Ethics in Financial Reporting: Cooking the Books

1. Ethics in Financial Reporting: Cooking the Books Sudha Krishnan

2. Definition – Earnings Management (EM) • Purposeful intervention in the external reporting process with the intent of obtaining some private gain (Schipper) • When managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholder about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers (Healy & Wahlen)

3. Intent of Management Is all EM unethical? –depends on management intent. • Management intent unobservable • Distinction between aggressive accounting choices including acceptable GAAP based estimates / judgments vs. fraudulent accounting practices intended to deceive others

4. Howard Schilit – Financial Shenanigans • Revenue recognition • Recording revenue too soon • Revenue is recorded before service is fully provided • Recording revenue of questionable quality • Revenue is recorded before customer’s unconditional acceptance • Recording made up revenue • Revenue is recorded even if it lacks economic substance • Shifting revenue to a future period • Purposely over-estimating sales returns and adjusting downward in future years

5. Howard Schilit – Financial Shenanigans • Shifting expenses • Capitalizing current costs • Shifting current expenses to later or earlier period • Changing accounting policies and shifting expenses to later period • Expensing future expenses as current • Accelerating discretionary expenses

6. Aggressive Accounting Choices Examples of accounting choices allowed by FASB • Changing life of assets affecting depreciation • Changing estimate of allowance for doubtful accounts affecting bad debt expense • Changing estimate of sales return allowances affecting net revenue • Choosing inventory valuation methods thus affecting cost of goods sold • Estimating higher restructuring charges than required affecting earnings before interest & taxes

7. Numbers Game Arthur Levitt Speech (1998) on accounting hocus-pocus • Big bath • Large estimates of restructuring charges that are deducted from revenues to show lower income in one quarter/year and then revised few quarters/years later to show higher income Note: 1/1/2003 onwards, restructuring charges to be actual – no more estimates allowed (ASC para 420)

8. Numbers Game Arthur Levitt Speech (1998) on accounting hocus-pocus • Creative acquisition accounting • Classifying large portions of acquisition price as in-process research & development and then written off immediately after the merger. That reduces future drag on income Note: all IPR&D to be capitalized and checked for impairment like goodwill (EITF09-2, FASB141(R), ASC para 805)

9. Numbers Game Arthur Levitt Speech (1998) on accounting hocus-pocus • Cookie jar reserves • Use unrealistic assumptions to estimate sales returns, loan losses or warranty costs, thus stashing accruals in cookie jars during the good times and reach into them when needed in the bad times.

10. Numbers Game Arthur Levitt Speech (1998) on accounting hocus-pocus • Materiality • Intentionally record errors with specified ceiling and then argue that the errors are not material Note: Staff Accounting Bulletin Codification Topic I para M for guidance on materiality

11. Numbers Game Arthur Levitt Speech (1998) on accounting hocus-pocus • Revenue recognition • Recognize a sale before it is complete, before the product is delivered to a customer, or at a time when the customer still has options to terminate, void or delay the sale. Note: Staff Accounting Bulletin 101 & 104 for guidance

12. Pressures to Manage Earnings Why does management manage earnings? • External pressures • Analysts’ forecasts • Access to debt markets • Competition • Contractual agreements & debt covenants • Roaring stock market • Emerging financial instruments • Market disregard for big charges

13. Pressures to Manage Earnings • Pressures within the company • Merger attractiveness • Management compensation • Short term focus • Unrealistic budgets and plans • Excessive profits followed by decline • Personal factors – bonus, promotions, job retention

14. Signals in Current Year Signals that should be checked in company reports • Read the audit report • Reduction in managed costs such as advertising in relation to sales • Changes in accounting policies towards more liberal applications • Unexpected increase in accounts receivable • Extension of trade payables longer than normal credit • Unusual increase in intangible assets • One time sources of income • Decline in gross margins

15. Signals in Current Year (Cont’d) • Reduction in reserves • Reliance on income sources other than core business • Nor reserving for future probable losses • Unusual increase in borrowings • Increase in deferred taxes • Increase in unfunded pension liability • Low cash and marketable securities at year end • Peak short borrowings at year end • Slowdown of inventory turnover ratio

16. Red Flags When should you pay more attention to the company? • Company has achieved significant market share and is growing faster than the industry • Frequent acquisitions of business • Management history • Firing of auditors • Rapid growth of company -- internal control issues • Company doing too well • Management growth strategy and emphasis on EPS goals

17. Cases • Worldcom (expense capitalization) • Satyam Computers (bogus revenue) • Tyco (executive loans, merger magic) • Adelphia (borrowing from company) • Waste Management (materiality) • SunBeam (channel stuffing, cookie jar reserves) • Healthsouth (false earnings)

18. Teaching Notes – Worldcom & Adelphia • Assign the citations at the end of the case for readings • Go over signals/red flags and pressures to manage earnings (earlier slides) with the class before assigning the case • Assign one case in class discussion and the second as homework (assessment). • Emphasize the importance of reading the SEC complaint and the AAERs • Ask the students to read the articles from general media such as WSJ, Business Week etc. • Use the opportunity to talk about SOX Act, corporate governance and the importance of independent auditors and audit committee • To make the discussion interesting, talk about the CEO/CFO involved in the scandal and what is their current status (that information is in the general media articles as well as the case)

19. WorldCom answers • How did WorldCom cook the books? • They capitalized the leasing expenses on the balance sheet instead of expensing them. • What is the impact on the income statement and the balance sheet and ratios of such actions taken by WorldCom? Provide examples. • The capitalizations of leasing expenses increased income and increased assets on the balance sheet. So ratios with income in the numerator looked better than before managing earnings. Also, the leased assets on the balance sheet gets depreciated over the estimated life, thus spreading the cost over many income statements

20. WorldCom numbers

21. WorldCom answers (cont’d) • Read the article “Twenty pressures to manage earnings” mentioned in the citations. Identify some of the pressures that caused the management to cook the books. • Meeting analyst forecast • Excessive profits in an environment where competitors were not doing as well. • Management greed and compensation • Almost all the red flags (as per the slide before)

22. Adelphia answers • Read the complaint on the SEC website. How did the management cook the books? • Borrowed funds along with other entities that were closely held but did not show the loans on the books of Adelphia. Liabilities were thus understated. • Rejected auditor recommendation that at least a footnote disclosure needs to be made re the loans • Equity was overstated by doing sham stock transactions (A=L+SE) • Inflated number of cable subscribers (criteria used in the industry to analyze cable companies) • Identified source of revenue – management fees (did not exist) • Recorded kickbacks from converter box sellers as income • Shifted Adelphia expenses to other entities run by the family

23. Adelphia answers (cont’d) • Who were the auditors of Adelphia during the fraud period? What were they accused of doing? How were they punished? • Deloitte & Touche • “Deloitte engaged in improper professional conduct and caused certain of Adelphia's books and records violations by failing to detect a massive fraud perpetrated by Adelphia and certain members of the Rigas family. Even though Deloitte identified Adelphia as one of its highest risk clients, Deloitte failed to design an audit appropriately tailored to address audit risk areas that Deloitte had explicitly identified” • Deloitte settled the case with the SEC by paying a penalty of $50 million

24. Contributions • This class material introduces students to ethical issues in financial reporting. It should be taught at the level of Intermediate Accounting I. • It uses cases to teach students some critical reasoning skills. • It gets them to read articles from the general business media such as Wall Street Journal, Fortune, Business Week etc. • It allows them to access the SEC website and read the Accounting & Auditing Enforcement Releases (AAER) & the Litigation Releases (LR) • It gives them exposure to unethical behavior – what not to do when reporting to investors.