Accrual Accounting and
Earnings Management
RCJ Chapters 1, 2(48-52), 3(126-132), 7(357-359)
Key Issues

Accrual accounting

Managers’ incentives and reporting abuses


Example: Revenue recognition
How earnings are managed
Paul Zarowin
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Accrual Accounting


Recognizes the financial benefits and obligations
accruing to an enterprise over the reporting period regardless of cash inflows and outflows.
Objective: Better indication of performance than
current cash receipts and payments.
Paul Zarowin
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Accrual Accounting: Characteristics

subjectivity

assumptions

discretion

incentives
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Earnings Management

The reporting discretion inherent in accrual accounting
can be opportunistically used by managers.
Manager
information
Investors
Reporting incentives:
• Higher bonus
• Cashing out on Stock options
• Career and personal ego
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Earnings Management (cont’d)

Why allow reporting discretion?
Rigid rules
(e.g. full
expensing of R&D)
trade-off
Flexible rules
(e.g. revenue
recognition)
 Reporting biases
 Enables better reporting of
larger number of businesses.
 No discretion
 Prone to manipulation
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Earnings Management (cont’d)
Important to understand: More often the problem is not
the flexibility of the reporting rules, but the fact that the
watchdogs are not doing their job!!!

Audit failure

Poor corporate governance

Shareholder involvement

SEC enforcement
Paul Zarowin
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Common Earnings Management Practices
1.
Shifting income between periods:
Revenues
Borrowing
1. Premature
earnings from the recognition of revenues
future
Example: Xerox
Postponing
earnings to the
future
Expenses
2. Capitalization of
expenses
Example: WorldCom
3. Deferring recognition 4. Exaggerating current
of revenues
expenses/losses to
create cookie jar
Example: Microsoft
reserves
Example: Microsoft
Note: t Earningst = t Cash Flowst
Paul Zarowin
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Common Earnings Management Practices (cont’d): J.E.
Actual J.E.
1. Borrowing
revenues from the
future
2. Deferring
expenses to the
future
3. Deferring
revenue to the
future
4. Exaggerating
current
expenses/losses to
create cookie jar
DR
Cash
later:
DR
Asset
Expense
DR
cash
later: def. revenue
later:
DR
loss
liability
Proper recognition J.E.
CR
revenue
DR
cash
later: def. revenue
CR
def. revenue
revenue
CR
cash
asset
DR
expense
CR
cash
CR
def. revenue
revenue
DR
Cash
CR
revenue
CR
liability/Asset
cash
Paul Zarowin
later:
DR
CR
No journal entry
loss
cash
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Common Earnings Management Practices (cont’d)
2.
Classification of gains and losses:


3.
Classifying one-time gains as earnings from continuing
operations
Classifying losses from continuing operations as one-time
items
Hiding Debt in unconsolidated subsidiaries

Example: Enron
Legitimate Earnings
Management (Within
GAAP)
Violation of GAAP
or SEC rules
Manipulation of accruals to:
I. smooth earnings
II. Turn permanent expenses into temporary losses
ex. P15-9
10
Example of Scope of Manipulations and
Incentives: Xerox Case




Xerox sells/leases copy machines, and related service
to be provided for several years after sale.
Recorded service revenue at the time of sale.
According to the SEC investigation, “accounting tricks”
boosted pretax profit by 1.5 billion from 1997 through
2000.
In November 1999, CFO told management:
"When accounting actions were stripped away, Xerox
had essentially no growth through the late 1990s.”
Q: Which of the 4 categories mentioned in slide #8 does
Xerox case falls into?
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Xerox Case: what were the incentives?
 Without the accounting scheme the company would
have missed Wall Street's consensus per-share
earnings targets in 11 of 12 quarters from 1997 to
1999.
 Accounting scheme helped keep Xerox's stock price
artificially high in the late 1990s so executives could
cash in $5 million in performance-based compensation
and more than $30 million from stock sales.
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Example of Reporting Discretion:
Seebeyond Case




On March 2002 SeeBeyond sold its software product for $2.2
million to a costumer.
Revenue recognition:
Deployment and payment for
1. Earned
the software in stages that could
2. Measurable
extend until March 2003.
This customer had bought and successfully deployed software
from SeeBeyond before.
SeeBeyond is interested in including the $2.2 million in the
revenues of the quarter ending on March 31, 2002. Is it
possible?
1. No. Revenue not earned.
2. No. Revenue not measurable
3. Yes. Revenue is both earned and measurable.
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SeeBeyond Case (cont’d)


SeeBeyond held a conference call telling investors that
revenues would fall short of the previous revenue
guidance by approximately $2 million.
The share fell 52% the next day!!! Why?
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