Earnings and Financial Reporting Quality MIM 517 Fall 2010 Class 6

Learning Objectives Understand subtle distinction between different types of “financial games” Overview motivations for “games” Overview different techniques & implications on earnings quality Learn how to analyze media coverage of earnings management/fraud

Financial Games Also known as “Creative Accounting” Question: What does all creative accounting have in common? Answer: Using the ambiguity inherent in accounting to alter in a specific way, how outsiders view the performance of the company.

Definitions – shades of gray Creative Accounting Practices Earnings management: Using the ambiguity inherent in accounting to achieve specific predetermined earnings targets Income smoothing: A form of earnings management intended to remove the “peaks and valleys” from a normal earnings stream. Aggressive accounting: intentional application of GAAP to achieve the highest possible earnings Conservative accounting: intentional application of GAAP to achieve the lowest possible earnings

“Crossing the line” How is “financial statement fraud” distinguished from “earnings management”? Fraudulent financial reporting is intentional misstatements or omitted disclosures (GAAP violations) intended to deceive users What causes the line to be crossed? Remember the range of acceptable net income Fraud ( Net Income)Fraud

Quality of Financial Reporting Definition: A subjective evaluation of the extent to which the financial reporting is free of manipulation and accurately reflects the financial condition and operating success of a business enterprise. “Earnings Quality” Both the numbers and disclosures Higher quality facilitates better understanding of the past and better prediction of the future.

Motivations for Creative Accounting Share price effects Borrowing cost effects Bonus plan effects Political cost effects

Situations Where Creative Accounting is More Likely Earnings short market expectation Firm preparing for IPO Earnings above minimum for incentive compensation Firm close to violating debt covenant Earnings trend above/below what management believes is a sustainable trend Earnings volatility induced by a series of non-recurring items A change has taken place in top management

Consider this situation… A company’s CFO has just reviewed the current year’s 3 rd quarter financial results and realized it is missing its annual earnings growth target of 12%. Achieving only a 9% growth in earnings will have a detrimental impact on the firm’s stock price. The CFO wants to develop plans to stimulate 4 th quarter earnings to hopefully hit the 12% target. What techniques could be used to increase earnings? Differentiate between those that would increase earnings and a) have a positive “real” impact on the firm’s financial performance, versus b) lower the quality of reported earnings

Earnings Management Techniques Premature or fictitious revenue recognition Aggressive capitalization and extended amortization policies Inappropriate use of reserves Big Bath: Large loss (restructuring) recorded to a period to increase the chances of better future earnings Cookie jar reserves: allowances or reserves increased in a particular year in order to boost future years’ earnings Misclassification in the Income Statement Misuse of “materiality”

Is it all rotten in the financial statements??? This is nothing new The high-risk firms most vulnerable Thing come out during “soft” times Boom times vs. bad times Bad times are true test of business If something seems too good, it likely is!

Environmental Factors Encouraging/Discouraging EM Encouraging Domineering CEO w/ substantial perks Disproportionate executive compensation Culture of “never fail” BOD primarily insiders Poor board committee structure Auditor problems Investment banker and analysts the same Debt covenant close to violation Aggressive EPS targets Discouraging CEO compensation balanced between salary and performance incentives BOD primarily outsiders Strong BOD committee structure Auditor independence Investment bankers and analysts independent SOX!

Misstated financial statements Consider current examples you found… What to present: Summary of company – what do, business model, etc Summarize the issue included in the SEC Enforcement Action Relate the “creative accounting” issue to the Earnings Management Techniques (slide 10 or your text)