1. Accrual Accounting and Earnings Management
RCJ Chapters 1, 2(48-52), 3( ), 7( )

2. Key Issues Accrual accounting
Managers’ incentives and reporting abuses
Example: Revenue recognition
How earnings are managed
Paul Zarowin

3. Accrual Accounting
Recognizes the financial benefits and obligations accruing to an enterprise over the reporting period - regardless of cash inflows and outflows.
Objective: Better indication of performance than current cash receipts and payments.
Paul Zarowin

4. Accrual Accounting: Characteristics
subjectivity
assumptions
discretion
incentives
Paul Zarowin

5. Earnings Management
The reporting discretion inherent in accrual accounting can be opportunistically used by managers.
information
Manager
Investors
Reporting incentives:
Higher bonus
Cashing out on Stock options
Career and personal ego
Paul Zarowin

6. Earnings Management (cont’d)
Why allow reporting discretion?
Rigid rules
(e.g. full expensing of R&D)
Flexible rules
(e.g. revenue recognition)
trade-off
Reporting biases
No discretion
Enables better reporting of larger number of businesses.
Prone to manipulation
Paul Zarowin

7. Earnings Management (cont’d)
Important to understand: More often the problem is not the flexibility of the reporting rules, but the fact that the watchdogs are not doing their job!!!
Audit failure
Poor corporate governance
Shareholder involvement
SEC enforcement
Paul Zarowin

8. Common Earnings Management Practices
Shifting income between periods:
Revenues
Expenses
Borrowing earnings from the future
1. Premature recognition of revenues
Example: Xerox
2. Capitalization of expenses
Example: WorldCom
Postponing earnings to the future
3. Deferring recognition of revenues
Example: Microsoft
4. Exaggerating current expenses/losses to create cookie jar reserves
Note: t Earningst = t Cash Flowst
Paul Zarowin

9. Common Earnings Management Practices (cont’d): J.E.
Actual J.E.
Proper recognition J.E.
1. Borrowing revenues from the future
DR CR
Cash revenue
DR CR
cash def. revenue
later: def. revenue revenue
2. Deferring expenses to the future
Asset cash
later: Expense asset
DR CR
expense cash
3. Deferring revenue to the future
DR CR
Cash revenue
4. Exaggerating current expenses/losses to create cookie jar
loss liability/Asset
later: liability cash
No journal entry
later: loss cash
Paul Zarowin

10. Common Earnings Management Practices (cont’d)
Classification of gains and losses:
Classifying one-time gains as earnings from continuing operations
Classifying losses from continuing operations as one-time items
Hiding Debt in unconsolidated subsidiaries
Example: Enron
Legitimate Earnings Management (Within GAAP)
Violation of GAAP or SEC rules
Manipulation of accruals to:
I. smooth earnings
II. Turn permanent expenses into temporary losses
ex. P15-9

11. Example of Scope of Manipulations and Incentives: Xerox Case
Xerox sells/leases copy machines, and related service to be provided for several years after sale.
Recorded service revenue at the time of sale.
According to the SEC investigation, “accounting tricks” boosted pretax profit by 1.5 billion from 1997 through 2000.
In November 1999, CFO told management:
"When accounting actions were stripped away, Xerox had essentially no growth through the late 1990s.”
Q: Which of the 4 categories mentioned in slide #8 does Xerox case falls into?
Paul Zarowin

12. Xerox Case: what were the incentives?
Without the accounting scheme the company would have missed Wall Street's consensus per-share earnings targets in 11 of 12 quarters from 1997 to 1999.
Accounting scheme helped keep Xerox's stock price artificially high in the late 1990s so executives could cash in $5 million in performance-based compensation and more than $30 million from stock sales.
Paul Zarowin

13. Example of Reporting Discretion: Seebeyond Case
On March 2002 SeeBeyond sold its software product for $2.2 million to a costumer.
Deployment and payment for
the software in stages that could
extend until March 2003.
This customer had bought and successfully deployed software from SeeBeyond before.
SeeBeyond is interested in including the $2.2 million in the revenues of the quarter ending on March 31, Is it possible?
No. Revenue not earned.
No. Revenue not measurable
Yes. Revenue is both earned and measurable.
Revenue recognition:
Earned
Measurable
Paul Zarowin

14. SeeBeyond Case (cont’d)
SeeBeyond held a conference call telling investors that revenues would fall short of the previous revenue guidance by approximately $2 million.
The share fell 52% the next day!!! Why?
Paul Zarowin