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Earnings Management: The Dark Side of Financial Reporting

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.

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  • 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 as mandated by US GAAP, thus recording a huge expense during the year of acquisition so that future years earnings won’t be significantly impacted by the acquisition costs. 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).

Further 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, American Institute of Certified Public Accountants (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

 

9 Comments

  1. Comment by Bruce La Rochelle:

    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

  2. Comment by Sara McIntosh:

    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

  3. Comment by Sara McIntosh:

    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

    • Comment by Narcisse:

      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.

  4. Comment by Sara McIntosh:

    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

    • Comment by Narcisse:

      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!)

  5. Comment by Sara McIntosh:

    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 🙂

    • Comment by Narcisse:

      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.

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