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Auditors need to be attuned to the red flags that fraud may exist because

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Earnings Management


Chapter 7


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Questions for Consideration


Should the SEC (and FASB) set specific rules governing non-GAAP disclosures?


Should auditors test these numbers to ensure there are no materially misleading amounts?


Should auditors include in their assessment of internal controls over financial reporting consideration of whether adequate controls exist to ensure the non-GAAP reported amounts comply with SEC guidelines and/or any regulations that are set?


How do considerations of earnings management influence the manner in which non-GAAP metrics are disclosed?


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Ethical Reflection


What ways can financial statements be manipulated?


Companies look for any advantage when they report GAAP earnings. One approach is to report non-GAAP earnings.


SafeNet enforcement action allegations:


SafeNet was unable to meet earnings targets through normal business operations


The CFO directed accountants to make improper accounting adjustments including reclassifying ordinary operating expenses as non-recurring


How can we assess whether auditors are meeting their ethical obligations and protecting the public interest with regard to identifying “financial shenanigans” and assessing earnings management and fraud?


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Motivation to Manage Earnings


Companies manage earnings when they ask, “How can we best report desired results?” rather than “how can we best report economic reality?”


Pressure to “make the numbers”


Emerged during 1990s and early 2000s


Stock market awards firms that meet or beat analysts’ forecasts and punish firms that miss earnings targets


Management may also use earnings management to maximize bonuses and the value of stock options


Another objective can be avoiding consequences of violation of debt covenants


Board of Directors should focus on long term strategic goals and shield managers from short-term pressure


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4


Nonfinancial Measures of Earnings


Constant pressure to report favorable earnings performance motivates many companies to report income numbers that exclude unusual events that almost always seem to be costly and depress earnings


These non-GAAP numbers put a positive spin on what otherwise might not be such good results under GAAP


Regulation G requires public companies that disclose or release non-GAAP financial measures to include a presentation of the most directly comparable GAAP financial measure and a reconciliation of the non-GAAP measure to the comparable GAAP measure


Auditors should be tasked with at least reviewing non-GAAP measures as part of their annual audit requirements


Copyright ©2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.


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Characteristics of Earnings Management


Gaa and Dunmore denote two basic possible earnings managements


Alter the numbers in the financial records by using discretionary accruals and other adjustments


Create or structure transactions to alter reported numbers


Another perspective is to divide the techniques into two categories


Operating earnings management – altering operating decisions to affect cash flows and net income for a period


Accounting earnings management – using the flexibility in accounting standards to alter earnings numbers


The end result of earnings management is to distort the application of GAAP, bringing into question the quality of earnings


Earnings manipulation is a form of earnings management and can be legitimate, marginally ethical, unethical, or illegal


Copyright ©2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.


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Income Smoothing


Motivation to smooth net income over time


Steady increase each year over a period of time is ideal


Investors are willing to pay premium for stocks with steady and predictable earnings streams


These practices lead to erosion in quality of earnings


Accelerate recognition of revenue


Delay recognition of expenses


“Cookie jar reserves”


Set aside reserves in good years


Used to prop up earnings in bad years


HealthSouth case


Banks more aggressive using loan-loss reserves


Companies also smooth tax liability over years


Copyright ©2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.


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Definition of Earnings Management


Schipper defines it in a negative light- “purposeful intervention in the external reporting process, with the intent of obtaining some private gain”


Healy and Wahlen define it as “when managers use judgment 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 accounting numbers”


Dechow and Skinner believe that a distinction should be made between making choices in determining earnings that may comprise aggressive, but acceptable, accounting estimates and judgments, as compared to fraudulent accounting practices that are clearly intended to deceive others


McKee characterizes it as “reasonable and legal management decision making and reporting intended to achieve stable and predictable financial results”


Copyright ©2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.


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How Do Managers and Accountants Perceive Earnings Management?


Survey by Elias


Accountants in orgs with high ethical values perceive earnings management as more unethical


Accountants in industry significantly less likely than CPAs in public practice to perceive high ethical values in their organizations


Survey by Bruns and Merchant


Managers disagree about ethics of earnings management


Manipulation of operating decisions was more ethical than manipulation by accounting method


Survey by Rosenzweig and Fischer


Accounting manipulation


Changing accounting methods


Recording expense in wrong year


Changing inventory valuation


Operating decisions


Deferring necessary expenditures to subsequent year


Attracting customers at year-end to draw sales into current year


Copyright ©2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.


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9


Ethics of Earnings Management


Use ethics framework to judge acceptability


Virtue ethics examines reasons for the actions taken by decision maker AND the action itself


McKee’s explanation is merely a rationalization


Doesn’t hold true to virtues of honesty and dependability


Ignores rights of shareholders and stakeholders to receive fair and accurate information


Masks true performance


Hopwood says ethics issue can be mitigated by disclosing aggressive accounting assumptions


Nothing more than rationalization for unethical behavior: disclosure should not be used to cure ills of earnings management


Act Utilitarian


A decision made by weighing benefits of management/ company to smooth net income vs. costs of providing false information to shareholders


Rule Utilitarian


Financial statements should never be manipulated for personal gain


The problem is there is no clear limit between what is ethical and what isn’t


Copyright ©2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.


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10


Needles Continuum of Earnings Management


Needles points out that the difference between an ethical and an unethical accounting choice is often merely the degree to which the choice is carried out.


The problem with many accounting judgments is that there is no clear limit beyond which a choice is obviously unethical.


A perfectly routine accounting decision, such as expense estimation, may be illegal if the estimated amount is extreme, but it is perfectly ethical if it is reasonable.


Needles provides an interesting example of how a manager might use the concept of an earnings continuum to decide whether to record the expense amount at the conservative end or aggressive end.


Copyright ©2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.


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Forward-looking Statements


“Forward-looking” statements focus on sales revenues or earnings expectations in light of industry and macro-economic trends


Guidance to investors and financial analysts about the companies earnings potential


Can create liability for issuers, underwriters, officers and directors if material misstatements of fact or omissions are made for public offerings


PSLRA enacted safe harbor provisions if forward-looking statements are identified as such and accompanied by meaningful cautionary statements that could cause actual results to differ from the statements.


Copyright ©2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.


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Green Mountain Coffee Roasters


Green Mountain used conference calls that provided earnings guidance to shareholders and analysts to mask a financial fraud


Manufacturer of the Keurig brewing system and K-Cup portion packs


Represented to investors that it was straining to meet consumer demand without accumulating excess inventory


Deceived PwC auditors on inventory levels by hiding bags and bags of coffee loaded on trucks, and blocking parts of the plant from auditor access


Hedge fund manager, David Einhorn, and Sam Antar, former CFO of Crazy Eddie, used analytical procedures to spot and warn of the red flags on inventory


Should auditors monitor conference calls with investors, analysts, and the financial press to determine whether something is said that could be false, fraudulent, or deceptive?


Copyright ©2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.


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Using Social Media to Report Earnings Guidance and Financial Results


The SEC said in April 2013, that postings on sites such as Facebook and Twitter are just as good as news releases and company Web sites as long as the companies have told investors which outlets they intend to use


The SEC guidelines on these matters are under the fair disclosure rule (Regulation FD) that requires companies to disseminate information in a way that wouldn’t be expected to give an advantage to one group of investors over another


Filing an 8-K form or holding an earnings call are both ways to ensure compliance with the regulation


Copyright ©2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.


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How Do Managers and Accountants Perceive Earnings Management? (continued)


Akers, Giacomino, and Bellovary Survey


Accounting manipulation is much less ethically acceptable than operating decision manipulation


Practitioners have few ethical qualms about operating decision manipulation


Operating decisions that influenced expenses were more suspect than those that influenced revenues


Case of Sunbeam Corporation


“Cookie Jar” reserves


Set aside amounts of revenue in “reserve” to be taken out to boost earnings when needed in future


“Big bath accounting”


Creates cookie jar effect while portraying the company as looking worse than it is


“Channel Stuffing”


Made deals with companies like Walmart to take product sooner than they really wanted it with discounts and liberal return policies.


Copyright ©2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.


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15


Earnings Quality


Dichev study relates to the prevalence, magnitude, and detection of earnings management:


CFOs believe that earnings are high quality when they are sustainable


High quality earnings are backed by actual cash flows


High quality earnings are consistent reporting choices over time and avoidance of long term estimates


Current GAAP standards are somewhat of a constraint in reporting high quality earnings; earnings quality would improve if reporting choices evolved from practice, not mandated from standards


Copyright ©2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.


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Accruals and Earnings Management


Accruals are needed because of matching and timing problems that can give wrong financial picture of company


Earnings are sum of a period’s change in accruals and its cash flows


Revenue recognition and matching principles


Can manage earnings through aggressive estimations or more conservative ones


Discretionary accruals (items that management has full control over and is able to delay or eliminate)


Nondiscretionary accruals (management has no control over)


Copyright ©2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.


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Earnings Management and Materiality Judgments


Concept exists that some financial transactions are so insignificant that they are not worth measuring and reporting with exact precision


Normally materiality is defined as the magnitude of an omission or misstatement that would have changed or influenced judgment of reasonable person


W.R. Grace & Company violated GAAP by establishing an all-purpose reserve fund to smooth earnings from 1991 to 1995


Hiding profits in good years and using them to disguise slower earnings in later years


Grace’s auditors, Andersen, discovered the buildup of earnings and repeatedly warned that it was improper but immaterial


Copyright ©2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.


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18


Gemstar – TV Guide International, Inc.


Shows danger of relying on quantitative analysis in making materiality judgments


KPMG auditors unreasonably determined that certain licensing and advertising revenues were immaterial


This was determined by quantitative factors only


Disregarded qualitative materiality, i.e. the revenue related to business lines watched by securities analysts had a material effect on valuation of Gemstar stock


SEC complaint provides insight into the techniques used to manage earnings


Recording revenue under expired, disputed, or nonexistent agreements


Revenue on an accelerated basis


Inflating advertising revenue by recording and reporting revenue from multiple-element transactions


Engaging in round-trip transactions


Failing to disclose that it had created cookie-jar reserves to smooth net income


Improperly recording advertising revenue from nonmonetary and barter transactions


Sound judgment is needed to review assumptions and estimates in accrual accounting to protect against unacceptable forms of earnings management


Copyright ©2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.


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19


Earnings Management: One More Thing


It is unethical if the primary motive for managing earnings is to deceive users of the true results of operations or reflect the economic substance


Often earnings management is carried out by otherwise honest people who tell the company’s side of the story rather than adhere to GAAP


Cycle of earnings manipulation


Often a company begins with a track record of success


It is becoming more difficult to maintain the sales and earnings growth expected


Management runs special incentives to accelerate sales and uses overtime to ship product out


Steps are repeated in the next quarter(s), as expectations are higher, only now the company may not accrue all of its expenses, and to keep the stock prices increasing


One aggressive interpretation leads to another until the quality of the financial information is in doubt


The company has gone from aggressive operating practices to financial fraud


Copyright ©2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.


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Financial Shenanigans


Actions or omissions intended to hide or distort real financial performance or financial condition of an entity


Overstate revenues and profits to enhance reported earnings and EPS


Understate revenues and profits to smooth net income/decrease volatility


Schilit’s 7 Common Financial Statement Shenanigans:


Recording Revenue too soon or of questionable quality


Recording bogus revenue


Boosting income with one-time gains


Shifting current expenses to a later or earlier period


Failing to record or improperly reducing liabilities


Shifting current revenue to a later period


Shifting future expenses to the current period as a special charge


Copyright ©2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.


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Red Flags of Earnings Management


Auditors need to be attuned to red flags or signs of aggressive accounting and fraud:


Growth in the market share that seems unbelievable.


Frequent acquisitions of businesses.


Management growth strategy and emphasis on earnings and/or EPS.


Reliance on income sources other than core business.


One-time sources of income.


Growth in revenue that doesn’t line up well with receivables or inventory.


Unexpected increase in accounts receivable.


Slowdown of inventory turnover.


Reduction in reserves:


Not reserving for possible future losses.


Reduction in discretionary costs at year-end (i.e., advertising; R&D).


Unusual increase in borrowings; short-term borrowing at year-end.


Extension of trade payables longer than normal credit.


Change in members of top management, especially the CFO.


Change in auditors.


Changes in accounting policies toward more liberal applications.


One forensic accountant is needed on each audit to help identify the signs.


Copyright ©2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.


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The Case of Xerox


Motivation for Fraud


Polish its reputation on Wall Street, and


Boost stock price


Fraudulent Lease Accounting


Valuation determination replaced by a formula that management could manipulate; revenue from multiple deliverables improperly recognized


Cushion Reserves


Used reserves to close the gap between actual results and earnings targets


Sanctions by SEC on KPMG


Paid $10 million in penalties, disgorged $10 million in audit fees, and paid $2.7 million in interest


Copyright ©2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.


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The Case of Lucent Technologies


Motivation


Drive to realize revenue


Meet internal sales targets


Obtain sales bonuses


Shenanigans


Side Agreements


Recording revenue too soon


Boosting income with one-time gains


Shifting current expenses to later period


Reducing liabilities


Created new reserves and released reserves into income


KPMG should have noticed red flags


Copyright ©2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.


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Accounting for Revenue in the Cloud


In 2017, Oracle settled a lawsuit with an accountant and senior finance manager who claimed she was fired for threatening to blow the whistle on its illegal accounting practices.


Blackburn said she was ordered to add millions of dollars in unsupported revenue to financial reports for Oracle’s cloud services, despite lack of billings to support those numbers.


There is subjectivity in recording revenue as either traditional revenue, or licensed software, and cloud or hosted software


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Accounting for Revenue in the Cloud (continued)


Oracle claimed in 2015 that it made $1.5 billion from its cloud offerings. Dan Woods, chief technology officer and editor of CITO Research, claims that Oracle’s cloud revenue numbers are bogus.


Analysts report that various tricks can be used by a vendor trying to inflate its cloud figures, including:


Lump on-premise and cloud figures together and then pretend it’s all cloud;


Give huge credit to customers moving their on-premise license value to the cloud and consider it as booked cloud sales;


Give a cloud product for free and then extrapolate its sales value to other modules;


Sell a cloud subscription for a pilot population but book it as if it were for the whole company headcount.


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The Story of Enron


Started because debt load was high and needed to finance borrowings that would not be shown on balance sheet


Needed long-term supply contracts, but these were not available in current market


Skilling’s “Gas Bank” Idea


Pooling investments in gas-supply contracts and selling long-term deals to utilities


Rather than booking the revenue on long-term contracts as it came in, Enron would book immediately like a marketable security


Fastow’s Special-Purpose Entities


To entice producers to invest in Gas plan, Enron needed cash to offer up front


Began to create partnerships that took money from banks and gave it to producers in return for a portion of existing gas reserves


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Growth of SPEs & The Culture


The Growth of SPEs


Transactions did not violate GAAP, initially


Financial institutions that were lending the 3% became cautious of SPE’s ability to repay interest


Enron began to back deals with promise of Enron stock…resulted in


No transfer of risk to SPE; therefore SPEs should have been consolidated into Enron’s statements


“Rank and Yank” employee-evaluation policy as incentive to keep employees quiet


Enron created Chewco to buy out its partner in another venture, JEDI


Virtually no outside ownership


Managed by a protégé of Fastow, Michael Kopper


Permitted by Code of Ethics, but waived by Board


Allowable through a lack of internal controls


It became increasingly harder to keep revenues growing each quarter


Executive Compensation far exceeded all competitors


Encouraged executives that by giving out stock options this would provide cash


Claimed if profits and stock price went up enough, the schedule for such options would be accelerated


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7-‹#›


The Story of Enron (continued)


Skilling resigned after 6 months as CEO


Sherron Watkin’s letter to Ken Lay, former and now current CEO and chair of board of directors


Described in detail problems with Enron’s partnerships


Assigned to be investigated by Vinson & Elkins


Reported findings to Lay and Derrick, claiming no reason for concern


The Final Days


November 2001 Enron announced overstatement of earnings by $586 million


Ken Lay and Jeff Skilling found guilty of fraud and conspiracy


Skilling was sentenced to 24 years and 4 months and fined; reduced in 2013 by DOJ to 10 years


Skilling released from prison in 2018 and will serve the remainder of his sentence in a halfway house in Texas.


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Enron: Review of Important Accounting Issues


Quality of financial reports were poor:


Improperly failing to consolidate SPE (Chewco)


Failure to disclose related-party transactions


Recording gains from selling assets to SPE’s


Use of reserves and failure to explain the basis for creation


Failure to disclose Fastow’s dual role with SPE and as CFO of Enron


Managed earnings through following techniques:


Used reserves to increase earnings


Used mark-to-market estimates to inflate earnings


Selected which operating assets to “sell” to SPE’s- affecting the amount of gain and earnings effect


Lack of strong controls contributed to fraud evidenced by:


Top management overrode internal controls


Lax oversight by board of directors


A culture established to make deals at any cost


A culture of fear created with its “rank or yank” policy


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Results of Enron


FASB Rules on SPEs


Original motivation was to establish a mechanism to encourage companies to invest in needed assets while keeping debt off its books


FASB Interpretation No. 46(R) Consolidation of Variable Interest Entities requires unconsolidated variable interest entities to be consolidated if they do not effectively disperse risk among parties involved


No longer a percentage ownership test


Enron’s Role in SOX


Prohibiting the provision of internal audit services for audit clients


Off-balance sheet financing activities must be disclosed in notes to financials


Related-party transactions must be disclosed in notes to financials


Lessons to be learned


Weak internal controls lead to possible fraud


Need for ethical tone at the top


Be cautious of the ethical slippery slope


Watch out for greed


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7-‹#›


Characteristics of of Restatements


Revision of financial statements that was previously publicly reported may be one of two types


Reissuance restatements are the more serious, as past or previous financial statements cannot be rely upon


Revision restatements do not undermine reliance on past financials


“Stealth Restatements”


A restatement disclosed only in periodic reports and not in the 8-K, or amended periodic report such as a 10-K/A or 10-Q/A


The SEC requires companies to disclose within four business days that past financial statements should no longer be relied on


The 8-K form is designed to be an early warning system so that the public knows immediately about the financial statement restatements and does not have to wait until the statements are filed with the SEC


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7-‹#›


Hertz Accounting Restatements


Hertz Global Holdings, Inc., filed its 2014 Form 10-K with restated results for 2012 and 2013 as well as selected unaudited restated financial information for 2011


Hertz addresses the issue of non-GAAP financial measures including EBITDA, Corporate EBITDA, and how these amounts were calculated


By comparing the validity of these amounts to pretax GAAP income, Hertz mislead readers into thinking that non-GAAP measures of earnings may be as reliable as GAAP amounts


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7-‹#›


Restatements Due to Errors in Accounting and Reporting


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34


Cubic Corporation


Cubic Corporation restated financial statements due to errors in calculating revenues on certain long-term development contracts and on long-term service contracts with non-U.S. Government customers


Cubic historically recognized sales and profits for development contracts using the cost-to-cost percentage-of-completion method of accounting, modified by a formulary adjustment which had the effect of deferring a portion of revenue and profits until later in the contract performance period


Cubic also used the cost-to-cost percentage-of completion to revenues for its service contracts, which is only acceptable for U.S. Government contracts


Copyright ©2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.


7-‹#›


Concluding Thoughts


Earnings management is typically motivated by a desire to meet or exceed forecasted results, meet financial analysts’ earnings estimates, inflate share price to make stock options more lucrative, and enhance bonuses


Techniques to manage earnings include channel stuffing, bill-and-hold transactions, round-tripping, cookie-jar reserves, delaying accruals and expense recognition, and presenting non-GAAP financial statements


When management manipulates earnings, the quality of such information suffers


Financial reporting needs to focus more on representational faithfulness, there should be agreement between the accounting measures or descriptions in financial reports and the economic events they purport to represent


Tone at the top, ethical leadership, and ethical culture are needed in the context of accounting decision making


Copyright ©2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.


7-‹#›


Video Links


Enron (The Smartest Guys in the Room – movie: 1 hour, 49 minutes)


Copyright ©2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.


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