Earnings Management
What is earnings management?
Why do managers do it?
How do they do it?
How can we detect it?
What?
• Aggressive Accounting
• Earnings Management
• Income Smoothing
• Fraudulent Reporting
• Creative Accounting
What?
The active manipulation of accounting results for
the purpose of creating an altered impression of
performance.
Managers choosing accounting policies so as to
maximize their own utility and/or the market value of
the firm.
Accounting Tricks - Examples
Waste Management Inc.
– Understated depreciation and capitalized interest
improperly, failed to write down impaired assets. Total
restatement $2 billion.
Waste Management
Overstated Income
900
800
700
600
500
400
300
200
100
0
-100
Original
Restated
92
93
94
95
96
97
Accounting Tricks - Examples
WorldCom
– Recorded expenses as capital expenditures, doublebooked revenues, booked revenues as cost reductions.
Total restatement $4.6 billion
WorldCom – Reported vs. Restated EBITDA
14000
12000
EBITDA (in millions)
10000
8000
Reported EBITDA
Restated EBITDA
6000
4000
2000
0
1999
2000
2001
Year
1st Qtr 2002
How would you detect this type of fraud?
• A decrease in the asset turnover ratio. A
fictitious asset cannot produce revenue
• PPE increases while revenue decreases
• When an expense that is fixed remains
constant as a percentage of sales, despite
decreases in revenue
• Possible from disclosures on significant
accounting policies
• Writing off previously capitalized cost
Ratio Analysis
2nd Qt 2000 to 1st Qt 2002
Line costs/revenue
40.73%
38.49%
42.53%
42.26% 41.83%
41.77% 42.09% 42.84%
Asset Turnover
10.47%
10.16%
9.71%
9.76%
47.4%
45.5%
8.74%
8.55%
8.16% 7.82%
Sales/PPE
59.2%
55.1%
44.1%
40.7% 35.6%
32.2%
Accounting Tricks - Examples
Xerox
– Recorded revenue on long-term leases of copiers
prematurely. Total restatement $3 billion (but part of this
increased later revenues).
Xerox – Reported and Restated Revenue
20,000
19,500
19,000
18,500
18,000
17,500
Original
17,000
Restated
16,500
16,000
15,500
15,000
14,500
1997
1998
1999
2000
2001
How would you detect?
• Examine Days in receivables – if this
increases because revenue is being
recognized significantly earlier than it is
collected.
• The relationship between CFFO and
revenue significantly decreases
Accounting Tricks - Examples
Adelphia
– Hid billions in debt off-balance sheet in unconsolidated
subsidiaries, diverted undetermined millions to the family
stockholders, inflated subscriber numbers in press
reports, overstated earnings.
Adelphia Debt Load
$3.5
Billion
Reported
$12.6
Billion
Actual
Accounting Tricks - Examples
Sunbeam
– Inflated revenues by channel stuffing and bill &hold.
Reduced expenses by capitalizing advertising costs,
reducing allowance for bad debts.
Sunbeam – Revenues and Net Income
1,400,000
1,200,000
1,000,000
800,000
Reported Revenue
600,000
Actual Revenue
400,000
Reported NI
Actual NI
200,000
0
(200,000)
(400,000)
1996
1997
Signals of this type of fraud
•
•
•
•
Days in Receivables increases
An increase in Gross Margin percentage
CFFO falls
Change to a more aggressive revenue
recognition policy
• Offers large discounts or other
inducements to get orders
• Revenue is recorded despite a right of
return
Accounting Tricks - Examples
Rite-Aid
– Inflated revenues by recording vendor rebates that
pertained to future purchases. Reduced expenses by
capitalizing expenses, not recording certain expenses,
failing to write off inventory shrinkage, understating
depreciation.
Rite-Aid – Net Income Restatement
250
200
150
Reported
100
Restated
50
0
1998
-50
1999
1Q2000
Detecting overstated inventory
• Not recording “shrinkage” of inventory
• Recognizing rebates from vendors
before Rite Aid actually sold the goods
Accounting Tricks - Examples
Enron
- Hiding debt and losses in unconsolidated entities
Enron – Reported and Restated Net Income
1200
1000
800
Reported
600
Restated
400
200
0
1997
1998
1999
2000
2001
Why?
-- Share price effects
-- Borrowing cost effects
-- Bonus plan effects
-- Political cost effects
How?
1. Flexibility of accounting principles
2. Choices, estimates, & judgments
3. Rule-based accounting loopholes
How? 1. Flexibility of
accounting principles
Choices:
–Inventory
–Depreciation
–Expensing vs. Capitalizing
–Software sales recognition
Why do we allow choices?
What problems does choice create?
How? 2. Choices, Estimates, &
Judgments
• Depreciation
–method
–useful life
–salvage value
• Allowance accounts
–bad debts
–sales returns
–warranties
Choices etc., cont’d.
•
•
•
•
•
•
•
Asset and goodwill impairments
Restructuring costs
Inventory write-downs
Environmental liabilities
Pension assumptions
In-process R&D
Percentage of completion contracts
How? 3. Rule-based versus
principle-based accounting
• What is rule-based accounting?
–What are its advantages and disadvantages?
•What is principle-based accounting?
–What are its advantages and disadvantages?
Sickening example – SPE’s