Chapter Seven Earnings Management and the Quality of Financial Reporting

1. Chapter Seven Earnings Management and the Quality of Financial Reporting

2. Defining Earnings Management • Inflate (deflate) revenues or earnings per share • By using aggressive accounting techniques such as capitalizing costs that should have been expensed • Establishing/altering the elements of an estimate to achieve a desired goal • Must have ethical intent to make moral decisions • Underlying motivation is pursuance of self-interest

3. Defining Earnings Management(cont) Different views on earnings management Negative light- “purposeful intervention in the external reporting process, with the intent of obtaining some private gain”- Schipper Positive light- “Reasonable and legal management decision making and reporting intended to achieve stable and predictable financial results”- McKee

4. Ethics of Earnings Management • 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 • Utilitarian Perspective • 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

5. The Acceptability of Earnings Management from a Materiality Perspective Defining Materiality • FASB Defines as: • “the magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement” • Both the qualitative and quantitative factors must be considered when assessing materiality • Judgments of materiality rely on the “reasonable person standard • Judged by relative amount and nature of item • SAB 99 lists qualitative factors that cause small misstatements to become material

6. Considerations of Materiality in Evaluating Internal Control Deficiencies Under Sarbanes-Oxley • Identify key control exceptions • Apply a materiality concept to determine financial impact • Vorhies 4 perspectives to help meet SOX Requirements: • The actual financial statement misstatement/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 • Design failure • Occurs when management fails to establish sufficient internal control • Operating failure • Adequately designed control doesn’t operate properly • Estimating financial events is necessary in accounting • As long as process is reasonable, the amount of variance is irrelevant

7. Current Auditing Standards and Presumptions • Materiality is matter of professional judgment • Based on auditor’s perception of needs of users of statements as a group; not as individuals • Users are assumed to: • Have appropriate knowledge of business and economic activities • Understand statements are prepared and audited to levels of materiality • Recognize uncertainties in amounts based on estimates, judgment, and future events • Make appropriate economic decisions based on information in financial statements • SAS No. 107- Uses benchmarks to evaluate materiality: • Total revenues, gross profit, or other categories of reported income

8. Restatements of Financial Statements • Revising (voluntarily or advised) financial information that was previously reported • Restatements increased during 2000-2006 • Since 2006, number has gone down • Due to SOX • And new PCAOB auditing standards • Restatements Due to Errors in Accounting and Reporting • 1,295 restatements in 2005 • Represents about one restatement per 12 public companies

9. SEC Advisory Committee on Improvements to Financial Reporting • Shift of materiality judgments from professional judgment and the “reasonable person” standard to emphasizing whether a restatement may be desirable to meet user (investor) needs • SAB 99 is being applied too broadly • Subcommittee believes market reaction is a factor in evaluating materiality • SEC’s position to reduce number of restatements • Restatements are important to users and should be based on ethical factors:

10. SEC Advisory Committee on Improvements to Financial Reporting (cont) • Dishonesty may be behind the restatement • Questions about integrity of management may persist • Environment of pressure may lead to manipulating earnings that have to be restated later • All companies with restatement should be required to disclose: • How the restatement was discovered • Why the restatement occurred • Corrective actions to prevent future errors

11. Earnings Management Techniques • 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

12. Descriptions of Financial Shenanigans • The Case of Xerox • Motivation for Fraud • “polish its reputation on Wall Street and to boost the company’s stock price” • Fraudulent Lease Accounting: • Value determination was substituted with formula which management could easily manipulate • “Cushion Reserves” • Violated SFAS No. 5 “Accounting for Contingencies” • Sanctions by the SEC on KPMG • Paid $10 million in penalties, disgorged $10 million in audit fees, and $2.7 million in interest

13. Descriptions of Financial Shenanigans • The Case of Lucent Technologies • Motivated by drive to: • Realize revenue • Meet internal sales targets • Obtain sales bonuses • Outstanding increases in operating income, net income, and stock price should have raised red flag to KPMG

14. Descriptions of Financial Shenanigans:The Story of Enron • Started because debt load was high and needed to finance borrowings that would not be shown on balance sheet • 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

15. The Story of Enron • The Culture at Enron • “Rank and yank” employee-evaluation policy • Set in place as incentive to keep employee’s quiet • Creation of Chewco • 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

16. The Story of Enron • Skilling resigned after 6 months as CEO • Sharron Watkin’s letter to Ken Lay • Described in detail problems with Enron’s partnerships • Vinson & Elkins claimed no reason for concern • The Final Days • Announced overstatement of earnings by $586 million • Ken Lay and Jeff Skilling found guilty of fraud and conspiracy

17. The Story of Enron • A Review of Important Accounting Issues • Caused by variety of factors: • Improperly failing to consolidate SPE (Chewco) • Failing to adequately disclose related-party relationship between Enron and SPE’s • Overstatement of earnings • Quality of financial reports were poor • Managed earnings • Lack of strong controls • FASB Interpretation No. 45(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

18. The Story of Enron • Enron’s Role in SOX • Provisions that were motivated by Enron fraud: • 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