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QUALITY OF EARNINGS QUALITY OF EARNINGS AND CORPORATE AND CORPORATE GOVERNANCEGOVERNANCE (1 of 2)(1 of 2)

Learning objectivesImportance of earningsQuality of earningsCommon ways to manipulate ear

nings

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QUALITY OF EARNINGS QUALITY OF EARNINGS AND CORPORATE AND CORPORATE GOVERNANCEGOVERNANCE (2 of 2)(2 of 2)

Business scandals of the early 2000’s

Sarbanes-Oxley Act of 2002Evaluating corporate governance

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Learning ObjectivesLearning Objectives(1 of 2)(1 of 2)

Explain Wall Street’s emphasis on earnings and the potential problems that result from this emphasis

Define quality of earnings and explain how it is measured

Recognize the common ways that firms can manipulate earnings

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Learning ObjectivesLearning Objectives(2 of 2)(2 of 2)

Describe the corporate accounting failures of the early 2000’s

Explain the requirements of the Sarbanes-Oxley Act of 2002

Explain how to evaluate a firm’s corporate governance

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Importance of EarningsImportance of Earnings

Earnings per share =     net income     avg # shs comstk

How does Wall Street react when quarterly EPS exceeds expectations?

Can quarterly EPS alone accurately assess a firm’s financial health? Why or why not?

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Quality of EarningsQuality of Earnings(1 of 4)(1 of 4)

How well a particular earnings number communicates the firm’s true performance

Factors associated with earnings qualitySelection of accounting principles

Conservative choices associated w/ higher quality earnings

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Quality of EarningsQuality of Earnings(2 of 4)(2 of 4)

Factors associated with earnings quality (continued)Application of accounting principles

Early revenue recognition or delayed expense recognition associated w/ lower quality earnings

Business riskSum of internal & external factors that affect

firm performance and survivalLower business risk associated w/ higher quality

earnings

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Quality of EarningsQuality of Earnings(3 of 4)(3 of 4)

Classification of accounting choicesConservative choices

Reduce net income, reduce assets, increase liabilities

Aggressive choicesIncrease net income, increase assets,

decrease liabilities

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Quality of EarningsQuality of Earnings(4 of 4)(4 of 4)

What is the conservative choice for the following accounting choices?Inventory cost flow assumption in

times of rising pricesUseful life of depreciable assets

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Common Ways to Common Ways to Manipulate EarningsManipulate Earnings

Big bath chargesCookie jar reservesRevenue recognition

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Big Bath Charges

Big bath theoryIf you are going to take a loss, then

take as big a loss as possibleIf not making earnings estimate,

write-off assets that may be written off in the next few years

How can you identify big bath behavior?

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Cookie Jar Reserves

Overestimating an expense related to an allowance account in one year to build a reserve that can be used to underestimate the expense in the future when it is neededMismatches expense with related revenueReserves may be used for a “rainy day” or

to “smooth” earnings

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Revenue Recognition(1 of 4)

When GAAP requires revenue recognitionFirm has earned the revenueCollection is reasonably assured

Continuum of violation of revenue recognition rules

Premature Create Fictitious Recognition Revenue

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Revenue Recognition(2 of 4)

Examples of improper revenue recognitionRecord goods sold at end of quarter when not

delivered until next quarterHow would shipping terms affect when the revenue is

recognized?Keep books open after quarters’ end until sales

goals are metHow does this affect sales for following quarter?

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Revenue Recognition(3 of 4)

Rate these schemes on ethics continuumRecord sales of goods shipped to customers who

had not placed orders for the goodsCreate fictitious documents for both purchases

and sales of goods to fictitious customersRecord sales for goods shipped to salespeople in

field for goods not delivered to customersShip goods to firm’s offsite locations and record

shipments as sales revenue

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Revenue Recognition(4 of 4)

Identifying revenue recognition problemsExamine notes to financial statement for

disclosure of revenue recognition policiesLook for changes in policies from prior years

Analyze relationship between sales and accounts receivableWhat may increasing AR/Sales ratio indicate?

What other methods can you think of?

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Business Scandals of The Business Scandals of The Early 2000’sEarly 2000’s

DefinitionsRecent business failures/scandalsExecutives convicted in failures/sc

andalsWhat we learned

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Definitions

Securities Acts of 1933 and 1934Laws for publicly traded companies

and their auditorsCorporate governance

The way a firm governs itself, as executed by the board directors

What recent legislation changed the corporate governance rules?What else did it change?

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Recent Business Failures/Scandals

(1 of 3)

Enron7th largest U.S. companyImproper accounting used to hide bad

investments and liabilitiesAdlphia

6th largest cable company in U.S.CEO arrested for conspiracy, bank

fraud, and securities fraud

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Recent Business Failures/Scandals

(2 of 3)

Arthur Andersen1 of world’s 5 largest accounting firmsGuilty of obstruction justice in Enron

caseFounded in 1914 and employed 28K

people

WorldComOverstated revenues by $3.8B

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Recent Business Failures/Scandals

(3 of 3)

TycoTwo executives stole >$600MExecutives could face 25 years in

prisonComputer Associates

>$2B improperly booked revenue

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Executives Convicted in Failures/Scandals (1 of 4)

EnronAndrew Festow, former CFO

Plead guilty to securities and wire fraudSentenced to 10 years in prison

WorldComBernard Ebbers, former CEOConvicted on all 9 counts for role in $11B

scandal. Could spend 25 years in prison

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Executives Convicted in Failures/Scandals (2 of 4)

AdelphiaJohn Rigas, founder and former CFOTook > $2B from co. for personal

use and lied to public about co.’s financial condition

Awaiting sentencing, could face 30 years

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Executives Convicted in Failures/Scandals (3 of 4)

Rite AidMartin Grass, co-founder and former CEOHelped commit accounting fraud3 years probation, $500K fine

CSFBFrank Quattrone, investment bankerObstruction of justice18 months in prison

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Executives Convicted in Failures/Scandals (4 of 4)

ImClone SystemsMartha Stewart, investor; founder of

Martha Stewart Living Omnimedia, Inc.Obstruction of justice in an insider-

trading probe5 months in prison, 5 months home

confinement, 2 years probation, $30K fine

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What We Learned(1 of 4)

Corp execs will do almost anything to meet earnings targets to prop up stock pricesHow do execs personally benefit

from stable or rising stock prices?Ethical climate set by top execs

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What We Learned(2 of 4)

Auditors must be independent to provide a meaningful quality auditCan a CPA firm be independent if the

audit client’s fees are a substantial portion of the firm’s revenues?

How do large consulting fees from a client affect auditor independence?

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What We Learned(3 of 4)

Earnings and financial statements must be more transparentShould management have discretion in

applying GAAP? How and where should it be disclosed?

Even the most stringent accounting standards cannot eliminate fraudAuditors and the SEC are making

progress in reducing fraud

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What We Learned(4 of 4)

Over-reliance on EPS or any single number can be disastrousWhat should investors use besides financial

statements to evaluate the financial health and viability of a company?

OECD issued 1st set of int’l corporate governance standardsWhy are int’l standards important?

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Sarbanes-Oxley Act (SOX) Sarbanes-Oxley Act (SOX) of 2002of 2002 (1 of 2) (1 of 2)

Purpose is to strengthen financial reporting and corporate governance of publicly traded companies

Currently applies to all publicly traded and int’l co’s traded on U.S. stock exchanges

32©2006 Prentice Hall, Inc.

Sarbanes-Oxley Act (SOX) Sarbanes-Oxley Act (SOX) of 2002of 2002 (2 of 2) (2 of 2)

Key groups affected by SOXManagementBoard of directors (BOD)External auditorsPCAOB

Downside to SOX

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Management(1 of 2)

CEO and CFO legally responsible for firm’s internal controlsAnnual report contains separate report

on effectiveness of internal controlsExternal auditors must attest to accuracy

of report

CEO and CFO legally responsible for accuracy of financial statements

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Management(2 of 2)

Internal auditorsLargely responsible for internal controlsIndependent of any dept or division

They are an internal control themselvesFirms must provide a way for

anonymous reporting of fraudulent activities of the companyIncludes hotline for reportingWhistleblower protection provided

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Board of Directors (BOD)

Elected by stockholdersEstablish general corporate policiesMake major company decisions

Oversee audit committeeOnly independent directors (not

mgmt) can be on audit committeeWhat are the audit committee’s

duties?

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External Auditors(1 of 2)

Trained to examine company’s financial statements and financial controls and report findings to external usersDo financial statements fairly present

the company’s financial position in accordance with GAAP?

How effective are a company’s internal controls?

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External Auditors(2 of 2)

SOX strengthens SEC’s rules related to auditor independenceEnsures objectivityAuditors can no longer provide

information processing consulting services to its audit clients?

Auditor now reports to audit committee instead of company’s management

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Public Company Accounting Oversight Board (PCAOB)

Established by SOX to regulate the audit professionAll accounting firms that audit publicly

traded companies must register with PCAOB and follow their rulesSEC must approve any rules set by PCAOB

Members appointed by Federal Reserve Board Chair

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Downside to Sarbanes-Oxley Act

Cost of implementing SOX, especially internal control requirements of Section 404

SOX does not require the BoD to have a financial expert

How could SOX negatively affect CEOs, directors, auditors and attorneys with running a company?

40©2006 Prentice Hall, Inc.

Evaluating Corporate Evaluating Corporate GovernanceGovernance (1 of 5) (1 of 5)

Elements for strong and effective corporate governanceIndependent, highly qualified, and

diverse board of directorsCEO encourages board involvementTransparency of financial information

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Evaluating Corporate Evaluating Corporate GovernanceGovernance (2 of 5) (2 of 5)

Elements for strong and effective corporate governance (continued)Mgmt. compensation w/ incentives for

performance that increases shareholder value

A strong and independent audit function

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Evaluating Corporate Evaluating Corporate GovernanceGovernance (3 of 5) (3 of 5)

Evaluating a firm’s corporate governanceWhere can you find information about

a company’s corporate governance?

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Evaluating Corporate Evaluating Corporate GovernanceGovernance (4 of 5) (4 of 5)

Standard and Poors’ rating systemInterviews with key stakeholders

E.g., CEO, finance director, BoD, key creditors and shareholders, independent auditor

Inspect company documentationE.g., public filings, BoD minutes

44©2006 Prentice Hall, Inc.

Evaluating Corporate Evaluating Corporate GovernanceGovernance (5 of 5) (5 of 5)

Standard and Poors’ rating system (con’d)Overall Scores from 0-10

0 for not providing sufficient informationFour individual categories scored from 0-10

Ownership structure and external influencesShareholder rights and stakeholder relationsTransparency, disclosure and auditBoard structure and effectiveness

Why does corporate governance matter?

Comments or questions about PowerPoint Slides?Contact Dr. Richard Newmark atUniversity of Northern Colorado’s

Kenneth W. Monfort College of Businessrichard.newmark@PhDuh.com 45

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