probably that the judgment of a reasonable person relying upon the report would have been changed or influenced by …correction of the item?”  Strives to eliminate INTENTIONAL failure to record immaterial items  Requires consideration of the materiality of misstatements individually, and in aggregate

SEC Actions: SAB #100 Restructuring and Impairment Charges SEC Actions: SAB #100 Restructuring and Impairment Charges  Prior to recording a restructuring, companies must: Have a detailed plan, approved by top management Communicate to employees their benefits entitlement Disclose expected headcount reductions, timetable for plan execution, and expected cost by category Report in detail, progress against the plan

Managing Earnings Expectations: Past Practices  Informal discussions with select analysts intended to influence earnings estimates  “Tipping” selected analysts in anticipation of earnings releases  Exchanging tipped information in exchange for agreement to “rein in” market expectations

Regulation FD “Fair Disclosure”  Whenever a company discloses material information, it must make public  Whenever non-intentional disclosure is made, the company must make it public within 24 hours.  Public disclosure includes – filing the information with the SEC – press release – providing public access to the conference call or meeting

Best Practices Going Forward  Stick to legitimate “operational” solutions  Make earnings forecasts public  Update forecasts regularly  Consider providing an earnings estimate range  Discuss short-term forecast within the context of long- term plans

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Earnings Management: Practices and Pitfalls Philip Livingston President and CEO Financial Executives International