Earnings Management

5/26/2018 Earnings Management

1/50

(EM)

Earnings ManagementJune 28, 2006


2/50

Group Members

Alfred DSouza

Aman Gill

Eric LindsaMar Guo

Mic!ael "laman

#an$ir %!angura&amm '!eung


3/50

(!at is Earnings Management)

(!at moti*ates Earnings Management)

'ommon A++roac!es

Eam+le - %ris+ %reme

'onse.uences

Agenda


4/50


/eal and (a!len, 111

Earnings management occurs 3!en managersuse 4udgment in financial re+orting and instructuring transactions to alter financial re+ortsto eit!er mislead some sta5e!olders a$out t!e

underling economic +erformance of t!ecom+an or to influence contractual outcomest!at de+end on re+orted accounting num$ers7


5/50


Sc!i++er 1819

: a +ur+oseful inter*ention in t!eeternal financial re+orting +rocess, 3it!t!e intent of o$taining some +ri*ate gain

as o++osed to merel facilitating t!eneutral o+eration of t!e +rocess7


6/50

; Worldcom 111 -20029- < 1 $illion o*erstatement t!roug! release of im+ro+er reser*es

; Xerox11= -20009

- < > $illion accelerated re*enue recognition- < ?00 million t!oug! @cus!ion reser*es- SE' le*ied < 0 mm in fines- o admission of guilt

; Lucent Technologies, Cendant, MicroStrateg (20009- Stoc5 mar5et lost >B $illion in t!ree das

EM - #ecent Eam+les


7/50

Conservative

Accounting

Aggressive

Accounting

Fraudulent

Accounting

Aggressive recognition of provisions and

reserves

Overvaluation of R&D purchase acquisitions

Overstate asset write-offs

Understate provision for bad debts

Drawing down provisions/reserves in an overl

aggressive !anner

Recording sales before reali"able# recording

fictitious sales

$ac%dating sales invoices

Overstating inventor

Within GAAP

Violates GAAP

EarningsManagement

"raud *s Earnings

Management


8/50

Determined by motive

(!en is EM "raudulent)

EM and accrual met!ods are fraudulent undert!e follo3ing circumstancesC- (!en t!e are used to satisf analsts e+ectations

- 2 (!en t!e are used to realize $onuses

- > (!en transactions are structured or carried out to alterfinancial re+orts

- B (!ene*er t!e are used for reasons ot!er t!an to +ro*ideaccurate financial information to in*estors and sta5e!olders


9/50

anipulate the co!pan's earnings so the

figures !atch a pre-deter!ined target

s Accrual Accounting a form of EM)

; Accrual accounting uses accrual, deferral, and allocationto reflect an entits +erformance during a +eriod

; Managers use GAA to ma5e re+orting decisions

; Ena$les its in*estors to assess t!e entits economic+erformance more accuratel t!an from 4ust cas! flo3s


10/50

Fualitati*e *s Fuantitati*e Earnings

; Size matters Most in*estors loo5 atcents +er s!are 3!en analzing earnings

; Fualit earnings !a*e > $asic .ualitiesC

- #e+eata$le

-'ontrolla$le- an5a$le


11/50

#e+eata$le

n t!e >rd .uarter of 200, Motorola+osted earnings +er s!are of B cents,$eating analsts e+ectations, $ut t!e

stoc5 fell ?H soon after

- &!e reason) Sales !ad s!run5, and t!e

econom 3as soft Most of t!e earningsgro3t! came $ 3a of 4o$ cuts and t!e saleof in*estments


12/50

'ontrolla$le

Some IS com+anies 3it! Euro+eansu$sidiaries are re+orting earnings t!atare $etter t!an e+ected

- &!e #eason) &!e falling IS dollar !asim+ro*ed earnings *ia t!e ec!ange rate

nflation can also affect earnings t!roug! t!e+rices of in+uts and out+uts


13/50

an5a$le

n 2002, 'ircuit 'its stoc5 +rice fell o*erB0H e*en t!oug! $ot! sales and earningss!o3ed siza$le increases

- &!e #eason) &!e size of t!e com+ansAccounts #ecei*a$le !ad more t!an dou$led

creating concerns around t!eir collecti$ilit


14/50

(! is EM not acce+ta$le)

; Misallocation of n*estment #esources

; Indue im+ro*ement in management

credi$ilit

; MDA +ro*ides room to e+lain *ariance

in +erformance

; Sign of 'om+romised 'ollusi*e Auditing


15/50



'ommon A++roac!es


'onse.uences

Agenda


16/50

(! does EM occur)

Three main reasons!

; 'a+ital Mar5et E+ectations andKaluation Earnings S!oc59

; 'ontracting Moti*es

; Antitrust and Go*ernment #egulations


17/50

'a+ital Mar5et Moti*ations

; Sample moti"es!

; S!ort term stoc5 +rice +erformance

; Kaluation +rior to management $uouts

; EM to meet t!e e+ectations of financialanalsts


18/50

$ut( studies show investors see through)

such *++ and instead rel on long ter!

strateg when allocating resources

'a+ital Mar5et Moti*ations

Sample methods!

; ncome increasing de+reciation met!odsand allo3ances in ear +rior to

; ncome smoot!ing


19/50

Earnings S!oc5

; ositi*e earnings sur+rises usuall arentsignificantl re3arded $ t!e mar5et

; egati*e earnings sur+rises are +enalized

!ars!l

The #eason

; Earnings targets are usuall conser*ati*e; E*er su$se.uent +ositi*e s!oc5 !as less of an

im+act


20/50

Earnings S!oc5 contd:

; ositi*e earnings sur+rises tend to $emore fre.uent t!an negati*e earningssur+rises as com+anies tr to @$eat do3n

e+ectations

; nterim #e+orts are not audited, t!uscreating more o++ortunit to manageearnings


21/50

$ut( ,tud showed onl of .. fir!s

delaed default through *++

'ontracting Moti*ations

; Lending Contracts

; Managers manage earnings to ensurecom+liance 3it! eisting lendingco*enants ie de$t ser*ice co*erage orde$t e.uit ratios9


22/50

$ut( stud shows personall !otivated

*++ has little effect on asset allocation

'ontracting Moti*ations

$% Management Compensation Contracts

; Managers use 4udgment to increase earnings

$ased $onus a3ards

; Managers manage earnings 3!en 4o$ securitis t!reatened


23/50

,trong evidence that *+ occurs when

co!panies are on verge of violating

regulator provisions+

#egulator Moti*ations

&ndustr #egulations

; an5s re.uired to satisf ca+ital ade.uacre.uirements

; nsurance com+anies must meet conditions forminimum financial !ealt!

; Itilities com+anies !a*e $een !istoricall +ermitted

to earn normal return on in*ested assets


24/50

,tud 0o!panies being investigated for anti-trust violations report inco!e decreasing

accruals

#egulator Moti*ations

'ntiTrust #egulations

'om+anies on *erge of in*estigation mamanage earnings to a++ear less +rofita$le


25/50


(!at moti*ates Earnings Management)'ommon A++roac!es


'onse.uences

Agenda


26/50

/o3 are Earnings Managed)

; @ig at! #estructuring

; 'oo5ie Jar #eser*e Accounting

; remature #e*enue #ecognition- 'amouflage of @/old and Sale transactions- &rans+orter +ic5s u+ ris5 of loss- Incertaint at cut off date- nflating standard orders

; E+ected li*es of long term assets

; $ligations for +ension $enefits

; Deferred &aes


27/50

$) Tuc a*acreate the

Cooie +ar

) -ip into the

Cooie +ar .re"ersal o/

accruals

0) Can1t manage

gro*ing maretexpectation

2) 3o real cash

/lo* Scraping

the bottom

&+ical Stages of EM


28/50

/o3 are Earnings Managed)

'ont; Deference of Asset m+airment

; "" *s L" met!ods of accounting eg!+er

inflationar countries9

; Accelerated Declining met!od of Amortization

; (or5ing 'a+ital Management - delaed s!i+ments

; &iming of ca+ital gains


29/50

t!er So+!isticated met!ods

; ff alance S!eet re+orting insu$sidiaries

; Snt!etic Leases

; roforma Estimates

; ntercom+an transactions


30/50

Some S+ecial 'ases

; an5s - Loan Loss #eser*es

; nsurance 'om+anies - 'laim ro*isions

; Large etrol '!emical ro4ects - Deferred &aAllo3ances

; usiness 'om$os - creati*e ac.uisition accounting

; E.uit structuring to a*oid N re.uire consolidation


31/50

/o3 auditors detect EM

; 'as! flo3s t!at are not correlated 3it! earnings

; #ecei*a$les t!at are not correlated 3it! re*enues

; Allo3ances for uncollecti$le accounts t!at are not correlated 3it!recei*a$les

; #eser*es t!at are not correlated 3it! re*enue gro3t! or $alances!eet items

; Fuestiona$le ac.uisition reser*es- restructuring c!arges or reser*es set aside for dis+osals

; Earnings t!at consistentl and +recisel meet analsts e+ectations


32/50

Ss 'ore Earnings Metric

; Attem+ts to +ro*ide consistenc andtrans+arenc related to earnings

; 'reated 3it! t!e in+ut of t!e in*estmentcommunit

; 'learl defines 3!at can and cannot $e includedas #e*enues and E+enses


33/50

What1s &n

Em+loee stoc5 o+tione+enses

#estructuring c!arges

ension fund costs

urc!ased #De+enses

(ritedo3ns andde+recia$le o+eratingassets

What1s 4ut Good3ill im+airment GainsNlosses from asset

sales

ension gains Litigation costsN+roceeds Inrealized gains from

!edging acti*ities

S 'ore Earnings


34/50

'riti.ue - Ss 'ore Earnings

; 'an o+tion e+enses $e fairl +riced)

- lac5Sc!oles +roduces !ig!l su$4ecti*eresultsO es+eciall 3it! *olatile stoc5s

; ension +lan gains are ecluded, $utlosses are included

- f returns are do3n in a gi*en ear, earnings3ill $e +enalized e*en if t!e +lan is flus!


35/50


(!at moti*ates Earnings Management)'ommon A++roac!es


'onse.uences

Agenda


36/50

!ris"y !reme # What Went Wrong$
http://www.krispykreme.com/http://www.krispykreme.com.au/espresso.html


37/50

ac5ground nformation

; %%D $egan in 1>= in t!e sout!east IS

; egan going national in 116, o+ening stores inMan!attan, LA, Los Kegas

; Declared /ottest rand in t!e Land7 $ "ortuneMagazine

; too5 +lace in 2000


38/50

%%DC nitial u$lic ffering

; in 2000, 4ust after t!e tec! $u$$le $urst

; n*estors 3ere eager for a $usiness t!e couldunderstand

; 'onsidered one of t!e $est s of t!at ear

; +riceC C


39/50

%%DC 'anadian #ig!ts

; 3ned $ %reme%o nc under eclusi*efranc!ising and licensing arrangement20009

; %reme%o re.uired to o+en >2 stores3it!in = ears


40/50

(!at !a++ened)

; Ma 200BC "irst e*er missed .uarter and first loss as a +u$liccom+an 'E $lames lo3 car$ diets9

; Jul 200BC SE' ma5es an informal in.uir into %%D $u$ac5s ofse*eral franc!ises

; Stoc5 +rice +lunges, s!are!olders file suit

; ct 200BC SE' in.uir u+graded to formal7

; %%D continued to add stores, t!oug! sales 3ere falling

; Jan200?C %%D decides to restate financialsO 'E re+laced $Ste+!en 'oo+er, 3!o 5e+t !is ot!er 4o$ as interim 'E of Enron


41/50

anage!ent's decision to include ingredient

and equip!ent sales does not accuratel reflect

overall health of co!pan 1 *++

/o3 %%D Managed Earnings)

; Getting Greed; %%D re.uired franc!isees to $u e.ui+ment and

ingredients at mar5ed u+ +rices

; >H of 200> came from selling ingredients ande.ui+ment

; %%D concentrated on gro3ing +arent com+an sales

instead of franc!isee +rofits


42/50


Snthetic Lease

; %%D financed a ? MM miing +lant 3it! an off$alances!eet synthetic lease

; ermissi$le onl 3!en lessee !as no intention ofac.uiring leased +ro+ert at term end

; Miing lant7 s!ould $e tec!nicall an asset to t!ecom+an and s!ould $e recorded on $alance s!eet

; %%D scuttled t!is +lan in "e$2002 after Enron


43/50


5udging the 3umbers

; ct 200>C 'om+an ac.uired se*en Mic!igan $asedfranc!ises for 2 MM

; urc!ase +rice recorded as intangi$le asset #eac.uired"ranc!ise #ig!ts9, 3!ic! it did not amortize

; urc!ase +rice 3as inflated so seller could ma5e interest+aments so *endor could +a interest for +ast dueloans

; nterest 3as recorded as income


44/50


'dditional &tems

; %%D rolled store closing costs, consulting fees intointangi$le ca+ital asset account

; %%D $oug!t 'alifornia $ased franc!ises at inflated +rices3!ic! 3ere o3ned $ 'Es e3ife

; %%D $oug!t Dallas $ased stores at inflated +rices t!at3ere +artl o3ned $ former director and $oard mem$er

; %%D em+loed > different '"s from 2000200B


45/50

%%Ds Moti*es

; Etreme +ressure to satisf e+ectations of+u$lic mar5et

; ersonal $enefit $ +aing ecess amounts forfranc!ises

; 'om+an faced SE' in.uiries

; '"s 4o$s 3ere not secure


46/50



'ommon A++roac!es


'onse.uences

Agenda


47/50

#eaction from Sta5e /oldersEtreme Distrust

; Dum+ stoc5 on ne3s of Managed Earnings

; ncreased reliance on non financial information

- n*estment $an5ers- "inancial analsts

- ond #ating Agencies

- "inancial ress

; 'lass action suits - ortel


48/50

De$ata$le *er #eactions

; Sto+ earnings guidance

- 'oca'ola

; #e3ard s!are!olders 3it! trust3ort!$oo55ee+ing not earnings

; 'lass action suits against auditors


49/50

#ealit

; &!e mar5ets are still more reliant onearnings re+orts t!an on cas! flo3s

; Management 4udgment $etter indicator offuture earnings t!an fluctuating cas! flo3s

; Almost e*er one does it in some 3a


50/50

THANK YOU

Date post:	16-Oct-2015
Category:	Documents
Upload:	fregat
View:	21 times
Download:	0 times

Earnings Management

Documents