Earnings Management & Company Viability

Dr. Naman Desai

 EARNINGS QUALITY

• Investors use accounting earnings to price stocks

• It is assumed that changes in earnings signal relevant information

about the current and future viability of a company

• All earnings are not equal when it comes to signaling a

company’s current economic progress and signaling future levels
of economic achievement
 EARNINGS QUALITY

• “Good” earnings quality typically comprises:

• Earnings derived from consistent use of appropriately conservative accounting
policies. Helps in increasing comparability of results across time
• Profits derived from recurring transactions rather than one time non-recurring
transactions
• Fast conversion of sales to cash. This makes earnings more closely associated
with cash flows
• Earnings growth that is not dependent on non-operational factors such as tax
breaks and FOREX gains
• Earnings based on trends that are stable, predictable and indicative of future
earnings levels
• Earnings based on appropriate accounting of assets and debt
• Earnings based on use of appropriate debt levels
 EARNINGS QUALITY

• Earnings are close to “economic reality”

• Earnings are easily “understandable”

 WHAT MOTIVATES EM

• PRESSURES
• Need to meet financing requirements at lowest possible costs
• Need to comply with debt covenants especially for financially troubled firms
• Need to meet earnings targets to earn bonuses and to satisfy analyst
expectations
• Top Management having large amount of stock options “in-the-money”. Stock
options sometimes make CEO wealth a convex function of stock price.
• Insider trading
• Back dating of options
• Earnings management has slowly been replaced by expectation management
 WHAT MOTIVATES EM

• OPPORTUNITIES
• Board of Director independence
• Presence of Audit Committees and their composition and compensation structures
• CEO being the founder; CEOs power over the BOD;
• Relatively unethical managers with past history of EM who are not likely to
reform

• ABILITY AND POSITION

• ABILITY TO RATIONALIZE
• Cognitive Dissonance and Neutralization
• Personality and Individual Differences
• Organizational Ethics and Leadership
 WHAT MOTIVATES EM

• M.I.C.E. (Kranacher et al. 2011 Money, Ideology, Coercion, Ego

(entitlement)). Not all frauds can be explained by non-shareable
financial problem.

• MICE modifies the pressure side of the Fraud Triangle, as it

provides an expanded set of motivations beyond a non-shareable
financial pressure.

• Ideology and Coercion are again related to rationalization and

pressure.
 EM AND FRAUD

• The most common fraud technique used is improper revenue recognition

(61 percent of the 347 companies). Overstatement of assets is the second
most common fraud technique (51 percent), followed by understatement
of expenses/liabilities (31 percent) and misappropriation of assets (14
percent).

• Inventory is the most common asset account used to perpetrate a fraud,

followed by accounts receivable and property, plant, and equipment.

• A variety of techniques can be used to conceal fraud acts including

incomplete disclosure of relevant information to auditors; side
agreements with vendors and customers withheld from auditors; altered
documents; and/or inappropriate general ledger entries, journal entries, or
account reconciliations.
Microsoft
 MICROSOFT

• The company follows overly conservative revenue and expense

recognition techniques

• R&D spending is expensed immediately at point of spending

• Revenues are deferred to the future

• Both these techniques lead to undervaluation of the company

JET AIRWAYS
 DEPRECIATION METHOD

• Company changed depreciation method for narrow bodied aircraft (NBA) from
written down value (WDV) to straight line method (SLM).

• This change defers recognition of depreciation expense to future years and as a

result increases net income in the current year.

• NBA experience greater wear and tear compared to wide bodied aircraft
(WBA) due to greater number of landing and take offs. So from an operational
perspective such a change may not be appropriate.

• The primary reason for changing depreciation method for NBAs was because
Jet carried a large number of NBAs in its fleet and only few WBAs
 DEPRECIATION METHOD

• Airlines try to balance out the maintenance charges and the depreciation
charges over the life of the aircraft.

• In the earlier years of an aircraft’s useful life, maintenance expenses are lower
and hence companies use WDV to write off a greater portion of the recorded
book value of the aircraft. In the later years when maintenance expenses
increase, due to the use of WDV the depreciation expenses decrease.

• With the change to SLM Jet will be forced to recognize high maintenance
expenses as well as relatively higher depreciation expenses in the later years of
the aircraft’s useful life.
 FOREX LOSSES

• As per GAAP FOREX losses or gains related to loans or other liabilities

are treated as incomes or losses in the year in which they are realized.

• However IFRS allows companies to adjust FOREX losses against the

value of assets that were acquired using that particular loan or liability.

• The rationale being that all payments necessary to acquire an asset or

make it operational can be added to the cost of that asset. Since the loan
was necessary to acquire the asset any loss incurred due to exchange rate
fluctuations should be added to the cost of the asset.
 FOREX LOSSES

• So rather than taking a one-time hit on the income statement, the FOREX loss
enters my income statement in the form of depreciation over the useful life of
the asset.

• This again defers expense recognition to future years and increases income in
the current year.
 REVALUATION OF ASSET

• As per GAAP you have to provide for all future losses and expenses however,
you should not provide for any potential future gains or incomes. Assets are
typically valued at lower of “cost or market”.

• Therefore if the book value of an asset falls below the market value, you should
provide for an impairment charge.

• However, if the book value is less than market value you cannot record a
revaluation related to the increase in market value.
 REVALUATION OF ASSET

• However, IFRS allows the recording of a notional gain in the form of an

increase in market value compared to book value.

• There is no impact on the Net Income or depreciation expense.

• However such a change allows the company to increase book values of their
assets and then maybe peddle them as collaterals to borrow more money or
transfer them to SPEs and raise additional capital throw borrowings.
 REVALUATION OF ASSET

• Example:
A company acquired its only building on January 1, 2008 at a cost of $4m. The
building has a 20-year life and is being depreciated on a straight-line basis. On
December 31, 2009, the net book value of the building was $3.6m. The company
revalued the building when the fair value of the building was $3.78m on
December 31, 2009. On December 31, 2011, the company sold the building for
$3.6m. Determine what accounts would be impacted and, in table format, show
the activity for the years 2008 through 2011. Also, show the journal entry to
record the sale.
 REVALUATION OF ASSET

IFRS Cost Dep. Exp.Accm Dep Book Value Rev. Sur Expense
1/1/2008 4 4
31/12/2008 4 0.2 0.2 3.8
31/12/2009 4 0.2 0.4 3.6
Revalue Step 1 -0.22 Step 2 -0.4 0.18 Step 3
3.78 0 3.78 0.18
31/12/2010 3.78 0.21 0.21 3.57 -0.01
31/12/2011 3.78 0.21 0.42 3.36 -0.01

Cash (Db) 3.6

Accm Dep (Db) 0.42
Rev. Sur. (Db) 0.16
Building (Cr) 3.78
Gain(Cr) 0.24
Ret. Earnings (Cr) 0.16
 NOW WHAT?

• Jet did not violate any accounting rules or regulations

• How does the stake holder react?

 RENT-WAY

WHAT IS GOING ON?

 RENT-WAY

• Red Flags related to Earnings Quality

• Positive earnings accompanied by negative cash flows

• A unit of activity method of depreciation is based on management’s revenue

projections for specific inventory items

• Management has little incentive to write off or write down slow moving rental
merchandise since off-rent rental merchandise other that computers is not
depreciated

• The large increase in deferred tax liability due to the faster depreciation of
rental merchandise for tax purposes indicates that earnings would be
considerably lower if time-based depreciation method was used for book
purposes.
 RENT-WAY

• Earnings after making an acquisition may be overstated because the company

writes down the acquired inventory and rents out the written down inventory at
the same rental payment charged for new products. (Due to reduced
depreciation costs)

• The acquired inventory write downs to their fair values are buried in goodwill
and charged to earnings over periods as long as 30 years, which leads to a gross
mismatching of cost to acquire inventory or assets and the inventory’s related
rental revenue. Goodwill balance is greater than owners equity!
 RENT-WAY

• The company is over reliant on external financing to grow, and buy

companies.

• The straight line method is used to amortize financing costs rather than the
declining balance method. This leads to an understatement of cost of financing
in the early years of a debt agreement. The company appears to be trying to
put off recognizing such costs to latter years.

• Gross rental merchandise inventory is growing faster than rental revenues

(17% vs 13%, Obsolete inventories!)
 RENT-WAY

• Net rental merchandise increase by 42% from Sep 1999 to June 2000
compared to 15% during 1999. Maybe build up of obsolete inventory.

• The company has been growing using a “roll up” acquisition strategy which
will be increasingly difficult to maintain as the company’s size increases
relative to the acquired companies