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11. Investments are sold to recognize a gain in order to offset a special charge aris- ing from an asset write-down
Another real action with an average ranking of 1.27. The motivation here may well be to reduce the volatility of earnings, one of the more common helpful features of earnings management, according to survey respondents, discussed in subsequent sections. Several respondents qualified their within-GAAP classification with the assumption that both the charge and gain were disclosed, that is, not netted.
12. Goods are shipped to a customer who has not yet placed an order but probably will during the next quarter.
This action is unambiguously a violation of GAAP. The average ranking of 3.67 indi- cates that the respondent groups also viewed this as potentially fraudulent financial reporting.
13. Sales are recognized on goods shipped to reseller customers who are not credit- worthy.
Somewhat surprisingly, this action appears to be seen as less objectionable than book- ing sales in the absence of an order. In order to recognize revenue, GAAP requires that the sale amount be collectible. The average ranking is 2.58 for this action versus 3.67 for action 12. However, about 20 respondents indicated that their response assumed the recording of an appropriate allowance for bad debts. In most cases a classification of 1 or 2 was recorded but would have been a 3 or 4 in the absence of an allowance. This action clearly raises questions about the wisdom of this business decision. Moreover, it is questionable that an appropriate allowance for bad debts could be determined in the case of customers who are not creditworthy. The addition of a statement that an allowance was not recorded would have moved the average ranking closer to the fraud- ulent reporting classification.
14. Revenue is recognized on disputed claims against customers prior to a definitive settlement.
Disputed customer claims are most common in the case of contractors and contract reporting. Here the relevant GAAP permits the recognition of revenue on disputed claims if the likelihood of receiving the amounts is probable and estimable.10The aver- age ranking of 2.87 places this action close to being beyond the flexibility afforded by
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GAAP. However, recognition is consistent with GAAP assuming that the judgments about the likelihood of collection and associated amounts are reliable.
15. Sales are recognized upon the shipment of goods to a company’s field represen- tatives.
A sale to a field representative does not normally represent the shifting of the risk of ownership. The average ranking of 3.52 indicates that respondents saw this action as well beyond the flexibility inherent in GAAP. A total of 136 respondents classified this action as fraudulent financial reporting.
16. Total order revenue is recognized even though only partial shipments were made.
Where applicable, shipment is normally the gold standard for revenue recognition.
With an average ranking of 3.57, respondents saw this action as beyond the flexibility provided by GAAP.
17. Revenue is recognized upon the consignment of goods but prior to their subse- quent sale by the consignee.
This is clearly at odds with GAAP; a consignment is not a sale, and revenue should not be recognized until the goods are sold by the consignee. The average rank of 3.61 indicates that this deviation from GAAP is, on average, understood by the respondents.
18. The value of an ending inventory was understated in order to decrease property taxes.
This action was in fact a basis for a SEC enforcement action. In addition to the inven- tory understatement, profits and tax obligations also were understated by this action. The financial statements were misleading and the act was deliberate. The average ranking of 3.82 was the most severe ranking for all of the 20 earnings-management actions.
19. Sales revenue was recognized when there were significant uncertainties about customer acceptance of the product and of the customer’s ability to pay.
With an average ranking of 3.12, respondents felt that this action went beyond GAAP, but they were not generally prepared to consider it to be fraudulent financial reporting.
There may well have been concerns about the levels of uncertainty concerning customer acceptance and the ability to pay.
20. Sales revenue was recognized when an absolute right of return was provided by means of a “side” letter, which is outside of standard firm policies.
The average ranking of 3.20 indicates that respondents considered this action to be beyond the flexibility inherent in GAAP. Several respondents classified this action as within GAAP based on the assumption that an adequate reserve for returns could be established.
Implications of Respondent Classifications
The key classifications that should be correctly classified most frequently are those that involve actions that go beyond the flexibility inherent in GAAP and especially those actions that could potentially represent fraudulent financial reporting. Significant harm can be done to all stakeholders if firms are determined to have engaged in fraudulent financial reporting. On average, the actions that could be considered potentially fraudu- lent were classified as such. That is, actions 2, 9, 12, and 15 through 18 had average clas- sification ranks of about 3.5 or higher. On balance, financial professionals recognize
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potentially fraudulent actions if they are presented to them. Whether such actions actu- ally would be detected on a timely basis is a separate matter.
However, within each of the groups there are some respondents who did not classify potentially fraudulent actions as such. If the classification of a potentially fraudulent action, a 4, were instead classified as either within or at the edge of GAAP flexibility—
that is, a 1 or a 2—then there were a total of 127 misclassifications. This represents an overall rate of misclassification of 9% (127 misclassifications divided by a total of 1337 classifications for the 7 potentially fraudulent actions).
Making the classifications clearly involves the exercise of judgment, and some respondents felt that the character of some of the actions was not totally clear and that more information was needed. However, on an overall basis, the results do appear to be reasonable for each of the actions presented for classification. Further judgments about the significance of differences across groups of respondents are limited by the size of the samples for some of the groups.
Views on Earnings Management Motivations and Objectives
Survey respondents also were asked to express varying degrees of agreement or dis- agreement with a number of statements about earnings management in this section. The possible responses are:
1. Definitely yes 2. Yes
3. No
4. Definitely no 5. No opinion
Analysis of Numerical Responses
The results of this section, displayed in Exhibit 5.5, are reported in terms of the average of choices 1 to 4. A score of 1.5 indicates more agreement with the statement than one of 3.5. As in the analysis of results in the previous section, averages for each respondent group, as well as weighted averages for the combined groups, are reported.
The responses to the first two items are quite consistent across the five groups of financial professionals surveyed.11While the averages range from 1.31 to 2.00, they indicate strong support for (1) earnings management being common and (2) the SEC’s campaign against earnings management being necessary. These results should provide a degree of support for those who believe that abusive earnings management is an impor- tant issue, especially for the SEC. The SEC’s concern with earnings management appears to be shared by a range of different financial professionals.
The responses to items 3 through 6 also indicate agreement with what often are claimed to be the underlying motivations for earnings management: (3) reducing earn- ings volatility, (4) supporting or increasing stock prices, (5) increasing earnings-based compensation, and (6) meeting consensus earnings forecasts.
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TE AM FL Y
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Exhibit 5.5 Earnings Management: Motivations and Objectives Weighted
Average ACPA FA Lender CPA MBA 1. Earnings management
is common 1.46 1.55 1.33 1.31 1.70 1.50
2. The SEC’s campaign against abusive earnings
management is necessary 1.88 1.89 2.00 1.92 1.80 1.94
3. Common goal of earnings management is to reduce
earnings volatility 1.72 1.68 1.65 1.92 1.50 1.97
4. Common goal of earnings management is to support
or increase stock prices 1.67 1.72 1.55 1.69 2.00 1.72 5. Common goal of earnings
management is to increase
earnings-based compensation 1.89 2.00 1.84 1.85 1.67 1.97 6. Common goal of earnings
management is to meet
consensus earnings forecasts 1.62 1.68 1.55 1.62 1.40 1.78 7. Investors are sometimes
harmed by earnings-
management practices 1.63 1.68 1.67 1.77 1.40 1.69
8. Earnings management
can be helpful to investors 2.28 2.37 2.32 2.00 2.57 2.33 9. Earnings management
has become more common
over the past decade 1.80 2.00 1.53 1.77 1.70 1.85
10. Reg. FD will increase earnings management to meet consensus earnings
forecasts 2.63 2.95 2.53 2.42 2.44 2.55
Source: Financial Numbers Game Survey ACPA = academics, most of whom are also CPAs
CFO = chief financial officer or comparable senior financial position, e.g., controller, etc.
FA = Financial analyst, CFAs in most cases Lender = Commercial bank lender
CPA = CPA in public practice
MBA = Advanced MBA students, most with some work experience, and enrolled in advanced elective courses in accounting and finance
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On items 7 and 8, respondents were in stronger agreement with the statement that earnings management could hurt investors (weighted average of 1.63) as opposed to help (weighted average of 2.28) investors.
The respondents agreed (item 9) that earnings management has become more com- mon over the past decade. Finally, the results on item 10, whether the SEC regulation on full disclosure would increase earnings management to meet consensus earnings fore- casts, do not appear to support this prospect. Here the expectation has been that some- what less guidance might be provided, as a result of Reg. FD, to analysts by management. This would in turn require more earnings management to meet analysts’
expectations.
Other Respondent Commentary
In addition to the numerical choices made by survey respondents, space also was pro- vided on the questionnaire to add written comments. A selection of these comments is provided in Exhibit 5.6. Additional and more expansive commentary on some of these items is provided in the following section.
Views on Earnings Management
This section of the survey asked for written responses on (1) earnings-management tech- niques that respondents had observed, (2) how they believed that earnings management could be detected, and also whether earnings management had the potential to (3) harm or (4) help investors and others.
Earnings Management Techniques Observed in Practice
The survey respondents provided a total of 227 examples of earnings-management tech- niques that they had observed. Interestingly, some CFO respondents felt the need to emphasize that they had not observed these earnings-management techniques in their companies. After reviewing all of the responses, the techniques were grouped into six categories, with a seventh category used for other diverse items. The categories and the number of techniques reported are presented in Exhibit 5.7.
The results in the exhibit reveal that the timing of expense recognition was the most commonly observed earnings-management technique. The combination of the expense- recognition classifications of (a) timing of operating expenses and (b) big-bath charges and cookie jar reserves represent 110, or 48.5%, of the total of 227 earnings-management techniques reported by the survey respondents. Making a distinction between these two categories sometimes involved close calls. The key was distinguishing between large nonrecurring charges, which were used to create reserves that later could be reversed into earnings, and the more routine fine-tuning of expense recognition.
Earnings management that is based on the timing of revenue recognition is the next most frequent earnings-management technique. This representation by revenue recogni- tion is comparable to that in a recently reported 10-year study of fraudulent financial reporting. While the categories in the fraudulent reporting study were somewhat differ-
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Exhibit 5.6 Comments by Survey Respondents to Earnings Management Statements
Earnings management is common
• Smart analysts and investors have a fair idea that this happens.—ACPA
• Yes, where motivation exists, which is commonplace. Not as much as in the past, but economic turn down represents serious motivation.—ACPA
• Yes, GAAP affords the flexibility to do so.—CFO
The SEC’s campaign against abusive earnings management is necessary
• Yes, but they have gone overboard to a point where leading practitioners are afraid to exercise professional judgment.—ACPA
• Yes, but at best they will mitigate the practice slightly.—ACPA
• Yes, if the CPAs will not, somebody should.—ACPA
• Yes, but I would support a less blunt instrument than the approach I perceive is being used by the SEC.—ACPA
• No. An ambivalent answer since much earnings management is transparent.—ACPA
• Yes, using the flexibility afforded by GAAP is prudent business. Going beyond (abu- sive) is not.—CFO
• Yes, industry needs to police itself and evolve appropriate consequences for improper behavior by management.–FA
• No, it is important that companies play by the same rules and it is inconceivable to believe that earnings shouldn’t fluctuate in ranges year to year. Straight-line trends should be uncommon.—CPA
Common goal of earnings is to reduce earnings volatility
• To the extent that meeting or exceeding expectations reduces volatility.—ACPA Common goal of earnings management is to support or increase stock prices
• Yes, it does not mean that it is necessarily successful.—ACPA
• Yes, decreased EPS variance is often associated with higher valuations.—FA
Common goal of earnings management is to increase earnings-based compensation
• Yes, but this may be an overemphasized goal.—ACPA
• Yes, the impression is that options are the primary compensation nowadays. Hence, the effect of earnings on compensation may be indirectly through stock price.—ACPA
• Yes, management is not the owner. They are economically motivated hired hands who have significant control over their own compensation. The behavior is predictable.—FA Common goal of earnings management is to meet consensus earnings forecasts
• Yes, this is an unfortunate pressure on companies that did not exist to some extent before.—ACPA
• Yes, but only when companies go outside the flexibility afforded by GAAP.—CFO
• Yes, but most companies manage consensus estimates by calling analysts whose esti- mates appear out of line.—FA
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Exhibit 5.6 (Continued)
Investors are sometimes harmed by earnings-management practices
• Yes, management decisions that are focused on short-term needs will invariably com- promise the long-term performance.—FA
• Yes, probably hurts potential investors or those who are currently investing based on inflatedearnings.—CPA
Earnings management can be helpful to investors
• Yes, to the degree that it permits better firm valuation estimates by providing informa- tion on permanent and transitory components of income.—ACPA
• No, mild earnings management aimed at reducing earnings volatility could be useful, but otherwise no.—ACPA
• Yes, sustained earnings growth consistent with earnings expectations is better for investors than volatile swings quarter to quarter.—CFO
• Yes, but only in the short term.—CPA
Earnings management has become more common over the past decade
• Yes, more pressure on management to meet earnings to have improving stock perfor- mance.—ACPA
• Yes, more emphasis on meeting analyst forecasts.—ACPA
• Yes, due to requirements to meet quarterly earnings estimates and the incredible volatil- ity of the markets.—CPA
The SEC’s regulation on fair disclosure will increase earnings management to meet consensus earnings forecasts
• Yes, prior to Reg. FD, management would steer analysts toward their numbers. Now analysts will create their own number and management will need to steer their number toward whatever analysts created.—FA
Source: Financial Numbers Game Survey ACPA = Academics, most of whom are also CPAs
CFO = Chief financial officer or comparable senior financial position, e.g., controller FA = Financial analyst, CFAs in most cases
Lender = Commercial bank lender CPA = CPA in public practice
MBA = Advanced MBA students, most with some work experience, and enrolled in advanced elective courses in accounting and finance
ent from those used in Exhibit 5.7, that study showed expense recognition to be some- what more common than revenue recognition.12Of course, the survey reported in this chapter is not confined to earnings management that could be considered to be fraudu- lent financial reporting.
The substantial representation of “real” actions used to manage earnings was some- what surprising. That is, management decisions involving the actual conduct of business often are used to manage earnings. For example, an asset might be sold to produce a gain to offset an operating loss. Real actions are distinguished from most other earnings-man- agement techniques that simply involve the timing of the recognition of revenues or expenses.
The area of inventory accounting was next to last in terms of specifically identified earnings-management techniques. Last-in, first-out (LIFO) dipping and inventory mis- statements were some of the techniques more frequently identified by survey respon- dents.13The rather low representation of inventory accounting in earnings management may simply reflect the growth in the economy of firms for whom inventories are not a significant factor.
Changes in accounting policies and practices, although often mentioned as likely earnings-management techniques, represented only 3.5% of total earnings-management techniques that were reported. Their visibility or transparency may make them less effec- tive as earnings-management techniques, assuming that they are fully and fairly dis- closed—something that may not always be the case. A representative sampling of the items included in the survey categories from Exhibit 5.7 is provided in Exhibit 5.8.
Detection of Earnings Management
We asked the survey respondents also to indicate how earnings-management practices could be detected. The survey respondents provided a total of 190 possible detection
Exhibit 5.7 Reported Earnings Management Techniques Observed in Practice
Category Number Percentage
Timing of operating expenses 71 31.3
Big bath charges and cookie jar reserves 39 17.2
Revenue recognition 42 18.5
Real actions 31 13.6
Inventory accounting 19 8.4
Changes in accounting policies and practices 8 3.5
Other techniques 17 7.5
—– —–––
Totals 227 100.0
Source:Financial Numbers Game Survey
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Exhibit 5.8 Earnings Management Techniques from the Survey Timing of Operating Expenses
• Underestimation of allowances—ACPA
• Accrual of losses and expenses to meet EPS forecasts—ACPA
• Under provisioning for bad debts, returns, etc.—ACPA
• Warranty reserve adjustments—CFO
• Manipulation of reserves and accruals—CFO
• Aggressive capitalization of costs—CFO
• Justifying the absence of write-downs until the “time is right”—CFO
• Optimistic depreciation and amortization terms—FA
• Accelerating expenses in a good year and revenue in a bad year—CPA
• Managing discretionary accruals, such as workers’ compensation and general liability, for the self-insured—CPA
• Overaccruals in high earnings periods so as not to set expectations too high—Lender
• Reserves boosted to even the flow of earnings in future periods—Lender Big Bath Charges and Cookie Jar Reserves
• Cookie jar reserves are far and away the most common practice I observed in public accounting—ACPA
• Overreserving for current contingencies to build reversible earnings to hedge future periods—ACPA
• Conservative valuation reserves—warranty, inventory obsolescence, etc.—with subsequent reversal to operations—CFO
• Overaccrual of restructuring reserves and subsequent crediting to smooth earnings—CFO
• Outside the bounds of GAAP, establishment of general reserves covering no particular exposure—CFO
• The practice of “saving a little for the future” has been common—usually by having excessive reserves—CFO
• Special charges offsetting gains—FA
• Large write-offs—FA
• Overuse of restructuring charges—CPA
• Excess bad debt reserves in good years—CPA
• Overuse of special charges that are taken back into income at a later date—Lender
• Overaccruals are done all the time—Lender Revenue Recognition
• Premature booking of revenue—ACPA
• Keeping year end “open” through the first few days of the following year—ACPA
• Bill-and-hold sales—ACPA
• Recording out-of-period revenue—CFO
• Recognition of income on service contracts prior to services being performed—CFO
• Recognition of sales prior to actual shipment to third party; i.e., loads still on dock for export sales—CFO
• Front-ending sales or revenue that should be spread out over a much longer period—FA (continues)