Earnings Management Chapter 7

• Financial statements include both “reissuance restatements” and “revision restatements” • Causes and effects of restatements include • Complexity of accounting standards and/or transactions • Weak financial governance and controls • Increased auditor and audit committee conservatism • Broad application of materiality • Earnings management • Lack of transparency • Fraud • What ways can financial statements be manipulated? • How is quality in financial reporting sacrificed? • How can accountants and auditors could do a better job looking for the red flags that signal fraud? • How can we assess whether auditors are meeting their ethical obligations and protecting the public interest with regard to identifying “financial shenanigans” and assessing earnings management?

• Companies manage earnings when they ask, “How can we best report desired results?” rather than “how can we best report economic reality?” • Pressure to “make the numbers” • Emerged during 1990s and early 2000s • Stock market awards firms that meet or beat analysts’ forecasts and punish firms that miss earnings targets • Management may also use earnings management to maximize bonuses and the value of stock options • Another objective can be avoiding consequences of violation of debt covenants • Board of Directors should focus on long term strategic goals and shield managers from short-term pressure

• Some earnings management techniques are acceptable under GAAP, others aren’t • If engaged in illegal accounting manipulations, substantial legal penalties (include substantial monetary penalties and violations of securities laws) can be assessed • Waste Management investigated by SEC for unreasonable quarterly earnings projections • Research finds mixed results on whether a long-term or short-term financial forecast help curb earnings management

• Green Mountain used conference calls that provided earnings guidance to shareholders and analysts to mask a financial fraud • Manufacturer of the Keurig brewing system and K-Cup portion packs • Represented to investors that it was straining to meet consumer demand without accumulating excess inventory • Deceived PwC auditors on inventory levels by hiding bags and bags of coffee loaded on trucks, and blocking parts of the plant from auditor access • Hedge fund manager, David Einhorn, and Sam Antar, former CFO of Crazy Eddie, used analytical procedures to spot and warn of the red flags on inventory • Should auditors monitor conference calls with investors, analysts, and the financial press to determine whether something is said that could be false, fraudulent, or deceptive?

Copyright ©2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Using Social Media to Report Earnings Guidance and Financial Results

• The SEC said in April 2013, that postings on sites such as Facebook and Twitter are just as good as news releases and company Web sites as long as the companies have told investors which outlets they intend to use • The SEC guidelines on these matters are under the fair disclosure rule (Regulation FD) that requires companies to disseminate information in a way that wouldn’t be expected to give an advantage to one group of investors over another • Filing an 8-K form or holding an earnings call are both ways to ensure compliance with the regulation

• Constant pressure to report favorable earnings performance motivates many companies to report income numbers that exclude unusual events that almost always seem to be costly and depress earnings • These non-GAAP numbers put a positive spin on what otherwise might not be such good results under GAAP • Regulation G requires public companies that disclose or release non-GAAP financial measures to include a presentation of the most directly comparable GAAP financial measure and a reconciliation of the non-GAAP measure to the comparable GAAP measure • Auditors should be tasked with at least reviewing non- GAAP measures as part of their annual audit requirements • Rackspace Hosting example: used adjusted EBITDA as a performance measure

• Motivation to smooth net income over time • Steady increase each year over a period of time is ideal • Investors are willing to pay premium for stocks with steady and predictable earnings streams • These practices lead to erosion in quality of earnings • Accelerate recognition of revenue • Delay recognition of expenses • “Cookie jar reserves” • Set aside reserves in good years • Used to prop up earnings in bad years • HealthSouth case • Banks more aggressive using loan-loss reserves • Companies also smooth tax liability over years

• Gaa and Dunmore denote two basic possible earnings managements • Alter the numbers in the financial records by using discretionary accruals and other adjustments • Create or structure transactions to alter reported numbers • Another perspective is to divide the techniques into two categories • Operating earnings management – altering operating decisions to affect cash flows and net income for a period • Accounting earnings management – using the flexibility in accounting standards to alter earnings numbers • The end result of earnings management is to distort the application of GAAP, bringing into question the quality of earnings • Earnings manipulation is a form of earnings management and can be legitimate, marginally ethical, unethical, or illegal

• Schipper defines it in a negative light- “purposeful intervention in the external reporting process, with the intent of obtaining some private gain” • Healy and Wahlen define it as “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 the company, or to influence contractual outcomes that depend on reported accounting numbers” • Dechow and Skinner believe that a distinction should be made between making choices in determining earnings that may comprise aggressive, but acceptable, accounting estimates and judgments, as compared to fraudulent accounting practices that are clearly intended to deceive others • McKee characterizes it as “reasonable and legal management decision making and reporting intended to achieve stable and predictable financial results”

• Use ethics framework to judge acceptability • Virtue ethics examines reasons for the actions taken by decision maker AND the action itself • McKee’s explanation is merely a rationalization • Doesn’t hold true to virtues of honesty and dependability • Ignores rights of shareholders and stakeholders to receive fair and accurate information • Masks true performance • Hopwood says ethics issue can be mitigated by disclosing aggressive accounting assumptions • Nothing more than rationalization for unethical behavior: disclosure should not be used to cure ills of earnings management • Act Utilitarian • A decision made by weighing benefits of management/ company to smooth net income vs. costs of providing false information to shareholders • Rule Utilitarian • Financial statements should never be manipulated for personal gain • Problem is no clear limit between what is ethical and what isn’t

Copyright ©2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. How Do Managers and Accountants Perceive Earnings Management?

• Survey by Elias • Accountants in orgs with high ethical values perceive earnings management as more unethical • Accountants in industry significantly less likely than CPAs in public practice to perceive high ethical values in their organizations • Rose and Rose found that audit committee members with less financial knowledge are more likely to accept insufficient client explanations for accounting judgment • Survey by Bruns and Merchant • Managers disagree about ethics of earnings management • Manipulation of operating decisions was more ethical than manipulation by accounting method • Survey by Rosenzweig and Fischer • Accounting manipulation • Changing accounting methods • Recording expense in wrong year • Changing inventory valuation • Operating decisions • Deferring necessary expenditures to subsequent year • Attracting customers at year-end to draw sales into current year

Needles Continuum of Earnings Management

• Needles points out that the difference between an ethical and an unethical accounting choice is often merely the degree to which the choice is carried out. • The problem with many accounting judgments is that there is no clear limit beyond which a choice is obviously unethical. • A perfectly routine accounting decision, such as expense estimation, may be illegal if the estimated amount is extreme, but it is perfectly ethical if it is reasonable. • Needles provides an interesting example of how a manager might use the concept of an earnings continuum to decide whether to record the expense amount at the conservative end or aggressive end.

• Akers, Giacomino, and Bellovary Survey • Accounting manipulation is much less ethically acceptable than operating decision manipulation • Practitioners have few ethical qualms about operating decision manipulation • Operating decisions that influenced expenses were more suspect than those that influenced revenues • Case of Sunbeam Corporation • “Cookie Jar” reserves • Set aside amounts of revenue in “reserve” to be taken out to boost earnings when needed in future • “Big bath accounting” • Creates cookie jar effect while portraying the company as looking worse than it is • Dunlap thought he could do this and blame it on previous CEO

• Dichev study relates to the prevalence, magnitude, and detection of earnings management; findings fall in 3 categories: • CFOs believe that earnings are high quality when they are sustainable, and are backed by actual cash flows; Quality when there are consistent reporting choices over time and avoidance of long term estimates • Current GAAP standards are somewhat of a constraint in reporting high quality earnings; earnings quality would improve if reporting choices evolved from practice, not mandated from standards • CFOs believe that 60% of earnings management is income- increasing, and 40% is income-decreasing; believe earnings misrepresentation occurs most in an attempt to influence stock price, because of outside and inside pressure to hit earnings benchmarks, and to avoid adverse compensation and career consequences for senior executives • CFO’s mention 3 major red flags: persistent deviations between earnings and the underlying cash flows, deviations from industry and other peer experience, and large and unexplained accruals and changes in accruals

• Accruals are needed because of matching and timing problems that can give wrong financial picture of company • Earnings are sum of a period’s change in accruals and its cash flows • Revenue recognition and matching principles • Can manage earnings through aggressive estimations or more conservative ones • Discretionary accruals (items that management has full control over and is able to delay or eliminate) • Nondiscretionary accruals (management has no control over)

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• Concept exists that some financial transactions are so insignificant that they are not worth measuring and reporting with exact precision • Normally materiality is defined as the magnitude of an omission or misstatement that would have changed or influenced judgment of reasonable person • W.R. Grace & Company violated GAAP by establishing an all-purpose reserve fund to smooth earnings from 1991 to 1995 • Hiding profits in good years and using them to disguise slower earnings in later years • Grace’s auditors, Andersen, discovered the buildup of earnings and repeatedly warned that it was improper • Andersen based its decision on the grounds that the improprieties were immaterial

• Standard is most often encountered in fraud litigation brought under Section 10(b) and Rule 10b-5 under the 1934 Act • Courts have adopted position of the SEC • Matrixx Initiatives, Inc., v. Siracusano, 2011 • Petitioners suggested that there should be bright line test for materiality • Supreme Court denied this and said “materiality of adverse event reports cannot be reduced to a bright-line rule” • Shareholder complaint that the company made false statements about its key product, Zicam, and increased earnings based on Zicam sales • Matrixx maintained that Zicam was safe even after research studies show patient reports of loss of smelling ability

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• Vorhies 4 perspectives to help meet SOX Requirements: • The actual financial statement misstatement or error • An internal control deficiency caused by the failure in design or operation of a control • A large variance in an accounting estimate compared with the actual determined amount • Financial fraud by management or other employees to enhance in company’s reported financial position and operating results • Section 302 of SOX, companies are required to • Review their disclosure controls and procedures quarterly • Identify all key control exceptions and determine which are internal control deficiencies • Assess each deficiency’s impact on the fair presentation of their financial statements • Identify and report significant control deficiencies or material weaknesses to the audit committee and the company’s independent auditor • An accounting estimate generally would not result in a control deficiency or misstatement if • The process is reasonable given available technology • The process is normal for the industry, and • The independent auditor reviewed and approved it

• Shows danger of relying on quantitative analysis in making materiality judgments • KPMG auditors unreasonably determined that certain licensing and advertising revenues were immaterial • This was determined by quantitative factors only • Disregarded qualitative materiality, i.e. the revenue related to business lines watched by securities analysts and had material effect on valuation of Gemstar stock • SEC complaint provides insight into the techniques used to manage earnings • Recording revenue under expired, disputed, or nonexistent agreements • Revenue on an accelerated basis • Inflating advertising revenue by recording and reporting revenue from multiple- element transactions • Engaging in round-trip transactions • Failing to disclose that it had created cookie-jar reserves to smooth net income • Improperly recording advertising revenue from nonmonetary and barter transactions • Sound judgment is needed to review assumptions and estimates in accrual accounting to protect against unacceptable forms of earnings management

• Concern whether principles-based system might lead preparers of financial statements to try and justify a specific accounting outcome in an attempt to manage earnings • Mergenthaler found a positive association between rules-based characteristics and the dollar magnitude of earnings management, possibly due to the expected cost of managing earnings is lower in a rules-based environment • SEC study of principles-based standards expressed its concern that, in a principles-based system, there may be "a greater difficulty in seeking remedies against ‘bad actors’ either through enforcement or litigation” • Folsom et al. found that managers use the discretion provided by principles-based standards to convey information better to investors

• Levitt described five techniques of “accounting hocus-pocus that summarized the most glaring abuses of the flexibility inherent to accrual accounting • Big- bath charges • Company takes one-time large restructuring charge/write down • To make this difficult FASB adopted: SFAS No. 144 on impairment losses and SFAS No. 146 on the timing of the recognition of restructuring obligations • Sunbeam case • Creative acquisition accounting • Allocate bulk of purchase price to acquiree's in-process R&D • SFAS Nos. 141 and 142 • Cookie jar reserves • Aimed at smoothing earnings over time • SAB 101 • Materiality • Gray area of accounting • Revenue recognition • Accelerate the recording of revenues • Xerox case

• Land Daniels, CPA and retail controller for CVS, was accused of manipulating the accounting for its Oct. 20, 2008, purchase of Longs Drugstores • In Jan. 2009, CVS received a draft report from a valuation firm applying a “continued use” premise that CVS would retain and continue to use all of Longs stores’ PP&E, except for identified stores to be closed • The independent auditors reviewed the valuation firm’s approach and concluded the firm’s methodology is reasonable • The valuation results were included in CVS’s audited financial statements for the fiscal year ended Dec. 31, 2008 • In March 2009, CVS lengthened the remaining useful lives of Longs PP&E and technology assets • In May 2009 Daniels notified the valuation firm that the CVS intended to discard all personal property in the Longs stores (CVS is improperly changing its real estate strategy after the acquisition date of Oct. 2008) • In third quarter 2009 10-Q CVS adjusted the values associated with the Longs store purchase with almost 85% of purchase price going to goodwill • The SEC concluded that the revision was not in accordance with GAAP

• SEC Staff Accounting Bulletin 101 (SAB 101) provides guidelines that revenue is generally realized or reliable when all of the following criteria are met: • Persuasive evidence of an arrangement exists • Delivery has occurred or services have been rendered • The seller’s price to the buyer is fixed or determinable • Collectability is reasonably assured • Some common recognition devices that have been used to manage earnings: • Multiple Deliverables • Channel Stuffing • Round-Tripping • Bill and Hold

• FASB and IASB jointly issued a new revenue recognition standard in May 2014 and effective for annual and interim periods beginning after December 15, 2016, for public companies • Companies required to follow a five-step process to recognize revenue • Identify contract(s) with a customer • Identify the separate performance obligations in the contract • Determine the transaction price • Allocate the transaction price to the separate performance obligations • Recognize revenue when the entity satisfies each performance obligation • This is more principles-based and may result in reporting that is more reflective of underlying economic reality • The new standard requires extensive disclosures including • Disaggregation of total revenue • Information about performance obligations • Changes in contract asset and liability accounts between periods • Key judgments and estimates

• It is unethical if the primary motive for managing earnings is to deceive users of the true results of operations or reflect the economic substance • Often earnings management is carried out by otherwise honest people who tell the company’s side of the story rather than adhere to GAAP • Cycle of earnings manipulation • Often a company begins with a track record of success • It is becoming more difficult to maintain the sales and earnings growth expected • Management runs special incentives to accelerate sales and uses overtime to ship product out • Steps are repeated in the next quarter(s), as expectations are higher, only now the company may not accrue all of its expenses, and to keep the stock prices increasing • One aggressive interpretation leads to another until the quality of the financial information is in doubt • The company has gone from aggressive operating practices to financial fraud

• Actions or omissions intended to hide or distort real financial performance or financial condition of an entity • Overstate revenues and profits to enhance reported earnings and EPS • Understate revenues and profits to smooth net income/decrease volatility • Schilit’s 7 Common Financial Statement Shenanigans: • Recording Revenue too soon or of questionable quality • Recording bogus revenue • Boosting income with one-time gains • Shifting current expenses to a later or earlier period • Failing to record or improperly reducing liabilities • Shifting current revenue to a later period • Shifting future expenses to the current period as a special charge

Auditors need to be attuned to red flags Reduction in reserves. or sign of aggressive accounting and fraud: • Not reserving for possible future losses. • Growth in the market share that seems unbelievable. • Reduction in discretionary costs at year-end (i.e., advertising; R&D). • Frequent acquisitions of businesses. • Unusual increase in borrowings; short- • Management growth strategy and term borrowing at year-end. emphasis on earnings and/or EPS. • Extension of trade payables longer • Reliance on income sources other than than normal credit. core business. • Change in members of top • One-time sources of income. management, especially the CFO. • Growth in revenue that doesn’t line up • Change in auditors. well with receivables or inventory. • Changes in accounting policies toward • Unexpected increase in accounts more liberal applications. receivable. • One forensic accountant is needed on • Slowdown of inventory turnover. each audit to help identify the signs.

• Motivation for Fraud • Polish its reputation on Wall Street, and • Boost stock price • Fraudulent Lease Accounting • Valuation determination replaced by a formula that management could manipulate; revenue from multiple deliverables improperly recognized • Cushion Reserves • Used reserves to close the gap between actual results and earnings targets • Sanctions by SEC on KPMG • Paid $10 million in penalties, disgorged $10 million in audit fees, and paid $2.7 million in interest

• Motivation • Drive to realize revenue • Meet internal sales targets • Obtain sales bonuses • Shenanigans • Side Agreements • Recording revenue too soon • Boosting income with one-time gains • Shifting current expenses to later period • Reducing liabilities • Created new reserves and released reserves into income • KPMG should have noticed red flags

• Started because debt load was high and needed to finance borrowings that would not be shown on balance sheet • Needed long-term supply contracts, but these were not available in current market • Skilling’s “Gas Bank” Idea • Pooling investments in gas-supply contracts and selling long- term deals to utilities • Rather than booking the revenue on long-term contracts as it came in, Enron would book immediately like a marketable security • Fastow’s Special-Purpose Entities • To entice producers to invest in Gas plan, Enron needed cash to offer up front • Began to create partnerships that took money from banks and gave it to producers in return for a portion of existing gas reserves

• The Growth of SPEs • Transactions did not violate GAAP, initially • Financial institutions that were lending the 3% became cautious of SPE’s ability to repay interest • Enron began to back deals with promise of Enron stock…resulted in • No transfer of risk to SPE; therefore SPEs should have been consolidated into Enron’s statements • “Rank and Yank” employee-evaluation policy as incentive to keep employees quiet • Enron created Chewco to buy out its partner in another venture, JEDI • Virtually no outside ownership • Managed by a protégé of Fastow, Michael Kopper • Permitted by Code of Ethics, but waived by Board • Allowable through a lack of internal controls • It became increasingly harder to keep revenues growing each quarter • Executive Compensation far exceeded all competitors • Encouraged executives that by giving out stock options this would provide cash • Claimed if profits and stock price went up enough, the schedule for such options would be accelerated

• Skilling resigned after 6 months as CEO • Sherron Watkin’s letter to Ken Lay, former and now current CEO and chair of board of directors • Described in detail problems with Enron’s partnerships • Assigned to be investigated by Vinson & Elkins • Reported findings to Lay and Derrick, claiming no reason for concern • The Final Days • November 2001 Enron announced overstatement of earnings by $586 million • Ken Lay and Jeff Skilling found guilty of fraud and conspiracy • Skilling was sentenced to 24 years and 4 months and fined; reduced in 2013 by DOJ to10 years • Skilling is eligible for parole in 2017

Enron: Review of Important Accounting Issues

• Quality of financial reports were poor: • Improperly failing to consolidate SPE (Chewco) • Failure to disclose related-party transactions • Recording gains from selling assets to SPE’s • Use of reserves and failure to explain the basis for creation • Failure to disclose Fastow’s dual role with SPE and as CFO of Enron • Managed earnings through following techniques: • Used reserves to increase earnings • Used mark-to-market estimates to inflate earnings • Selected which operating assets to “sell” to SPE’s- affecting the amount of gain and earnings effect • Lack of strong controls contributed to fraud evidenced by: • Top management overrode internal controls • Lax oversight by board of directors • A culture established to make deals at any cost • A culture of fear created with its “rank or yank” policy

• FASB Rules on SPEs • Original motivation was to establish a mechanism to encourage companies to invest in needed assets while keeping debt off its books • FASB Interpretation No. 46(R) Consolidation of Variable Interest Entities requires unconsolidated variable interest entities to be consolidated if they do not effectively disperse risk among parties involved • No longer a percentage ownership test • Enron’s Role in SOX • Prohibiting the provision of internal audit services for audit clients • Off-balance sheet financing activities must be disclosed in notes to financials • Related-party transactions must be disclosed in notes to financials • Lessons to be learned • Weak internal controls lead to possible fraud • Need for ethical tone at the top • Be cautious of the ethical slippery slope • Watch out for greed

• Revision of financial statements that was previously publicly reported may be one of two types • Reissuance restatements are the more serious, as past or previous financial statements cannot be rely upon • Revision restatements do not undermine reliance on past financials • “Stealth Restatements” • A restatement disclosed only in periodic reports and not in the 8-K, or amended periodic report such as a 10-K/A or 10-Q/A • The SEC requires companies to disclose within four business days that past financial statements should no longer be relied on • The 8-K form is designed to be an early warning system so that the public knows immediately about the financial statement restatements and does not have to wait until the statements are filed with the SEC

• Hertz Global Holdings, Inc., filed its 2014 Form 10-K with restated results for 2012 and 2013 as well as selected unaudited restated financial information for 2011 • Hertz addresses the issue of non-GAAP financial measures including EBITDA, Corporate EBITDA, and how these amounts were calculated • By comparing the validity of these amounts to pretax GAAP income, Hertz is misleading the readers into thinking that non-GAAP measures of earnings may be as reliable as GAAP amounts

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• In a June 2014 form 8-K filing, Hertz warned that • Current quarterly filing would be late; financials for 2011 should no longer be relied upon • At least one material weakness in internal control over financial reporting had been identified • Disclosure controls and procedures were ineffective as of December 31,2013 • Chairman of its audit committee had discussed the matter with PwC, and expects a revised audit opinion to an adverse opinion on internal controls • Question of whether Hertz’s managers and PwC should have been aware of the problems earlier, and how those problems were discovered • Hertz reported in its 2013 year-end Form 10-K that it had discovered “certain out-of-pocket errors” in the fourth quarter, which were not material in any given period, but would be material to the fourth quarter • Hertz’s 10-K filing identified accounting errors in four areas • Capitalization and timing of depreciation for certain non-fleet assets • Allowances for doubtful accounts in Brazil • Allowances for uncollectible amounts with respect to renter obligations for damaged vehicles • Restoration obligations at the end of the end of facility leases

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Category Cause of Restatements

Revenue Recognition Improper revenue recognition, questionable items and misreported revenue

Expense Recognition Improper expense recognition, period of recognition, incorrect amounts

Misclassification Improper classification on income statement, balance sheet or cash flow statement

Equity Improper accounting for earnings per share, stock-based compensation plans, securities

Other comprehensive Improper accounting for OCI transactions, unrealized gains and losses on investments income(OCI) in debt and equity securities, derivatives; and pension-liability adjustments Capital assets Improper accounting for asset impairments, asset placed in service dates, depreciation

Inventory Improper accounting for valuation of inventory, market adjustments, obsolescence

Reserves/allowances Improper accounting for bad debt or loan loss reserves, reserves for inventory

Liabilities/ Improper estimation of liability claims, loss contingencies, litigation matters, contingencies commitments and certain accruals

• Cubic Corporation restated financial statements due to errors in calculating revenues on certain long-term development contracts and on long-term service contracts with non-U.S. Government customers • Cubic historically recognized sales and profits for development contracts using the cost-to-cost percentage-of-completion method of accounting, modified by a formulary adjustment which had the effect of deferring a portion of revenue and profits until later in the contract performance period • Cubic also used the cost-to-cost percentage-of completion to revenues for its service contracts, which is only acceptable for U.S. Government contracts

• Earnings management is typically motivated by a desire to meet or exceed forecasted results, meet financial analysts’ earnings estimates, inflate share price to make stock options more lucrative, and enhance bonuses • Techniques to manage earnings include channel stuffing, bill-and-hold transactions, round-tripping, cookie-jar reserves, and delaying accruals and expense recognition • When management manipulates earnings, the quality of such information suffers • Financial reporting needs to focus more on representational faithfulness, meaning that there should be a correspondence or agreement between the accounting measures or descriptions in financial reports and the economic events they purport to represent

• 25 Biggest Frauds: https://www.youtube.com/watch?v=LrJaOOGJLW0 • Enron: • https://www.youtube.com/watch?v=TCpZUDIquQw (Frontline: 55 minutes) • https://www.youtube.com/watch?v=BIwFO4_SWQQ (The Smartest Guys in the Room – movie: 1 hour, 49 minutes)