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Earnings Management
Chapter 6
Intermediate Accounting
16E
Prepared by: Sarita Sheth | Santa Monica College
COPYRIGHT © 2007
Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are
trademarks used herein under license.
Learning Objectives
1. Identify the factors that motivate earnings
management.
2. List the common techniques used to
manage earnings.
3. Critically discuss whether a company
should manage its earnings.
4. Describe the common elements of an
earnings management meltdown.
5. Explain how good accounting standards
and ethical behavior by accountants lower
the cost of obtaining capital.
Motivation for Earning
Management
Forces pushing managers to manipulate
results:
1. Meet internal targets.
2. Meet external
expectations.
3. Provide income
smoothing.
4. Provide window
dressing for an IPO or a
loan.
Chairman Levitt’s Top 5
Accounting Hocus-Pocus Items
1. Big bath charges
2. Creative acquisition
accounting
3. Cookie jar reserves
4. Materiality
5. Revenue
recognition
Arthur Levitt
Former SEC
Chairman
Creative Acquisition Accounting
• SFAS Nos. 141 and
142 gave extensive
guidelines on how
the purchase price of
business acquisitions
should be allocated.
• The SEC staff
informed companies
they would be
skeptical of large
amounts being
allocated to R&D.
Cookie Jar Reserves
• Recognizing estimated expenses when
revenue is high, so that less estimated
expenses can be recognized when earnings
are lower.
• Likewise, deferring revenue
for “tougher times” is an
example of building a cookie
jar reserve.
• The SEC has issued SAB 101,
identifying when it
appropriate to defer revenue.
Materiality
• A change in one penny per share can
cause a company to lose billions of
dollars in market value.
• If a questionable practice helps a firm
meet analysts’ expectations, the firm
should be required to change the data
or to convince the auditor that they
comply with GAAP.
• The SEC released SAB 99, a more
comprehensive definition of materiality.
Revenue Recognition
• Firms would like to report revenue when
contracts are signed or partially complete
rather than waiting until the promised
product or service has been fully delivered.
• The SEC has released SAB 101 to more
carefully identify the circumstances in
which it is appropriate for a company to
recognize revenue.
Pro Forma Earnings
• Pro forma earnings is derived from the regular
GAAP earnings number with some revenues,
expenses, gains, and losses excluded.
• The concern with pro forma earnings is that
companies can report pro forma earnings
merely in an effort to make their results seem
better than they actual were.
Cost of Capital
• Cost of capital- the cost a company bears to
obtain external financing.
• Cost of debt financing- the after-tax interest
cost for borrowing money.
• Cost of equity financing- expected return
(both as dividends and an increase in
market value) necessary to entice investors
to provide equity capital
• Cost of capital is important because it
determines what long-term projects are
profitable to undertake.
Role of Accounting Standards
• The FASB and AICPA help lower the
U.S. cost of capital by promulgating
uniform recognition and disclosure
standards for companies.
• The SEC’s “primary mission…is to
protect investors and maintain the
integrity of the securities markets.”
• IASB plays an important role in
improving the credibility of
international financial reporting.