Ethics in Financial Reporting:
Cooking the Books
Sudha Krishnan
Definition – Earnings Management (EM)
• Purposeful intervention in the external reporting
process with the intent of obtaining some private
gain (Schipper)
• When managers use judgment in financial
reporting and in structuring transactions to alter
financial reports to either mislead some
stakeholder about the underlying economic
performance of the company or to influence
contractual outcomes that depend on reported
accounting numbers (Healy & Wahlen)
Intent of Management
Is all EM unethical? –depends on management
intent.
• Management intent unobservable
• Distinction between aggressive accounting
choices including acceptable GAAP based
estimates / judgments vs. fraudulent
accounting practices intended to deceive
others
Howard Schilit – Financial Shenanigans
• Revenue recognition
– Recording revenue too soon
• Revenue is recorded before service is fully provided
– Recording revenue of questionable quality
• Revenue is recorded before customer’s unconditional
acceptance
– Recording made up revenue
• Revenue is recorded even if it lacks economic substance
– Shifting revenue to a future period
• Purposely over-estimating sales returns and adjusting
downward in future years
Howard Schilit – Financial Shenanigans
• Shifting expenses
– Capitalizing current costs
– Shifting current expenses to later or earlier period
• Changing accounting policies and shifting expenses to
later period
– Expensing future expenses as current
• Accelerating discretionary expenses
Aggressive Accounting Choices
Examples of accounting choices allowed by FASB
• Changing life of assets affecting depreciation
• Changing estimate of allowance for doubtful
accounts affecting bad debt expense
• Changing estimate of sales return allowances
affecting net revenue
• Choosing inventory valuation methods thus affecting
cost of goods sold
• Estimating higher restructuring charges than
required affecting earnings before interest & taxes
Numbers Game
Arthur Levitt Speech (1998) on accounting
hocus-pocus
• Big bath
– Large estimates of restructuring charges that are
deducted from revenues to show lower income in
one quarter/year and then revised few
quarters/years later to show higher income
Note: 1/1/2003 onwards, restructuring charges to be actual
– no more estimates allowed (ASC para 420)
Numbers Game
Arthur Levitt Speech (1998) on accounting
hocus-pocus
• Creative acquisition accounting
– Classifying large portions of acquisition price as inprocess research & development and then written
off immediately after the merger. That reduces
future drag on income
Note: all IPR&D to be capitalized and checked for impairment
like goodwill (EITF09-2, FASB141(R), ASC para 805)
Numbers Game
Arthur Levitt Speech (1998) on accounting
hocus-pocus
• Cookie jar reserves
– Use unrealistic assumptions to estimate sales
returns, loan losses or warranty costs, thus
stashing accruals in cookie jars during the good
times and reach into them when needed in the
bad times.
Numbers Game
Arthur Levitt Speech (1998) on accounting
hocus-pocus
• Materiality
– Intentionally record errors with specified ceiling
and then argue that the errors are not material
Note: Staff Accounting Bulletin Codification Topic I para M for
guidance on materiality
Numbers Game
Arthur Levitt Speech (1998) on accounting
hocus-pocus
• Revenue recognition
– Recognize a sale before it is complete, before the
product is delivered to a customer, or at a time
when the customer still has options to terminate,
void or delay the sale.
Note: Staff Accounting Bulletin 101 & 104 for guidance
Pressures to Manage Earnings
Why does management manage earnings?
• External pressures
– Analysts’ forecasts
– Access to debt markets
– Competition
– Contractual agreements & debt covenants
– Roaring stock market
– Emerging financial instruments
– Market disregard for big charges
Pressures to Manage Earnings
• Pressures within the company
– Merger attractiveness
– Management compensation
– Short term focus
– Unrealistic budgets and plans
– Excessive profits followed by decline
– Personal factors – bonus, promotions, job
retention
Signals in Current Year
Signals that should be checked in company reports
 Read the audit report
 Reduction in managed costs such as advertising in relation to
sales
 Changes in accounting policies towards more liberal
applications
 Unexpected increase in accounts receivable
 Extension of trade payables longer than normal credit
 Unusual increase in intangible assets
 One time sources of income
 Decline in gross margins
Signals in Current Year (Cont’d)
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Reduction in reserves
Reliance on income sources other than core business
Nor reserving for future probable losses
Unusual increase in borrowings
Increase in deferred taxes
Increase in unfunded pension liability
Low cash and marketable securities at year end
Peak short borrowings at year end
Slowdown of inventory turnover ratio
Red Flags
When should you pay more attention to the company?
• Company has achieved significant market share and is
growing faster than the industry
• Frequent acquisitions of business
• Management history
• Firing of auditors
• Rapid growth of company -- internal control issues
• Company doing too well
• Management growth strategy and emphasis on EPS goals
Cases
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Worldcom (expense capitalization)
Satyam Computers (bogus revenue)
Tyco (executive loans, merger magic)
Adelphia (borrowing from company)
Waste Management (materiality)
SunBeam (channel stuffing, cookie jar
reserves)
• Healthsouth (false earnings)
Teaching Notes – Worldcom & Adelphia
• Assign the citations at the end of the case for readings
• Go over signals/red flags and pressures to manage earnings (earlier slides)
with the class before assigning the case
• Assign one case in class discussion and the second as homework
(assessment).
• Emphasize the importance of reading the SEC complaint and the AAERs
• Ask the students to read the articles from general media such as WSJ,
Business Week etc.
• Use the opportunity to talk about SOX Act, corporate governance and the
importance of independent auditors and audit committee
• To make the discussion interesting, talk about the CEO/CFO involved in the
scandal and what is their current status (that information is in the general
media articles as well as the case)
WorldCom answers
• How did WorldCom cook the books?
– They capitalized the leasing expenses on the balance sheet instead of
expensing them.
• What is the impact on the income statement and the balance
sheet and ratios of such actions taken by WorldCom? Provide
examples.
– The capitalizations of leasing expenses increased income and
increased assets on the balance sheet. So ratios with income in the
numerator looked better than before managing earnings. Also, the
leased assets on the balance sheet gets depreciated over the
estimated life, thus spreading the cost over many income statements
WorldCom numbers
Form Filed
With the
Commission
Reported Line
Cost Expenses
Reported Income
(before Taxes
and Minority
Actual Line
Interests)
Cost Expenses
Actual Income
(before Taxes
and Minority
Interests)
10-Q, 3rd Q. 2000
$3.867 billion
$1.736 billion
$4.695 billion
$908 million
10-K, 2000
10-Q, 1st Q. 2001
$15.462 billion
$4.108 billion
$7.568 billion
$988 million
$16.697 billion
$4.879 billion
$6.333 billion
$217 million
10-Q, 2nd Q. 2001
$3.73 billion
$159 million
$4.29 billion
$401 million loss
10-Q, 3rd Q. 2001
$3.745 billion
$845 million
$4.488 billion
$102 million
10-K, 2001
$14.739 billion
$2.393 billion
$17.754 billion
$622 million loss
10-Q, 1st Q. 2002
$3.479 billion
$240 million
$4.297 billion
$578 million loss
WorldCom answers (cont’d)
• Read the article “Twenty pressures to manage earnings”
mentioned in the citations. Identify some of the pressures
that caused the management to cook the books.
– Meeting analyst forecast
– Excessive profits in an environment where competitors were not doing
as well.
– Management greed and compensation
• Almost all the red flags (as per the slide before)
Adelphia answers
• Read the complaint on the SEC website. How did the
management cook the books?
– Borrowed funds along with other entities that were closely held but
did not show the loans on the books of Adelphia. Liabilities were thus
understated.
– Rejected auditor recommendation that at least a footnote disclosure
needs to be made re the loans
– Equity was overstated by doing sham stock transactions (A=L+SE)
– Inflated number of cable subscribers (criteria used in the industry to
analyze cable companies)
– Identified source of revenue – management fees (did not exist)
– Recorded kickbacks from converter box sellers as income
– Shifted Adelphia expenses to other entities run by the family
Adelphia answers (cont’d)
• Who were the auditors of Adelphia during the fraud period? What were
they accused of doing? How were they punished?
– Deloitte & Touche
– “Deloitte engaged in improper professional conduct and caused
certain of Adelphia's books and records violations by failing to detect a
massive fraud perpetrated by Adelphia and certain members of the
Rigas family. Even though Deloitte identified Adelphia as one of its
highest risk clients, Deloitte failed to design an audit appropriately
tailored to address audit risk areas that Deloitte had explicitly
identified”
– Deloitte settled the case with the SEC by paying a penalty of $50
million
Contributions
• This class material introduces students to ethical issues in
financial reporting. It should be taught at the level of
Intermediate Accounting I.
• It uses cases to teach students some critical reasoning skills.
• It gets them to read articles from the general business media
such as Wall Street Journal, Fortune, Business Week etc.
• It allows them to access the SEC website and read the
Accounting & Auditing Enforcement Releases (AAER) & the
Litigation Releases (LR)
• It gives them exposure to unethical behavior – what not to do
when reporting to investors.