(EM)

Earnings Management
June 28, 2006
Group Members
Alfred DSouza
Aman Gill
Eric Lindsa
Mar Guo
Mic!ael "laman
#an$ir %!angura
&amm '!eung
(!at is Earnings Management)
(!at moti*ates Earnings Management)
'ommon A++roac!es
E,am+le - %ris+ %reme
'onse.uences
Agenda
(!at is Earnings Management)
/eal and (a!len, 0111
2Earnings management occurs 3!en managers
use 4udgment in financial re+orting and in
structuring transactions to alter financial re+orts
to eit!er mislead some sta5e!olders a$out t!e
underling economic +erformance of t!e
com+an or to influence contractual outcomes
t!at de+end on re+orted accounting num$ers67
(!at is Earnings Management)
Sc!i++er 801819
2: a +ur+oseful inter*ention in t!e
e,ternal financial re+orting +rocess, 3it!
t!e intent of o$taining some +ri*ate gain
8as o++osed to merel facilitating t!e
neutral o+eration of t!e +rocess7
;
Worldcom 80111 -20029
- < 1 $illion o*erstatement t!roug! release of im+ro+er reser*es
;
Xerox 8011= -20009
-
< > $illion accelerated re*enue recognition
-
< ?00 million t!oug! @cus!ion reser*es
- SE' le*ied < 00 mm in fines
- Ao admission of guilt
;
Lucent Technologies, Cendant, MicroStrateg (20009
- Stoc5 mar5et lost >B $illion in t!ree das
EM - #ecent E,am+les
Conservative
Accounting
Aggressive
Accounting
Fraudulent
Accounting
Aggressive recognition of provisions and
reserves
Overvaluation of R&D purchase acquisitions
Overstate asset write-offs
Understate provision for bad debts
Drawing down provisions/reserves in an overl
aggressive !anner
Recording sales before reali"able# recording
fictitious sales
$ac%dating sales invoices
Overstating inventor
Within GAAP
Violates GAAP
Earnings
Management
"raud *s6 Earnings
Management
Determined by motive
(!en is EM "raudulent)
EM and accrual met!ods are fraudulent under
t!e follo3ing circumstancesC
-
06 (!en t!e are used to satisf analsts e,+ectations6
- 26 (!en t!e are used to realize $onuses6
-
>6 (!en transactions are structured or carried out to alter
financial re+orts6
- B6 (!ene*er t!e are used for reasons ot!er t!an to +ro*ide
accurate financial information to in*estors and sta5e!olders
&anipulate the co!pan's earnings so the
figures !atch a pre-deter!ined target
Ds Accrual Accounting a form of EM)
;
Accrual accounting uses accrual, deferral, and allocation
to reflect an entits +erformance during a +eriod
;
Managers use GAAE to ma5e re+orting decisions
;
Ena$les its in*estors to assess t!e entits economic
+erformance more accuratel t!an from 4ust cas! flo3s
Fualitati*e *s Fuantitati*e Earnings
;
Size matters6 Most in*estors loo5 at
cents +er s!are 3!en analzing earnings
;
Fualit earnings !a*e > $asic .ualitiesC
-
#e+eata$le
-
'ontrolla$le
-
Gan5a$le
#e+eata$le
Dn t!e >rd .uarter of 2000, Motorola
+osted earnings +er s!are of B cents,
$eating analsts e,+ectations, $ut t!e
stoc5 fell 0?H soon after6
-
&!e reason) Sales !ad s!run5, and t!e
econom 3as soft6 Most of t!e earnings
gro3t! came $ 3a of 4o$ cuts and t!e sale
of in*estments
'ontrolla$le
Some I6S com+anies 3it! Euro+ean
su$sidiaries are re+orting earnings t!at
are $etter t!an e,+ected6
-
&!e #eason) &!e falling I6S dollar !as
im+ro*ed earnings *ia t!e e,c!ange rate6
Dnflation can also affect earnings t!roug! t!e
+rices of in+uts and out+uts6
Gan5a$le
Dn 2002, 'ircuit 'its stoc5 +rice fell o*er
B0H e*en t!oug! $ot! sales and earnings
s!o3ed siza$le increases6
-
&!e #eason) &!e size of t!e com+ans
Accounts #ecei*a$le !ad more t!an dou$led
creating concerns around t!eir collecti$ilit
(! is EM not acce+ta$le)
;
Misallocation of Dn*estment #esources
;
Indue im+ro*ement in management
credi$ilit
;
MDJA +ro*ides room to e,+lain *ariance
in +erformance
;
Sign of 'om+romised 'ollusi*e Auditing
(!at is Earnings Management)
(!at moti*ates Earnings Management)
'ommon A++roac!es
E,am+le - %ris+ %reme
'onse.uences
Agenda
(! does EM occur)
Three main reasons!
;
'a+ital Mar5et E,+ectations and
Kaluation 8Earnings S!oc59
;
'ontracting Moti*es
;
AntiLtrust and Go*ernment #egulations
'a+ital Mar5et Moti*ations
;
Sample moti"es!
;
S!ort term stoc5 +rice +erformance
;
Kaluation +rior to management $uouts
;
E6M6 to meet t!e e,+ectations of financial
analsts
$ut( studies show investors see through)
such *+&+ and instead rel on long ter!
strateg when allocating resources
'a+ital Mar5et Moti*ations
Sample methods!
;
Dncome increasing de+reciation met!ods
and allo3ances in ear +rior to DEM
;
Dncome smoot!ing
Earnings S!oc5
;
Eositi*e earnings sur+rises usuall arent
significantl re3arded $ t!e mar5et6
;
Aegati*e earnings sur+rises are +enalized
!ars!l
The #eason
;
Earnings targets are usuall conser*ati*e6
;
E*er su$se.uent +ositi*e s!oc5 !as less of an
im+act6
Earnings S!oc5 contd:
;
Eositi*e earnings sur+rises tend to $e
more fre.uent t!an negati*e earnings
sur+rises as com+anies tr to @$eat do3n
e,+ectations
;
Dnterim #e+orts are not audited, t!us
creating more o++ortunit to manage
earnings
$ut( ,tud showed onl - of .. fir!s
delaed default through *+&+
'ontracting Moti*ations
;
06 Lending Contracts
;
Managers manage earnings to ensure
com+liance 3it! e,isting lending
co*enants 8i6e6 de$t ser*ice co*erage or
de$t e.uit ratios9
$ut( stud shows personall !otivated
*+&+ has little effect on asset allocation
'ontracting Moti*ations
$% Management Compensation Contracts
;
Managers use 4udgment to increase earnings
$ased $onus a3ards
;
Managers manage earnings 3!en 4o$ securit
is t!reatened
,trong evidence that *+& occurs when
co!panies are on verge of violating
regulator provisions+
#egulator Moti*ations
&ndustr #egulations
;
Gan5s re.uired to satisf ca+ital ade.uac
re.uirements
;
Dnsurance com+anies must meet conditions for
minimum financial !ealt!
;
Itilities com+anies !a*e $een !istoricall +ermitted
to earn normal return on in*ested assets
,tud/ 0o!panies being investigated for anti-
trust violations report inco!e decreasing
accruals
#egulator Moti*ations
'nti(Trust #egulations
'om+anies on *erge of in*estigation ma
manage earnings to a++ear less +rofita$le
(!at is Earnings Management)
(!at moti*ates Earnings Management)
'ommon A++roac!es
E,am+le - %ris+ %reme
'onse.uences
Agenda
/o3 are Earnings Managed)
; @Gig Gat! #estructuring
;
'oo5ie Jar #eser*e Accounting
; Eremature #e*enue #ecognition
- 'amouflage of @/old and Sale transactions
- &rans+orter +ic5s u+ ris5 of loss
- Incertaint at cut off date
- Dnflating standard orders
; E,+ected li*es of long term assets
;
M$ligations for +ension $enefits
; Deferred &a,es
$) Tuc) a*a(
create the
Coo)ie +ar
,) -ip into the
Coo)ie +ar .
re"ersal o/
accruals
0) Can1t manage
gro*ing mar)et
expectation
2) 3o real cash
/lo* ( Scraping
the bottom
&+ical Stages of EM
/o3 are Earnings Managed)
'ont66
;
Deference of Asset Dm+airment
;
"D"M *s LD"M met!ods of accounting 8e6g6!+er
inflationar countries9
;
Accelerated Declining met!od of Amortization
;
(or5ing 'a+ital Management - delaed s!i+ments
;
&iming of ca+ital gains
Mt!er So+!isticated met!ods
;
Mff Galance S!eet re+orting in
su$sidiaries
;
Snt!etic Leases
;
EroLforma Estimates
;
DnterLcom+an transactions
Some S+ecial 'ases
;
Gan5s - Loan Loss #eser*es
;
Dnsurance 'om+anies - 'laim Ero*isions
;
Large Eetrol '!emical Ero4ects - Deferred &a,
Allo3ances
;
Gusiness 'om$os - creati*e ac.uisition accounting
;
E.uit structuring to a*oid N re.uire consolidation
/o3 auditors detect EM
; 'as! flo3s t!at are not correlated 3it! earnings
;
#ecei*a$les t!at are not correlated 3it! re*enues
; Allo3ances for uncollecti$le accounts t!at are not correlated 3it!
recei*a$les
; #eser*es t!at are not correlated 3it! re*enue gro3t! or $alance
s!eet items
;
Fuestiona$le ac.uisition reser*es
- restructuring c!arges or reser*es set aside for dis+osals
; Earnings t!at consistentl and +recisel meet analsts e,+ectations
SJEs 'ore Earnings Metric
;
Attem+ts to +ro*ide consistenc and
trans+arenc related to earnings
;
'reated 3it! t!e in+ut of t!e in*estment
communit
;
'learl defines 3!at can and cannot $e included
as #e*enues and E,+enses
What1s &n

Em+loee stoc5 o+tion

e,+enses

#estructuring c!arges

Eension fund costs

Eurc!ased #JD
e,+enses

(riteLdo3ns and
de+recia$le o+erating
assets
What1s 4ut

Good3ill im+airment

GainsNlosses from asset

sales

Eension gains

Litigation costsN+roceeds

Inrealized gains from

!edging acti*ities
SJE 'ore Earnings
'riti.ue - SJEs 'ore Earnings
;
'an o+tion e,+enses $e fairl +riced)
-
Glac5LSc!oles +roduces !ig!l su$4ecti*e
resultsO es+eciall 3it! *olatile stoc5s
;
Eension +lan gains are e,cluded, $ut
losses are included6
-
Df returns are do3n in a gi*en ear, earnings
3ill $e +enalized e*en if t!e +lan is flus!
(!at is Earnings Management)
(!at moti*ates Earnings Management)
'ommon A++roac!es
E,am+le - %ris+ %reme
'onse.uences
Agenda

!ris"y !reme # What Went Wrong$
Gac5ground Dnformation
;
%%D $egan in 01>= in t!e sout!east I6S6
;
Gegan going national in 0116, o+ening stores in
Man!attan, L6A, Los Kegas
;
Declared 2/ottest Grand in t!e Land7 $ "ortune
Magazine
;
DEM too5 +lace in 2000
%%DC Dnitial Eu$lic Mffering
;
DEM in 2000, 4ust after t!e tec! $u$$le $urst
;
Dn*estors 3ere eager for a $usiness t!e could
understand
;
'onsidered one of t!e $est DEMs of t!at ear
;
DEM +riceC <20:6 $ August 200>C <?0
;
200BC <66?66 MM in sales, <1B6= MM in +rofit, B00 total
stores 8Australia, 'anada, %orea9
%%DC 'anadian #ig!ts
;
M3ned $ %reme%o Dnc6 under e,clusi*e
franc!ising and licensing arrangement
820009
;
%reme%o re.uired to o+en >2 stores
3it!in = ears 8<IS B0,000 +re store +lus
roalties9
(!at !a++ened)
; Ma 200BC "irst e*er missed .uarter and first loss as a +u$lic
com+an 8'EM $lames lo3 car$ diets9
;
Jul 200BC SE' ma5es an informal in.uir into %%D $u$ac5s of
se*eral franc!ises
; Stoc5 +rice +lunges, s!are!olders file suit
; Mct6 200BC SE' in.uir u+graded to 2formal7
;
%%D continued to add stores, t!oug! sales 3ere falling
;
Jan6200?C %%D decides to restate financialsO 'EM re+laced $
Ste+!en 'oo+er, 3!o 5e+t !is ot!er 4o$ as interim 'EM of Enron6
&anage!ent's decision to include ingredient
and equip!ent sales does not accuratel reflect
overall health of co!pan 1 *+&+
/o3 %%D Managed Earnings)
;
Getting Greed
;
%%D re.uired franc!isees to $u e.ui+ment and
ingredients at mar5ed u+ +rices
;
>0H of 200> came from selling ingredients and
e.ui+ment
;
%%D concentrated on gro3ing +arent com+an sales
instead of franc!isee +rofits
/o3 %%D Managed Earnings)
Snthetic Lease
;
%%D financed a <>? MM mi,ing +lant 3it! an offL$alance
s!eet synthetic lease
;
Eermissi$le onl 3!en lessee !as no intention of
ac.uiring leased +ro+ert at term end
;
2Mi,ing Elant7 s!ould $e tec!nicall an asset to t!e
com+an and s!ould $e recorded on $alance s!eet
;
%%D scuttled t!is +lan in "e$62002 after Enron
/o3 %%D Managed Earnings)
5udging the 3umbers
;
Mct6 200>C 'om+an ac.uired se*en Mic!igan $ased
franc!ises for <>260 MM
;
Eurc!ase +rice recorded as intangi$le asset 8#eac.uired
"ranc!ise #ig!ts9, 3!ic! it did not amortize
;
Eurc!ase +rice 3as inflated so seller could ma5e interest
+aments so *endor could +a interest for +ast due
loans
;
Dnterest 3as recorded as income
/o3 %%D Managed Earnings)
'dditional &tems
;
%%D rolled store closing costs, consulting fees into
intangi$le ca+ital asset account
;
%%D $oug!t 'alifornia $ased franc!ises at inflated +rices
3!ic! 3ere o3ned $ 'EMs e,L3ife
;
%%D $oug!t Dallas $ased stores at inflated +rices t!at
3ere +artl o3ned $ former director and $oard mem$er
;
%%D em+loed > different '"Ms from 2000L200B
%%Ds Moti*es
;
E,treme +ressure to satisf e,+ectations of
+u$lic mar5et
;
Eersonal $enefit $ +aing e,cess amounts for
franc!ises
;
'om+an faced S6E6'6 in.uiries
;
'"Ms 4o$s 3ere not secure
(!at is Earnings Management)
(!at moti*ates Earnings Management)
'ommon A++roac!es
E,am+le - %ris+ %reme
'onse.uences
Agenda
#eaction from Sta5e /oldersL
E,treme Distrust
;
Dum+ stoc5 on ne3s of Managed Earnings
;
Dncreased reliance on non financial information
-
Dn*estment $an5ers
-
"inancial analsts
-
Gond #ating Agencies
-
"inancial Eress
;
'lass action suits - Aortel
De$ata$le M*er #eactions
;
Sto+ earnings guidance
-
'ocaL'ola
;
#e3ard s!areL!olders 3it! trust3ort!
$oo5L5ee+ing not earnings
;
'lass action suits against auditors
#ealit
;
&!e mar5ets are still more reliant on
earnings re+orts t!an on cas! flo3s
;
Management 4udgment $etter indicator of
future earnings t!an fluctuating cas! flo3s
;
Almost e*er one does it in some 3a
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