盈利质量和盈余管理

Earnings Management and Earnings Quality1. What is Earnings Management? (Bryan Halls Webpage)Earnings management is defined by accounting literature as “distorting the application of generally accepted accounting principles.” Arthur Levitt, the old SEC Chairman, defined earnings management as “practices by which earnings reports reflect the desires of management rather than the underlying financial performance of the company.”Earnings management is often defined as the planned timing of revenues, expenses, gains and losses to smooth out bumps in earnings. In most cases, earnings management is used to increase income in the current year at the expense of income in future years. For example, companies prematurely recognize sales before they are complete in order to boost earnings. Earnings management can also be used to decrease current earnings in order to increase income in the future. The classic case is the use of cookie jar reserves, which are established, by using unrealistic assumptions to estimate liabilities for such items as sales returns, loan losses, and warranty returns.Managers engage in income smoothing activities because they know that volatile earnings streams typically lead to lower market valuations. Many successful management teams believe that the strategic timing of investments, sales, expenditures, and financing decisions is an important and necessary strategy for managers committed to maximizing shareholder value.Investors are dissatisfied with the management of earnings; however, investors become enraged when quarterly or annual earnings forecast are not met by firms. Therefore, investors and the public view minor earnings management as acceptable and an everyday business practice. In response to public complaints and concern for earnings management, the SEC has issued bulletins to help prevent earnings management.2.The Public Perception of Earnings ManagementEarnings management has a negative effect on the quality of earnings if it distorts the information in a way that it less useful for predicting future cash flows. Within the Conceptual Framework, useful information is both relevant and reliable. However, earnings management reduces the reliability of income, because the income measure is biased (up or down) and/or the reported income that is not representationally faithful to that which it is supposed to report (e.g., volatile earnings are made to look more smooth).The term quality of earnings refers to the credibility of the earnings number reported. Companies that use liberal accounting policies report higher income numbers in the short-run. In such cases, we say that the quality of earnings is low. Similarly if a nonrecurring gain increases income, but the gain is obviously not sustainable, then the quality of earnings is considered low.For the markets to work efficiently, it is vital that investors be able to trust the earnings numbers of the companies in which they have chosen to invest their capital. Recent studies have shown that the investing public believes that the occurrence of earnings management is both widespread and pervasive in the financial statements of corporations worldwide. However, it is interesting to note that the investing public does not necessarily view minor earnings management as unethical, but in fact as a common and necessary practice in the everyday business world. It is only when the impact of earnings management is great enough to affect the investors portfolio that they feel fraud has been committed.3.The Impact of Earnings ManagementPublic perception about the widespread occurrence of earnings management is affecting the publics confidence in external financial reporting. The practice ofearnings management damages the perceived quality of reported earnings over the entire market, resulting in the belief that reported earnings do not reflect economic reality. Investors rely on financial information provided by the company to make their investment decisions, and when investors believe they are being given meaningless information they become wary of trusting the companies they have invested in. Investors apprehension will eventually lead to unnecessary stock price fluctuation. As investors lose faith in reported earnings, they are forced into a guessing game concerning the actual financial position of a company. This uncertainty ultimately has the potential to undermine the efficient flow of capital thereby damaging the markets as a whole.4. Incentives to Manage EarningA. EXTERNAL FORCES Analyst Forecasts - Companies are under extreme pressure to meet analysts earnings estimates in order to prevent large drops in their stock price. Debt markets and contractual obligations - Companies depend on achieving certain earnings figures to obtain access to debt markets, or even to meet their current debt covenants and other contractual obligations. Competition - There is pressure in highly competitive industries to stay at the top of the industry in terms of revenue or market share. Companies may want to manage these figures to stay above competitors.B.INTERNAL FACTORS Potential mergers - If the company is hoping to enter a merge, a strong financial position will make it look much more attractive to other companies. Management Compensation - Stock option and bonus programs that are tied to earnings performance will provide incentive for managers to manipulate earnings numbers to boost their own compensation. Planning and budgets - Sometimes companies will establish unrealistic plans and budgets to push managers to overachieve. This can provide pressure for management to boost earnings to meet the companys own expectations. Unlawful transactions - Some companies even use earnings management to cover up their own unlawful transactions such as embezzlement, fraud, misappropriation, and bribery.C.PERSONAL FACTORS Personal bonuses - Some compensation policies are heavily weighted towards incentives, and individuals hope to receive a bonus based on their good performance. Promotions and job retention - Fudging numbers to make performance look better may lead to personal promotions, or even help to retain an employees current job.5.SEC Response to Earnings ManagementRecently, several staff accounting bulletins concerning earnings management were released by the SEC and many more such regulations have been promised in the future. These bulletins and promises of more to come are partly the result of former SEC chairman Arthur Levitts crusade to eradicate the problem of earnings management in United States companies. Recent publicity of high profile earnings management from some of the nations most elite companies, combined with a sagging economy have heightened investors fears about the occurrence of earnings management. Throughout the last few years of the chairmans term Mr. Levitt widely publicized his beliefs about the pervasiveness of earnings management and his intention to address these issues. This crusade resulted in a torrent of staff accounting bulletins beginning with the issuance of SAB 99 regarding Materiality in August of 1999. This bulletin attempts to clarify an auditors appropriate scope of materiality while conducting an audit. Since a favorite practice of corrupt management is to justify earnings management by claiming it is immaterial, this statement is particularly helpful to current and future auditors. SAB 100 was released in November of 1999 in an attempt to eradicate the common earnings management practice of taking a “big bath” through the use of restructuring and impairment charges. Another favorite component of earnings management was addressed in March of 2000 when SAB 101A concerning Revenue Recognition was released. The most common form of earnings management is the intentional manipulation of revenue recognition, therefore this statement and its later counterpart SAB 101B are also very helpful to an auditor attempting to snuff out earnings management. Finally, July of 2001 saw the issuance of SAB 102 concerning Loan Loss Allowances, another preferred tool of earnings management. These bulletins will not completely prevent earnings management, and therefore they will not be the last of their kind. Earnings management will remain an important problem facing the markets as long as there is pressure on companies and individual managers to perform. However, careful auditing procedures and continuing attentiveness by the SEC and other regulatory bodies will help reduce the occurrence of earnings management into the future.6.Types of Earnings Management and Manipulation (by Scott McGregor)a. Cookie-jar ReservesThe accrual of expenses is to reflect the period in which the expense was incurred. For example, if a firm hires a consultant to perform a particular activity, it should reflect the expense related to that activity in the period in which it is incurred, not when the bill is paid or invoice received. In many cases, the accrual of expenses, or reserves in particular industries such as insurance and banking, are based on estimates. As such, the estimates have varying degrees of accuracy. During times of strong earnings, the firm establishes additional expense accruals and subsequently reduces the liability to generate earnings when needed in the future - pulling a cookie from the jar.b. Capitalization practices-Intangible assets, software capitalization, research and development. In 1997, companies were allowed to capitalize the costs of internally developed software and amortize it over the useful life, generally three to five years. Capitalization is to represent the development costs. The capitalization process of companies has the potential for manipulation because these assets are often intangible and based on judgment. A firm may allocate more expenses to a project that can be capitalized to reduce current operating expenses.c. Big bath one-time chargesUnusual or non-recurring charges have become one-technique used by firms to escape the maze of over aggressive accounting practices. Many believe and anecdotal evidence has shown that analysts overlook non-recurring charges because they are not part of the firms ongoing operations or operating income. Typical non-recurring charges include writing down assets, discontinuance of an operating division or product line and establishing restructuring reserves. As discussed previously, firms practicing earnings management deplete the economic earnings from future periods. As their ability to sustain earnings growth diminishes, they may seek an event that can be characterized as one-time event and overload the expenses attributable to that event. The one-time charge may be discounted by analysts as not being part of operating earnings while the stock price does not suffer the consequences normally associated with missing earnings targets. To provide itself with more cookie jar reserves or mask its past sins, the firm may take other write-offs or create other accruals not directly tied to the event and attribute those expenses to the one-time event. A study by Elliot and Hanna (1996) reported that reports of large, one-time items increased dramatically between 1975 and 1994. In 1975, less than 5% of companies reported a large negative write-off compared to 21% in 1994. The authors also showed that companies that had previously reported similar write-offs were more likely to do so.d. Operating activitiesManagers often have the ability to modify the timing of events such that the accounting system will record those activities in the period that is most advantageous to management. The activity does not alter the long-term economic value of the transaction, just the timing and thus, comparability of financial statements. For example, a company could accelerate its sales and delivery process such that it records sales in December that normally would have been reported in January. Thus, the company reports higher fourth quarter sales, revenue and profits. In the long-term, the company would ultimately report the same sales and profits; however, it has inflated its growth in the near term, and reduced profits in the future period.e. Merger and acquisition activitiesOne type of significant event that may be used to mask other charge-off is mergers and acquisitions. In most cases, there is some form of restructuring involved creating the need for a large one-time charge along with other merger-related expenses. The event provides the acquirer with the opportunity to establish accruals for restructuring the transaction, possibly attribute more expense than necessary for the transaction. The company may also identify certain expenses that are revalued on the sellers balance sheet, increasing goodwill. If the conservative valuations prove to be excessive, the company is able to reduce its operating expenses in the near term by reducing its estimate for the liability. The additional goodwill created would be amortized over a long period of time and not have a significant impact on near term results. There are two methods of accounting for mergers and acquisitions. Pooling of interests (pooling) accounting and purchase accounting. Pooling recognizes the transaction as a merger of equals, thus the transaction is recorded as company A plus company B. Purchase accounting treats the transaction as a purchase. The fair value of the purchased company is assessed and compared to the purchase price. Any excess or premium paid above the fair value of the assets is recognized as goodwill. Goodwill is amortized over a period of time not to exceed forty years.1. Pooling on interestsAbraham Brilloff, professor emeritus at Baruch College, in an article in the October 23, 2000 issue of Barrons entitled Pooling and Fooling brought attention to the use of pooling accounting by Cisco Systems to inflate its operating earnings. Cisco has been an active acquirer paying $16 billion for twelve companies in fiscal 2000 alone, but through the use of pooling accounting, Cisco only recognized only $133 million in cost in its capital accounts for these transactions. In addition, five of the acquisitions were deemed too immaterial to restate prior period financial statements. Brilloff contends that Ciscos earnings for 2000 should have been reduced by $2.5 billion reducing the $2.1 billion gain into a $.4 billion loss.If a company pays a premium to acquire another firm, the premium, or goodwill, is amortized and reduces earnings going forward. Thus, companies seek transactions that will allow them to use pooling of interests. It has been contended that additional premiums have been paid in instances where pooling of interests will be allowed.Criticism of pooling accounting has been significant and the FASB has reacted by announcing the elimination of the method. However, the effective date has been delayed as the FASB has received strong opposition from industry.2. Purchase accounting and goodwillUnder the purchase method of accounting for acquisitions if the price paid by the acquiring firm exceeds the fair value of the company acquired, the difference is recorded as an intangible asset, goodwill. Goodwill is amortized over future periods, thus, the creation of goodwill causes future expenses, therefore reducing reported earnings. If the acquirer conservatively values assets (such as private placement or illiquid securities and real estate) or liabilities (reserves, accrued liabilities), the company may be able to recognize additional earnings in the near future as it estimates become less conservative.Professor Brilloff has also been a critic of the accounting practices of Conseco, a financial services company. Mr. Brilloff contended that Conseco had manipulated its earnings through its acquisition practices. In summary, he argued that Conseco had inflated the loss or claim reserves of the insurance entities it acquired and recognized a corresponding asset of goodwill at the time of acquisition. It could then reduce the reserves over the near term to inflate earnings while amortizing the goodwill over a significantly longer period of time.f. Revenue RecognitionThe timing of the recognition of revenue is the most likely area to target for management and manipulation. From an operational standpoint, firms can take aggressive actions to boost revenues and sales in one period through providing incentives to their sales force, utilize overtime to push shipments out the door. They may also take aggressive accounting actions such as selling securities classified held for sales recognize gains in income versus stockholders equity, aggressive in the timing of the recognition of sales or aggressive in the application of broad or unclear accounting guidance.g. Immaterial misapplication of accounting principlesMateriality is a concept that has been under fire from the SEC due to its misuse. As previously discussed. Errors, misstatements and misapplication of accounting principles have been overlooked if they fell below the materiality threshold. A company may knowingly misstate earnings by amounts that fall below the materiality threshold by not correcting known errors or other misstatements. If the practice continues for a number of periods, the balance sheet (retained earnings) may become significantly misstated.h. Reserve one-time chargesThe use of one-time charges, established in the form of a reserve, can be used to manage earnings. The company conservatively recognizes a one-time charge in the form of a contingency reserve for a possible future loss or future expense. They anticipate that analysts will discount the charge since it is not deemed to be part of operating income. Over time, the company changes its estimate (reduces) to recognize additional earnings.7.Examples of c