Chapter 8 Earnings Management

Motivating Factors

Financial Accounting, 7e Stice/Stice, 2006 © Thomson Internal Targets Designed as incentive device Can lead to earnings management –Accelerate earnings to meet target –Delay earnings if target already met

Financial Accounting, 7e Stice/Stice, 2006 © Thomson External Expectations Financial analysts’ earnings forecast Incentive to “meet or beat” the forecast –Stock price impact Managers’ pessimistic guidance

Financial Accounting, 7e Stice/Stice, 2006 © Thomson Income Smoothing Timing revenue and expense recognition to even out reported earnings from year to year Company appears less volatile

Financial Accounting, 7e Stice/Stice, 2006 © Thomson Window Dressing Critical to report ‘good’ earnings –Initial public offering (IPO) –Secure debt financing

Common Techniques

Financial Accounting, 7e Stice/Stice, 2006 © Thomson The same flexibility that allows accountants to use professional judgment to produce financial statements that accurately portray a company’s financial condition also allows desperate managers to manipulate the reported numbers.

Financial Accounting, 7e Stice/Stice, 2006 © Thomson Earnings Management Continuum

Financial Accounting, 7e Stice/Stice, 2006 © Thomson Earnings Management Continuum Strategic matching –Positioning transactions in the most advantageous quarter Change in methods or estimates with full disclosure –Methods can be chosen to achieve a desired outcome –Disclosure permits assessment

Financial Accounting, 7e Stice/Stice, 2006 © Thomson Earnings Management Continuum Change in methods or estimates with little or no disclosure –Statement users are misled Non-GAAP accounting –Undiscovered errors –Fraudulent reporting Fictitious transactions –Concealing actual transactions –Creating nonexistent transactions

Financial Accounting, 7e Stice/Stice, 2006 © Thomson Pro Forma Earnings GAAP earnings with certain omissions Purpose in reporting –A better reflection of economic performance –To de-emphasize poor operating performance

Should a Company Manage Earnings?

Financial Accounting, 7e Stice/Stice, 2006 © Thomson Public Relations Investor Relations as a subset of Public Relations Financial statements as a communication device

Financial Accounting, 7e Stice/Stice, 2006 © Thomson Entity Ethics GAAP flexibility –Different methods and assumptions –Different results Policy: Conservative approach to accounting Attitude: Optimistic accounting assumptions

Financial Accounting, 7e Stice/Stice, 2006 © Thomson GAAP Continuum

Financial Accounting, 7e Stice/Stice, 2006 © Thomson Personal Ethics Personal ethics and financial reporting are inextricably connected Accounting is not a matter of simply applying a list of rules to a set of objective facts Earnings management –For better communication of economic performance –With an intent to deceive

Elements of an Earnings Meltdown

Financial Accounting, 7e Stice/Stice, 2006 © Thomson Elements of a Meltdown  Massive loss of reputation  Regulatory investigation  Insufficient user skepticism  Auditor’s calculated risk  Attempted accounting solution  Pressure to meet expectations  Down turn in business Healthy earnings lessen the need for earnings management

Financial Accounting, 7e Stice/Stice, 2006 © Thomson Elements of a Meltdown  Massive loss of reputation  Regulatory investigation  Insufficient user skepticism  Auditor’s calculated risk  Attempted accounting solution  Pressure to meet expectations  Down turn in business Both internal and external

Financial Accounting, 7e Stice/Stice, 2006 © Thomson Elements of a Meltdown  Massive loss of reputation  Regulatory investigation  Insufficient user skepticism  Auditor’s calculated risk  Attempted accounting solution  Pressure to meet expectations  Down turn in business Rather than a functional solution

Financial Accounting, 7e Stice/Stice, 2006 © Thomson Elements of a Meltdown  Massive loss of reputation  Regulatory investigation  Insufficient user skepticism  Auditor’s calculated risk  Attempted accounting solution  Pressure to meet expectations  Down turn in business Accept a debatable accounting treatment or risk loosing the client to opinion shopping

Financial Accounting, 7e Stice/Stice, 2006 © Thomson Elements of a Meltdown  Massive loss of reputation  Regulatory investigation  Insufficient user skepticism  Auditor’s calculated risk  Attempted accounting solution  Pressure to meet expectations  Down turn in business By both investors and analysts

Financial Accounting, 7e Stice/Stice, 2006 © Thomson Elements of a Meltdown  Massive loss of reputation  Regulatory investigation  Insufficient user skepticism  Auditor’s calculated risk  Attempted accounting solution  Pressure to meet expectations  Down turn in business SEC charges; criminal charges

Financial Accounting, 7e Stice/Stice, 2006 © Thomson Elements of a Meltdown  Massive loss of reputation  Regulatory investigation  Insufficient user skepticism  Auditor’s calculated risk  Attempted accounting solution  Pressure to meet expectations  Down turn in business Public Awareness

GAAP, Ethical Behavior, Cost of Obtaining Capital

Financial Accounting, 7e Stice/Stice, 2006 © Thomson The Cost of Capital After-tax interest for debt Expected return to secure investors Assess long-term projects Direct relationship: risk and cost Good financial reporting –Reduces investors’ and creditors’ uncertainty –Decreases cost of capital

Financial Accounting, 7e Stice/Stice, 2006 © Thomson Role of Accounting Standards AICPA and FASB –Recognized standards lower the cost of capital SEC –Mission of investor protection reduces information risk and cost of capital IASB –Global standard setting enhances transparency and reliability

Financial Accounting, 7e Stice/Stice, 2006 © Thomson Necessity of Ethical Behavior AICPA Code of Ethics...members should act with integrity, guided by the precept that when members fulfill their responsibility to the public, clients’ and employers’ interest are best served.

Financial Accounting, 7e Stice/Stice, 2006 © Thomson In Summary... Management of earnings ranges from timing of transactions to fraudulent reporting Pro Forma earnings may provide better information about a company’s performance or may be used to hide poor performance GAAP is not a rigid set of rules; within the flexibility of GAAP management has much discretion Management meltdown occurs through seven stages Ethical behavior reduces the cost of capital