Earnings and Financial Reporting Quality

1
Earnings and Financial Reporting Quality

• MIM 517
• Fall 2010
• Class 6

2
Learning Objectives

• Understand subtle distinction between different
  types of financial games
• Overview motivations for games
• Overview different techniques implications on
  earnings quality
• Learn how to analyze media coverage of earnings
  management/fraud

3
Financial Games

• Also known as Creative Accounting
• Question What does all creative accounting have
  in common?
• Answer Using the ambiguity inherent in
  accounting to alter in a specific way, how
  outsiders view the performance of the company.

4
Definitions shades of gray

• Creative Accounting Practices
• Earnings management Using the ambiguity inherent
  in accounting to achieve specific predetermined
  earnings targets
• Income smoothing A form of earnings management
  intended to remove the peaks and valleys from a
  normal earnings stream.
• Aggressive accounting intentional application of
  GAAP to achieve the highest possible earnings
• Conservative accounting intentional application
  of GAAP to achieve the lowest possible earnings

5
Crossing the line

• How is financial statement fraud distinguished
  from earnings management?
• Fraudulent financial reporting is intentional
  misstatements or omitted disclosures (GAAP
  violations) intended to deceive users
• What causes the line to be crossed?
• Remember the range of acceptable net income
• Fraud (Net Income) Fraud

6
Quality of Financial Reporting

• Definition A subjective evaluation of the extent
  to which the financial reporting is free of
  manipulation and accurately reflects the
  financial condition and operating success of a
  business enterprise.
• Earnings Quality
• Both the numbers and disclosures
• Higher quality facilitates better understanding
  of the past and better prediction of the future.

7
Motivations for Creative Accounting

• Share price effects
• Borrowing cost effects
• Bonus plan effects
• Political cost effects

8
Situations Where Creative Accounting is More
Likely

• Earnings short market expectation
• Firm preparing for IPO
• Earnings above minimum for incentive compensation
  
• Firm close to violating debt covenant
• Earnings trend above/below what management
  believes is a sustainable trend
• Earnings volatility induced by a series of
  non-recurring items
• A change has taken place in top management

9
Consider this situation

• A companys CFO has just reviewed the current
  years 3rd quarter financial results and realized
  it is missing its annual earnings growth target
  of 12. Achieving only a 9 growth in earnings
  will have a detrimental impact on the firms
  stock price. The CFO wants to develop plans to
  stimulate 4th quarter earnings to hopefully hit
  the 12 target. What techniques could be used to
  increase earnings? Differentiate between those
  that would increase earnings and
• a) have a positive real impact on the firms
  financial performance, versus
• b) lower the quality of reported earnings

10
Earnings Management Techniques

• Premature or fictitious revenue recognition
• Aggressive capitalization and extended
  amortization policies
• Inappropriate use of reserves
• Big Bath Large loss (restructuring) recorded to
  a period to increase the chances of better future
  earnings
• Cookie jar reserves allowances or reserves
  increased in a particular year in order to boost
  future years earnings
• Misclassification in the Income Statement
• Misuse of materiality

11
Is it all rotten in the financial statements???

• This is nothing new
• The high-risk firms most vulnerable
• Thing come out during soft times
• Boom times vs. bad times
• Bad times are true test of business
• If something seems too good, it likely is!

12
Environmental Factors Encouraging/Discouraging EM

• Encouraging
• Domineering CEO w/ substantial perks
• Disproportionate executive compensation
• Culture of never fail
• BOD primarily insiders
• Poor board committee structure
• Auditor problems
• Investment banker and analysts the same
• Debt covenant close to violation
• Aggressive EPS targets

• Discouraging
• CEO compensation balanced between salary and
  performance incentives
• BOD primarily outsiders
• Strong BOD committee structure
• Auditor independence
• Investment bankers and analysts independent
• SOX!

13
Misstated financial statements

• Consider current examples you found
• What to present
• Summary of company what do, business model, etc
• Summarize the issue included in the SEC
  Enforcement Action
• Relate the creative accounting issue to the
  Earnings Management Techniques (slide 10 or your
  text)