1、http:/ (海量营销管理培训资料下载 )http:/ (海量营销管理培训资料下载 ) 1Earnings 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 C
2、hairman, 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 e
3、arnings. 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 earnin
4、gs 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 becaus
5、e 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 shareholde
6、r 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 pu
7、blic 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 pr
8、edicting 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
9、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 q
10、uality 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.http:/ (海量营销管理培训资料下载 )http:/ (海量营销管理培训资料下载 ) 2For the markets to work efficiently, it is vital that investors be able to trust the e
11、arnings 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 interesti
12、ng 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 fra
13、ud 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 of earnings management damages the perceived quality of reported earnings over the enti
14、re 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 comp
15、anies 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
16、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 contra
17、ctual 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
18、 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. http:/ (海量营销管理培训资料下载 )http:/ (海量营销管
19、理培训资料下载 ) 3 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 p
20、ush 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.
21、 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 he
22、lp 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 th
23、e 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
24、 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 wi
25、th 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
26、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 ad
27、dressed 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
28、out earnings management. Finally, http:/ (海量营销管理培训资料下载 )http:/ (海量营销管理培训资料下载 ) 4July 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
29、 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 occ
30、urrence 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, i
31、t 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
32、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 capitalizatio
33、n, 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 f
34、or 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 escap
35、e 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 a
36、n 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 http:/ (海量营销管理培训资料下载 )http:/ (海量营销管理
37、培训资料下载 ) 5event 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 earnin
38、gs 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-t
39、ime 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 oft
40、en 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 sta
41、tements. 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
42、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 res
43、tructuring 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 ma
44、y 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 create
45、d 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, thu
46、s 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 http:/ (海量营销管理培训资料下载 )http:/ (海量营销管理培训资料下载 ) 6assessed and compared to the purchase price. Any excess or premium paid above the fair value o
47、f 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
48、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 t
49、ransactions. 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 an
