Ethics Ch. 7

Earnings Management and the Quality of Financial Reporting

Ethics Reflection• Five basic types of financial statement fraud

fictitious sales improper expense recognition hidden liabilities incorrect asset valuationinadequate disclosures

• Vast majority of public companies engage in some form of questionable earnings management

• Most common reason for companies to make restatements/SEC actions is due to revenue recognition, normally premature recognition

• Are auditors adequately meeting their ethical obligations and protecting the public interest with regard to fraud detection?

Motivation to Manage Earnings

• Companies manage earnings when they ask, “How can we best report desired results?”

• 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 • Avoid consequences of violation of debt covenants• Meet budgeted goals; enhance performance • BOD should focus on long term strategic goals and shield

managers from short-term pressure

Is it legal?• Some earnings management techniques are

acceptable under GAAP, others aren’t• If engaged in illegal accounting manipulations,

substantial legal penalties --monetary penalties and violations of securities laws

• Waste Management investigated by SEC – Provided false earnings guidance– Substantial monetary penalties incurred– Executives also had illegal insider trading

Income Smoothing• Motivation to smooth net income over time• Steady increase each year over a period of time is ideal• Investors 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• Techniques smooth tax liability over years

Defining Earnings Management• Inflate (deflate) revenues or earnings per share

1. By using aggressive accounting techniques such as capitalizing costs that should have been expensed

2. Establishing/altering the elements of an estimate to achieve a desired goal• Operating earnings management and accounting earnings management• Earnings manipulation is form of earnings management• Managerial intent• Underlying motivation may be self-interest, not interests of stakeholders• Different views on earnings management

– Negative light- “purposeful intervention in the external reporting process, with the intent of obtaining some private gain”- Schipper

– Positive light- “Reasonable and legal management decision making and reporting intended to achieve stable and predictable financial results”- McKee

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 creditors/investors 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

– 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– Problem is no clear limit between what is ethical and what isn’t

How Do Managers and Accountants Perceive Earnings Management?

• Survey by Elias– Accountants in organizations with high ethical values perceive earnings management

as more unethical– Accountants in industry significantly less likely to perceive high ethical values

• Rose and Rose found that audit committee members with less financial knowledge are more likely to accept insufficient client explanations for accounting judgment

• Survey by Bruns and Merchant – Managers disagree about ethics of earnings management– Manipulation of operating decisions more ethical than manipulation by accounting

methods• Survey by Rosenzweig and Fischer

– Found accounting manipulations through 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

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

• 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 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• Dunlap thought he could do this and blame it on previous CEO

Accruals and Earnings Management• Accruals are needed because of matching and timing

problems that can give inaccurate 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• Waste Management used aggressive estimations

– Discretionary accruals (items that management has full control over and is able to delay or eliminate-i.e., bonus payable)

– Nondiscretionary accruals (management has no control over-i.e., salary/taxes payable)

SAB 99• SAB 99 lists qualitative factors affecting materiality

– Arises from an estimate or item capable of precise measurement– Masks a change in earnings or other trends– Hides a failure to meet analysts’ expectations – Changes a loss into income or vice versa– Concerns a segment playing a significant role in operations or profitability– Affects the registrant’s compliance with regulatory requirements– Affects the registrant’s compliance with loan covenants or other contractual

requirements– Has the effect of increasing management’s compensation - bonuses or

incentive compensation– Involves concealment of an unlawful transaction

• Auditors should be on alert for these red flags

The Acceptability of Earnings Management from a Materiality Perspective

• FASB defines materiality as magnitude of omission/misstatement that would have changed or influenced judgment of reasonable person

• SAB 99 and Legal Decisions find it unacceptable exclusive use of percentage materiality criteria– Both the qualitative and quantitative factors must be

considered when assessing materiality– Judgments of materiality --“reasonable person” standard– Judged by relative amount and nature of item– Common law precedents: info is material for securities

fraud purposes if a reasonable investor would have viewed it as having meaningfully altered the total mix of information • WR Grace: Established “all-purpose” reserve fund

Materiality and Legal Decisions

• Standard is most often encountered in fraud litigation brought under Section 10(b) and Rule 10b-5 under the 1934 Act

• Court adopted position of the SEC: total mix of information might lead a reasonable investor to conclude disclosure/proper accounting influences judgment (TSC Industries In. v Northway decision)

• Matrixx Initiatives, Inc., v. Siracusano – Should be bright line test for materiality– Supreme Court denied this and said “materiality of adverse

event reports cannot be reduced to a bright-line rule”

Considerations of Materiality in Evaluating Internal Control Deficiencies Under Sarbanes-Oxley

• Vorhies 4 perspectives to help meet SOX Requirements:1. The actual financial statement misstatement/error2. An internal control deficiency due to failure in design or operation of a control3. A large variance in an accounting estimate compared with the actual

determined amount4. Financial fraud by management or other employees to enhance in company’s

reported financial position and operating results• Design failure

– Occurs when management fails to establish sufficient internal control• Operating failure

– Adequately designed control doesn’t operate properly• Estimating financial events is necessary in accounting

– As long as process is reasonable, the amount of variance is irrelevant

Audit Risk and Materiality• 3 components of audit risk:– Inherent risk, which is the possibility that a material

misstatement will occur within the reporting of company's accounting information system

– Control risk, which is the possibility that a material misstatement that has occurred will not be detected on a timely basis by the company's control system

– Detection risk, which is the possibility that a material misstatement that has occurred will not be caught by the independent auditor's testing

• Risk of material misstatement= inherent risk and control risk

Current Auditing Standards and Presumptions

• Materiality is matter of professional judgment• Based on auditor’s perception of needs of users of statements as a

group; not as individuals• Users are assumed to:

– Have appropriate knowledge of business and economic activities – Understand statements are prepared and audited to levels of materiality– Recognize uncertainties in amounts based on estimates, judgment, and

future events– Make appropriate economic decisions based on information in financial

statements

• AU 320 - Uses benchmarks to evaluate materiality:– Total revenues, gross profit, or other categories of reported income

Gemstar TV Guide International• 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 and had material effect on valuation of Gemstar stock

Nature of Restatements• Liabilities, expense, reserves, cash flow statement, compensation

issues, mergers, reorganization, revenue recognition, tax expense, and accrual estimate failures are among major cause of financial statements restatements

• “Stealth Restatements”– One disclosed only in periodic reports and not in amended filings to SEC

(i.e., 8-K form)– Percentage of NYSE’s total restatements from stealth restatements has

increased to more than 50 percent • SEC’s Final Report of the Advisory Committee on Improvements to

Financial Reporting – Determining whether accounting error is material should be separated

from how to correct error– SEC supports a stricter rule than current practice of accounting errors

Restatements Due to Errors in Accounting and Reporting

Category Cause of Restatements

Revenue Recognition Improper revenue recognition. questionable items and misreported revenue

Expense Recognition Improper expense recognition, period of recognition, incorrect amounts

Misclassification Improper classification on income statement, balance sheet or cash flow statement

Equity Improper accounting for earnings per share; stock-based compensation plans, securities

Other comprehensive Improper accounting for OCI transactions, unrealized gains and losses on investments

income(OCI) in debt and equity securities, derivatives; and pension-liability adjustments

Capital assets Improper accounting for asset impairments, asset placed in service dates, depreciation

Inventory Improper accounting for valuation of inventory, market adjustments, obsolescence

Reserves/allowances Improper accounting for bad debt or loan loss reserves, reserves for inventory

Liabilities/ Improper estimation of liability claims, loss contingencies, litigation matters,

contingencies commitments and certain accruals

Accounting Hocus Pocus• Big bath charges

– Company takes one-time large restructuring charge/write down – To make this difficult FASB adopted: SFAS No. 144 on impairment losses and

SFAS No. 146 on the timing of the recognition of restructuring obligations – Sunbeam case

• Creative acquisition accounting– Allocate bulk of purchase price of acquiree's in-process R&D – SFAS Nos. 141 and 142

• Cookie jar reserves– Aimed at smoothing earnings over time– SAB 101

• Materiality– Gray area of accounting– SAB 99

• Revenue recognition – Accelerate the recording of revenues– Xerox case

Earnings Management Techniques Schilit’s Financial Shenanigans

• Actions or omissions intended to hide or distort real financial performance or financial condition of an entity– Inflating (deflating) current reported income– Deflating (inflating) current expenses – Movement of items within categories of income statements– Basic Techniques

1. Recording Revenue Too Soon or of Questionable Quality2. Recoding Recording Bogus Revenue3. Boosting Income with One-Time Gains4. Shifting Current Expenses to a Later or Earlier Period5. Failing to Record or Improperly Reducing Liabilities6. Shifting Current Revenue to a Later Period7. Shifting Future Expenses to the Current Period as a Special Charge

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• Cushion Reserves– Used reserves to close the gap between actual results

and earning targets• Sanctions by SEC on KPMG– Paid $10 million in penalties, disgorged $10 million in

audit fees, and $2.7 million in interest

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– Failed to write down impaired assets– Shifting current expenses to later period– Reducing liabilities– Created new reserves and released reserves into income

• KPMG should have noticed red flags

Descriptions of Financial Shenanigans: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

Enron Corporation’s SPEs

3% outside

(independent)

capital

financing

Financial Institution

Special Purpose

Entity (SPE)

ENRON

1 2

3

Explanations:1. Friends of Enron invest in SPE’s2. SPE borrows money from a

financial institution and is responsible for debt

3. Enron sells a non-producing asset to the SPE and, in return, gets the money that had been loaned from the financial institution

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 guarentees of Enron stock– This resulted in no transfer of risk to SPE, therefore should have been

consolidated into Enron’s statements• The Culture at Enron

– “Rank and yank” employee-evaluation policy• Set in place as incentive to keep employee’s quiet

The Force to Compensation– 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

The Story of Enron – con’t• Skilling resigned after 6 months as CEO• Sharron Watkin’s letter to Ken Lay, former and now current CEO and

chair of board of directors – company will “implode in a wave of accounting scandals”– Described in detail problems with Enron’s partnerships– Assigned to be investigated by Vinson & Elkins

• Lawyers stated 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

Lay-Skilling Criminal Trial

• Lay and Skilling found guilty of fraud and conspiracy– Lay passed away just weeks after the verdict– Skilling sentenced • 24 years and 4 months in prison• Fined $45 million

Appeals on the Verdict

• Skilling's Efforts to Overturn the Verdict– 2 Issues• Whether the federal “honest services” fraud statute

required government to prove Skilling’s conduct was intended to achieve “private gain”• “In-house judging”- presumption of jury prejudice

arises because of widespread community impact of defendant’s alleged conduct

– In 2013 DOJ reduced Skilling’s sentence by 10 years

Enron: Review of Important Accounting Issues– Caused by variety of factors:

• Improperly failing to consolidate SPE (Chewco)• Failing to adequately disclose related-party relationship between Enron and SPE’s• Overstatement of earnings

– Quality of financial reports were poor:• 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• 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

GAAP Rules on SPEs• FASB Rules on SPEs– Original motivation• Establish mechanism to encourage companies to invest

in needed assets while keeping debt off its books

– FASB Interpretation No. 45(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

Sarbanes Oxley Act of 2002• Enron’s Role in creating SOX

– Provisions that were motivated by Enron fraud:• 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

Earnings Quality• Dichev study relates to the prevalence, magnitude, and detection of

earnings management; findings fall in 3 categories:– CFOs believe that earnings are high quality when they are

sustainable, and are backed by actual cash flows; Quality when there are consistent reporting choices over time and avoidance of long term estimates

1) Current GAAP standards are somewhat of a constraint in reporting high quality earnings; issue fewer rules and convergence of U.S. GAAP with IFRS; earnings quality would improve if reporting choices evolved from practice, not mandated from standards

Earnings Quality (cont)

2) CFOs believe that 60% of earnings management is income-increasing, and 40% is income-decreasing; believe earnings misrepresentation occurs most in an attempt to influence stock price, because of outside and inside pressure to hit earnings benchmarks, and to avoid adverse compensation and career consequences for senior executives• CFO’s mention 3 major red flags: persistent deviations

between earnings and the underlying cash flows, deviations from industry and other peer experience, and large and unexplained accruals and changes in accruals

Concluding Thoughts• Fraud results from a lack of professional and ethical judgment• Finally after numerous accounting scandals SOX has given us:

– Stronger internal controls– Mandatory certification of financial statements– More meaningful communication between auditors and audit

committees• In order to not repeat history, we need:

– Strong internal control environment– Adherence to ethical values– An effective corporate governance system– True commitment to ethics