The Student CPA

As I explained in my previous post, accrual accounting is not an exact science. Indeed,  a variety of assumptions and accounting estimates is used in arriving at the final earnings figures. In assessing the health of a company, lenders and investors alike almost always look at the quality of its earnings first. However, it is nearly impossible for a company to consistently report stellar periodical earnings over a long period of time. This is because a company's business activities can be affected by changes in economic cycles, seasonal changes, new legislation, and other extraordinary events. In order to "normalize" the continuous succession of ebbs and flows in financial results characteristic of any  typical business, company managers, more often than not, resort to a practice known as earnings management. According to Healy and Wahlen (A review of the earnings management literature and its implications for standard setting', Accounting Horizons, December 1999, pp. 365–383.), "earnings management" occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of a company or influence contractual outcomes that depend on reported accounting numbers. In other words, earnings numbers are deliberately manipulated by management for the purpose of meeting company's objectives whatever they might be.  There are about three types of companies that are likely to adopt an earnings management policy: companies where executive compensation is tied to earnings, publicly traded companies because they are under constant pressure to meet or beat analysts earnings forecasts, and companies getting ready for major debt financing or for an IPO (Initial Public Offering). Contrary to what you may think, most earnings management techniques are often within the boundaries of Generally Accepted Accounting Principles (GAAP). Indeed, all it takes is a well trained accountant that understands how changes in accounting judgments and estimates can be used to upwardly or downwardly affect earnings. In his remarks entitled "The Numbers Game" made on September 28, 1998 at the New York University Center for Law and Business, then-SEC (Securities and Exchange Commission) Chairman Arthur Levitt described five techniques of "accounting hocus-pocus" that summarized the most glaring abuses of the flexibility inherent to accrual accounting: big bath charges, creative acquisition accounting, cookie jar reserves, materiality, and revenue recognition.

• Big Bath Charges: this is when a company resorts to taking a one time huge restructuring charge/write down as opposed to appropriately recording the losses over several fiscal years. This is to avoid a succession of years of earnings decline that would have otherwise made the company financial health look bad in the eyes of stakeholders. To make it more difficult for companies to abuse of "big bath charges", in 1998, the FASB adopted SFAS No. 144 on impairment losses and SFAS No. 146 on the timing of the recognition of restructuring obligations.
• Creative Acquisition Accounting: This is when following a business acquisition, the acquirer  allocate the bulk of the total purchase price to the acquiree's in-process Research & Development as opposed to its long lived assets, thus recording a huge expense during the year of acquisition as mandated by US GAAP. Since 1998 however, SFAS Nos. 141 and 142 have been adopted to provide clearer guidelines on how the purchase price in a business acquisition should be allocated.
• Cookie Jar Reserves: This can take place in two ways. In the first scenario, a company with record revenues  overstates its bad debt expense in quarter/year A so as to record little bad debt expense in subsequent quarters/years when it expects to achieve below average revenues. In the second scenario, a company understates revenues by inflating unearned revenues in quarter/year A so as to pad revenue figures in subsequent quarters/years should they fall below market expectations.  Since 1998, the SEC has released Staff Accounting Bulletin (SAB) 101 outlining with more clarity when deferring revenue is a permissible practice.
• Materiality: the concept of materiality is a gray area of accounting and consequently is subject to different interpretations. Chairman Levitt invited auditors to use more professional skepticism in the way they look at materiality when conducting financial statements audits. Sometimes, publicly  traded companies resort to questionable accounting practices with immaterial effects but that allow the company  to meet or beat analysts earnings expectations. In this type of situation, Chairman Levitt recommends that the misstatement be considered as material because it is very likely that the company's stock price would have declined if the misstatement had been corrected. In 1999, the SEC released SAB 99 providing a better understanding of the definition of materiality.
• Revenue Recognition: Some companies accelerate the recording of revenues to give a nice face lift to their operating results because they are in desperate need of financing. This situation is very peculiar to companies in their early stages of growth. This is the reason why SAB 101 was released as explained in the "Cookie Jar Reserves" section.

I have no doubt that there is a host of companies out there always looking for additional loopholes in the established financial reporting standards so as to keep managing their earnings. As demonstrated by former SEC Chairman Arthur Levitt, earnings management techniques may follow the letter of the rules of standard accounting practices, however they certainly deviate from the spirit of those rules. I personally think that it is rather unethical for a company's management to condone the use of legitimate accounting techniques that have for sole design to misrepresent the quality of earnings to existing and potential users of financial statements. With the proposed adoption of IFRS (International Financial Reporting Standards) by the SEC, I wonder if the practice of managing earnings won't become more pervasive since IFRS seems to be more of a principles-based system (involving more judgment) whereas US GAAP is more of a rules-based system (involving less judgment).

Suggested reading:

1. Earnings Management and the Abuse of Materiality, Journal of Accountancy
2. Quality of Earnings and Earnings Management: A Primer for Audit Committee Members, AICPA
3. Detecting Earnings Management, Dr. Gary Giroux, Mays School of Business at Texas A&M University
4. Earnings Management: Short Term Gains, Longer Terms Costs, Dr. Nicole Jenkins, Owen Graduate School of Management at Vanderbilt University