chapter 6
Earnings
Management
1
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.
2
1. 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.
3
Motivation for Earning
Management
1. Meet Internal Targets
Internal earnings
targets represent an
important tool in
motivating manager to
increase sales efforts,
control costs, and use
resources more
efficiently.
4
Motivation for Earning
Management
1. Meet Internal Targets
There is a tendency for
the person being
evaluated to forget the
economic factors
underlying the
measurement and
instead focus on the
measured number itself.
Performance
5
Motivation for Earning
Management
2. Meet External Expectations
Employees and
customers want a
company to do well so
that it can survive for a
long run and make good
on its long-term pension
and warranty obligations.
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Motivation for Earning
Management
2. Meet External Expectations
Suppliers want assurance
that they will receive
payment and that the
purchasing company will be
a reliable purchaser for
many years into the future.
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Motivation for Earning
Management
3. Provide Income Smoothing
60
50
40
Company A
Company B
30
20
10
0
1 2 3 4 5 6 7 8 9 10
The practice of carefully
timing the recognition of
revenues and expenses to
even out the reported
earnings from year to year
is called income
smoothing.
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Motivation for Earning
Management
3. Provide Income Smoothing
60
50
40
Company A
Company B
30
20
10
0
1
2
3
4
5
6
Years
7
8
9 10
9
Motivation for Earning
Management
4. Provide Window Dressing
for an IPO or a Loan
For companies entering a phase in
which it is critical that reported
earnings look good, such as just
before making a large loan
application or just before an IPO
of stock, accounting assumptions
can be stretched.
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2. Earnings Management
Techniques
The Earnings Management Continuum
Savvy
transaction
timing
Strategic
matching
General
Electric
Aggressive
accounting
Deceptive
accounting
Change in
methods or
estimates
Delta
with
full
Airlines
disclosure
Change in
methods or
estimates but
withXerox
little or
no disclosure
11
Earnings Management
Techniques
The Earnings Management Continuum
Fraudulent
reporting
Fraud
Non-GAAP
accounting
Fictitious
transactions
Enron
ZZZZ
Best
12
Chairman Levitt’s Top Five
Accounting Hocus-Pocus Items
1. Big bath charges
2. Creative acquisition
accounting
3. Cookie jar reserves
Arthur Levitt
Former SEC
Chairman
4. Materiality
5. Revenue recognition
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1. Big Bath Charges
20
15
10
5
0
-5
-10
-15
-20
-25
-30
-35
1
2
3
4
5
6
Years
7
8
9 10
Company C
Company D
Company D recognized
all of its bad news in
one year—thus, took a
“big bath” loss.
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2. 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.
15
Allocating a large
amount of a “basket
purchase” to
ongoing research
and development,
then expensing these
costs immediately
had the same effect
as “big bath.”
3. 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.
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4. Materiality
A change in one penny per share can
cause a company to lose billions of
dollars in market value. Chairman Levitt
encouraged auditors to challenge
questionable accounting practices
involving materiality.
17
4. Materiality - Cont’d
If the questionable practice allows the firm
to meet analysts’ earnings expectations, the
firm should be required either to change the
data resulting from the questionable practice
or to convince the auditor that it in
accordance with GAAP.
The SEC released SAB 99 that
outlines a more comprehensive
definition of materiality.
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5. Revenue Recognition
Firms eager to show operating results to
lenders and potential investors, 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.
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Pro Forma Earnings
A pro forma
earnings number is
the regular GAAP
earnings number
with some
revenues, expenses,
gains, and losses
excluded.
20
Pro Forma Earnings
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
Do the pro forma earnings
were.
numbers help financial
statement users better
understand a company,…
…or are they a blatant attempt to
cover up poor performance?
That’s the key question.
21
Pro Forma Earnings
In December 2001, the SEC
encouraged companies to provide a
reconciliation between GAAP and
pro forma earnings…see page 330
22
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3. Critically discuss whether a
company should manage its earnings
• There is no true earnings figure
• However, If the intent in using earnings
management techniques is to deceive,
then most people would consider it
wrong.
• However, it would not be wrong to
convey financial which is useful to
decision makers
4. Seven Elements of an Earnings
Management Meltdown
1
Downturn
in
business
2
Pressure to
meet
expectations
5
Insufficient
user
skepticism
3
Attempted
accounting
solutions
6
Regulatory
investigation
4
Auditor’s
calculated
risk
7
Massive
loss of
reputation
24