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? 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.

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

Waste Management Overstated Income

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

WorldCom – Reported vs. Restated EBITDA

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

Ratio Analysis 2 nd Qt 2000 to 1 st 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%

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

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

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 ReportedActual

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

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

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

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

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

Enron – Reported and Restated Net Income

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

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

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?

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

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

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