Accrual Accounting and

Earnings Management

RCJ Chapters 1, 2(48-52), 3(126-132),

7(357-359)
Key Issues
 Accrual accounting
 Managers’ incentives and reporting abuses
 Example: Revenue recognition
 How earnings are managed

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 Accrual Accounting
 Recognizes the financial benefits and
obligations accruing to an enterprise over the
reporting period - regardless of cash inflows and
outflows.
 Objective: Better indication of performance than
current cash receipts and payments.

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Accrual Accounting: Characteristics
 subjectivity
 assumptions
 discretion
 incentives

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Earnings Management
 The reporting discretion inherent in accrual
accounting can be opportunistically used by
managers.
information
Manag Investors
er
Reporting incentives:
• Higher bonus
• Cashing out on Stock options
• Career and personal ego

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Earnings Management (cont’d)
 Why allow reporting discretion?

Rigid rules Flexible rules

(e.g. full (e.g. revenue
expensing of trade-off recognition)
R&D)
 Reporting biases  Enables better reporting of
larger number of
 No discretion businesses.
 Prone to manipulation

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Earnings Management (cont’d)

Important to understand: More often the problem

is not the flexibility of the reporting rules, but the
fact that the watchdogs are not doing their job!!!
 Audit failure
 Poor corporate governance
 Shareholder involvement
 SEC enforcement

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Common Earnings Management
Practices
1. Shifting income between periods:
Revenues Expenses
Borrowing 1. Premature 2. Capitalization of
earnings from recognition of expenses
the future revenues Example: WorldCom
Example: Xerox
Postponing 3. Deferring 4. Exaggerating
earnings to the recognition of current
future revenues expenses/losses to
Example: Microsoft create cookie jar
reserves
Example: Microsoft
Note: Σt Earningst = Σt Cash Flowst
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Common Earnings Management Practices (cont’d):
J.E.

Actual J.E. Proper recognition J.E.

1. Borrowing DR CR DR CR
revenues from Cash revenue cash def.
the future revenue
later: def. revenue revenue
2. Deferring DR CR DR CR
expenses to the Asset cash expense cash
future later: Expense asset
3. Deferring DR CR DR CR
revenue to the cash def. Cash revenue
future revenue
later: def. revenue
4. Exaggerating DR CR DR CR
current revenue
loss No journal entry
expenses/losses liability/Asset later: loss cash
to create cookie later: liability cash
jar
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Common Earnings Management Practices
(cont’d)
1. Classification of gains and losses:
 Classifying one-time gains as earnings from
continuing operations
 Classifying losses from continuing operations as one-
time items
2. Hiding Debt in unconsolidated subsidiaries
 Example: Enron
Legitimate Violation of
Earnings GAAP or SEC rules
Management (Within
GAAP) of accruals to:
Manipulation
I. smooth earnings
II. Turn permanent expenses into temporary losses
ex. P15-9 10
Example of Scope of Manipulations
and Incentives: Xerox Case
 Xerox sells/leases copy machines, and related
service to be provided for several years after
sale.
 Recorded service revenue at the time of sale.
 According to the SEC investigation, “accounting
tricks” boosted pretax profit by 1.5 billion from
1997 through 2000.
 In November 1999, CFO told management:
"When accounting actions were stripped away,
Xerox had essentially no growth through the
late 1990s.”

Q: Which of the 4 categories mentioned in slide

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Xerox Case: what were the
incentives?
 Without the accounting scheme the company
would have missed Wall Street's consensus per-
share earnings targets in 11 of 12 quarters from
1997 to 1999.
 Accounting scheme helped keep Xerox's stock
price artificially high in the late 1990s so
executives could cash in $5 million in
performance-based compensation and more
than $30 million from stock sales.

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Example of Reporting Discretion:
Seebeyond Case
 On March 2002 SeeBeyond sold its software product for
$2.2 million to a costumer.
 Deployment and payment for Revenue
recognition:
the software in stages that could
extend until March 2003. 2. Earned
 3. Measurable
This customer had bought and successfully deployed
software from SeeBeyond before.
 SeeBeyond is interested in including the $2.2 million in
the revenues of the quarter ending on March 31, 2002.
Is it possible?
1. No. Revenue not earned.
2. No. Revenue not measurable
3. Yes. Revenue is both earned and measurable.

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SeeBeyond Case (cont’d)

 SeeBeyond held a conference call telling

investors that revenues would fall short of the
previous revenue guidance by approximately $2
million.
 The share fell 52% the next day!!! Why?

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