1 ©2006 Prentice Hall, Inc.

2 QUALITY OF EARNINGS AND CORPORATE GOVERNANCE (1 of 2)  Learning objectives Learning objectives  Importance of earnings Importance of earnings  Quality of earnings Quality of earnings  Common ways to manipulate earnings Common ways to manipulate earnings

3 ©2006 Prentice Hall, Inc. QUALITY OF EARNINGS AND CORPORATE GOVERNANCE (2 of 2)  Business scandals of the early 2000’s Business scandals of the early 2000’s  Sarbanes-Oxley Act of 2002 Sarbanes-Oxley Act of 2002  Evaluating corporate governance Evaluating corporate governance

4 ©2006 Prentice Hall, Inc. Learning Objectives (1 of 2)  Explain Wall Street’s emphasis on earnings and the potential problems that result from this emphasis  Define quality of earnings and explain how it is measured  Recognize the common ways that firms can manipulate earnings

5 ©2006 Prentice Hall, Inc. Learning Objectives (2 of 2)  Describe the corporate accounting failures of the early 2000’s  Explain the requirements of the Sarbanes-Oxley Act of 2002  Explain how to evaluate a firm’s corporate governance

6 ©2006 Prentice Hall, Inc. Importance of Earnings  Earnings per share = net income avg # shs comstk  How does Wall Street react when quarterly EPS exceeds expectations?  Can quarterly EPS alone accurately assess a firm’s financial health? Why or why not?

7 ©2006 Prentice Hall, Inc. Quality of Earnings (1 of 4)  How well a particular earnings number communicates the firm’s true performance  Factors associated with earnings quality  Selection of accounting principles  Conservative choices associated w/ higher quality earnings

8 ©2006 Prentice Hall, Inc. Quality of Earnings (2 of 4)  Factors associated with earnings quality (continued)  Application of accounting principles  Early revenue recognition or delayed expense recognition associated w/ lower quality earnings  Business risk  Sum of internal & external factors that affect firm performance and survival  Lower business risk associated w/ higher quality earnings

9 ©2006 Prentice Hall, Inc. Quality of Earnings (3 of 4)  Classification of accounting choices  Conservative choices  Reduce net income, reduce assets, increase liabilities  Aggressive choices  Increase net income, increase assets, decrease liabilities

10 ©2006 Prentice Hall, Inc. Quality of Earnings (4 of 4)  What is the conservative choice for the following accounting choices?  Inventory cost flow assumption in times of rising prices  Useful life of depreciable assets

11 ©2006 Prentice Hall, Inc. Common Ways to Manipulate Earnings  Big bath charges Big bath charges  Cookie jar reserves Cookie jar reserves  Revenue recognition Revenue recognition

12 ©2006 Prentice Hall, Inc. Big Bath Charges  Big bath theory  If you are going to take a loss, then take as big a loss as possible  If not making earnings estimate, write-off assets that may be written off in the next few years  How can you identify big bath behavior?

13 ©2006 Prentice Hall, Inc. Cookie Jar Reserves  Overestimating an expense related to an allowance account in one year to build a reserve that can be used to underestimate the expense in the future when it is needed  Mismatches expense with related revenue  Reserves may be used for a “rainy day” or to “smooth” earnings

14 ©2006 Prentice Hall, Inc. Revenue Recognition (1 of 4)  When GAAP requires revenue recognition  Firm has earned the revenue  Collection is reasonably assured  Continuum of violation of revenue recognition rules Premature Create Fictitious Recognition Revenue

15 ©2006 Prentice Hall, Inc. Revenue Recognition (2 of 4)  Examples of improper revenue recognition  Record goods sold at end of quarter when not delivered until next quarter  How would shipping terms affect when the revenue is recognized?  Keep books open after quarters’ end until sales goals are met  How does this affect sales for following quarter?

16 ©2006 Prentice Hall, Inc. Revenue Recognition (3 of 4)  Rate these schemes on ethics continuum  Record sales of goods shipped to customers who had not placed orders for the goods  Create fictitious documents for both purchases and sales of goods to fictitious customers  Record sales for goods shipped to salespeople in field for goods not delivered to customers  Ship goods to firm’s offsite locations and record shipments as sales revenue

17 ©2006 Prentice Hall, Inc. Revenue Recognition (4 of 4)  Identifying revenue recognition problems  Examine notes to financial statement for disclosure of revenue recognition policies  Look for changes in policies from prior years  Analyze relationship between sales and accounts receivable  What may increasing AR/Sales ratio indicate?  What other methods can you think of?

18 ©2006 Prentice Hall, Inc. Business Scandals of The Early 2000’s  Definitions Definitions  Recent business failures/scandals Recent business failures/scandals  Executives convicted in failures/scandals Executives convicted in failures/scandals  What we learned What we learned

19 ©2006 Prentice Hall, Inc. Definitions  Securities Acts of 1933 and 1934  Laws for publicly traded companies and their auditors  Corporate governance  The way a firm governs itself, as executed by the board directors  What recent legislation changed the corporate governance rules?  What else did it change?

20 ©2006 Prentice Hall, Inc. Recent Business Failures/Scandals (1 of 3)  Enron  7 th largest U.S. company  Improper accounting used to hide bad investments and liabilities  Adlphia  6 th largest cable company in U.S.  CEO arrested for conspiracy, bank fraud, and securities fraud

21 ©2006 Prentice Hall, Inc. Recent Business Failures/Scandals (2 of 3)  Arthur Andersen  1 of world’s 5 largest accounting firms  Guilty of obstruction justice in Enron case  Founded in 1914 and employed 28K people  WorldCom  Overstated revenues by $3.8B

22 ©2006 Prentice Hall, Inc. Recent Business Failures/Scandals (3 of 3)  Tyco  Two executives stole >$600M  Executives could face 25 years in prison  Computer Associates  >$2B improperly booked revenue

23 ©2006 Prentice Hall, Inc. Executives Convicted in Failures/Scandals (1 of 4)  Enron  Andrew Festow, former CFO  Plead guilty to securities and wire fraud  Sentenced to 10 years in prison  WorldCom  Bernard Ebbers, former CEO  Convicted on all 9 counts for role in $11B scandal. Could spend 25 years in prison

24 ©2006 Prentice Hall, Inc. Executives Convicted in Failures/Scandals (2 of 4)  Adelphia  John Rigas, founder and former CFO  Took > $2B from co. for personal use and lied to public about co.’s financial condition  Awaiting sentencing, could face 30 years

25 ©2006 Prentice Hall, Inc. Executives Convicted in Failures/Scandals (3 of 4)  Rite Aid  Martin Grass, co-founder and former CEO  Helped commit accounting fraud  3 years probation, $500K fine  CSFB  Frank Quattrone, investment banker  Obstruction of justice  18 months in prison

26 ©2006 Prentice Hall, Inc. Executives Convicted in Failures/Scandals (4 of 4)  ImClone Systems  Martha Stewart, investor; founder of Martha Stewart Living Omnimedia, Inc.  Obstruction of justice in an insider- trading probe  5 months in prison, 5 months home confinement, 2 years probation, $30K fine

27 ©2006 Prentice Hall, Inc. What We Learned (1 of 4)  Corp execs will do almost anything to meet earnings targets to prop up stock prices  How do execs personally benefit from stable or rising stock prices?  Ethical climate set by top execs

28 ©2006 Prentice Hall, Inc. What We Learned (2 of 4)  Auditors must be independent to provide a meaningful quality audit  Can a CPA firm be independent if the audit client’s fees are a substantial portion of the firm’s revenues?  How do large consulting fees from a client affect auditor independence?

29 ©2006 Prentice Hall, Inc. What We Learned (3 of 4)  Earnings and financial statements must be more transparent  Should management have discretion in applying GAAP? How and where should it be disclosed?  Even the most stringent accounting standards cannot eliminate fraud  Auditors and the SEC are making progress in reducing fraud

30 ©2006 Prentice Hall, Inc. What We Learned (4 of 4)  Over-reliance on EPS or any single number can be disastrous  What should investors use besides financial statements to evaluate the financial health and viability of a company?  OECD issued 1 st set of int’l corporate governance standards  Why are int’l standards important?

31 ©2006 Prentice Hall, Inc. Sarbanes-Oxley Act (SOX) of 2002 (1 of 2)  Purpose is to strengthen financial reporting and corporate governance of publicly traded companies  Currently applies to all publicly traded and int’l co’s traded on U.S. stock exchanges

32 ©2006 Prentice Hall, Inc. Sarbanes-Oxley Act (SOX) of 2002 (2 of 2)  Key groups affected by SOX  Management Management  Board of directors (BOD) Board of directors (BOD)  External auditors External auditors  PCAOB PCAOB  Downside to SOX Downside to SOX

33 ©2006 Prentice Hall, Inc. Management (1 of 2)  CEO and CFO legally responsible for firm’s internal controls  Annual report contains separate report on effectiveness of internal controls  External auditors must attest to accuracy of report  CEO and CFO legally responsible for accuracy of financial statements

34 ©2006 Prentice Hall, Inc. Management (2 of 2)  Internal auditors  Largely responsible for internal controls  Independent of any dept or division  They are an internal control themselves  Firms must provide a way for anonymous reporting of fraudulent activities of the company  Includes hotline for reporting  Whistleblower protection provided

35 ©2006 Prentice Hall, Inc. Board of Directors (BOD)  Elected by stockholders  Establish general corporate policies  Make major company decisions  Oversee audit committee  Only independent directors (not mgmt) can be on audit committee  What are the audit committee’s duties?

36 ©2006 Prentice Hall, Inc. External Auditors (1 of 2)  Trained to examine company’s financial statements and financial controls and report findings to external users  Do financial statements fairly present the company’s financial position in accordance with GAAP?  How effective are a company’s internal controls?

37 ©2006 Prentice Hall, Inc. External Auditors (2 of 2)  SOX strengthens SEC’s rules related to auditor independence  Ensures objectivity  Auditors can no longer provide information processing consulting services to its audit clients?  Auditor now reports to audit committee instead of company’s management

38 ©2006 Prentice Hall, Inc. Public Company Accounting Oversight Board (PCAOB)  Established by SOX to regulate the audit profession  All accounting firms that audit publicly traded companies must register with PCAOB and follow their rules  SEC must approve any rules set by PCAOB  Members appointed by Federal Reserve Board Chair

39 ©2006 Prentice Hall, Inc. Downside to Sarbanes-Oxley Act  Cost of implementing SOX, especially internal control requirements of Section 404  SOX does not require the BoD to have a financial expert  How could SOX negatively affect CEOs, directors, auditors and attorneys with running a company?

40 ©2006 Prentice Hall, Inc. Evaluating Corporate Governance (1 of 5)  Elements for strong and effective corporate governance  Independent, highly qualified, and diverse board of directors  CEO encourages board involvement  Transparency of financial information

41 ©2006 Prentice Hall, Inc. Evaluating Corporate Governance (2 of 5)  Elements for strong and effective corporate governance (continued)  Mgmt. compensation w/ incentives for performance that increases shareholder value  A strong and independent audit function

42 ©2006 Prentice Hall, Inc. Evaluating Corporate Governance (3 of 5)  Evaluating a firm’s corporate governance  Where can you find information about a company’s corporate governance?

43 ©2006 Prentice Hall, Inc. Evaluating Corporate Governance (4 of 5)  Standard and Poors’ rating system  Interviews with key stakeholders  E.g., CEO, finance director, BoD, key creditors and shareholders, independent auditor  Inspect company documentation  E.g., public filings, BoD minutes

44 ©2006 Prentice Hall, Inc. Evaluating Corporate Governance (5 of 5)  Standard and Poors’ rating system (con’d)  Overall Scores from 0-10  0 for not providing sufficient information  Four individual categories scored from 0-10  Ownership structure and external influences  Shareholder rights and stakeholder relations  Transparency, disclosure and audit  Board structure and effectiveness  Why does corporate governance matter?

Comments or questions about PowerPoint Slides? Contact Dr. Richard Newmark at University of Northern Colorado’s Kenneth W. Monfort College of Business 45 ©2006 Prentice Hall, Inc.