You are on page 1of 23

CHAPTER 6

QUESTIONS
1. The four factors that might motivate a
manager to attempt to manage
earnings are as follows:
(a) Meet internal targets
(b) Meet external expectations
(c) Provide income smoothing
(d) Provide window dressing for an
IPO or a loan
2. (a) Internal earnings targets are an
important tool in motivating
managers to increase sales efforts,
control costs, and use resources
more efficiently.
(b) The risk with internal earnings
targets is that the person eing
evaluated will forget the underlying
purpose of the measurement and
instead focus on the measured
numer itself.
3. !cademic research has demonstrated
that managers su"ect to an earnings#
ased onus plan are more likely to
manage earnings upward if they are
close enough to reach the onus
threshold and are more likely to
manage earnings downward, saving
the earnings for a rainy day, if reported
earnings sustantially exceed the
maximum onus level.
4. $ecause the existence of an earnings#
ased onus plan increases the
incentive of managers to manipulate
the reported numers, auditors
consider such plans to e a risk factor
as they plan the nature and extent of
their audit work. !s a result, it is
possile that the existence of such a
plan might increase the amount of audit
work performed.
5. The figure in %xhiit &' displays a
trough "ust elow (ero, indicating that
the numer of companies with earnings
"ust elow (ero is significantly lower
than expected. In addition, there is a
lump on the distriution "ust aove
(ero, indicating that the numer of
companies with earnings "ust aove
(ero is significantly greater than
expected. This suggests that
companies that compute a preliminary
earnings numer that is slightly less
than (ero make more favorale accrual
assumptions to get earnings to e
positive.
6. If analysts) earnings forecasts are
merely a mathematical forecast of a
mechanically generated numer, the
forecasts should e less than actual
earnings half the time and more than
actual earnings half the time. The fact
that many companies meet or exceed
analysts) forecasts for many *uarters in
a row strongly suggests that the
process is eing managed in some
way. The figure in %xhiit &'
demonstrates that managers do indeed
manage reported earnings. There is
also evidence that managers provide
+guidance, to analysts to try to ensure
that the analysts) forecasts are not too
high to reach. -o, companies can
consistently meet or eat analysts)
forecasts ecause they manage
earnings and they also manage the
forecasts.
7. Income smoothing is the practice of
carefully timing the recognition of
revenues and expenses to even out the
amount of reported earnings from one
year to the next.
8. !s descried in the text of the chapter,
.eneral %lectric)s usiness structure is
particularly well suited to income
smoothing ecause of the company)s
large numer of diverse operating units
/e.g., financial services, heavy
manufacturing, home appliances0. !
large one#time loss reported y one
usiness unit can fre*uently e
matched with an offsetting gain
reported y another unit. $y carefully
timing the recognition of these gains
and losses, .% can avoid reporting
earnings that ounce up and down
from year to year. Perhaps more
237
important, .% has had very successful
underlying operations over the past '1
years. $ecause of this, any income
smoothing undertaken y .% has een
merely the carefully timing of the
recognition of income, not a desperate
attempt to create earnings out of thin
air.
9. Many studies have demonstrated the
tendency of managers in 2.-.
companies to oost their reported
earnings using accounting assumptions
in the period efore an initial pulic
offering /IPO0. 3esearch has also
shown that socialist managers in
4hinese state#owned enterprises
/-O%s0 do exactly the same thing in
advance of selling shares of the -O% to
the pulic.
10. !n important piece of evidence that
2.-. companies can sumit to the 2.-.
International Trade 4ommission /IT40
when petitioning for import arriers is
financial statements showing a
reduction in profitaility corresponding
to an increase in the import of
competing foreign products. 3esearch
suggests that, at least in the past, 2.-.
companies may have managed
earnings downward in advance of filing
a petition with the IT4.
11. !ccountants, using the concepts of
accrual accounting and the accounting
standards that have een patiently
developed over the course of the past
511 years, add information value y
using estimates and assumptions to
convert the raw cash flow data into
accrual data. 6et income is a etter
measure of a company)s economic
performance for a period than is
operating cash flow. Thus, even though
the flexiility of accrual accounting
opens the door to some ause, the
asic system provides useful
information for financial statement
users.
12. The five laels in the earnings
management continuum, and the
general types of actions associated
with each, are as follows:
ab!" T#$!% &' Ac()&*%
7 -avvy
Transaction
Timing
-trategic matching
' !ggressive
!ccounting
4hange in methods
or estimates with full
disclosure
8 9eceptive
!ccounting
4hange in methods
or estimates with little
or no disclosure
: ;raudulent
3eporting
6on#.!!P
accounting
5 ;raud ;ictitious
transactions
13. 4hanging accounting estimates to
reflect the most current information
availale is an essential part of accrual
accounting. <owever, to ensure that
financial statement users can
meaningfully compare the results for this
year /prepared using the new estimate0
with the results for last year /prepared
using the old estimate0, the impact of
such changes in estimate must e fully
disclosed.
14. 6on#.!!P accounting can e the result
of intentional, fraudulent misstatement
or an inadvertent error.
15. The five items in the earnings
management continuum /see %xhiit
&:0 mirror the progression in earnings
management strategies followed y
individual companies. It is unlikely that a
company would "ump straight to creating
fictitious transactions in order to manage
earnings. Instead, the company would
proaly start with small and legitimate
attempts to improve reported
performance, such as the careful timing
of transactions. The company would
then progress through accounting
changes, oth disclosed and
undisclosed, and then to non#.!!P
accounting. The creation of fictitious
transactions is typically a last#ditch effort
to manage reported results after other,
less drastic, measures have fallen short.
238
16. The five techni*ues of accounting
hocus#pocus identified y !rthur =evitt
are as follows:
(a) $ig ath charges
(b) 4reative ac*uisition accounting
(c) 4ookie "ar reserves
(d) Materiality
(!) 3evenue recognition
17. If a company expects to have a series of
losses or large expenses in future years,
the notion of a ig ath is that it is etter
to try to recogni(e all of the ad news in
one year, leaving future years unspoiled
y continuing losses. !ccording to this
notion, after a year or two financial
statement users will have forgotten
aout the horrile ath year and instead
will e impressed that no additional
pieces of ad news have hit the financial
statements.
18. -ince 7>>?, the ;!-$ has limited the
flexiility companies have to recogni(e
ig ath restructuring charges y
adopting SFAS No. 144 on impairment
losses and SFAS No. 146 on the timing
of the recognition of restructuring
oligations.
19. ! company can +take a ath, when
recording the ac*uisition of another
company y allocating a large amount of
the purchase price to +purchased in#
process 3@9., Purchased in#process
3@9 is expensed immediately in
accordance with the mandated 2.-.
.!!P treatment of all 3@9
expenditures. The net result is similar to
a ig ath in that a large 3@9 expense
is recorded in the ac*uisition year, and
expenses in suse*uent years are lower
than they would have een had the
purchase price een allocated to a
depreciale asset.
20. Ahen a company estalishes a cookie
"ar reserve, it overreports expenses or
underreports revenues during the
current year in the anticipation that
these deferred earnings can than e
recogni(ed as needed in a future year.
Thus, the most likely candidate for a
company to e tempted to estalish a
cookie "ar reserve is one that has etter#
than#expected performance in the
current year ut with concern aout
future years.
239
':1 4hapter &
21. The traditional concept of materiality is
ased on straightforward numerical
thresholds such as 7B of sales, 5B of
operating income, or 71B of
stockholders) e*uity. The concept of
materiality in SAB 99 re*uires that one
look at the context to decide whether an
amount is material. ;or example, if a
C711,111 expense is "ust 'B of
operating income ut the nonrecognition
of this expense would result in a
company having earnings high enough
to meet analysts) expectations, the item
is material.
22. In order to limit the ause of revenue
recognition to manage earnings, the
-%4 has released SAB 101, identifying
more carefully the circumstances in
which it is appropriate for a company to
recogni(e revenue.
23. ! pro forma earnings number is the
regular .!!P earnings numer with
some revenues, expenses, gains, or
losses excluded. In a general sense,
+pro forma, results are those that would
have happened or will happen under
certain defined circumstances. Thus, pro
forma numers offer a +what#if,
scenario. The controversy aout pro
forma earnings numers is that the
exclusions from .!!P earnings are
sometimes made merely to make the
earnings numer look etter, not
necessarily to provide a etter picture of
the company.
24. ! trustworthy manager can reveal even
etter information aout the underlying
economics of the usiness through
appropriate ad"ustments to .!!P
income in computing pro forma
earnings. The danger with pro forma
earnings is that a desperate manager
seeking to hide operating prolems
might try to use the flexiility of pro
forma reporting to report deceptively
positive pro forma results.
25. The -%4 endorsed the recommendation
made y the ;inancial %xecutives
International /;%I0 and the 6ational
Investor 3elations Institute that firms
give a reconciliation to .!!P net
income whenever reporting pro forma
numers. This reconciliation highlights
the ad"ustments made y management
in reporting pro forma earnings.
26. The financial statements are one of a
large numer of vehicles used y the
managers of a company to
communicate information aout the
company to the pulic. In this sense,
financial reporting is part of a company)s
general pulic relations effort.
27. (a) Point % represents the highest
earnings of the five points included
in %xhiit &DE Point 4 represents
the second highest earnings.
<owever, Point % is different from
Point 4 in that Point % violates
.!!P whereas Point 4 is in
conformity with .!!P.
(b) Points ! and 4 are oth in
conformity with .!!P. They differ in
that Point ! represents consistently
conservative choices within .!!P
resulting in the lowest .!!P
earnings possile. Point 4
represents the highest .!!P
earnings possile.
28. Ahether a manager violates .!!P in an
effort to manage earnings is a function
of the costs of getting caught, of the
company)s general ethical culture, of the
manager)s personal ethics, and of the
manager)s awareness of the ease with
which one can unwittingly pass from the
inside to the outside of the .!!P oval if
one is not careful.
29. One way to distinguish etween
earnings management that is ethically
right and earnings management that is
ethically wrong is management intent. If
earnings management is undertaken
within .!!P to etter communicate the
economic performance of the usiness
to financial statement users, it is
ethically right. If the intent of earnings
management is to deceive financial
statement users, it is ethically wrong.
30. The seven elements of an earnings
management meltdown are as follows:
(a) 9ownturn in usiness
(b) Pressure to meet expectations
(c) !ttempted accounting solution
(d) !uditor)s calculated risk
(!) Insufficient user skepticism
(') 3egulatory investigation
C+a$(!, 6 ':7
(-) Massive loss of reputation
31. !nother way to respond to the pressure
caused y poor operating performance
is to seek to fix the underlying usiness
prolems through etter operations and
etter marketing.
32. Ahen signing an audit opinion, the
auditor is alancing the multiyear future
revenues from continuing as a
company)s auditor with the potential
costs of eing swept up in an accounting
scandal, losing valuale reputation, and
perhaps losing a large lawsuit.
33. -ome financial analysts work for
rokerage houses that also do
investment anking work for clients. If a
financial analyst releases a report on a
company that is very unfavorale, that
company may e less likely to use that
analyst)s rokerage house for
investment anking work.
34. !fter finding evidence of misleading
financial reporting, the most common
punishment y the -%4 is a cease and
desist order that instructs a company to
stop its misleading practices and not to
repeat them. The -%4 also charges
fines such as the C71 million fine levied
against Ferox for misleading financial
reporting.
35. !n earnings management meltdown
does not ecome pulic knowledge until
stage &, the regulatory investigation.
$efore that, the usiness downturn and
resulting earnings management coverup
are "ust a secret earnings management
meltdown waiting to happen.
36. The cost of capital is the cost of
otaining the external financing
necessary to fund a company)s
operations and expansion. The cost of
det capital is the after#tax interest cost
associated with orrowing the money.
The cost of e*uity financing is the
expected return /oth as dividends and
as an increase in the market value of the
investment0 necessary to induce
investors to provide e*uity capital.
37. ! company produces financial
statements to etter inform lenders and
investors aout the performance of the
company. 4onse*uently, good financial
statements reduce the uncertainty of
lenders and investors. Aith lower
uncertainty, the information risk
surrounding the company is lower, and
the company)s cost of capital is lower.
38. $y increasing the *uality of financial
reporting, good accounting standards
are ale to reduce information risk.
Thus, the overall cost of capital is lower
when accounting standards are of
higher *uality.
39. !ccording to the !I4P! 4ode of
Professional 4onduct, the guiding
precept in
':' 4hapter &
alancing conflicting pressures among
clients) interests and the pulic)s interest
is that acting ethically and in the pulic
interest is also in the est long#run
interest of the client.
40. The est long#run usiness practice is
ethical ehavior.
':8 4hapter &
.ISCUSSION CASES
.)%c/%%)&* Ca%! 61
The advantage of an earnings#ased onus plan is clear: %mployees are unified and directly
interested in the overall performance of the company. <owever, there are a numer of
disadvantages:
1. The existence of an earnings#ased onus plan greatly increases the incentive of employees
to manage earnings. %ven employees at a low level in the organi(ation may misstate the
reported results to report higher earnings. Thus, an earnings#ased onus plan puts pressure
on the crediility of the financial reporting system. This also increases the audit risk and may
re*uire the auditor to conduct more tests.
2. %ncouraging employees to focus on periodic income may cause them to adopt a short#term
focus. Thus, employees may oppose long#term strategic initiatives that may result in a short#
term drop in profits.
.)%c/%%)&* Ca%! 62
4hris can revise many accounting estimates that will lower expenses and increase net income.
;or example, he can reevaluate the allowance for ad dets to look at the possiility of lowering
the allowance. <e can examine the depreciation life estimates to see how they relate to industry
norms. If some depreciation life estimates are on the low end of the range of industry norms,
4hris might consider increasing those estimates. <e can also look again at the estimates for
warranty expenses, environmental cleanup expenses, and so forth. In short, many estimated
expenses might e lowered a little on closer scrutiny.
4hris should e concerned aout the precedent that will e set if he uses accounting ad"ustments
to change a loss into a profit. %xternally, 4hris should consider what type of message this will
send to users of the financial statements. 9allas 4ompany may develop a reputation as having
low#*uality financial statements. This reputation can e costly as 9allas tries to otain loans and
raise investment capital in the future. Personally, 4hris should e concerned aout his own
reputation. If he develops a reputation as a flexile accountant who is willing to change estimates
to satisfy the oard)s earnings targets, he may find it more difficult in the future to maintain his
personal integrity in the face of more aggressive re*uests to manage earnings.
.)%c/%%)&* Ca%! 63
This is almost surely not a coincidence. If there is an e*ual chance of a forecast eing too low or
too high, the odds of forecasting too low 'D *uarters in a row are 7 in 78: million. -tella may e a
poor forecaster, ut the evidence provided doesn)t provide support one way or the other on that
issue. Ahat is almost certainly happening is that Olsen 4ompany has een managing its
earnings and the +guidance, it gives to analysts to ensure the aility to meet or eat the analysts)
forecasts on a consistent asis. In addition, to maintain a good relationship with the financial
executives of Olsen, -tella may have een careful not to forecast earnings so high that Olsen
couldn)t reach the forecasted amount. !n important part of the "o of an analyst is maintaining
information contacts. -tella has had to alance her desire to maintain good relations with Olsen
with her desire to maintain her forecasting crediility. It appears that so far she has decided that
maintaining her relationship with Olsen has een more important than preparing uniased
earnings forecasts.
':: 4hapter &
.)%c/%%)&* Ca%! 64
Over the past three years, 4lark 4ompany has had a more stale, predictale earnings series. !s
a result, an analyst would typically feel more comfortale making a forecast aout sustainale
future earnings for 4lark 4ompany than for 9urfee 4ompany. The earnings series makes 9urfee
appear to e a more volatile and risky investment. Thus, in the asence of any conflicting
evidence, an investor would proaly e willing to pay more for a share of 4lark 4ompany than
for a share of 9urfee 4ompany.
The chapter information discussed the possiility that a company could time its transactions and
use ad"ustments in accounting estimates to smooth the reported amount of earnings from one
year to the next. !n analyst would want to look at the reported operating cash flow numers for
these two companies to determine whether the underlying cash#flow#generating aility of 4lark
4ompany is as stale as its apparent earnings#generating aility. !n analyst would also want to
look carefully at the notes to 4lark)s financial statements for the past three years to find whether
any accounting changes have een made that might have contriuted to the smooth earnings
stream. !n analyst also would like to see the *uarterly earnings amountsE one would e
suspicious of 4lark)s reported annual amounts if the *uarterly earnings in the first three *uarters
were widely variale ut the fourth *uarter results consistently led to steady overall income
growth for the year. ;inally, an analyst would like to get a sense for the character of the managers
of oth companies. ;or example, if the managers of 4lark 4ompany are people of high personal
integrity, the analyst can place much more reliance on the smooth reported earnings series.
.)%c/%%)&* Ca%! 65
Mr. Ghang has several motives for releasing very honest, straightforward financial statements.
;irst, he has his own personal integrity to consider. -econd, he is aware of the enefits of
estalishing the crediility of the company with investors. This reputation for crediility will e
particularly valuale if a decision to sell more shares of 9alian to the pulic is made in the future.
Mr. Ghang also has some incentives to push for the issuance of very positive, perhaps overly
positive, financial statements. Aith stronger financial statements, the IPO price likely will e
higher and more funds will flow into the udget of the ministry of which Mr. Ghang is an employee.
This additional cash inflow will e good for the people of 4hina. In addition, the more funds that
are raised through the IPO, the etter Mr. Ghang looks to his superiors. Thus, Mr. Ghang)s future
career may e impacted y the type of financial statements released in connection with this IPO.
!s mentioned in the chapter, there is some evidence that the financial statements of 4hinese
state#owned enterprises are su"ect to some earnings management efforts in advance of an IPO.
.)%c/%%)&* Ca%! 66
The primary issue that should e weighing upon your mind is the pulic relations disaster that will
result if ;lame 4ontrol reports record earnings ecause of the fires that have destroyed the
state)s forests. The financial statements could very well e used as evidence in the state
legislature as laws are considered that would punish profiteering from natural calamities such as
forest fires. %ven in the asence of direct punishment from such legislation, ;lame 4ontrol will
have lost a large amount of pulic goodwill y seeming to profit from the misfortunes of the rest of
the state. !s a result, you as ;lame 4ontrol)s 4;O will feel a strong incentive to make pessimistic,
income#decreasing assumptions as you supervise the preparation of the financial statements.
Hou may consider decreasing depreciation life assumptions, increasing ad det estimates, and
so forth.
C+a$(!, 6 ':5
.)%c/%%)&* Ca%! 66 (C&*c"/d!d)
3ather than rely on accounting assumptions to lower your reported earnings and conceal the fact
that, from a usiness standpoint, you had a record year at the expense of the rest of the state,
you might convince the oard of directors to address the issue head on. Hes, ;lame 4ontrol
makes more money when there are more fires. That also means, however, that ;lame 4ontrol
suffers financially in years that are relatively fire free. Perhaps in recent years ;lame 4ontrol has
had to lay off workers ecause of slowdowns at its factories associated with a low incidence of
forest fires. ;lame 4ontrol might also e advised to use some of its windfall profits to reuild the
communities harmed y the fires. In summary, the reported earnings of ;lame 4ontrol are going
to provide politically sensitive information this year. 3ather than trying to cover over its financial
success with accounting assumptions, ;lame 4ontrol might consider more direct ways to placate
pulic anger.
Note: Iarious industries in the 2nited -tates have faced this exact issue in the past. In the mid#
7>D1s, soaring oil prices generated windfall profits for the ig oil companies. 4ongress even
passed a +Aindfall Profits Tax, to try to extract some of the oil profits that appeared to have een
generated through the suffering of the !merican people. In the mid#7>>1s, pulic scrutiny focused
on the profits generated y pharmaceutical companies.
.)%c/%%)&* Ca%! 67
The frustration of your finance professor is understandale. <owever, we should e careful not to
allow this frustration to throw out the practice of accrual accounting that has een carefully
developed over the past 511 years. -ome points that you might make in response to the finance
professor are as follows:
3esearch has demonstrated that net income is a etter measure of a company)s
economic performance for a period than is operating cash flow. This indicates that, on
average, the accrual assumptions made y accountants add value to the data.
3esearch has also demonstrated that current net income is a etter forecaster of future
operating cash flow than is current operating cash flow.
Operating cash flow is also su"ect to manipulation through the timing of cash payments
near the end of a *uarter.
3ather than throwing out earnings, it makes more sense to punish those companies and
managers who issue deceptive financial reports and reward those companies that engage in
transparent financial reporting. Much of this punishment and reward can take place as financial
statement users ecome more discriminating in their analysis of financial statements and the
assumptions that underlie them.
.)%c/%%)&* Ca%! 68
Of course, 4ruella)s opinion is personally repugnant and reflects a very cynical view of the world.
In addition, her opinion may very well reflect poor usiness "udgment. Once financial statement
users are aware of her opinion, they will e very skeptical aout any financial statements she
prepares. 2sers will have to do more independent verification to ensure that her financial
statements are not intentionally misleading. $asically, 4ruella)s approach will increase her
company)s cost of capital.
':& 4hapter &
.)%c/%%)&* Ca%! 69
!ccounting assumptions can e used to improve <eidelerg)s reported earnings as follows:
epreciation. <eidelerg can use longer depreciation lives. !lso, if the company is using
an accelerated method for any of its long#term assets, it can switch to straight line.
Ba! !ebts. <eidelerg can reduce its ad det allowance as a percentage of outstanding
accounts receivale. This is e*uivalent to reducing ad det expense as a percentage of
sales.
"ensions. !s explained in 4hapter 7D, two key assumptions related to accounting for a
defined enefit pension plan are the assumption aout the implicit interest cost
associated with the unpaid pension oligation to the employees and the expected long#
run rate of return to e earned on the pension fund. =owering the former percentage and
raising the latter reduces the reported amount of pension expense.
;our ma"or categories of financial statement users are investors /including financial analysts0,
anks, the oard of directors, and other stakeholders /such as suppliers, employees, local
governments, and so forth0. The first three groups are usually sophisticated financial statement
users and are the least likely to e influenced y latant earnings management. The final group,
the other stakeholders, are the least sophisticated of financial statement users. They are most
likely to e influenced, in a pulic relations sense, y the four *uarters of reported profits in the
centennial year. They also are the least likely to carefully scrutini(e the financial statements to
see whether any deceptive earnings management has taken place.
This scenario matches the general fact situation in a well#known <arvard $usiness -chool case,
<arnischfeger 4orporation, written y Professor Jrishna Palepu.
.)%c/%%)&* Ca%! 610
;irst, whether a company is a good investment or not depends primarily on what the current
market price of the stock is. %very stock is a good investment at some price. -etting that aside,
your analysis of 9enethor)s financial statements suggests that the company may have engaged
in earnings management in the most recent year y changing its depreciation life estimates. The
explanation given in the financial statement notes looks to e merely a oilerplate "ustificationE no
explanation is given for what changed this year to cause the depreciation estimate to e changed.
The evidence suggests that the key factor motivating the change was a desire to report positive
rather than negative earnings. Once you put all of this together, the one definitive statement is
that you now are *uestioning the crediility of 9enethor)s management. It would proaly e
appropriate to pass along these douts to your client.
.)%c/%%)&* Ca%! 611
In !ccounting and !uditing %nforcement 3elease 6o. 7:15, !dministrative Proceeding ;ile 6o.
8#71578 dated Kune 7>, '117, the -%4 had the following to say with respect to the !rthur
!ndersen audit of Aaste Management:
Aaste ManagementLs financial statements were not presented fairly, in all material
respects, in conformity with .!!P for 7>>8 through 7>>&. ;or each year 7>>8 through
7>>&, !ndersen, as a result of the conduct of certain of its partners as descried herein,
knew or was reckless in not knowing that the 4ompanyLs financial statements were not
presented fairly, in all material respects, in conformity with .!!P ut nonetheless approved
the issuance of an un*ualified audit report on the financial statements each year.
The key phrase in the -%4 statement is that !ndersen was +reckless in not knowing, aout the
lack of conformity to .!!P in Aaste Management)s financial statements. It is not sufficient
"ustification to say that a prolem was overlooked ecause of an innocent mistake. The audit
should e designed to detect such errors if they are of a material magnitudeE so if the audit didn)t
C+a$(!, 6 ':D
reveal the misstatements, the audit firm recklessly designed it. The -%4 formally sanctioned
!rthur !ndersen in this case.
.)%c/%%)&* Ca%! 612
It may e possile for you to assemle enough evidence to get an indictment against Kohn and
Mary. It is reported that -ol Aachtler, the former 4hief Kudge of the 6ew Hork -tate 4ourt of
!ppeals, oserved, M%ven a modestly competent district attorney can get a grand "ury to indict a
ham sandwich.M .etting a conviction won)t e so easy. Ahat %arnings Management, Inc., is doing
certainly appears to e slea(y and unethical. <owever, on closer inspection, it isn)t clear what
laws Kohn and Mary have roken. They have merely taken unsavory little facts and packaged
them for sale. <owever, a venture capitalist or a anker might like to get a list of Kohn and Mary)s
clients to know what companies to avoid when investing or lending money.
.)%c/%%)&* Ca%! 613
The first year of a new management offers a uni*ue opportunity for making asset impairment
write#downs ecause the negative impact on earnings will e lamed on the previous
management. Managements are typically replaced ecause of dissatisfaction with their
performance. !ccordingly, reevaluations of the assets are expected. In calculating these charges,
the new management has no incentive to understate their magnitude. Ahen faced with a difficult
decision of whether or not to write off an asset, new management would always have an incentive
to write it off in the first year when old management will e lamed rather than waiting until
suse*uent years when the new management will e held responsile for poor earnings.
.)%c/%%)&* Ca%! 614
To accomplish the 4%O)s directive to show ig earnings growth in the next few years, you want to
allocate as much of the purchase price as possile to in#process 3@9, which is expensed
immediately. 4osts that are expensed immediately are then not included in the computation of
depreciation expense in future years. This suggests that you choose !llocation '. To give 3osie
4ompany the maximum flexiility to show consistently increasing earnings in future years, you
want to pick depreciation lives at the low end of the acceptale range. This then gives you
flexiility to increase the depreciation lives, within the acceptale range, in future years, resulting
in increasingly lower depreciation expense. Hou should thus choose a 75#year life for the uilding
and a 8#year life for the machinery.
This re*uest from the 4%O should trigger a host of concerns. ;rom a practical standpoint, you
must e concerned whether this accounting for the ac*uisition will pass the scrutiny of your
auditor and the -%4 staff /if you are pulicly traded0. In addition, this re*uest confirms the 4%O)s
reputation of eing without scruples. Hou should e concerned aout the wisdom of continuing to
work for such a person. In addition, if you go along with this re*uest, what will happen to your
personal reputationN
':? 4hapter &
.)%c/%%)&* Ca%! 615
-cenario 7. %arnings this year are high, ut earnings in future years are in dout. If =ily
4ompany)s oard wants to estalish a cookie "ar reserve that can e used to olster earnings in
future years, a :B ad det expense should e used this year. This will allow for the reporting of
lower ad det expense in future years if earnings are low.
-cenario '. %arnings this year are low, ut those in future years are expected to e strong. If =ily
4ompany)s oard wants to show consistent, steady income growth, a 7B ad det expense
should e used this year. This low expense will increase reported income this year. In future
years, experience may necessitate a higher ad det percentage estimate, ut that can e
alanced against the expected future profit improvements.
$y using the ad det percentage estimate to create a cookie "ar reserve to smooth earnings, =ily
4ompany runs the risk of reducing the crediility of its financial reports. ;inancial statement users
will e ale to detect the fluctuating ad det estimates. If changes in usiness conditions do not
"ustify these changes, =ily will e suspected of eing an earnings manager. This will cause
financial statement users to e more skeptical of future financial reports and perhaps other claims
y =ily)s oard or managers.
.)%c/%%)&* Ca%! 616
$y making his comment, 3ex has informed the assistant controller that no *uestionale items
less than C'51,111 in amount will e actively investigated. If the accounting staff at Jirtland
4ompany wanted to hide anything from the auditor, they now know that they can hide *uite a it
"ust y making sure that the amounts of the items are less than C'51,111. On the other hand, 3ex
proaly hasn)t revealed any crucial state secrets. It is likely that some of the people on Jirtland
4ompany)s accounting team have previously worked for the same audit firm that is now doing the
audit. !s such, they are familiar with the way the audit firm computes its materiality thresholds
and could proaly deduce the numer if they desired.
!ny numerical threshold is dangerous if the auditor focuses only on the dollar amount of the
threshold ut doesn)t put the audit evidence in a roader context. ;or example, the nature of an
apparent error in the client ooks might e more important than the dollar amount, such as a
C51,111 cash payment to a vendor that is not on the approved list and is identified only y a post
office ox numer. In addition, as mentioned in the text of the chapter, an audit difference that
results in a company reporting a profit instead of a loss should e considered to e material no
matter what the amount.
.)%c/%%)&* Ca%! 617
3evenue cannot e recogni(ed until the company has sustantially completed its performance.
!lthough the memership fees are nonrefundale, the memership is for the person)s lifetime.
Thus, the revenue should e spread over the estimated time that a memer will use the facilities.
In attempting to secure a new loan, Jristen and her partners wish to portray the performance of
their health clu in the est light possile. If a potential lender is nervous aout the clu)s
economic viaility, the loan may e offered on very unfavorale terms. Thus, Jristen and her
partners would like to recogni(e as much revenue as possile. Timing is very important since the
loan is eing sought nowE revenue recogni(ed next year or the year after won)t improve the
financial statements given to a potential lender now. On the other hand, Jristen and her partners
do have an economic incentive for maintaining, or increasing, their crediility with their lender. If
the revenue recognition rules are stretched and extra revenue is reported, the lender could very
well ignore the financial statement numers and focus instead on the negative connotation that
this earnings management has with respect to the character of Jristen and her partners. Through
straightforward financial reporting and revenue recognition, Jristen and her partners might
increase their crediility and lower their cost of orrowing.
C+a$(!, 6 ':>
.)%c/%%)&* Ca%! 618
The Aorthington 4ompany pro forma disclosure is an example of how pro forma reporting can
help financial statement users etter understand a company)s earnings. $y removing the effects
of one#time items, the Aorthington pro forma numer gives the financial statement user a etter
measure of the sustainale or permanent component of the company)s earnings. In contrast, the
Millward 4ompany pro forma earnings numer is an illustration of the ause of the flexiility of pro
forma reporting. One can make an argument that the costs of the strategic initiative and the
employee training are economically e*uivalent to long#term capital investments. <owever, it is
e*ually likely that these costs are re*uired for the company merely to maintain its current
operating performance and do not add productive capacity. It appears that Millward)s pro forma
earnings disclosure is merely an attempt to report higher earnings.
.)%c/%%)&* Ca%! 619
$enefits
2nder Kaco Marley, 9ickens 4ompany)s financial reporting system is extremely reliale.
;inancial statement users can e assured that no attempt has een made to fluff the
numers to meet earnings forecasts or other targets.
Marley)s approach removes the financial statements from the set of strategic actions that
9ickens) management can use to improve reported performance. Marley)s approach
forces management to fix the underlying usiness rather than rely on accounting
solutions to paper over any prolems.
4osts
Marley is wrong in thinking that the financial statements speak for themselves and need
no clarification or amplification. ! usiness is a very complicated entity, and its economic
performance over any period of time cannot possily e completely captured in a set of
financial statements.
-ome financial statement numers are est understood in the context of ongoing
developments in a company. It can e useful to a company to have the financial
statement numers placed in context y someone inside the company who has a fuller
perspective than do external users. $y refusing to do this, Marley is depriving financial
statement users of important ackground information.
!s in every aspect of usiness, personal relationships are critical. $y refusing to uild
relationships with the investment community, Marley is contriuting to an isolation of
9ickens 4ompany. In a crisis, a company would e well served y having sympathetic
allies in the usiness community. Marley is driving away these potential allies.
.)%c/%%)&* Ca%! 620
Hour est defense is a reputation within the company for consistent ethical ehavior with respect
to financial reporting. If you have developed a reputation for cutting corners and eing willing to
change accounting estimates to meet earnings targets, you are proaly in troule. !ssuming
that you have a solid reputation, you might make some of the following points:
3eliale financial reporting is crucial to the well#eing of the company.
Part of reliale financial reporting is the use of consistent and defensile estimates in the
preparation of the financial statements.
These estimates must e not only defensile ut also reasonale in light of what other, similar
companies are using.
.iven a certain set of estimates, only one earnings numer is possile for a given set of facts.
<owever, there is no sure way to identify the single est set of estimates for a given company
in a given year.
'51 4hapter &
.)%c/%%)&* Ca%! 620 (C&*c"/d!d)
Thus, the purpose of the presentation is to show the shareholders what earnings would e if
other sets of acceptale estimates had een used.
This is not to say that this range of possile earnings numers was examined and the most
favorale numer chosen to e reported. Instead, a set of estimates, consistent with the
estimates that have een made in prior years, was applied to the facts, resulting in the
reported earnings numer.
.)%c/%%)&* Ca%! 621
Jara thinks that the time she spends explaining *uarterly earnings to the usiness community
could e much more productively spent in developing long#run initiatives to improve her usiness,
initiatives that might not ear fruit within the current reporting period ut which are in the est
long#run interest of the company.
!s descried in 4hapter 7?, the $usiness 3oundtale /an organi(ation of '11 4%Os of top 2.-.
corporations0 has claimed that *uarterly earnings reports are very costly in terms of preparation
and are counterproductive ecause they cause management to focus on short#term earnings
rather than long#term growth. This concern aout the counterproductivity of *uarterly reporting
was echoed y Peter !. Magowan, then#4%O of -afeway, the large supermarket chain ased in
Oakland, 4alifornia. In 6ovemer 7>?&, -afeway was taken private in a C5.8 illion leveraged
uyout /=$O0. In looking ack on the success of the restructuring that followed the =$O,
Magowan reported that one of the key advantages en"oyed y -afeway was that as a private
company, it was no longer locked into the cycle of fixation on reported *uarterly earnings.
!ccording to Magowan, this freedom from pressure to report ever#increasing *uarterly profits
made it possile for -afeway to institute aggressive pricing, store expansion, and increased
spending for training and technologyOall actions that would hurt reported profits in the short run
ut were for the company)s long#term good.
.)%c/%%)&* Ca%! 622
It is important to rememer that every audit involves a calculated risk. It is impossile for an audit
firm to take the time and incur the expense to check every transaction a client entered into during
a year. !ccordingly, the final issuance of the audit opinion is an act of faith that the audit
procedures have een designed properly to detect all material misstatements. Aith riskier clients,
the possiility of an undetected material misstatement increases. <owever, this increased risk
would also "ustify an increased audit fee. ;or any potential audit client, there is an audit fee that is
large enough to "ustify the level of risk that the audit firm must ear with respect to that client. In
doing this assessment, the audit firm must e careful to factor in not only the potential cost of
lawsuits associated with an audit failure ut also the potential cost of a loss of reputation. Once all
of those factors have een considered, if the audit fee is high enough, the audit firm should
consider accepting the audit client no matter what the risk factor rating.
.)%c/%%)&* Ca%! 623
The criticism aout overly optimistic forecasts is directed at sell#side analysts. -ell#side analysts
work for rokerage houses and are thus susceptile to some pressure to help secure clients.
Thus, a sell#side analyst must alance his or her incentives to produce accurate earnings
forecasts with the desire to keep clients and potential clients happy. ! uy#side analyst is
employed to help an investment fund identify good investments. Thus, a uy#side analysts has no
incentive to curry favor with the companies whose earnings he or she is forecasting. Instead, the
uy#side analyst has an incentive to identify good investments on ehalf of the investors in the
fund. This identification of good investments is est done y making uniased earnings forecasts.
C+a$(!, 6 '57
.)%c/%%)&* Ca%! 624
Aith no financial statements availale from any of the 711 companies in Tara(ania, the est an
investor can do is estimate a company)s average profitaility and financial soundness and
assume that each company is aout average. !ccordingly, when it ecomes legal to release
financial statements, the company with the greatest incentive to release financial statements is
the one with profitaility and financial soundness most aove average. In fact, all companies that
are aove average have an incentive to release financial statements. Once this happens, the
ottom 51 companies will e left, and the est that investors can do is assume that each of these
companies has profitaility and financial soundness e*ual to the average of the ottom 51
companies. -o, the companies that are in the top half of the ottom 51 will have an incentive to
release financial statements to differentiate themselves from the ottom half of the ottom 51.
This process will repeat itself until >> companies have released financial statements to reveal to
investors that they are not the worst of the 711 companies. !t that point, the 711th company
might as well release its financial statements. -o, even with voluntary reporting, it is proale that
all, or almost all, companies would release their financial statements to the pulic.
This analysis is ased on the following well#known article: .eorge !. !kerlof, MThe Market for
P=emons): Quality 2ncertainty and the Market Mechanism,M #uarterl$ %ournal of &conomics'
!ugust l>D1. Professor !kerlof was the co#winner of the '117 6oel Pri(e for %conomics.
.)%c/%%)&* Ca%! 625
The reporting choice that 4ompanies ! and $ face is similar to the famous prisoners) dilemma.
The standard way to analy(e a prisoners) dilemma is using a payoff matrix. %ach cell contains the
amount of investment funds that you receive, given the comination of your action and the other
company)s action, as follows:
T+! O(+!, C&0$a*#1% Ac()&*
Hour !ction
Transparent
3eporting
9eceptive
3eporting
Transparent reporting C5 million C1
9eceptive reporting C? million C7 million
=ook at the columns Transparent 3eporting and 9eceptive 3eporting. These are the two options
open to the other company. In the first column, which assumes that the other company reports
transparently, you see that you can increase the investment amount that you receive from C5
million to C? million y issuing a deceptive rather than a transparent report. In the second column,
which assumes that the other company will report deceptively, you can increase the amount of
the investment funds that you receive from C1 to C7 million. -o, no matter what you expect the
other company to do, you can increase the amount of investment funds that you will receive y
reporting deceptively rather than transparently. Hour only rational choice, given these conditions,
is to report deceptively.
The other company will construct this same matrix and come to the same conclusion. <ence,
oth 4ompany ! and 4ompany $ will report deceptively and oth will receive C7 million in
investment funds. The reason that this prisoners) dilemma scenario is so tough is that oth
companies would e etter off if they oth reported transparently. <owever, such a solution is not
stale ecause if one company expects the other to report transparently, that company has an
incentive to report deceptively and increase the investment funds it receives from C5 million to C?
million. The only stale solution to the dilemma is the unsatisfying solution in which oth
companies report deceptively. In this case, neither company has a desire to change its action
after the fact ecause its action is the est it can do given what the other company did. This is
called a Nash e(uilibrium after Kohn 6ash, the mathematician who initially derived it. Kohn 6ash
was the su"ect of the ook and !cademy !ward#winning movie A Beautiful )in!.
.)%c/%%)&* Ca%! 625 (C&*c"/d!d)
'5' 4hapter &
The more you think aout this 6ash e*uilirium, the more unsettling it ecomes ecause the two
companies could oth e etter off if they were to report transparently and receive C5 million each
in investment funds. The 6ash e*uilirium of dual deceptive reporting is, however, the only stale
solution.
! key part of the prolem of this prisoners) dilemma is that deceptive reporting has no long#run
conse*uences. If this scenario were played out each year over the course of many years, the
companies might reali(e that they could oth improve their long#run positions y reporting
transparently. The est long#run solution is for oth companies to report transparently each period
so that each gets C5 million in investment funds each period. This illustrates that perverse
ehavior sometimes arises ecause a company or an individual does not properly evaluate the
long#run conse*uences of actions that may have short#term enefit.
C+a$(!, 6 '58
SOUTIONS TO 2O3E. ITE4S
4)c,&%&'( C+a,-!d 5)(+ E%(ab")%+)*- C&&6)! 7a, R!%!,8!% ($$. 3289329)
1. The second revenue recognition criterion is that the revenue has een earned through
sustantial completion of the activities involved in the earnings process. Microsoft reports
that sustantial completion of its earnings process is not accomplished until technical
support has een provided over the product life cycle. This approach makes theoretical
sense ut also introduces a practical difficulty in determining how much of the revenue
should e recogni(ed immediately and over what period the remaining revenue should e
deferred.
2. ! company)s management would desire to report smooth earnings to give the impression of
staility and predictale growth. =enders in particular are made nervous y companies with
volatile earnings.
3. ! simple definition of conservatism is that revenues and gains are deferred until certain,
whereas expenses and losses are recogni(ed immediately. $y this definition, the Microsoft
revenue deferral practice is conservative. <owever, this case illustrates that conservative
accounting is not necessarily good accounting. If a company defers revenue to manipulate
its reported performance, the conservative practice results in distorted financial statements.
4onservatism should not e used as an excuse for delierate misstatement of a company)s
economic performance.
A,(+/, A*d!,%!*: A Ta"! &' T5& C+&)c!% ($$. 3329333)
1. If a company has a reputation for unending integrity, that company will find it much easier
to convince other companies to enter into commitments with it. !n audit firm with a solid
reputation is ale to attract high#*uality audit clients who are eager to signal the market that
their financial statements and financial practices are aove suspicion. -uch an audit firm
would also find it easier to attract professionals with high levels of personal integrity. !
manufacturing or service firm with a solid reputation finds it easier to uild relationships of
trust with suppliers, customers, and employees. It is easier for such a firm to design
purchase contracts, warranty commitments, and long#term compensation agreements
ecause the company)s stakeholders don)t have to worry aout eing deceived.
'5: 4hapter &
SOUTION TO STOP ; RESEARCH
Stop & Research (p. 338): One reason for the very harsh treatment of !rthur !ndersen in the
%nron case in '11' is that the audit firm had een severely reprimanded y the -%4 in '117 for
its actions in the audit of Aaste Management. This reprimand can e found at
http:RRwww.sec.govRlitigationRadminR8:#:::::.htm. !ccess this document and determine how the
!ndersen partners "ustified the issuance of an un*ualified opinion in connection with the 7>>8
audit of Aaste Management.
The following comes from -ection 9.8 of the -%4 censure of !rthur !ndersen:
+!ndersen audited Aaste ManagementLs 7>>8 financial statements. $y ;eruary 7, 7>>:, the
engagement team *uantified current and prior period misstatements totaling C7'? million, which,
if recorded, would have reduced net income efore special items y 7'B. The engagement team
prepared Proposed !d"usting Kournal %ntries /MP!K%sM0 in that amount for the 4ompany to record
in 7>>8. The engagement team also identified accounting practices that gave rise to other known
and likely misstatements involving understatements of operating expenses for which it did not
prepare P!K%s. The engagement team informed Maier of the P!K%s and accounting practices
giving rise to the other known and likely misstatements. The 4ompany refused to record the
P!K%s or to correct the accounting practices giving rise to the P!K%s and other misstatements
and likely misstatements.
+!ndersenLs !udit O"ectives and Procedures Manual /the P!OP Manual)0 re*uired that !llgyer
consult with partners having firmwide responsiilities when cumulative P!K%s exceeded ?B of
net income from continuing operations. !s a result, on ;eruary 7, 7>>:, !llgyer and Maier
consulted with the Practice 9irector and the !udit 9ivision <ead. These partners reviewed and
discussed the unrecorded P!K%s and what the engagement team identified as Mcontinuing audit
issues.M They determined that !ndersen would nonetheless issue an un*ualified audit report on
Aaste ManagementLs 7>>8 financial statements. !pplying an analytical procedure for evaluating
the materiality of audit findings referred to as the Mroll#forwardM method, these partners
determined that, ecause the ma"ority of P!K%s concerned prior period misstatements, the
impact of the P!K%s relating to current period misstatements on the 4ompanyLs 7>>8 income
statement was not material. They instructed !llgyer to inform the 4ompany that !ndersen would
issue an un*ualified audit report. In addition, they instructed !llgyer to emphasi(e that !ndersen
expected the 4ompany to change its accounting practices and to reduce the cumulative amount
of the P!K%s in the future.,
Stop & Research (p. 341): The !I4P! 4ode of Professional 4onduct can e found at the
following Ae address: http:RRwww.aicpa.orgRaoutRcodeRindex.htm. !ccess this site, and find
-ection 71' on Integrity and O"ectivity. Ahat constitutes a knowing misrepresentation in the
preparation of financial statementsN
+.1' 71'#7OJnowing misrepresentations in the preparation of financial statements or records. !
memer shall e considered to have knowingly misrepresented facts in violation of rule 71' S%T
section 71'.17T when he or she knowinglyO
a. Makes, or permits or directs another to make, materially false and misleading entries in an
entityLs financial statements or recordsE or
. ;ails to correct an entityLs financial statements or records that are materially false and
misleading when he or she has the authority to record an entryE or
c. -igns, or permits or directs another to sign, a document containing materially false and
misleading information.,
C+a$(!, 6 '55
CO4PETENC< ENHANCE4ENT OPPORTUNITIES
.!c)$+!,)*- 691 (T+! =a"( .)%*!# C&0$a*#)
In its 6ovemer ?, '117 press release, 9isney reported pro forma net income for fiscal '117 of
C7,5'5 million, compared to a .!!P net loss of C75? million. ! close estimate of this amount can
e generated as follows:
/in millions0
6et loss for '117 according to .!!P C /75?0
!dd restructuring and impairment charges 7,:5:
-utract gain on sale of usinesses /''0
!dd cumulative effect of accounting changes 'D?
+%stimated, pro forma net income for '117 C 7,55'
This estimate of C7,55' million is close to the actual pro forma earnings, ut only ecause it
ignores two offsetting factors. ;irst, in its computation of pro forma earnings, 9isney only added
ack C?D? million of the restructuring and impairment charges. The remainder of the restructuring
charge was considered to e sufficiently integral to normal operations to re*uire that it e
included in the computation of pro forma earnings. -econd, increasing the amount of reported
pretax earnings will change the reported income tax expenseE that factor is ignored in the simple
calculation presented aove.
.!c)$+!,)*- 692 (3!,&>)
!s discussed in the text of 4hapter &, the peak period of earnings management at Ferox was in
7>>?. The following gross profit percentage numers confirm that Ferox was ale to maintain its
apparent operating profitaility until 7>>>:
'111 7>>> 7>>? 7>>D
.ross profit percentage :1.&B :&.?B :>.8B :>.?B
/.ross profitR3evenues0
Most informative are the operating cash flow numers. If the cash generated y the selling of the
finance receivales is removed from the 7>>> operating cash flow, the trend for the : years is as
follows:
/in millions0 '111 7>>> 7>>? 7>>D
6et income /loss0 C/'5D0 C7,:': C 8>5 C7,:5'
Operating cash flow /&&80 /'D70 /7,7&50 :D'
The negative operating cash flow numers indicate that Ferox was having serious operating
prolems at least as early at 7>>?, and those prolems continued through '111. This example
confirms that one must look at oth net income and operating cash flow in order to get a complete
picture of a company)s performance. In addition, the finance receivales securiti(ation in 7>>>
demonstrates that there are actions that a company can take to manage reported operating cash
flow.
'5& 4hapter &
=,)()*- A%%)-*0!*(
=+# d)d 5! 0a*a-! !a,*)*-%?
To: 9ee!nn Martine(, -enior Iice President, Hosef $ank
;rom: Hour 6ame, 4ontroller, 4am#3y Industries
-u"ect: Poor Kudgment and %arnings Management
Thank you for agreeing to meet with me next week. !s the new management team at 4am#3y
guides the company out of the mess that we are in, we will need the support of our long#time
customers, suppliers, employees, and you, our anker.
I personally apologi(e for my part in providing you with misleading financial statements for the
past two years. I wish I could say that the entire earnings management scheme took place
without my knowledge, ut that would not e true. I knew what our former 4%O was up to, and I
failed to act to stop the release of the deceptive financial statements. !long with our 4%O, I got
caught up in working for our final o"ective, a successful e*uity offering next year, and I
overlooked the unethical means /misleading financial reports0 that were used to try to reach that
o"ective. 9on)t think that I have escaped punishmentE even though I have kept my "o, my
usiness reputation is now in tatters and it will take me years to restore it.
Our new 4%O has placed a high priority on restoring good relations with Hosef $ank. If you have
lost confidence in me personally, then the new 4%O will appoint someone from the new
management team at 4am#3y to represent us in our dealings with your ank. In addition to a new
management team, we also have a new auditor, new financial reporting controls, and a new
ethical attitude in the company. Please don)t let your disappointment in my personal ehavior get
in the way of working with this new management team.
!gain, thanks for agreeing to meet with me next week. If you think it would e appropriate for a
different memer of the new senior management team at 4am#3y to come in my place, please let
me know.
R!%!a,c+ P,&@!c(
Q/a")(# &' !a,*)*-%
In the case, +! 4ontroller)s 4hallenge,, the controller Kim Aoodruff is reluctant to order the
acceleration of the C' million shipment ecause to complete the goods early will re*uire the
company to spend an extra C711,111 in overtime charges. Kim wonders: +Ahy would I endorse
spending real money to move profits a few weeks aheadN, Other earnings management issues
introduced in this case are the li*uidation of =I;O layers, the potential capitali(ation of
experimental development costs that would normally e expensed, delaying the initiation of
depreciation on a new facility that is "ust eginning to e used, and so forth. The pressure to
manage the ottom line is illustrated in a *uote from the company president in the case: +3unning
a usiness means having to alance out the ups and downs on the ottom line. Ae can get a
si(ale chunk of it from SacceleratingT the SC' millionT Imperial order. The rest is mostly accounting
issues. The target is a millionsee if you can get it.,
The !I4P!)s Quality of %arnings 4ase -tudy 4ollection contains over a do(en cases that explore
earnings management issues. In addition, there are many other sources of information aout
*uality of earnings accessile through the !!!)s Quality of %arnings Pro"ect.
C+a$(!, 6 '5D
T+! .!ba(!
I% c&*%!,8a()8! acc&/*()*- -&&d acc&/*()*-?
The two teams in the deate might make some of the following points:
C&*%!,8a()%0
!s mentioned in the text of 4hapter &, financial reporting is part of the roader pulic relations
effort of a company. !s such, accountants feel a natural loyalty to their company and, thus,
tend to make estimates and "udgments that would present the performance of the company in
the est possile light. ! strict policy of conservatism would counteract this natural tendency.
Managers are naturally optimistic aout the prospects of their usiness, perhaps even overly
optimistic. If they did not elieve in their usiness, they would not e ale to unreservedly
devote their efforts to making the usiness successful. This predictale overoptimism will
inevitaly manifest itself in the form of overoptimistic accounting estimates, "udgments, and
assumptions. 4onservatism is a counteralance to this tendency.
In addition to the factors mentioned aove, managers also have strong economic incentives
to ias the financial statements to report good news. These incentives include management
onuses, favorale ank loan agreements, a rising stock price, and so forth. !ccounting
conservatism helps mitigate the positive ias in financial statements introduced ecause of
these economic incentives.
!ccounting conservatism imposes greater discipline upon a company)s financial reporting.
The practice of conservatism removes a large amount of the freedom that companies have to
manage earnings y insisting that ad news e reported as soon as it is suspected and that
good news not e reported until it has een concretely reali(ed.
A,!!d&0 ',&0 2)a%
Misleading financial statements are misleading whether they paint an overly optimistic picture
or an overly pessimistic picture. ;inancial reports should fairly reflect a company)s
performance and should not e conservatively iased to intentionally present a worst#case
scenario.
4onservatively iased financial statements harm those investors and creditors who would
have invested in or lent to a company if they had received accurate information. Those
investors and creditors have een deceived and have had to put their capital to use in less
productive ways. 4onservatively iased financial statements make the overall economy less
efficient ecause the misleading information prevents capital from flowing to its most efficient
use.
2sing a conservative ias in financial statements to counteract overoptimism among
managers follows the faulty old +two wrongs make a right, argument.
;inancial reporting should not e used to impose discipline in a corporate structure. If there
are concerns aout management)s ehavior, then those concerns should e addressed
directly. The financial reporting system should e designed to provide uniased information.
E(+)ca" .)"!00a
=+a( %+&/"d #&/ d& 5)(+ /*$"!a%a*( a*d /*5!"c&0! a/d)( !8)d!*c!?
Hou are in a difficult situation ecause you owe loyalty to a numer of different parties whose
interests may e somewhat at odds with one another. These parties are as follows:
Hour audit team: !n important part of your responsiility as an audit manager is to train the
staff who work for you. Ahat type of professional training will you e giving them y sweeping
the channel stuffing evidence under the rugN
.iff 6ielsen, the partner in charge: Hou might e tempted to go around 6ielsen and talk to
other partners at 9oman @ 9etmer. Hou should only do this if you are convinced that 6ielsen
will never act on the channel stuffing evidence. $y going around 6ielsen, you run the risk of
'5? 4hapter &
harming his career, perhaps unfairly. %veryone will e etter off if you can convince 6ielsen to
take this evidence seriously and act on it.
9oman @ 9etmer: The entire audit firm of !rthur !ndersen ceased to exist ecause of the
conduct of a small group of professionals on the %nron audit. -urely, some of those
professionals sensed that the conduct advocated y the partner in charge of the engagement
was wrong. If one of those professionals had acted *uickly and decisively, !rthur !ndersen
would still e a strong international audit firm today.
The pulic /users of McMahon)s financial statements0: !s mentioned near the end of 4hapter
&, the !I4P! 4ode of Professional 4onduct says the following aout resolving conflicting
loyalties:
+In discharging their professional responsiilities, memers may encounter
conflicting pressures. In resolving those conflicts, memers should act with
integrity, guided y the precept that when memers fulfill their responsiility
to the pulic, clientsL and employersL interests are est served.,
Hourself: Hour personal reputation is at stake. If you ac*uiesce and ury this channel stuffing
evidence, everyone in the firm of 9oman @ 9etmer will soon know that you will not stand on
principle. Hour audit team will look on you with less respect. Other partners in the firm may e
reluctant to work with you on future engagements.
Hour est option in this situation is to prepare a etter case and return to .iff 6ielsen to convince
him of the importance of following up on this channel stuffing evidence. Hou should provide
6ielsen with the arguments he will need to convince the other partners of 9oman @ 9etmer that
the additional audit work is necessary to ensure that the firm is not caught up in a catastrophic
audit failure. Hou should help 6ielsen prepare a presentation to the oard of directors of
McMahon showing the impact of the apparent channel stuffing and the financial reporting risk that
the company is running y insisting on reporting these shipments as sales in the current period.
I*(!,*!( S!a,c+
1. The following is from the -%4)s civil action complaint against Ferox, dated !pril 77, '11':
Paragraph 7&. FeroxLs senior management was informed of the most material of these
accounting actions and the fact that they were taken for the purpose of what the company called
Mclosing the gapM to meet performance targets. These accounting actions were directed or
approved y senior Ferox management, sometimes over protests from managers in the field who
knew the actions distorted their operational results.
2. The following is from the -%4)s civil action complaint against Michael K. Jopper, dated
!ugust '7, '11':
Paragraph ':. ;rom 9ecemer 7>>D through 9ecemer '111, Jopper received various
payments relating to 4hewco, which he secretly shared with %nronLs 4;O. Jopper received
approximately C7.5 million in Mmanagement feesM relating to 4hewco, which he shared with
%nronLs 4;O mainly through checks payale to memers of the 4;OLs family. In 9ecemer 7>>?,
%nronLs 4;O caused %nron to pay a C:11,111 Mnuisance feeM to 4hewco as compensation for
agreeing to amend K%9ILs partnership agreement. Jopper transferred approximately C&D,'': of
the nuisance fee ack to %nronLs 4;O, again through checks written to the 4;O or memers of
his family. In addition, Jopper paid the 4;OLs wife approximately C5:,111 for acting as a 4hewco
administrative assistant.
C+a$(!, 6 '5>
3. The following is from the -%4)s initial complaint against Aorld4om, dated Kune '&, '11':
Paragraph 5. -tarting at least in '117, Aorld4om engaged in an improper accounting scheme
intended to manipulate its earnings to keep them in line with Aall -treetLs expectations, and to
support Aorld4omLs stock price. One of Aorld4omLs ma"or operating expenses was its so#called
Mline costs.M In general, Mline costsM represent fees Aorld4om paid to third party
telecommunication network providers for the right to access the third partiesL networks. 2nder
.!!P, these fees must e expensed and may not e capitali(ed. 6evertheless, eginning at
least as early as the first *uarter of '117, Aorld4omLs senior management improperly directed
the transfer of line costs to Aorld4omLs capital accounts in amounts sufficient to keep
Aorld4omLs earnings in line with the analystsL consensus on Aorld4omLs earnings. Thus, in this
manner, Aorld4om materially understated its expenses, and materially overstated its earnings,
therey defrauding investors.

You might also like