Earnings Management What is earnings management? Creative accounting Cook the books – falsify their financial statements. Earnings? - profit of company Investors and analysts look at earnings - attractiveness of stock - generate profit in future affects stock price now Management deliberately manipulate earnings so that figures match a predetermined target

Richmond, Inc. , operates a chain of 44 department stores Richmond, Inc., operates a chain of 44 department stores. Two years ago, the board of directors of Richmond approved a large-scale remodeling of its stores to attract a more upscale clientele. Before finalizing these plans, two stores were remodeled as a test. Linda Perlman, assistant controller, was asked to oversee the financial reporting for these test stores, and she and other management personnel were offered bonuses based on the sales growth and profitability of these stores. While completing the financial reports, Perlman discovered a sizeable inventory of outdated goods that should have been discounted for sale or returned to the manufacturer. She discussed the situation with her management colleagues; the consensus was to ignore reporting this inventory as obsolete because reporting it would diminish the financial results and their bonuses.

Income smoothing - instead of good and bad years - keep relatively stable - adding/removing cash Accelerating revenues, delaying expenses Inappropriate accruals and estimates of liabilities Excessive provisions and generous reserve accounting Cookie jar - income smoothing", because earnings are understated in good years and overstated in bad years. Slush fund - earnings from one time frame are hidden just in case the profit from next time frame is not big enough for management to make their bonuses

Could be material and intentional misrepresentation of results May or may not follow rules of standard accounting practices but deviate from spirit of rule Root of many accounting scandals Hard to detect in some cases - can be very sophisticated or covert

What? Aggressive accounting - practice of inappropriately misconstruing income statements for the purpose of pleasing investors and inflating stock prices. Managers choosing accounting policies so as to maximize their own utility and/or the market value of the firm.

Why? -- Share price effects – beat analysis estimates to keep share price increasing -- Borrowing cost effects – showing good results will lower costs of borrowing -- Bonus plan effects – management get bonuses -- Political cost effects – keep earnings within what is considered an acceptable range to make sure the firms does not attract undue regulatory oversight. Example – a firm like GE making lots of money but not paying any US taxes attracts IRS scrutiny.

How? 1. Flexibility of accounting principles Choices: Inventory – FIFO, LIFO Depreciation – straight line, double declining Expensing vs. Capitalizing Why do we allow choices? What problems does choice create?

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

Asset impairments - sharp and unexpected decline in value - new competition and technological innovations – large write off Restructuring costs - "Wall Street cheered when AT&T Corp. announced drastic cutbacks of 40,000 employees and a $4 billion restructuring charge on Jan. 2. AT&T’s stock surged $2.625 a share to $67.375 on the company’s vow to get into fighting trim before splitting into three parts starting later this year.“ - fact that AT&T’s stock price went up indicates that "the market" believes that the restructuring has created value to shareholders

Inventory write-downs - lower of cost or market Environmental liabilities - potential for fines, penalties, and jail terms for violations of environmental laws - clean-up obligations Pension assumptions - highly unionized workforces - very real financial liability - inflate the reported GAAP earnings - adjust the assumptions used in estimating pension expense In-process R&D Percentage of completion contracts

What is rule-based accounting? specific details in an attempt to address as many potential contingencies as possible standards longer and more complex arbitrary criteria for accounting treatments that allow companies to structure transactions to circumvent unfavorable reporting What are its advantages and disadvantages? What is principle-based accounting? SEC - concise statement of substantive accounting principle where the accounting objective has been incorporated as an integral part of the standard and where few, if any, exceptions or internal inconsistencies are included in the standard What are its advantages and disadvantages?

Sickening example – SPE’s Special purpose entity body corporate - created to fulfill narrow, specific or temporary objectives, primarily to isolate financial risk, usually bankruptcy but sometimes a specific taxation or regulatory risk Financial engineering: SPEs are often used in complex financial engineering schemes which have, as their main goal, the avoidance of tax or the manipulation of financial statements. Possibly the most famous example of a company using SPEs to achieve the latter goal is Enron.

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

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

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

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

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

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.

Enron - Hiding debt and losses in unconsolidated entities