Lecture Notes on Earnings Quality and Management

Pressures of Public-listed firms:

1. Meet or beat targets (analysts)

o If not met, downgraded = stock price will fall
2. Comply with debt covenants
o If not met, interest rates on their debts will increase
3. Growth : Market would reward growth

Earnings Management (EM) (not always fraud; not always illegal)

1. Timing transactions (strategic matching) : to produce a gain or loss with the primary
purpose of manipulating the earnings number
2. Changing methods or estimate (e.g. FIFO to LIFO, depreciation method, bad debts)
a. Full disclosure = ethical
b. Little or no disclosure = not ethical

EM Techniques

1. Cookie Jar Reserves

Materiality (for large companies e.g. 5%)

 2. Big Bath Charges

EM is not fraud, unless:

1. Fictitious transactions
o Inventing sales (revenue recognition)
o Hiding expenses
2. Non-GAAP accounting
o Failure to consolidate affiliated entities (Enron)
o Misclassification
o Capitalizing cost instead of expensing
o Creative Acquisition Accounting (e.g. 50%+ = Assets and Liabilities at market value)

Sarbanes-Oxley Act of 2002

o New rules for publicly traded companies
o New rules for audit firms
o Creation of PCAOB

Rules for companies

1. CEO and CFO must certify the FS

i. Enhanced criminal penalties (particularly if they destroy documents)
2. The company must assess the effectiveness of its internal controls (and issue a report)

Rules for audit firms

1. Must implement quality control if they have a publicly-traded client

2. A second partner must review and approve audit reports (apart of the lead partner)
3. Lead partner and reviewing partner must rotate out every 5 years
4. Must audit the client’s internal controls (and issue a report) – Section 404
a. Major complaint: very costly especially for the small businesses (audit work + internal
controls)
5. Prohibited from providing many non-audit services (e.g. MAS, tax) to audit clients
Creation of PCAOB (Public Company Accounting Oversight Board)

o Before PCAOB, audit firms are self-regulated

o Non-profit organization created by US Congress in 2002
o Regulates the auditing industry (watchdog)

Structure of the PCAOB

o 5 Board members appointed by SEC to 5-year term

o SEC oversees the PCAOB (approve budget, monitor the activities)
o Funded by fees paid by public companies

Roles of PCAOB

1. Registration
2. Monitoring (sample some of the audit reports = quality control = within standards?)
3. Standard setting (not GAAP, but auditing standards)
4. Enforcement (including sanction)

Module I: Earnings Sustainability and Responsible Professional Conduct

IMA Statement of Ethical Professional Practice

Members of IMA shall behave ethically. A commitment to ethical professional practice includes
overarching principles that express our values and standards that guide member conduct.

Principles

IMA’s overarching ethical principles include: Honesty, Fairness, Objectivity, and Responsibility. Members
shall act in accordance with these principles and shall encourage others within their organizations to
adhere to them.

Standards

IMA members have a responsibility to comply with and uphold the standards of Competence,
Confidentiality, Integrity, and Credibility. Failure to comply may result in disciplinary action.

I. COMPETENCE
1. Maintain an appropriate level of professional leadership and expertise by enhancing knowledge and
skills.
2. Perform professional duties in accordance with relevant laws, regulations, and technical standards.
3. Provide decision support information and recommendations that are accurate, clear, concise, and
timely. Recognize and help manage risk.
II. CONFIDENTIALITY
1. Keep information confidential except when disclosure is authorized or legally required.
2. Inform all relevant parties regarding appropriate use of confidential information. Monitor to ensure
compliance.
3. Refrain from using confidential information for unethical or illegal advantage.

III. INTEGRITY
1. Mitigate actual conflicts of interest. Regularly communicate with business associates to avoid
apparent conflicts of interest. Advise all parties of any potential conflicts of interest. 
2. Refrain from engaging in any conduct that would prejudice carrying out duties ethically.
3. Abstain from engaging in or supporting any activity that might discredit the profession.
4. Contribute to a positive ethical culture and place integrity of the profession above personal interests.

IV. CREDIBILITY
1. Communicate information fairly and objectively.
2. Provide all relevant information that could reasonably be expected to influence an intended user’s
understanding of the reports, analyses, or recommendations.
3. Report any delays or deficiencies in information, timeliness, processing, or internal controls in
conformance with organization policy and/or applicable law.
4. Communicate professional limitations or other constraints that would preclude responsible judgment
or successful performance of an activity

Resolving Ethical Issues

In applying the Standards of Ethical Professional Practice, the member may encounter unethical issues
or behavior. In these situations, the member should not ignore them, but rather should actively seek
resolution of the issue. In determining which steps to follow, the member should consider all risks
involved and whether protections exist against retaliation. When faced with unethical issues, the
member should follow the established policies of his or her organization, including use of an anonymous
reporting system if available. If the organization does not have established policies, the member should
consider the following courses of action:

 The resolution process could include a discussion with the member’s immediate supervisor. If
the supervisor appears to be involved, the issue could be presented to the
next level of management.

 IMA offers an anonymous helpline that the member may call to request how key elements of
the IMA Statement of Ethical Professional Practice could be applied to the ethical issue.

 The member should consider consulting his or her own attorney to learn of any legal obligations,
rights, and risks concerning the issue.

If resolution efforts are not successful, the member may wish to consider disassociating from the
organization.
Effective corporate governance enhances stockholders’ confidence that a company is being run in their
best interests rather than in the interests of top managers. Corporate governance is the system by
which a company is directed and controlled. If properly implemented, the corporate governance system
should provide incentives for the board of directors and top management to pursue objectives that are
in the interests of the company’s owners and it should provide for effective monitoring of performance.

Unfortunately, history has repeatedly shown that unscrupulous top managers, if unchecked, can exploit
their power to defraud stockholders. This unpleasant reality became all too clear in 2001 when the fall
of Enron kicked off a wave of corporate scandals. These scandals were characterized by financial
reporting fraud and misuse of corporate funds at the very highest levels—including CEOs and CFOs.
While this was disturbing in itself, it also indicated that the institutions intended to prevent such abuses
weren’t working, thus raising fundamental questions about the adequacy of the existing corporate
governance system. In an attempt to respond to these concerns, the U.S. Congress passed the most
important reform of corporate governance in many decades — The Sarbanes-Oxley Act of 2002. 

The Sarbanes-Oxley Act of 2002 was intended to protect the interests of those who invest in publicly
traded companies by improving the reliability and accuracy of corporate financial reports and
disclosures. We would like to highlight six key aspects of the legislation.

First, the Act requires that both the CEO and CFO certify in writing that their company’s financial
statements and accompanying disclosures fairly represent the results of operations—with possible jail
time if a CEO or CFO certifies results that they know are false. This creates very powerful incentives for
the CEO and CFO to ensure that the financial statements contain no misrepresentations.

Second, the Act established the Public Company Accounting Oversight Board to provide additional
oversight over the audit profession. The Act authorizes the Board to conduct investigations, to take
disciplinary actions against audit firms, and to enact various standards and rules concerning the
preparation of audit reports.

Third, the Act places the power to hire, compensate, and terminate the public accounting firm that
audits a company’s financial reports in the hands of the audit committee of the board of directors.
Previously, management often had the power to hire and fire its auditors. Furthermore, the Act specifies
that all members of the audit committee must be independent, meaning that they do not have an
affiliation with the company they are overseeing, nor do they receive any consulting or advisory
compensation from the company.

Fourth, the Act places important restrictions on audit firms. Historically, public accounting firms earned
a large part of their profits by providing consulting services to the companies that they audited. This
provided the appearance of a lack of independence because a client that was dissatisfied with an
auditor’s stance on an accounting issue might threaten to stop using the auditor as a consultant. To
avoid this possible conflict of interests, the Act prohibits a public accounting firm from providing a wide
variety of non-auditing services to an audit client.

Fifth, the Act requires that a company’s annual report contain an internal control report . Internal
controls are put in place by management to provide assurance to investors that financial disclosures are
reliable. The report must state that it is management’s responsibility to establish and maintain adequate
internal controls and it must contain an assessment by management of the effectiveness of its internal
control structure. The internal control report is accompanied by an opinion from the company’s audit
firm as to whether management has maintained effective internal control over its financial reporting
process.

Finally, the Act establishes severe penalties of as many as 20 years in prison for altering or destroying
any documents that may eventually be used in an official proceeding and as many as 10 years in prison
for managers who retaliate against a so-called whistleblower who goes outside the chain of command to
report misconduct. Collectively, these six aspects of the Sarbanes-Oxley Act of 2002 should help reduce
the incidence of fraudulent financial reporting.

Sustainability is becoming increasingly important in the contemporary business environment.

Sustainability involves considering broader perspectives than shareholder and customer value. It
requires organisations to consider the interrelated impacts of their activities on the economy, the
environment and society. The greater awareness of sustainability has led an increasing number of
organisations to produce sustainability reports or to report their sustainability performance in their
annual reports. This has led organisations to develop sustainability strategies and to implement
processes to measure, track and report sustainability performance. Management accounting can
support the formulation and implementation of sustainability strategies and sustainability reporting by
contributing to the high quality data needed to measure sustainability performance and impact.

Corporate sustainability requires organizations to consider the interrelated impacts of their activities on
the economy, the environment and society. For many organizations, sustainability is a strategic priority,
and the adoption of sustainability practices may lead to improved financial performance through the
adoption of more efficient workflows and process redesign and the creation of markets for new
products.

Sustainability reports measure and communicate the economic, environmental and social impact caused
by an organization’s activities. The major framework that guides sustainability reporting is the Global
Reporting Initiative (GRI) Framework. The recently released International Integrated Reporting
Framework captures whether an organisation’s activities add value or decrease value across the six
capitals, including natural capital.

One reason for the growing adoption of external sustainability practices and sustainability reporting is
the changing demands of stakeholders such as customers, employees, investors, banks, suppliers,
community groups, non-government organisations
(NGOs), the media, governments and regulators.

The growing adoption of sustainability practices and external sustainability reporting has implications for
the design of management accounting systems, including the need to define, track and report new types
of costs, and report a broader range of performance measures.

Environmental and social impacts can be difficult to recognize because future ecological and social
issues are not yet known, many costs and benefits occur outside the organisation, and many costs and
benefits are difficult to measure in financial terms.

In this module, we describe recent trends in sustainability reporting and discuss how management
accounting can support sustainability goals and strategies by analysing environmental costs, adopting
sustainability approaches in supply chain management, introducing sustainability indicators in
performance measurement systems and including sustainability concepts in the appraisal of long-term
projects.