Earnings Management and Earnings Quality
Earnings management is defined by accounting literature as “distorting the application of generally accepted accounting principles.” Arthur Levitt, the old SEC Chairman, defined earnings management as “practices by which earnings reports reflect the desires of management rather than the underlying financial performance of the company.”
Earnings management is often defined as the planned timing of revenues, expenses, gains and losses to smooth out bumps in earnings. In most cases, earnings management is used to increase income in the current year at the expense of income in future years. For example, companies prematurely recognize sales before they are complete in order to boost earnings. Earnings management can also be used to decrease current earnings in order to increase income in the future. The classic case is the use of "cookie jar" reserves, which are established, by using unrealistic assumptions to estimate liabilities for such items as sales returns, loan losses, and warranty returns.
Managers engage in income smoothing activities because they know that volatile earnings streams typically lead to lower market valuations. Many successful management teams believe that the strategic timing of investments, sales, expenditures, and financing decisions is an important and necessary strategy for managers committed to maximizing shareholder value.
Investors are dissatisfied with the management of earnings; however, investors become enraged when quarterly or annual earnings forecast are not met by firms. Therefore, investors and the public view minor earnings management as acceptable and an everyday business practice. In response to public complaints and concern for earnings management, the SEC has issued bulletins to help prevent earnings management.
2.The Public Perception of Earnings Management
Earnings management has a negative effect on the quality of earnings if it distorts the information in a way that it less useful for predicting future cash flows. Within the Conceptual Framework, useful information is both relevant and reliable. However, earnings management reduces the reliability of income, because the income measure is biased (up or down) and/or the reported income that is not representationally faithful to that which it is supposed to report (e.g., volatile earnings are made to look more smooth).
The term quality of earnings refers to the credibility of the earnings number reported. Companies that use liberal accounting policies report higher income numbers in the short-run. In such cases, we say that the quality of earnings is low. Similarly if a nonrecurring gain increases income, but the gain is obviously not sustainable, then the quality of earnings is considered low.
For the markets to work efficiently, it is vital that investors be able to trust the earnings numbers of the companies in which they have chosen to invest their capital. Recent studies have shown that the investing public believes that the occurrence of earnings management is both widespread and pervasive in the financial statements of corporations worldwide. However, it is interesting to note that the investing public does not necessarily view minor earnings management as unethical, but in fact as a common and necessary practice in the everyday business world. It is only when the impact of earnings management is great enough to affect the investors’ portfolio that they feel fraud has been committed.
3.The Impact of Earnings Management
Public perception about the widespread occurrence of earnings management is affecting the public’s confidence in external financial reporting. The practice of earnings management damages the perceived quality of reported earnings over the entire market, resulting in the belief that reported earnings do not reflect economic reality. Investors rely on financial information provided by the company to make their investment decisions, and when investors believe they are being given meaningless information they become wary of trusting the companies they have invested in. Investors’ apprehension will eventually lead to unnecessary stock price fluctuation. As investors lose faith in reported earnings, they are forced into a guessing game concerning the actual financial position of a company. This uncertainty ultimately has the potential to undermine the efficient flow of capital thereby damaging the markets as a whole.
• Analyst Forecasts - Companies are under extreme pressure to meet analysts’ earnings estimates in order to prevent large drops in their stock price.
• Debt markets and contractual obligations - Companies depend on achieving certain earnings figures to obtain access to debt markets, or even to meet their current debt covenants and other contractual obligations.
• Competition - There is pressure in highly competitive industries to stay at the top of the industry in terms of revenue or market share. Companies may want to manage these figures to stay above competitors.
B.INTERNAL FACTORS
• Potential mergers - If the company is hoping to enter a merge, a strong financial position will make it look much more attractive to other companies.
• Management Compensation - Stock option and bonus programs that are tied to earnings performance will provide incentive for managers to manipulate earnings numbers to boost their own compensation.
• Planning and budgets - Sometimes companies will establish unrealistic plans and budgets to push managers to overachieve. This can provide pressure for management to boost earnings to meet the company’s own expectations.
• Unlawful transactions - Some companies even use earnings management to cover up their own unlawful transactions such as embezzlement, fraud, misappropriation, and bribery.
C.PERSONAL FACTORS
• Personal bonuses - Some compensation policies are heavily weighted towards incentives, and individuals hope to receive a bonus based on their good performance.
• Promotions and job retention - Fudging numbers to make performance look better may lead to personal promotions, or even help to retain an employee’s current job.
5.SEC Response to Earnings Management
Recently, several staff accounting bulletins concerning earnings management were released by the SEC and many more such regulations have been promised in the future. These bulletins and promises of more to come are partly the result of former SEC chairman Arthur Levitt’s crusade to eradicate the problem of earnings management in United States companies. Recent publicity of high profile earnings management from some of the nation’s most elite companies, combined with a sagging economy have heightened investor’s fears about the occurrence of earnings management. Throughout the last few years of the chairman’s term Mr. Levitt widely publicized his beliefs about the pervasiveness of earnings management and his intention to address these issues.
This crusade resulted in a torrent of staff accounting bulletins beginning with the issuance of SAB 99 regarding Materiality in August of 1999. This bulletin attempts to clarify an auditor’s appropriate scope of materiality while conducting an audit. Since a favorite practice of corrupt management is to justify earnings management by claiming it is immaterial, this statement is particularly helpful to current and future auditors. SAB 100 was released in November of 1999 in an attempt to eradicate the common earnings management practice of taking a “big bath” through the use of restructuring and impairment charges. Another favorite component of earnings management was addressed in March of 2000 when SAB 101A concerning Revenue Recognition was released. The most common form of earnings management is the intentional manipulation of revenue recognition, therefore this statement and its later counterpart SAB 101B are also very helpful to an auditor attempting to snuff out earnings management. Finally, July of 2001 saw the issuance of SAB 102 concerning Loan Loss Allowances, another preferred tool of earnings management.
These bulletins will not completely prevent earnings management, and therefore they will not be the last of their kind. Earnings management will remain an important problem facing the markets as long as there is pressure on companies and individual managers to perform. However, careful auditing procedures and continuing attentiveness by the SEC and other regulatory bodies will help reduce the occurrence of earnings management into the future.
6.Types of Earnings Management and Manipulation (by Scott McGregor)
a. "Cookie-jar" Reserves
The accrual of expenses is to reflect the period in which the expense was incurred. For example, if a firm hires a consultant to perform a particular activity, it should reflect the expense related to that activity in the period in which it is incurred, not when the bill is paid or invoice received. In many cases, the accrual of expenses, or reserves in particular industries such as insurance and banking, are based on estimates. As such, the estimates have varying degrees of accuracy. During times of strong earnings, the firm establishes additional expense accruals and subsequently reduces the liability to generate earnings when needed in the future - pulling a "cookie from the jar".
b. Capitalization practices-Intangible assets, software capitalization, research and development.
In 1997, companies were allowed to capitalize the costs of internally developed software and amortize it over the useful life, generally three to five years. Capitalization is to represent the development costs. The capitalization process of companies has the potential for manipulation because these assets are often intangible and based on judgment. A firm may allocate more expenses to a project that can be capitalized to reduce current operating expenses.
c. "Big bath" one-time charges
Unusual or non-recurring charges have become one-technique used by firms to escape the maze of over aggressive accounting practices. Many believe and anecdotal evidence has shown that analysts overlook non-recurring charges because they are not part of the firms ongoing operations or operating income. Typical non-recurring charges include writing down assets, discontinuance of an operating division or product line and establishing restructuring reserves.
As discussed previously, firms practicing earnings management deplete the economic earnings from future periods. As their ability to sustain earnings growth diminishes, they may seek an event that can be characterized as one-time event and "overload" the expenses attributable to that event. The one-time charge may be discounted by analysts as not being part of operating earnings while the stock price does not suffer the consequences normally associated with missing earnings targets. To provide itself with more "cookie jar" reserves or mask its past sins, the firm may take other write-offs or create other accruals not directly tied to the event and attribute those expenses to the one-time event.
A study by Elliot and Hanna (1996) reported that reports of large, one-time items increased dramatically between 1975 and 1994. In 1975, less than 5% of companies reported a large negative write-off compared to 21% in 1994. The authors also showed that companies that had previously reported similar write-offs were more likely to do so.
d. Operating activities
Managers often have the ability to modify the timing of events such that the accounting system will record those activities in the period that is most advantageous to management. The activity does not alter the long-term economic value of the transaction, just the timing and thus, comparability of financial statements. For example, a company could accelerate its sales and delivery process such that it records sales in December that normally would have been reported in January. Thus, the company reports higher fourth quarter sales, revenue and profits. In the long-term, the company would ultimately report the same sales and profits; however, it has inflated its growth in the near term, and reduced profits in the future period.
e. Merger and acquisition activities
One type of significant event that may be used to mask other charge-off is mergers and acquisitions. In most cases, there is some form of restructuring involved creating the need for a large one-time charge along with other merger-related expenses. The event provides the acquirer with the opportunity to establish accruals for restructuring the transaction, possibly attribute more expense than necessary for the transaction. The company may also identify certain expenses that are revalued on the seller's balance sheet, increasing goodwill. If the conservative valuations prove to be excessive, the company is able to reduce its operating expenses in the near term by reducing its estimate for the liability. The additional goodwill created would be amortized over a long period of time and not have a significant impact on near term results.
There are two methods of accounting for mergers and acquisitions. Pooling of interests ("pooling") accounting and purchase accounting. Pooling recognizes the transaction as a merger of equals, thus the transaction is recorded as company A plus company B. Purchase accounting treats the transaction as a purchase. The fair value of the purchased company is assessed and compared to the purchase price. Any excess or premium paid above the fair value of the assets is recognized as goodwill. Goodwill is amortized over a period of time not to exceed forty years.
1. Pooling on interests
Abraham Brilloff, professor emeritus at Baruch College, in an article in the October 23, 2000 issue of Barron's entitled "Pooling and Fooling" brought attention to the use of pooling accounting by Cisco Systems to inflate its operating earnings. Cisco has been an active acquirer paying $16 billion for twelve companies in fiscal 2000 alone, but through the use of pooling accounting, Cisco only recognized only $133 million in cost in its capital accounts for these transactions. In addition, five of the acquisitions were deemed "too immaterial" to restate prior period financial statements. Brilloff contends that Cisco's earnings for 2000 should have been reduced by $2.5 billion reducing the $2.1 billion gain into a $.4 billion loss.
If a company pays a premium to acquire another firm, the premium, or goodwill, is amortized and reduces earnings going forward. Thus, companies seek transactions that will allow them to use pooling of interests. It has been contended that additional premiums have been paid in instances where pooling of interests will be allowed.
Criticism of pooling accounting has been significant and the FASB has reacted by announcing the elimination of the method. However, the effective date has been delayed as the FASB has received strong opposition from industry.
2. Purchase accounting and goodwill
Under the purchase method of accounting for acquisitions if the price paid by the acquiring firm exceeds the fair value of the company acquired, the difference is recorded as an intangible asset, goodwill. Goodwill is amortized over future periods, thus, the creation of goodwill causes future expenses, therefore reducing reported earnings. If the acquirer conservatively values assets (such as private placement or illiquid securities and real estate) or liabilities (reserves, accrued liabilities), the company may be able to recognize additional earnings in the near future as it estimates become less conservative.
Professor Brilloff has also been a critic of the accounting practices of Conseco, a financial services company. Mr. Brilloff contended that Conseco had manipulated its earnings through its acquisition practices. In summary, he argued that Conseco had inflated the loss or claim reserves of the insurance entities it acquired and recognized a corresponding asset of goodwill at the time of acquisition. It could then reduce the reserves over the near term to inflate earnings while amortizing the goodwill over a significantly longer period of time.
f. Revenue Recognition
The timing of the recognition of revenue is the most likely area to target for management and manipulation. From an operational standpoint, firms can take aggressive actions to boost revenues and sales in one period through providing incentives to their sales force, utilize overtime to push shipments out the door. They may also take aggressive accounting actions such as selling securities classified held for sales recognize gains in income versus stockholders equity, aggressive in the timing of the recognition of sales or aggressive in the application of broad or unclear accounting guidance.
g. Immaterial misapplication of accounting principles
Materiality is a concept that has been under fire from the SEC due to its misuse. As previously discussed. Errors, misstatements and misapplication of accounting principles have been overlooked if they fell below the materiality threshold. A company may knowingly misstate earnings by amounts that fall below the materiality threshold by not correcting known errors or other misstatements. If the practice continues for a number of periods, the balance sheet (retained earnings) may become significantly misstated.
h. Reserve one-time charges
The use of one-time charges, established in the form of a reserve, can be used to manage earnings. The company conservatively recognizes a one-time charge in the form of a contingency reserve for a possible future loss or future expense. They anticipate that analysts will discount the charge since it is not deemed to be part of operating income. Over time, the company changes its estimate (reduces) to recognize additional earnings.
7.Examples of cases of earnings manipulation
a. Cendant
Cendant (AAER 1272,06/14/00) Cendant was created in a 1997 "merger of equals" between CUC International and HFS. In April 1998, legacy HFS officials learned that prior to the merger, CUC executives had engaged in accounting irregularities that inappropriately recorded over $500 million in phony profits. The accounting irregularities at CUC were widespread, used at least four earnings manipulation techniques and involved more than 20 employees.
SEC documents assert that the accounting manipulations at CUC were driven by senior management's determination to meet Wall Street analyst's expectations and "fueled by disregard for any obligation that the earnings reported needed to be `real'." According to the SEC documents, CUC management maintained an annual schedule setting forth "opportunities" that were available to inflate operating income, creating a "cheat sheet" listing the opportunities that would be used in the coming year and the amounts that would be needed from each opportunity.
At the end of each fiscal quarter, financial reporting personnel at CUC headquarters prepared preliminary consolidated quarterly financial results. CUC management then directed topside adjustments consisting of simply adding or deducting specific lump-sum amounts to or from reported revenues and expenses until reported results met or exceeded published earnings expectations. Once income was adjusted, CUC senior management would make additional alterations among specific line items to ensure that reported expense categories were set at approximately the same percentage of revenues as in previous quarters. According to the SEC, the changes directed by management were "a deliberate, top-down process of `reverse engineering,' virtually divorced from whatever fiscal and business realities actually had transpired in that quarter at CUC" and, therefore, "the quarterly reports that CUC filed with the Commission and released to investors were equally divorced from those realities.! "
Since the CUC income was added in quarterly top-side adjustments during the consolidation process and did not appear in division's books, CUC management used unsupported post-closing journal entries carrying effective dates spread retroactively throughout the year to conceal their earnings manipulations schemes from outside auditors. To make the adjustments less noticeable, the unsupported entries were disaggregated into smaller components and intentionally created in odd amounts.
In the earlier years of the manipulation schemes, management relied primarily on manipulating the recognition of membership sales revenue and associated liabilities arising from allowances for rejects, cancellations and obligations to pay commissions. Senior management would review projected membership sales figures, calculate additional amounts needed to inflate income to desired levels and generate operating results at predetermined amounts. CUC also manipulated income by posting fictitious entries to keep membership sales rejects offbooks, intentionally understating membership cancellation reserves, and, occasionally, simply reversing the cancellation reserve or the commissions payable liability directly into revenue or operating expense accounts. For example, in fiscal 1997, CUC managers directed post-closing entries moving $9.12 million from commissions payable directly to revenue. CUC management used schedules and other devices to support understating commissions payable.
SEC documents indicate that by the mid-1990s, opportunities related to CUC's membership sales could no longer sustain the manipulation schemes. Accordingly, in the mid-1990s management decided to keep revenue-related opportunities at constant percentage levels and use opportunities related to acquisition and purchase reserves to keep income in line with ever-increasing goals.
In 1996, CUC established merger reserves in connection with several new acquisitions. According to SEC documents, CUC's accounting for liabilities related to its business combinations went far beyond what GAAP permitted. CUC managers arbitrarily determined the amounts that CUC would reserve for liabilities, at times simply doubling the amounts calculated as CUC's true costs. In addition, the SEC stated that "acquisitions were viewed in large part as opportunities to ensure the viability of future 'earnings' at CUC," and that liabilities in the form of reserves "were established to stockpile future income." The acquisition reserves were "subsequently reversed to bring those future earnings to fruition."
At fiscal year end, CUC managers utilized the "cushion" reserves by reversing the reserves directly into revenue or operating expense accounts. According to SEC documents, CUC managers directed subordinates to reverse specific aggregate amounts to revenue or expense accounts, "leaving it to the subordinates to decide arbitrarily which accounts should benefit and in what amounts." CUC managers also transferred part of the acquisition reserves to income accounts on division's books. For these types of transactions, CUC management typically selected smaller divisions that they knew would not be fully audited.
When operating shortfalls at a new CUC division depleted its reserves, CUC was desperate for a major business combination and began discussions with HFS. In May 1997, the merger discussions resulted in the Cendant agreement and the possibility of reserves large enough to continue the earnings manipulation schemes.
In addition to using the Cendant merger reserves to continue its revenue manipulation schemes, CUC management also directed that millions of dollars of CUC assets, both impaired and unimpaired, be written off against the Cendant reserve. The write off of impaired assets was necessary to cover CUC's failure to write off the assets in the fiscal years preceding the December 1997 merger with HFS. The write off of unimpaired assets allowed CUC/ Cendant to avoid massive asset-related charges to income from continuing operations.
In April 1998, Cendant became aware of some of the accounting irregularities at CUC, restated earnings, and agreed to change its revenue accounting practices. In June 2000, the SEC brought civil and administrative fraud charges against seven former officials of CUC, including the chief financial officer, the controller, the vice president of accounting and financial reporting and the director of financial reporting. The charges against these individuals included violations of the antifraud, periodic reporting, corporate record-keeping, internal controls and lying to auditors provisions of the federal securities laws. The SEC also brought charges against Cendant for violating the periodic reporting, corporate record-keeping and internal controls provisions of the federal securities laws. In December, Ernst &Young, CUC's auditors, agreed to pay Cendant shareholders $335 million.
The current investigation of Enron's accounting practices by the SEC and several Congressional Committees may lead to the same types of sanctions against individuals as those imposed on Cendant executives. Recent reports suggest that several high-level executives at Enron engaged in deliberate attempts to conceal the magnitude of Enron's debt from investors and creditors, using offbalance sheet partnerships to conceal debt obligations (Emshwiller et al, 2001). According to published reports, Enron violated GAAP by setting up partnerships which it controlled and recording the transfer of Enron stock to the partnerships in exchange for notes receivable (Emshwiller and Smith, 2002). Published reports also indicate that Enron used the partnerships it controlled to exchange impaired assets for notes receivable. This practice allowed Enron to increase earnings by the excess of the notes receivable over the book value of the assets exchanged and, at the same time, remove impaire! d assets from its balance sheet (Emshwiller and Smith, 2002). Although the accounting practices in published reports have not been confirmed by SEC investigation, Enron's past accounting practices led them to restate earnings by $586 million (Emshwiller et al, 2001).
b. Manhattan Bagel
From its initial public offering in 1994 to June 1996, the stock price of Manhattan Bagel rose from $5 per share to $29. The company grew to be the third largest bagel franchise in the United States with ambitious plans for substantial expansion. Sales and earnings were growing. The company began to expand through acquisition. In January 1996, the company acquired a West Coast bagel operation, however, the firm failed to perform the necessary due diligence and acquired millions of dollars of overstated revenues.
In June 1996, the firm announced accounting problems in its recently acquired West Coast operations, and its stock price was cut in half within days. The free-fall in its stock price continued and with the negative publicity and shareholder lawsuits that followed, the company was unable to sell franchises at anywhere near their previous pace. Eventually, the company was forced to seek bankruptcy protection.
c. Sunbeam
Sunbeam, a maker of small consumer appliances such as Mr.Coffee, has drawn much attention in recent years for its disappointing financial results and cutthroat tactics of its former CEO, "Chainsaw Al" Dunlap. The nickname was given to Mr. Dunlap for the manner in which he cut the size of the employee base.
In mid-November 2000, the SEC concluded its investigation into accounting practices at Sunbeam. The SEC charged that Sunbeam recognized revenues prematurely from sales promotions with retailers in 1997. This activity was prior to the dismissal of Sunbeam's infamous CEO, who was terminated in 1998. Although not discussed in the SEC ruling, it would not be surprising if the stress of the environment contributed to the aggressive revenue recognition.
d. Tyco
Recently, Tyco was forced to restate fiscal 1999 and the first quarter of 2000 due to certain merger, restructuring and other non-recurring charges, increasing 1999 earnings and decreasing earnings for the first quarter of 2000. Tyco is still under investigation for its usage of pooling of interest accounting in its merger and acquisition activities. Based on the SEC ruling, it appears that Tyco set aside "cookie jar reserves" in 1999 and began to reduce the liabilities in 2000, thus, increasing earnings.
e. Sensormatic
Between 1994 and 1995, Sensormatic recognized out-of-period revenue, overstating earnings to meet analysts' expectations. The Chairman and CFO had to pay penalties of $50,000 and $40,000, respectively. Most likely, there were quite a few individual investors who incurred greater financial losses as a result of their actions.
f. 3Com
3Com agreed in November 2000 to pay $259 million to settle shareholder lawsuits involving accounting irregularities following its 1997 acquisition of U.S. Robotics Corp. 3Com had allegedly concealed losses at U.S. Robotics when they combined the companies. Under pressure from the SEC, 3Com was forced to reduce it stated net income for 1997 by $111 million and reduce a purchase-related charge for 1998 by $158 million.
g. W.R. Grace
WR Grace & Co. was charged by the SEC with manipulation of its earnings through the use of "cookie jar" reserves used to smooth reported earnings in its National Medical Care Inc. unit.
The above cases are just a sample of some of the recent cases. These cases display some of the circumstances and ways in which earnings can be manipulated, including cases of blatant fraud, aggressive revenue recognition, cookie jar reserves and inadequate due diligence in mergers and acquisition practices.
h. MicroStrategy (AAER 1350,12/14/ 00), MAX (AAER 1430,08/01/01), and Indus (AAER 1437,09/01/01)
MicroStrategy began business in 1989, and went public in June 1998. In April 2000, when MicroStrategy disclosed that it had overstated its revenue and earnings over a three-year period, its stock price dropped from a high of $333 per share to $33 per share. In December 2000, the SEC announced that it was bringing charges against MicroStrategy, its founder, and several members of management. The SEC alleged that MicroStrategy had materially overstated its revenues and earnings, showing a growing company with positive net income when it should have reported net losses.
MicroStrategy's reporting failures were primarily the result of premature recognition of revenue. The SEC documented that MicroStrategy's written company policy required that management counter-sign all contracts received from customers before revenue could be recognized. However, management did not sign contracts received near the end of quarters until after it determined how much revenue was required to achieve desired quarterly results. At that time, it would assign &quo