Earnings Management and Earnings Quality

What is Earnings Management?

Arthur Levitt: practices by which earnings reports reflect the desires of management rather than the underlying financial performance of the company. Earnings management (or income smoothing) is often defined as the planned timing of revenues, expenses, gains and losses to smooth out bumps in earnings. In most cases, earnings management is used to increase income in the current year at the expense of income in future years. Earnings management can also be used to decrease current earnings in order to increase income in the future.

The Public Perception of Earnings Management

Earnings management has a negative effect on the quality of earnings if it distorts the information in a way that it less useful for predicting future cash flows. The term quality of earnings refers to the credibility of the earnings number reported. Earnings management reduces the reliability of income. The investing public does not necessarily view minor earnings management as unethical, but in fact as a common and necessary practice in the everyday business world. It is only when the impact of earnings management is great enough to affect the investors portfolio that they feel fraud has been committed.

How company smoothes earnings

Check list

Does level discretionary cost conform to past Is there a drop in trend of discretionary costs as percentage of sales Does cost cutting program involve significant cut in discretionary costs Does cost cutting program eliminate fat? Do discretionary costs show fluctuations relative to sales Is there a sizable jump in discretionary costs?

The Impact of Earnings Management

The practice of earnings management damages the perceived quality of reported earnings over the entire market, resulting in the belief that reported earnings do not reflect economic reality. This will eventually lead to unnecessary stock price fluctuation. This uncertainty ultimately has the potential to undermine the efficient flow of capital thereby damaging the markets as a whole.

Incentives to Manage Earning

A. EXTERNAL FORCES Analyst Forecasts Debt markets and contractual obligations Competition B. INTERNAL FACTORS Potential mergers Management Compensation Planning and budgets Unlawful transactions C. PERSONAL FACTORS Personal bonuses Promotions and job retention

SEC Response to Earnings Management

SAB 99 regarding Materiality in August of 1999: A favorite practice of corrupt management is to justify earnings management by claiming it is immaterial. SAB 100 was released in November of 1999 in an attempt to eradicate the common earnings management practice of taking a big bath through the use of restructuring and impairment charges. SAB 101A concerning Revenue Recognition was released at March of 2000, and later SAB 101B. The issuance of SAB 102 concerning Loan Loss Allowances, which is another preferred tool of earnings management, July of 2001.

Types of Earnings Management and Manipulation (by Scott McGregor)

a. "Cookie-jar" Reserves b. Capitalization practices-Intangible assets, software capitalization, research and development. c. "Big bath" one-time charges d. Operating activities e. Merger and acquisition activities 1. Pooling on interests 2. Purchase accounting and goodwill f. Revenue Recognition g. Immaterial misapplication h. Reserve one-time charges

Examples of Fraudulent Earnings Management (I)

Aug.22, 2005: The SEC filed civil fraud charges against former officers of Bristol-Myers Squibb (BMS) Fraudulent Earnings Management Scheme Deceiving investors about the true performance, profitability and growth trends of the company Sold excessive amounts of its products to wholesalers ahead of demand and improperly recognized revenue of $1.5 billion Used cookie jar reserves to further inflate its earnings

Examples of Fraudulent Earnings Management (II)

Nov.30, 2004: The SEC announced filing and settling charges against American International Group (AIG) Offer and sale of an Earnings Management product Special Purpose Entities to enable the buyer to remove troubled or other potentially volatile assets from its balance sheet Enabling the buyer to avoid charges to its reported earnings from declines in the value of theses assets

Examples of cases of earnings manipulation

a. Cendant b. Manhattan Bagel c. Sunbeam d. Tyco e. Sensormatic f. 3Com g. W.R. Grace h. MicroStrategy i. Lucent

Cendant

Cendant was created in 1997 by merge of equals between CUC and HFS. HFS later found CUC recorded 500M phony profit before merger. This is driven by managements determination to meet Wall Street analysts expectations. CUC management maintained an annual schedule setting forth opportunities that were available to inflate operating income. Top down approach. Top management allocate the amount that each subsidiary needs to come up with the earnings. Then the management make additional adjustment to ensure the earnings and expenses ratios are similar to that of previous year.

Cendant

1996 CUC established merger reserve that is double its cost, simply view as opportunity the viability of future earnings at CUC. 1997 CUC used merger with HFS as another chance to cover up its shortfall of earnings. In April 1998, Cendant suited 7 former CUC executives for accounting fraud. SEC brought similar charges in June 1998. The day after fraudulent financial reporting was announced in April 1998, Cendants stock price drop 46.5%, eliminating $14 billion in market capitalization. 1998 December, Ernst and Young, CUCs auditors agreed to pay $335M to Cendant stockholders.

MicroStrategy

MicroStrategy's reporting failures were primarily the result of premature recognition of revenue. Management did not sign contracts received near the end of quarters until after it determined how much revenue was required to achieve desired quarterly results. MicroStrategy engage in complex transactions involving the sale of software as well as extensive software application development and consulting services. The nature of the multiple element deals at MicroStrategy gave rise to accounting practices that were not in accordance with GAAP.

MicroStrategy

SEC documents detail a transaction in which MicroStrategy negotiated a $4.5 million transaction to provide software licenses and extensive consulting and development services. The majority of the software licenses were to be used in conjunction with to-be developed applications, indicating that the product and service elements were interdependent. However, MicroStrategy recognized the entire $4.5 million received in the transaction as software product license revenue, allocating no revenue to the extensive service obligations.

MicroStrategy

MicroStrategy also entered into an agreement in which it agreed to provide software licenses, maintenance and services to a large retailer. In a side letter to the agreement, MicroStrategy's sales staff promised the retailer future product at no cost, although the product had not yet been developed. Under GAAP, the revenue should have been deferred because the value of the future product could not be determined.

MicroStrategy

MicroStrategy announced that it would restate earnings for three years to comply with GAAP. After the announcement, MicroStrategy stock fell 62 percent in one day. Its stock price dropped from a high of $333 per share to $33 per share. In April 2001, the company settled a class action suit alleging fraud arising from its accounting practices. Three of its executive officers at the time of the restatement agreed to fraud injunctions and paid penalties of $350,000 each. The company agreed to undertake corporate governance changes and implement a system of internal controls.

Lucent

Lucent Technologies, an AT&T spin-off, started trading publicly in 1996 with an initial public offering that was, at the time, the largest in domestic history. In December 1999, Lucent's stock was selling at $77.78 and was the nation's fourth most widely held stock. However, by July 2001, Lucent's stock was trading at $6.43, the SEC was investigating its accounting practices and several former, high-level managers. The decline in Lucent's stock value has been attributed to a Nov. 21, 2000 announcement in which Lucent said it had voluntarily reported accounting irregularities to the SEC. As a result of its own internal investigation, Lucent restated its Sept. 30, 2000 financial statements, reducing revenue by $679 million.

Lucent

According to a January 2000 Wall Street Journal article, Lucent had used "a whole myriad of aggressive accounting moves to boost its growth." One analyst estimated that Lucent added about 27 cents a share to its earnings through "deft accounting moves," including creative acquisition accounting. In October 1998, Business Week reported that Lucent avoided some goodwill amortization by writing off $2.3 billion of in-process research and development as companies were acquired. Lucent's earnings also benefited from a $2.8 billion reserve for "big bath" restructuring charges that were recorded as part of Lucent's spin-off from AT&T. Some analysts believe Lucent put aside far more than was needed to cover restructuring expenses and used the excess reserves to smooth earnings .

Lucent

Although revenue and accounts receivable increased in fiscal 1999, Lucent lowered its bad-debt reserves. In addition, some observers believe that Lucent improperly lowered its reserves for obsolete inventory in 1999. Lucent's December 2000 restatement in which revenues were reduced by $679 million, created doubt. Two-thirds of the $679 million reduction in revenue, or $452 million, was attributed to "channel stuffing" sales, in which transfers of products to distributors are recorded as sales although the products are not yet sold to end-users. The restatement also reduced revenues by $199 million because customers were promised discounts, credits and rights of return. Lucent also nullified $28 million in revenue recognized on a partial shipment of equipment.

The Cendant, MicroStrategy and Lucent cases share several common characteristics
1. The earnings management activities took place over extended periods of time, escalating from questionable and improper revenue recognition practices to other forms of earnings management; 2. The earnings management practices were initiated "at the top," but eventually involved high-level managers and their subordinates; and 3. The earnings management practices were not uncovered by external auditors or audit committees.
These characteristics and the SEC's announced policy of enforcing action against companies engaging in abusive earnings management suggest that accountants and auditors should be vigilant in their attempts to identify earnings management activity in its early stages.

A survey of fraudulent accounting management -When earnings management becomes fraud?

Done by Internal Auditing, Sept./Oct. 2002
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In most cases, top management is involved with perpetrating the fraud. Those industries in Computer Software, Medical Service, and Telecommunications are most likely to conduct fraudulent accounting management. Improper revenue recognition is the most often seen violation of GAAP.

Corporate Mechanisms to avoid fraudulent Earnings Management (by Raymund Breu)

Board oversight External Audit Internal Audit reporting to Audit Committee of Board Accounting manuals Training Whistleblower procedures Code of Conduct Code of Ethics of Financial Officer