EARNINGS MANAGEMENT

Instructor: M.Jibran Sheikh

E-mail:
jibransheikh@comsats.edu.pk
What is Earnings Management?
 Earnings
– 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
 Discontinued Operations
• Arise where companies sell off poor-performing or
non-core businesses in order to increase the value
of their remaining operations.
• Companies prefer to report on a "with and
without" basis even before the sale occurs.
Discontinued operations, a reporting mechanism,
allows companies to separate the performance of a
business to be sold from the rest of their
operations.
• In looking at the core “sustainable earnings” of a
company the discontinued operations should be
ignored.
 Extraordinary/Exceptional gains and losses
Those items presented as exceptional are items which, in the
judgement of the company, need to be disclosed separately by
virtue of their size or incidence in order to obtain a proper
understanding of the financial information.
•A judgement needs to be made as to the frequency. 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, 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.
 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.
• 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, or to influence contractual
outcomes that depend on reported numbers.”
• Operating & discretionary accounting methods to adjust
earnings to a desired outcome; the incentives of management to
modify earnings in their own best interests
• Earnings manipulation includes aggressive earnings
management and fraud
 Why Earnings Manipulation?
• “It pays to do it, 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
 Important Concepts
• Accounting Choice: Discretionary alternatives for
reporting various financial items, 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, often when losses
are recorded to that period anyway & this can
increase the changes of better earnings in future
periods
 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
 Terry Smith 2004
• Terry Smith in 1992 tried to explain the creative accounting dodges
UK companies were using. It added impetus to the work of Sir David
Tweedie, then of the Accounting Standards Board, who in 1990 had
commenced his task of cleaning up UK financial reporting.
• In 2004 Smith returned to the debate. He made it plain that Tweedie
had done a tremendous job in clearing away the creative accounting of
the early 1990s. But he said that the problem now is that companies
have no need for creative accounting. The analysts, in effect, do it for
them.
• His view is that analysts now are so lazy and gullible that companies
no longer have to be devious. "Analysts are sent the numbers in a
press release, and none ever read a profit and loss account." Spin has
taken over from creative accounting. (Financial Director 16 Jul 2004)
 Corporate Governance
• In the 1991 the new Financial Reporting Council, 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. The Chairman, Sir Adrian Cadbury, and
his committee started the corporate governance “movement”.
• Corporate governance has been defined as: …the system by which companies are
directed and controlled. (Cadbury report, 1992; p. 15)
• After Cadbury came Greenbury in the mid-90s, and the Hampel Committee 1998 and
Turnbull in 1999.
• By the end of the 90’s, headlines about UK scandals and corporate collapses were
becoming a distant memory.
• In July 2003, the Combined Code of Corporate Governance was published. The Code
superseded the Combined Code 1998 and integrated the recommendations of the
Turnbull, Higgs and Smith committees. 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 second is devoted to institutional shareholders. This further enhances and reflects
the power and influence that institutional shareholders have in corporate governance.
 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.g., limits
non-audit services)
 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
 Accounting for long lived assets
• The choice of depreciation method impacts both the income statement
and balance sheet; for capital-intensive companies the impact can be
highly significant.
• Depreciation method has no impact on the cash flow statement.
• Accelerated depreciation methods tend to depress both net profit and
shareholders funds when compared with straight-line method.
• 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.
• When a company changes depreciation method or the useful life of an
asset, the impact of the change on operating performance should be
analysed; What is the contribution of the change to current year
earnings?
 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.
• A pattern of losses would suggest that depreciation
expense is understated and that fixed assets are overvalued
on the balance sheet.
• 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.”
• Sale of significant portion of fixed assets is an indicator of
change--in product line or production location.
 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, since no one is interested
in investigating much when stock prices
are high and everyone’s making big money.
Barbara
Toffler
 Enron
• Fortune Magazine selected Enron as "America's most
innovative company" for six straight years from 1996
to 2001.
• Stogy gas transmission company started with massive
debt
• Formed a gas trading company, expanded into
electricity, risk mgt. & telecom; expanded
internationally
• Based on economic reality, many of these were failures
• Based on earnings magic, all were successful
 Enron 2
• Gas trading: deregulated & volatile, 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 3
• Importance of meeting quarterly earnings,
initially through cost savings, then
increasingly more gimmicks
• Scheme 1: revalue physical assets using
“fair value” models (SFAS 125, designed
for financial assets)—front-loading profits
• Scheme 2: using SPEs in virtually any
complex context to record earnings
 Enron 4
• SPEs were mishandled
• CFO Andy Fastow manipulated these for his
own enrichment + independence problem
• Particularly shady SPEs approved by auditor
Arthur Andersen, attorneys, & board of
directors; accommodated by investment
banks & no obvious oversight by SEC
 Enron 5
• Some operations were successful, others were
major blunders; the net effect was to dramatically
increase financial risk, & Enron’s unwillingness to
disclose real losses as they occurred
• Mid-2001: stock price dropped, executives bailed
out of stock options, bond ratings back to junk
status
• Enron restated earnings in 3rd quarter 2001
• With no credibility, Enron declared bankruptcy in
December 2001, the biggest bankruptcy until …
 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 79.3%, but half the
assets were goodwill & other intangibles
• In 2002 internal audit found operating expenses
capitalized
 WorldCom 2
• New auditor KPMG reviewed the books,
old auditor Arthur Andersen was fired;
Ebbers resigned in April
• In June 2002 WorldCom announced $3.8
billion in accounting errors, mainly by
capitalizing “line costs” (fees to other
telecom companies for network access
rights—these are operating expenses)
 WorldCom 3
• WorldCom restated earnings, CFO was
fired
• Actual capitalization misstatements totaled
over $11 billion
• WorldCom filed for bankruptcy in July
2002, replacing Enron as the largest
bankruptcy in US history
 Tyco
• Starting as a research lab, Tyco became a
conglomerate through acquisitions
• CEO “Deal a Day Dennis” Kozlowski acquired
750 companies, 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 2
• Big loss on sale of CIT & total $9.4 billion loss
for 2002
• Kozlowski indicted for evading taxes & “raiding”
Tyco
• Tyco did not go bankrupt
• Despite obvious manipulation & deception on a
vast scale, it’s not clear that the company actually
engaged in criminal acts (court cases pending)
 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
 What do Enron, 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 Happened at Arthur
Andersen?
• One of original Big 8, founded in 1913, stressing
integrity & consistency
• Especially since the 1980s, AA had a history of
“aggressive auditing,” clients became too valuable
to defy (Toffler)
• Associated with many of the big scandals:
Sunbeam, Waste Management, Enron, WorldCom
& Global Crossing
• Found guilty of obstruction of justice in Enron case
 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”.