(EM)
June 28, 2006

Alfred D’Souza
Aman Gill
Eric Lindsay
Mary Guo
Michael Flaman
Ranbir Khangura
Tammy Cheung

What is Earnings Management?
What motivates Earnings Management?
Common Approaches
Example – Krispy Kreme
Consequences

Healy and Wahlen, 1999
“Earnings management occurs 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.”

“… a purposeful intervention in the external financial reporting process, with the intent of obtaining some private gain
(as opposed to merely facilitating the neutral operation of the process”

• Worldcom (1999 –2002)
– $ 9 billion overstatement through release of improper reserves
• Xerox (1997 –2000)
– $ 3 billion accelerated revenue recognition
– $ 500 million though ‘cushion’ reserves
– SEC levied $ 10 mm in fines
– No admission of guilt
• Lucent Technologies, Cendant, MicroStrategy ( 2000)
– Stock market lost 34 billion in three days

“ Conservative”
Accounting
• Aggressive recognition of provisions and reserves
• Overvaluation of R&D purchase acquisitions
• Overstate asset write-offs
Earnings
Management
Within GAAP
“Aggressive”
Accounting
“Fraudulent”
Accounting
• Understate provision for bad debts
• Drawing down provisions/reserves in an overly aggressive manner
• Recording sales before realizable; recording fictitious sales
• Backdating sales invoices
Violates GAAP
• Overstating inventory

EM and accrual methods are fraudulent under the following circumstances:
–
1. When they are used to satisfy analysts’ expectations.
– 2. When they are used to realize bonuses.
– 3. When transactions are structured or carried out to alter financial reports.
– 4. Whenever they are used for reasons other than to provide accurate financial information to investors and stakeholders

• Accrual accounting uses accrual, deferral, and allocation to reflect an entity’s performance during a period
• Managers use GAAP to make reporting decisions
• Enables its investors to assess the entity’s economic performance more accurately than from just cash flows
Manipulate the company’s earnings so the figures match a pre-determined target

• Size matters. Most investors look at cents per share when analyzing earnings
• Quality earnings have 3 basic qualities:
– Repeatable
– Controllable
– Bankable

In the 3rd quarter of 2001, Motorola posted earnings per share of 4 cents, beating analysts’ expectations, but the stock fell 15% soon after.
– The reason? Sales had shrunk, and the economy was soft. Most of the earnings growth came by way of job cuts and the sale of investments

Some U.S companies with European subsidiaries are reporting earnings that are better than expected.
– The Reason? The falling U.S dollar has improved earnings via the exchange rate.
Inflation can also affect earnings through the prices of inputs and outputs.

In 2002, Circuit City’s stock price fell over
40% even though both sales and earnings showed sizable increases.
– The Reason? The size of the company’s
Accounts Receivable had more than doubled creating concerns around their collectibility

• Misallocation of Investment Resources
• Undue improvement in management credibility
• MD&A provides room to explain variance in performance
• Sign of Compromised Collusive Auditing

What is Earnings Management?
What motivates Earnings Management?
Common Approaches
Example – Krispy Kreme
Consequences

Three main reasons:
• Capital Market Expectations and
Valuation (Earnings Shock)
• Contracting Motives
• Anti-trust and Government Regulations

• Sample motives:
• Short term stock price performance
• Valuation prior to management buyouts
• E.M. to meet the expectations of financial analysts

Sample methods:
• Income increasing depreciation methods and allowances in year prior to IPO
• Income smoothing
But… studies show investors “see through” such E.M. and instead rely on long term strategy when allocating resources

• Positive earnings surprises usually aren’t significantly rewarded by the market.
• Negative earnings surprises are penalized harshly
The Reason
• Earnings targets are usually conservative.
• Every subsequent positive shock has less of an impact

• Positive earnings surprises tend to be more frequent than negative earnings surprises as companies try to ‘beat down’ expectations
• Interim Reports are not audited, thus creating more opportunity to manage earnings

• 1. Lending Contracts
• Managers manage earnings to ensure compliance with existing lending covenants (i.e. debt service coverage or debt equity ratios)
But… Study showed only 5 of 22 firms delayed default through E.M.

1. Management Compensation Contracts
• Managers use judgment to increase earnings based bonus awards
• Managers manage earnings when job security is threatened
But… study shows personally motivated
E.M. has little effect on asset allocation

Industry Regulations
• Banks required to satisfy capital adequacy requirements
• Insurance companies must meet conditions for minimum financial health
• Utilities companies have been historically permitted to earn normal return on invested assets
Strong evidence that E.M occurs when companies are on verge of violating regulatory provisions.

Anti-Trust Regulations
Companies on verge of investigation may manage earnings to appear less profitable
Study: Companies being investigated for antitrust violations report income decreasing accruals

What is Earnings Management?
What motivates Earnings Management?
Common Approaches
Example – Krispy Kreme
Consequences

• ‘Big Bath’ Restructuring
• Cookie Jar Reserve Accounting
• Premature Revenue Recognition
– Camouflage of ‘Hold and Sale’ transactions
– Transporter picks up risk of loss
– Uncertainty at cut off date
– Inflating standard orders
• Expected lives of long term assets
• Obligations for pension benefits
• Deferred Taxes

1) Tuck awaycreate the
Cookie Jar
2) Dip into the
Cookie Jar – reversal of accruals
3) Can’t manage growing market expectation
4) No real cash flow - Scraping the bottom

• Deference of Asset Impairment
• FIFO vs LIFO methods of accounting (e.g.hyper inflationary countries)
• Accelerated Declining method of Amortization
• Working Capital Management – delayed shipments
• Timing of capital gains

• Off Balance Sheet reporting in subsidiaries
• Synthetic Leases
• Pro-forma Estimates
• Inter-company transactions

• Banks – Loan Loss Reserves
• Insurance Companies – Claim Provisions
• Large Petrol Chemical Projects – Deferred Tax
Allowances
• Business Combos – creative acquisition accounting
• Equity structuring to avoid / require consolidation

• Cash flows that are not correlated with earnings
• Receivables that are not correlated with revenues
• Allowances for uncollectible accounts that are not correlated with receivables
• Reserves that are not correlated with revenue growth or balance sheet items
• Questionable acquisition reserves
– restructuring charges or reserves set aside for disposals
• Earnings that consistently and precisely meet analysts’ expectations

• Attempts to provide consistency and transparency related to earnings
• Created with the input of the investment community
• Clearly defines what can and cannot be included as Revenues and Expenses

What’s In
 Employee stock option expenses
 Restructuring charges
 Pension fund costs
 Purchased R&D expenses
 Write-downs and depreciable operating assets





What’s Out
Goodwill impairment
Gains/losses from asset sales
Pension gains
Litigation costs/proceeds
Unrealized gains from hedging activities

• Can option expenses be fairly priced?
– Black-Scholes produces highly subjective results; especially with volatile stocks
• Pension plan gains are excluded, but losses are included.
– If returns are down in a given year, earnings will be penalized even if the plan is flush

What is Earnings Management?
What motivates Earnings Management?
Common Approaches
Example – Krispy Kreme
Consequences

• KKD began in 1937 in the southeast U.S.
• Began going national in 1996, opening stores in
Manhattan, L.A, Los Vegas
• Declared “Hottest Brand in the Land” by Fortune
Magazine
• IPO took place in 2000

• IPO in 2000, just after the tech bubble burst
• Investor’s were eager for a business they could understand
• Considered one of the best IPO’s of that year
• IPO price: $21…. by August 2003: $50
• 2004: $665.6 MM in sales, $94.7 MM in profit, 400 total stores (Australia, Canada, Korea)

• Owned by KremeKo Inc. under exclusive franchising and licensing arrangement
(2000)
• KremeKo required to open 32 stores within
7 years ($US 40,000 pre store plus royalties)

• May 2004: First ever missed quarter and first loss as a public company (CEO blames low carb diets)
• July 2004: SEC makes an informal inquiry into KKD buybacks of several franchises
• Stock price plunges, shareholders file suit
• Oct. 2004: SEC inquiry upgraded to “formal”
• KKD continued to add stores, though sales were falling
• Jan.2005: KKD decides to restate financials; CEO replaced by
Stephen Cooper, who kept his other job as interim CEO of Enron.

• Getting Greedy
• KKD required franchisee’s to buy equipment and ingredients at marked up prices
• 31% of 2003 came from selling ingredients and equipment
• KKD concentrated on growing parent company sales instead of franchisee profits
Management’s decision to include ingredient and equipment sales does not accurately reflect overall health of company = E.M.

Synthetic Lease
• KKD financed a $35 MM mixing plant with an off-balance sheet synthetic lease
• Permissible only when lessee has no intention of acquiring leased property at term end
• “Mixing Plant” should be technically an asset to the company and should be recorded on balance sheet
• KKD scuttled this plan in Feb.2002 after Enron

Fudging the Numbers
• Oct. 2003: Company acquired seven Michigan based franchises for $32.1 MM
• Purchase price recorded as intangible asset (Reacquired
Franchise Rights), which it did not amortize
• Purchase price was inflated so seller could make interest payments so vendor could pay interest for past due loans
• Interest was recorded as income

Additional Items
• KKD rolled store closing costs, consulting fees into intangible capital asset account
• KKD bought California based franchises at inflated prices which were owned by CEO’s ex-wife
• KKD bought Dallas based stores at inflated prices that were partly owned by former director and board member
• KKD employed 3 different CFO’s from 2000-2004

• Extreme pressure to satisfy expectations of public market
• Personal benefit by paying excess amounts for franchises
• Company faced S.E.C. inquiries
• CFO’s jobs were not secure

What is Earnings Management?
What motivates Earnings Management?
Common Approaches
Example – Krispy Kreme
Consequences

• Dump stock on news of Managed Earnings
• Increased reliance on non financial information
– Investment bankers
– Financial analysts
– Bond Rating Agencies
– Financial Press
• Class action suits – Nortel

• Stop earnings guidance
– Coca-Cola
• Reward share-holders with trustworthy book-keeping not earnings
• Class action suits against auditors

• The markets are still more reliant on earnings reports than on cash flows
• Management judgment better indicator of future earnings than fluctuating cash flows
• Almost every one does it in some way