Accounts case study Earnings Management

Accounts case study
Earnings Management

Chapter 7

7-#

Questions for Consideration

Should the SEC (and FASB) set specific rules governing non-GAAP disclosures?

Should auditors test these numbers to ensure there are no materially misleading amounts?

Should auditors include in their assessment of internal controls over financial reporting consideration of whether adequate controls exist to ensure the non-GAAP reported amounts comply with SEC guidelines and/or any regulations that are set?

How do considerations of earnings management influence the manner in which non-GAAP metrics are disclosed?

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Ethical Reflection

What ways can financial statements be manipulated?

Companies look for any advantage when they report GAAP earnings. One approach is to report non-GAAP earnings.

SafeNet enforcement action allegations:

SafeNet was unable to meet earnings targets through normal business operations

The CFO directed accountants to make improper accounting adjustments including reclassifying ordinary operating expenses as non-recurring

How can we assess whether auditors are meeting their ethical obligations and protecting the public interest with regard to identifying financial shenanigans and assessing earnings management and fraud?

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Motivation to Manage Earnings

Companies manage earnings when they ask, How can we best report desired results? rather than how can we best report economic reality?

Pressure to make the numbers

Emerged during 1990s and early 2000s

Stock market awards firms that meet or beat analysts forecasts and punish firms that miss earnings targets

Management may also use earnings management to maximize bonuses and the value of stock options

Another objective can be avoiding consequences of violation of debt covenants

Board of Directors should focus on long term strategic goals and shield managers from short-term pressure

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Nonfinancial Measures of Earnings

Constant pressure to report favorable earnings performance motivates many companies to report income numbers that exclude unusual events that almost always seem to be costly and depress earnings

These non-GAAP numbers put a positive spin on what otherwise might not be such good results under GAAP

Regulation G requires public companies that disclose or release non-GAAP financial measures to include a presentation of the most directly comparable GAAP financial measure and a reconciliation of the non-GAAP measure to the comparable GAAP measure

Auditors should be tasked with at least reviewing non-GAAP measures as part of their annual audit requirements

7-#

Characteristics of Earnings Management

Gaa and Dunmore denote two basic possible earnings managements

Alter the numbers in the financial records by using discretionary accruals and other adjustments

Create or structure transactions to alter reported numbers

Another perspective is to divide the techniques into two categories

Operating earnings management altering operating decisions to affect cash flows and net income for a period

Accounting earnings management using the flexibility in accounting standards to alter earnings numbers

The end result of earnings management is to distort the application of GAAP, bringing into question the quality of earnings

Earnings manipulation is a form of earnings management and can be legitimate, marginally ethical, unethical, or illegal

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Income Smoothing

Motivation to smooth net income over time

Steady increase each year over a period of time is ideal

Investors are willing to pay premium for stocks with steady and predictable earnings streams

These practices lead to erosion in quality of earnings

Accelerate recognition of revenue

Delay recognition of expenses

Cookie jar reserves

Set aside reserves in good years

Used to prop up earnings in bad years

HealthSouth case

Banks more aggressive using loan-loss reserves

Companies also smooth tax liability over years

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Definition of Earnings Management

Schipper defines it in a negative light- purposeful intervention in the external reporting process, with the intent of obtaining some private gain

Healy and Wahlen define it as when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company, or to influence contractual outcomes that depend on reported accounting numbers

Dechow and Skinner believe that a distinction should be made between making choices in determining earnings that may comprise aggressive, but acceptable, accounting estimates and judgments, as compared to fraudulent accounting practices that are clearly intended to deceive others

McKee characterizes it as reasonable and legal management decision making and reporting intended to achieve stable and predictable financial results

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How Do Managers and Accountants Perceive Earnings Management?

Survey by Elias

Accountants in orgs with high ethical values perceive earnings management as more unethical

Accountants in industry significantly less likely than CPAs in public practice to perceive high ethical values in their organizations

Survey by Bruns and Merchant

Managers disagree about ethics of earnings management

Manipulation of operating decisions was more ethical than manipulation by accounting method

Survey by Rosenzweig and Fischer

Accounting manipulation

Changing accounting methods

Recording expense in wrong year

Changing inventory valuation

Operating decisions

Deferring necessary expenditures to subsequent year

Attracting customers at year-end to draw sales into current year

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Ethics of Earnings Management

Use ethics framework to judge acceptability

Virtue ethics examines reasons for the actions taken by decision maker AND the action itself

McKees explanation is merely a rationalization

Doesnt hold true to virtues of honesty and dependability

Ignores rights of shareholders and stakeholders to receive fair and accurate information

Masks true performance

Hopwood says ethics issue can be mitigated by disclosing aggressive accounting assumptions

Nothing more than rationalization for unethical behavior: disclosure should not be used to cure ills of earnings management

Act Utilitarian

A decision made by weighing benefits of management/ company to smooth net income vs. costs of providing false information to shareholders

Rule Utilitarian

Financial statements should never be manipulated for personal gain

The problem is there is no clear limit between what is ethical and what isnt

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Needles Continuum of Earnings Management

Needles points out that the difference between an ethical and an unethical accounting choice is often merely the degree to which the choice is carried out.

The problem with many accounting judgments is that there is no clear limit beyond which a choice is obviously unethical.

A perfectly routine accounting decision, such as expense estimation, may be illegal if the estimated amount is extreme, but it is perfectly ethical if it is reasonable.

Needles provides an interesting example of how a manager might use the concept of an earnings continuum to decide whether to record the expense amount at the conservative end or aggressive end.

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Forward-looking Statements

Forward-looking statements focus on sales revenues or earnings expectations in light of industry and macro-economic trends

Guidance to investors and financial analysts about the companies earnings potential

Can create liability for issuers, underwriters, officers and directors if material misstatements of fact or omissions are made for public offerings

PSLRA enacted safe harbor provisions if forward-looking statements are identified as such and accompanied by meaningful cautionary statements that could cause actual results to differ from the statements.

7-#

Green Mountain Coffee Roasters

Green Mountain used conference calls that provided earnings guidance to shareholders and analysts to mask a financial fraud

Manufacturer of the Keurig brewing system and K-Cup portion packs

Represented to investors that it was straining to meet consumer demand without accumulating excess inventory

Deceived PwC auditors on inventory levels by hiding bags and bags of coffee loaded on trucks, and blocking parts of the plant from auditor access

Hedge fund manager, David Einhorn, and Sam Antar, former CFO of Crazy Eddie, used analytical procedures to spot and warn of the red flags on inventory

Should auditors monitor conference calls with investors, analysts, and the financial press to determine whether something is said that could be false, fraudulent, or deceptive?

7-#

Using Social Media to Report Earnings Guidance and Financial Results

The SEC said in April 2013, that postings on sites such as Facebook and Twitter are just as good as news releases and company Web sites as long as the companies have told investors which outlets they intend to use

The SEC guidelines on these matters are under the fair disclosure rule (Regulation FD) that requires companies to disseminate information in a way that wouldnt be expected to give an advantage to one group of investors over another

Filing an 8-K form or holding an earnings call are both ways to ensure compliance with the regulation

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How Do Managers and Accountants Perceive Earnings Management? (continued)

Akers, Giacomino, and Bellovary Survey

Accounting manipulation is much less ethically acceptable than operating decision manipulation

Practitioners have few ethical qualms about operating decision manipulation

Operating decisions that influenced expenses were more suspect than those that influenced revenues

Case of Sunbeam Corporation

Cookie Jar reserves

Set aside amounts of revenue in reserve to be taken out to boost earnings when needed in future

Big bath accounting

Creates cookie jar effect while portraying the company as looking worse than it is

Channel Stuffing

Made deals with companies like Walmart to take product sooner than they really wanted it with discounts and liberal return policies.

7-#

Earnings Quality

Dichev study relates to the prevalence, magnitude, and detection of earnings management:

CFOs believe that earnings are high quality when they are sustainable

High quality earnings are backed by actual cash flows

High quality earnings are consistent reporting choices over time and avoidance of long term estimates

Current GAAP standards are somewhat of a constraint in reporting high quality earnings; earnings quality would improve if reporting choices evolved from practice, not mandated from standards

7-#

Accruals and Earnings Management

Accruals are needed because of matching and timing problems that can give wrong financial picture of company

Earnings are sum of a periods change in accruals and its cash flows

Revenue recognition and matching principles

Can manage earnings through aggressive estimations or more conservative ones

Discretionary accruals (items that management has full control over and is able to delay or eliminate)

Nondiscretionary accruals (management has no control over)

7-#

Earnings Management and Materiality Judgments

Concept exists that some financial transactions are so insignificant that they are not worth measuring and reporting with exact precision

Normally materiality is defined as the magnitude of an omission or misstatement that would have changed or influenced judgment of reasonable person

W.R. Grace & Company violated GAAP by establishing an all-purpose reserve fund to smooth earnings from 1991 to 1995

Hiding profits in good years and using them to disguise slower earnings in later years

Graces auditors, Andersen, discovered the buildup of earnings and repeatedly warned that it was improper but immaterial

7-#

Gemstar TV Guide International, Inc.

Shows danger of relying on quantitative analysis in making materiality judgments

KPMG auditors unreasonably determined that certain licensing and advertising revenues were immaterial

This was determined by quantitative factors only

Disregarded qualitative materiality, i.e. the revenue related to business lines watched by securities analysts had a material effect on valuation of Gemstar stock

SEC complaint provides insight into the techniques used to manage earnings

Recording revenue under expired, disputed, or nonexistent agreements

Revenue on an accelerated basis

Inflating advertising revenue by recording and reporting revenue from multiple-element transactions

Engaging in round-trip transactions

Failing to disclose that it had created cookie-jar reserves to smooth net income

Improperly recording advertising revenue from nonmonetary and barter transactions

Sound judgment is needed to review assumptions and estimates in accrual accounting to protect against unacceptable forms of earnings management

7-#

Earnings Management: One More Thing

It is unethical if the primary motive for managing earnings is to deceive users of the true results of operations or reflect the economic substance

Often earnings management is carried out by otherwise honest people who tell the companys side of the story rather than adhere to GAAP

Cycle of earnings manipulation

Often a company begins with a track record of success

It is becoming more difficult to maintain the sales and earnings growth expected

Management runs special incentives to accelerate sales and uses overtime to ship product out

Steps are repeated in the next quarter(s), as expectations are higher, only now the company may not accrue all of its expenses, and to keep the stock prices increasing

One aggressive interpretation leads to another until the quality of the financial information is in doubt

The company has gone from aggressive operating practices to financial fraud

7-#

Financial Shenanigans

Actions or omissions intended to hide or distort real financial performance or financial condition of an entity

Overstate revenues and profits to enhance reported earnings and EPS

Understate revenues and profits to smooth net income/decrease volatility

Schilits 7 Common Financial Statement Shenanigans:

Recording Revenue too soon or of questionable quality

Recording bogus revenue

Boosting income with one-time gains

Shifting current expenses to a later or earlier period

Failing to record or improperly reducing liabilities

Shifting current revenue to a later period

Shifting future expenses to the current period as a special charge

7-#

Red Flags of Earnings Management

Auditors need to be attuned to red flags or signs of aggressive accounting and fraud:

Growth in the market share that seems unbelievable.

Frequent acquisitions of businesses.

Management growth strategy and emphasis on earnings and/or EPS.

Reliance on income sources other than core business.

One-time sources of income.

Growth in revenue that doesnt line up well with receivables or inventory.

Unexpected increase in accounts receivable.

Slowdown of inventory turnover.

Reduction in reserves:

Not reserving for possible future losses.

Reduction in discretionary costs at year-end (i.e., advertising; R&D).

Unusual increase in borrowings; short-term borrowing at year-end.

Extension of trade payables longer than normal credit.

Change in members of top management, especially the CFO.

Change in auditors.

Changes in accounting policies toward more liberal applications.

One forensic accountant is needed on each audit to help identify the signs.

7-#

The Case of Xerox

Motivation for Fraud

Polish its reputation on Wall Street, and

Boost stock price

Fraudulent Lease Accounting

Valuation determination replaced by a formula that management could manipulate; revenue from multiple deliverables improperly recognized

Cushion Reserves

Used reserves to close the gap between actual results and earnings targets

Sanctions by SEC on KPMG

Paid $10 million in penalties, disgorged $10 million in audit fees, and paid $2.7 million in interest

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The Case of Lucent Technologies

Motivation

Drive to realize revenue

Meet internal sales targets

Obtain sales bonuses

Shenanigans

Side Agreements

Recording revenue too soon

Boosting income with one-time gains

Shifting current expenses to later period

Reducing liabilities

Created new reserves and released reserves into income

KPMG should have noticed red flags

7-#

Accounting for Revenue in the Cloud

In 2017, Oracle settled a lawsuit with an accountant and senior finance manager who claimed she was fired for threatening to blow the whistle on its illegal accounting practices.

Blackburn said she was ordered to add millions of dollars in unsupported revenue to financial reports for Oracles cloud services, despite lack of billings to support those numbers.

There is subjectivity in recording revenue as either traditional revenue, or licensed software, and cloud or hosted software

7-#

Accounting for Revenue in the Cloud (continued)

Oracle claimed in 2015 that it made $1.5 billion from its cloud offerings. Dan Woods, chief technology officer and editor of CITO Research, claims that Oracles cloud revenue numbers are bogus.

Analysts report that various tricks can be used by a vendor trying to inflate its cloud figures, including:

Lump on-premise and cloud figures together and then pretend its all cloud;

Give huge credit to customers moving their on-premise license value to the cloud and consider it as booked cloud sales;

Give a cloud product for free and then extrapolate its sales value to other modules;

Sell a cloud subscription for a pilot population but book it as if it were for the whole company headcount.

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The Story of Enron

Started because debt load was high and needed to finance borrowings that would not be shown on balance sheet

Needed long-term supply contracts, but these were not available in current market

Skillings Gas Bank Idea

Pooling investments in gas-supply contracts and selling long-term deals to utilities

Rather than booking the revenue on long-term contracts as it came in, Enron would book immediately like a marketable security

Fastows Special-Purpose Entities

To entice producers to invest in Gas plan, Enron needed cash to offer up front

Began to create partnerships that took money from banks and gave it to producers in return for a portion of existing gas reserves

7-#

Growth of SPEs & The Culture

The Growth of SPEs

Transactions did not violate GAAP, initially

Financial institutions that were lending the 3% became cautious of SPEs ability to repay interest

Enron began to back deals with promise of Enron stockresulted in

No transfer of risk to SPE; therefore SPEs should have been consolidated into Enrons statements

Rank and Yank employee-evaluation policy as incentive to keep employees quiet

Enron created Chewco to buy out its partner in another venture, JEDI

Virtually no outside ownership

Managed by a protégé of Fastow, Michael Kopper

Permitted by Code of Ethics, but waived by Board

Allowable through a lack of internal controls

It became increasingly harder to keep revenues growing each quarter

Executive Compensation far exceeded all competitors

Encouraged executives that by giving out stock options this would provide cash

Claimed if profits and stock price went up enough, the schedule for such options would be accelerated

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The Story of Enron (continued)

Skilling resigned after 6 months as CEO

Sherron Watkins letter to Ken Lay, former and now current CEO and chair of board of directors

Described in detail problems with Enrons partnerships

Assigned to be investigated by Vinson & Elkins

Reported findings to Lay and Derrick, claiming no reason for concern

The Final Days

November 2001 Enron announced overstatement of earnings by $586 million

Ken Lay and Jeff Skilling found guilty of fraud and conspiracy

Skilling was sentenced to 24 years and 4 months and fined; reduced in 2013 by DOJ to 10 years

Skilling released from prison in 2018 and will serve the remainder of his sentence in a halfway house in Texas.

7-#

Enron: Review of Important Accounting Issues

Quality of financial reports were poor:

Improperly failing to consolidate SPE (Chewco)

Failure to disclose related-party transactions

Recording gains from selling assets to SPEs

Use of reserves and failure to explain the basis for creation

Failure to disclose Fastows dual role with SPE and as CFO of Enron

Managed earnings through following techniques:

Used reserves to increase earnings

Used mark-to-market estimates to inflate earnings

Selected which operating assets to sell to SPEs- affecting the amount of gain and earnings effect

Lack of strong controls contributed to fraud evidenced by:

Top management overrode internal controls

Lax oversight by board of directors

A culture established to make deals at any cost

A culture of fear created with its rank or yank policy

7-#

Results of Enron

FASB Rules on SPEs

Original motivation was to establish a mechanism to encourage companies to invest in needed assets while keeping debt off its books

FASB Interpretation No. 46(R) Consolidation of Variable Interest Entities requires unconsolidated variable interest entities to be consolidated if they do not effectively disperse risk among parties involved

No longer a percentage ownership test

Enrons Role in SOX

Prohibiting the provision of internal audit services for audit clients

Off-balance sheet financing activities must be disclosed in notes to financials

Related-party transactions must be disclosed in notes to financials

Lessons to be learned

Weak internal controls lead to possible fraud

Need for ethical tone at the top

Be cautious of the ethical slippery slope

Watch out for greed

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Characteristics of of Restatements

Revision of financial statements that was previously publicly reported may be one of two types

Reissuance restatements are the more serious, as past or previous financial statements cannot be rely upon

Revision restatements do not undermine reliance on past financials

Stealth Restatements

A restatement disclosed only in periodic reports and not in the 8-K, or amended periodic report such as a 10-K/A or 10-Q/A

The SEC requires companies to disclose within four business days that past financial statements should no longer be relied on

The 8-K form is designed to be an early warning system so that the public knows immediately about the financial statement restatements and does not have to wait until the statements are filed with the SEC

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Hertz Accounting Restatements

Hertz Global Holdings, Inc., filed its 2014 Form 10-K with restated results for 2012 and 2013 as well as selected unaudited restated financial information for 2011

Hertz addresses the issue of non-GAAP financial measures including EBITDA, Corporate EBITDA, and how these amounts were calculated

By comparing the validity of these amounts to pretax GAAP income, Hertz mislead readers into thinking that non-GAAP measures of earnings may be as reliable as GAAP amounts

7-#

Restatements Due to Errors in Accounting and Reporting

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Cubic Corporation

Cubic Corporation restated financial statements due to errors in calculating revenues on certain long-term development contracts and on long-term service contracts with non-U.S. Government customers

Cubic historically recognized sales and profits for development contracts using the cost-to-cost percentage-of-completion method of accounting, modified by a formulary adjustment which had the effect of deferring a portion of revenue and profits until later in the contract

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Accounts case study Earnings Management

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