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BBA Instructor: M.Jibran Sheikh E-mail:

What is Earnings Management?

– Two key measures of the performance of a company are: – Earnings per share
– Price earnings ratio= Market Value of share EPS – Both measure incorporate ―earnings‖ from the Income Statement. To arrive at a suitable earnings figure to use, an analyst has to address two areas: – Earnings Sustainability – Earnings Management

Earnings Sustainability
Financial disclosures in 6 specific categories are prime candidates for judging the sustainability of current earnings: • Discontinued operations • Extraordinary/Exceptional gains and losses • Changes in accounting principles • Impairment losses on long-lived assets • Changes in estimates/accruals • Gains and losses from peripheral activities

• In looking at the core ―sustainable earnings‖ of a company the discontinued operations should be ignored. . allows companies to separate the performance of a business to be sold from the rest of their operations. Discontinued operations. a reporting mechanism. • Companies prefer to report on a "with and without" basis even before the sale occurs.Discontinued Operations • Arise where companies sell off poor-performing or non-core businesses in order to increase the value of their remaining operations.


need to be disclosed separately by virtue of their size or incidence in order to obtain a proper understanding of the financial information. If infrequent earnings can be adjusted to exclude such amounts: Thorntons Note to the Accounts: Exceptional items Exceptional items are material items which derive from events or transactions which individually or. if of a similar type. . • A judgement needs to be made as to the frequency. in aggregate need to be disclosed by virtue of their size or incidence if the financial statements are to give a true and fair view. in the judgement of the company.Extraordinary/Exceptional gains and losses Those items presented as exceptional are items which.



or to influence contractual outcomes that depend on reported numbers. • Healy & Whalen (1999: 368) ―Earnings Management occurs when managers use judgement in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company.‖ • Operating & discretionary accounting methods to adjust earnings to a desired outcome.Earnings Management • ―Earnings Management‖ --A process of taking deliberate steps within the constraints of generally accepted accounting practice (GAAP) to bring about a desired level of reported earnings. the incentives of management to modify earnings in their own best interests • Earnings manipulation includes aggressive earnings management and fraud .

it’s easy to do.and it’s unlikely that you’ll get caught (Schilit) • Opportunism: self-interest with guile— violating normal ethical boundaries for personal gain • Executive incentives include bonuses and stock options .Why Earnings Manipulation? • ―It pays to do it.

often when losses are recorded to that period anyway & this can increase the changes of better earnings in future periods . such as depreciation or inventory method • Income Smoothing: Earnings management to smooth out erratic revenue and earnings behavior • Normalizing Income: Restating earnings results to better reflect economic reality • Big Bath: Large loss (or other reduction to earnings) for a specific purpose.Important Concepts • Accounting Choice: Discretionary alternatives for reporting various financial items.

Conditions Influencing Earnings Management • Accounting Regulation history Accounting Standards are largely a compromise and result of: • Political pressure • Existing accounting practice • Accounting theory .

Reasons why earnings disclosures might be managed • Bonus Contracts based on reported earnings • Maximise reporting of ―good‖ news and minimise ―bad news‖ • Smooth changes in earnings over time to reduce the perceived risk of the firm and its cost of capital Minimise reported earnings to avoid: • government antitrust actions against the firm (USA) • upsetting the public post-privatisation • threat of windfall profits tax .

Reasons against earnings management • Earnings and cash flows ultimately coincide so firms cannot manage earnings forever • Capital markets penalise firms identified as obvious earnings ―managers‖ .

Accounting for Growth .

The Smith List of accounting techniques • • • • • • • • • • • • write down of pre-acquisition costs or potential future costs profits on disposal of a business deferred purchase consideration extraordinary and exceptional items of income and expenditure off-balance sheet finance contingent liabilities capitalisation of costs brand accounting changes in depreciation policy convertible securities pension fund accounting treatment of foreign currency items .

and none ever read a profit and loss account." Spin has taken over from creative accounting. who in 1990 had commenced his task of cleaning up UK financial reporting. • His view is that analysts now are so lazy and gullible that companies no longer have to be devious. The analysts. then of the Accounting Standards Board. It added impetus to the work of Sir David Tweedie. But he said that the problem now is that companies have no need for creative accounting. He made it plain that Tweedie had done a tremendous job in clearing away the creative accounting of the early 1990s. • In 2004 Smith returned to the debate. "Analysts are sent the numbers in a press release. do it for them.Terry Smith 2004 • Terry Smith in 1992 tried to explain the creative accounting dodges UK companies were using. in effect. (Financial Director 16 Jul 2004) .

and the Hampel Committee 1998 and Turnbull in 1999. • • • . The Chairman. 15) After Cadbury came Greenbury in the mid-90s. In July 2003. There are two sections to the Code. The first section deals with issues relating to the company such as the board and directors’ remuneration. The Code superseded the Combined Code 1998 and integrated the recommendations of the Turnbull. p. (Cadbury report. and his committee started the corporate governance ―movement‖. This further enhances and reflects the power and influence that institutional shareholders have in corporate governance.Corporate Governance • • • In the 1991 the new Financial Reporting Council. 1992. Sir Adrian Cadbury. The second is devoted to institutional shareholders. the Combined Code of Corporate Governance was published. Higgs and Smith committees. headlines about UK scandals and corporate collapses were becoming a distant memory. the London Stock Exchange and the accountancy profession -with the backing of the government -set up the committee on the Financial Aspects of Corporate Governance. By the end of the 90’s. Corporate governance has been defined as: …the system by which companies are directed and controlled.

limits non-audit services) ..g.Sarbanes-Oxley Act of 2002 • Expanded corporate governance requirements. stressing independent directors & mandatory committees (including audit & compensation) • Established the PCAOB • Requires the audit committee to be independent • Mandated internal control attestation by auditors • Requires management (CEO & CFO) certification of ―fair presentation‖ • Add audit independence requirements (e.

) .Public Company Accounting Oversight Board (PCAOB) • Established by Sarbanes-Oxley • 5-member independent board • Regulates auditors & establishes auditing standards • Establishes rules for internal control attestation • Requires auditor registration for SEC clients • Auditor inspection (audit the auditors--review auditor working papers. etc.

Some Methods of Managing Earnings Disclosure         Capitalisation –v-Expensing Research and Development Costs Revenue Recognition Leases Versus Purchase Capitalisation of Interest Costs Financial Statement effects: Profit variability Cash Flow unchanged .


the impact of the change on operating performance should be analysed. • Depreciation method has no impact on the cash flow statement. for capital-intensive companies the impact can be highly significant. • When a company changes depreciation method or the useful life of an asset. What is the contribution of the change to current year earnings? . • Depreciation lives and residual values also impact both depreciation expense and stated asset values. Shorter lives and lower salvage values are considered conservative in that they add to higher computed depreciation expense. • Accelerated depreciation methods tend to depress both net profit and shareholders funds when compared with straight-line method.Accounting for long lived assets • The choice of depreciation method impacts both the income statement and balance sheet.


• A pattern of losses would suggest that depreciation expense is understated and that fixed assets are overvalued on the balance sheet.Asset sales • A pattern of gains suggests that the company's depreciation method is conservative. . resulting in net carrying amounts for fixed assets below market values.‖ • Sale of significant portion of fixed assets is an indicator of change--in product line or production location. • Gains and losses resulting from asset sales are considered by many analysts to be ―nonrecurring‖ in nature and the inclusion of such gains in reported income lowers the ―quality of earnings.

.Creative Accounting • Most attempts at Creative Accounting can be categorised as follows: • Inflating reported profits and thus EPS • Reporting profits without generating an equivalent amount of cash • Reporting lower borrowings • The analyst has to reinstate the accounts to reflect these and then carry out the required analysis.

Industry specific earnings management • Banks:-bad debt provisions • High Tech companies:-potential for inventory losses as a result of technology change • Chemicals and pharmaceuticals:-product liability claims • Manufacturers:-warranty liabilities .



Environment for Earnings Management • • • • • • Strong CEO with substantial perks Board made up primarily of insiders Poor board committee structure Audit problems Executive compensation problems Investment banking problems .

Why the Scandals • Accounting fraud does tend to come in waves. and is discovered most often after a market collapse. Barbara Toffler . since no one is interested in investigating much when stock prices are high and everyone’s making big money.

all were successful . risk mgt. & telecom. • Stogy gas transmission company started with massive debt • Formed a gas trading company. expanded into electricity.Enron • Fortune Magazine selected Enron as "America's most innovative company" for six straight years from 1996 to 2001. many of these were failures • Based on earnings magic. expanded internationally • Based on economic reality.

need for spot market purchases & related derivatives. volatility increased trading profits • Problem of massive & potential junk bond ratings • Use of special purpose entities (SPEs) to reduce perception of too much debt .Enron 2 • Gas trading: deregulated & volatile.

Enron 3 • Importance of meeting quarterly earnings. initially through cost savings. designed for financial assets)—front-loading profits • Scheme 2: using SPEs in virtually any complex context to record earnings . then increasingly more gimmicks • Scheme 1: revalue physical assets using ―fair value‖ models (SFAS 125.

attorneys. & board of directors. accommodated by investment banks & no obvious oversight by SEC .Enron 4 • SPEs were mishandled • CFO Andy Fastow manipulated these for his own enrichment + independence problem • Particularly shady SPEs approved by auditor Arthur Andersen.

& Enron’s unwillingness to disclose real losses as they occurred • Mid-2001: stock price dropped.Enron 5 • Some operations were successful. the net effect was to dramatically increase financial risk. executives bailed out of stock options. bond ratings back to junk status • Enron restated earnings in 3rd quarter 2001 • With no credibility. the biggest bankruptcy until … . Enron declared bankruptcy in December 2001. others were major blunders.

3%. but half the assets were goodwill & other intangibles • In 2002 internal audit found operating expenses capitalized .WorldCom • Bernie Ebbers started long-distance telecom company in 1983 (name changed to WorldCom in 1995) • Growth through merger strategy (note earnings magic of business combinations) • WorldCom ―looked‖ solid. with total assets of $104 billion & debt-to-equity of 79.

old auditor Arthur Andersen was fired. Ebbers resigned in April • In June 2002 WorldCom announced $3. mainly by capitalizing ―line costs‖ (fees to other telecom companies for network access rights—these are operating expenses) .WorldCom 2 • New auditor KPMG reviewed the books.8 billion in accounting errors.

replacing Enron as the largest bankruptcy in US history . CFO was fired • Actual capitalization misstatements totaled over $11 billion • WorldCom filed for bankruptcy in July 2002.WorldCom 3 • WorldCom restated earnings.

Tyco • Starting as a research lab. using the earnings magic of combination accounting • Acquisition of CIT Group a particular fiasco. resulting in big losses (& extra financial reporting that showed many of Tyco’s manipulation shenanigans . Tyco became a conglomerate through acquisitions • CEO ―Deal a Day Dennis‖ Kozlowski acquired 750 companies.

it’s not clear that the company actually engaged in criminal acts (court cases pending) .4 billion loss for 2002 • Kozlowski indicted for evading taxes & ―raiding‖ Tyco • Tyco did not go bankrupt • Despite obvious manipulation & deception on a vast scale.Tyco 2 • Big loss on sale of CIT & total $9.

Adelphia • John Regas transformed a cable franchise into a communications empire • Restated earnings in 2002. including billion in off-balance-sheet ―co-borrowing agreements‖ • Filed for bankruptcy in June 2002 • Regas & others charged with financial fraud .

WorldCom & Tyco Have in Common • Deception on a massive scale—manipulation at the highest levels of the companies • Growth through acquisitions plus related Business combination accounting abuse • Importance of meeting quarterly earnings targets at all costs—related enrichment of senior executives • Accommodating auditors. attorneys & boards of directors • All three restated earnings .What do Enron.

‖ clients became too valuable to defy (Toffler) • Associated with many of the big scandals: Sunbeam. stressing integrity & consistency • Especially since the 1980s. founded in 1913. AA had a history of ―aggressive auditing.What Happened at Arthur Andersen? • One of original Big 8. Enron. WorldCom & Global Crossing • Found guilty of obstruction of justice in Enron case . Waste Management.

Some closing comments Revsine (1991) “Research evidence is consistent with the notion that managers use latitude in existing financial reporting to benefit themselves”... Tweedie “I find it frightening some people are just lifting the numbers and using them as sancrosant . . some of them would be better off driving buses -it would be safer for a lot of us” AUSTIN MITCHELL: ―CREATIVE ACCOUNTING COULD BE BETTER CALLED MANIPULATIVE ACCOUNTING BECAUSE IT HAS MORE IN COMMON WITH THE MASSAGE PARLOUR THAN THE CREATIVITY OF THE LITERARY SALON‖.