Earnings Management

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Earnings Management
What is earnings management?
Why do managers do it?
How do they do it?
How can we detect it?
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What?
Aggressive accounting
Earnings management
Income smoothing
Fraudulent reporting
Creative accounting
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What?
The active manipulation of accounting results for
the purpose of creating an altered impression of
performance.
Managers choosing accounting policies so as to
maximize their own utility and/or the market
value of the firm.
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Why?
-- Share price effects
-- Borrowing cost effects
-- Bonus plan effects
-- Political cost effects
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How?
1. Flexibility of accounting principles
2. Choices, estimates, judgments
3. Rule-based accounting loopholes
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How? 1. Flexibility of accounting principles

• Choices
• Inventory
• Depreciation
• Expensing vs. Capitalizing
• Software sales recognition

Why do we allow choices?

• What problems does choice create?

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How? 2. Choices, Estimates, Judgments

• Depreciation

• method

• useful life

• salvage value

• Allowance accounts

• bad debts

• sales returns

• warrantees

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Choices etc., contd.

• Asset impairments
• Restructuring costs
• Inventory write-downs
• Environmental liabilities
• Pension assumptions
• In-process RD
• Percentage of completion contracts

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How? 3. Rule-based versus principle-based
accounting

• What is rule-based accounting?
• What are its advantages and disadvantages?

• What is principle-based accounting?
• What are its advantages and disadvantages?

Sickening example SPEs
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Accounting Tricks - Examples
Waste Management Inc.
Understated depreciation and capitalized
interest improperly, failed to write down
impaired assets. Total restatement 2 billion.

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Waste ManagementOverstated Income
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Accounting Tricks - Examples
WorldCom
Recorded expenses as capital expenditures,
double-booked revenues, booked revenues as cost
reductions. Total restatement 4.6 billion

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WorldCom Reported vs. Restated EBITDA
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Accounting Tricks - Examples
Xerox
Recorded revenue on long-term leases of copiers
prematurely. Total restatement 3 billion (but
part of this increased later revenues).

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Xerox Reported and Restated Revenue
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Accounting Tricks - Examples
Adelphia
Hid billions in debt off-balance sheet in
unconsolidated subsidiaries, diverted
undetermined millions to the family stockholders,
inflated subscriber numbers in press reports,
overstated earnings.
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Adelphia Debt Load
3.5 Billion
12.6 Billion
Reported
Actual
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Accounting Tricks - Examples
Sunbeam
Inflated revenues by channel stuffing and bill
hold. Reduced expenses by capitalizing
advertising costs, reducing allowance for bad
debts.
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Sunbeam Revenues and Net Income
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Accounting Tricks - Examples
Rite-Aid
Inflated revenues by recording vendor rebates
that pertained to future purchases. Reduced
expenses by capitalizing expenses, not recording
certain expenses, failing to write off inventory
shrinkage, understating depreciation.
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Rite-Aid Net Income Restatement
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Accounting Tricks - Examples
Enron
- Hiding debt and losses in unconsolidated
entities
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Enron Reported and Restated Net Income