Bruce:

Thank you for the heads up. I certainly hope that your students make the best use out of this post and the related debate that it generated.

I am using this article and related debate in an Accounting Theory course that I am teaching this term at the Telfer School of Management, in Ottawa, Canada. I have also commented on the article and related debate elsewhere, in the interest of encouraging the dissemination of knowledge like this:

http://brucelarochelle.wordpress.com/2010/11/11/d…

Hello Narcisse,

Thank you for the very nice compliments on my writing and thinking. I think more and more of you with each interaction as well.

I am very pleased that I could make you laugh out loud. I was trying to liven up the tone of our discussion so others would read it. As always, you raise some very interesting points that really make me think about my replies.

Of course we can agree to disagree on this debate, and on any others in the future (which I hope there will be).

Many thanks to you for the intellectual stimulation and inspiration.

Au revoir,

Sara

Good evening Sara:

Thank you for giving me credit with regard to the source of your inspiration in writing your post entitled: "Hidden Intentions". This is a very well written post. I did burst into laugh however when I arrived at the paragraph dealing with how you thought you were getting the best of me in this debate…

I honestly thought that our debate on the appropriateness of earnings management practices was over. I have tremendous respect for the depth and breath of your understanding of GAAP and fraudulent financial reporting techniques. I would love to keep the debate going but I am afraid that we are at a dead end. You made your points and I did the same. Nothing you said in your latest comment nor in your latest post "Hidden Intentions" has caused me to reconsider my views on earnings management practices. Just as I said in my prior comment, sometimes it is good to accept to disagree.

I do however want to reiterate my thanks to you for debating this subject with me. I look forward to many more good spirited discussions on a whole range of issues.

Good evening, Narcisse.

I hope you will read my post from earlier today, entitled “Hidden Intentions”.

Your debate with me at my blog (and copied at your blog) inspired my post, in answer to your question about can you tell when earnings management is a good thing or a wicked one. I think you can tell, but not by outlawing certain financial processes or financial products.

As for your reference to the effective of reporting frequency on the quantity of earnings management tactics, I was surprised by the report you referenced as a resource. The study was conducted on companies from the 1950s through 1974. We were barely out of the industrial era, and not yet into the full-swing of the financial era. The full-scale financial statement manipulation and Wall Street’s complex fun and games, hadn’t truly begun yet. Most of today’s perpetrators hadn’t even been born.

I don’t have a study to back up my assertion that in today’s world, the more frequent the reporting period (e.g. monthly or quarterly at a minimum), the less leeway there is for earnings manipulation. Most techniques rely on changed assumptions about economic or other “outside” conditions, and given less opportunity for new information in the shorter time frames there’s less opportunity to change assumptions (and financial results) on demand.

I base my comments about the relationship of reporting frequency to earnings manipulation ease on my 30+ years of experience. Maybe you’ll find a study some day that backs me up!

Thanks again for the inspiration, Narcisse.

Ciao for Now,

Sara McIntosh

Good evening Sara.

First, I would like to thank you for your very thorough response. This little chit chat we are having is turning out to be quite interesting.

I never argued that people or companies ought to blindly invest their money. The reality is that not everybody can afford the services of a financial adviser or stock broker that has her customers best interests in mind. Inevitably, some individual investors are going to take matters in their own hands. After careful thought however, I do recognize that my point about some investors not being able to decipher financial statements is irrelevant to the discussion at hand. Therefore, I am going ask that you disregard it.

The expression "deceptive practices" is correct. I really don't understand where you get this idea of processes unable to think. It seems to me that you somewhat misconstrued what I said when I stated that "earnings management practices are inherently deceptive" I still stand by that statement even though I reckon that it might come back to haunt me some day… When it comes to earnings management as it relates to publicly traded companies, it can be very difficult to differentiate a corporate board trying to exercise its fiduciary responsibilities to shareholders from one that is ensuring that its equity and/or earnings performance based compensation keeps appreciating. Can you tell one from the other?

There has been empirical research on the issue about quarterly reporting vs semi annual reporting and the findings do not corroborate your theory: Does More Frequent Financial Reporting Make Investors Better Off? I am sure you can find some research that would support your views.

You will convene with me that there is absolutely nothing wrong with the both of us accepting to disagree. Maybe one day, I will adhere to your school of thought as it relates to the need for companies to manage their earnings. For now I do know that my learning curve is very steep. I do also admit that you have a very good mastery of accounting rules and regulations. I am glad we are having this discussion because I am learning quite a bit from it or from you should I say.

I must also admit that you are indeed a very gifted and persuasive writer.

Au plaisir to vous relire si le coeur vous en dit! (Tentative translation: I look forward to reading more of your writings at your earliest convenience!)

Good morning, Narcisse. Thanks for the quick reply.

To summarize, there are 3 points in your opinion about earnings management that I’m responding to: 1) That the average shareholder can barely make sense out of the financial statements of the companies they choose to invest in; 2) That you consider earnings management practices to be inherently deceptive; 3) That you believe moving from quarterly financials to some less frequent reporting requirement will lessen the pressure to manage earnings.

With respect to #1: People and companies should not blindly invest their money. If you don’t understand something–get up to speed on the topic/investment or put your money into something you do understand.

With respect to #2: A process can not think, nor act on its own. Therefore a process can not be deceptive. Therefore earnings management practices are not “inherently deceptive.” However, people conducting earnings management processes may or may not have a deceptive intent. It is not all good, nor is it all bad. If earnings management is being done with the intent of maintaining stability in stock prices, shareholder dividend policies, or debt covenant agreements, and is done within GAAP (the rules of engagement agreed to in advance) most likely it is being done in the best interest of shareholders–to whom the company executives conducting the earnings management are accountable. Deciding when intent has moved from wellness intent to deceptive intent is the nearly impossible job of the SEC. (As you know from reading my post Massages Gone Wild)

With respect to #3: A reduction in reporting frequency would just put more pressure on corporate managers to meet/beat earnings expectations, not less. That’s why the whole 10Q process was implemented in addition to the annual 10K process. The more frequently reporting is required, the less room for earnings manipulation there is, since assumptions/judgment calls should remain consistent in the short-term (no new information). Additionally repeatedly “scrubbing the numbers” takes a lot of time and tracking that becomes cost-time prohibitive in shorter time spans. So while, I too am a fan of greater transparency in financial reporting, I disagree that lengthening the gap between required reporting periods will improve the situation. It will have the opposite effect.

My response probably hasn’t converted you to an earnings management fan, yet. But I wonder, Narcisse, can you at least agree that there are times when earnings management may indeed be desirable?

Ciao for Now,

Sara McIntosh

Sara:

Thank you for taking the time to drop a note.

The only issue I have with earnings management practices is they are inherently deceptive. There is not a better way to describe them. You know as well as I do that the average shareholder can barely make sense out of an income statement and even less so out of the footnotes to the financial statements where all the bad stuff often get buried. For the purpose of creating further transparency in the financial reporting of publicly traded companies, I believe that quarterly filings should be switched to semester/semi annual filings. This, in my opinion, will help lessen the burden on corporate managers to find creative ways to beat each quarter's earnings expectations.

Hello Narcisse,

Nice post. You do a good job recapping some of the more popular earnings management tools.

And as you point out, most of them, most of the time, fall well within GAAP's guidelines. So, if the practice is disclosed as JP Morgan Chase's $1.1 billion Q1 2010 credit card reserve manuever was, and their auditors signed off on it, what's the problem?

(See my post entitled There's Something About You, Jamie Dimon)

Ciao for Now,

Sara McIntosh, author of Shell Games (available at Amazon.com)

P.S. I've included the same question back at my site. I'm enjoying the dialogue-Thanks