Solution Manual For Ethical Obligations and Decision Making in Accounting Text and Cases 4th Edition

Solution Manual for Ethical Obligations and Decision-Making in Accounting: Text and Cases 4t
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Decision-Making in Accounting: Text and Cases 4th
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Chapter 7 Discussion Questions1
Suggested Discussion and Solutions
1. In Arthur Levitt’s speech that was referred to in the opening quote he also said:
“…I fear that we are witnessing an erosion in the quality of earnings, and therefore,
the quality of financial reporting. Managing may be giving way to manipulation;
Integrity may be losing out to illusion.” Explain what you think Levitt meant by this
statement. What role do financial analysts’ earnings expectations play in the quality
of earnings?
The financial reporting process becomes unreliable when corporate managers, auditors,
and analysts all work together to deceive the investing public. The reason for the auditing
process is to independently verify that the financial statements present fairly financial
position and results of operations. Manipulation of financial reports leads to
compromising its usefulness, and a lack of integrity in the financial reporting process
compromises the faithful representation of the financial numbers thereby leading to an
erosion of the quality of earnings.
Financial analysts’ report projected earnings expectations for the market. Shareholders
act on such expectations, and if they are not the results expected by the marketplace, the
result can be a loss of share value and difficulty attracting future shareholders. Analyst
projections motivate some managers to manage earnings by income smoothing or
financial shenanigan techniques to meet those expectations.
Extended Discussion
What are Consensus Earnings?
Consensus earnings estimates are watched by many investors and play an important role
in measuring the appropriate valuation for a stock. Investors measure stock performance
on the basis of a company's earnings power. To make a proper assessment, investors seek
a sound estimate of this year's and next year's earnings per share (EPS), as well as a
strong sense of how much the company will earn even farther down the road.
Novartis CEO Dan Vasella told Fortune magazine that:2
In the “practice by which CEOs offer guidance about their expected quarterly earnings
performance, analysts set “targets” based on that guidance, and then companies try to
1
See the last page of this document for a pending FASB rules to eliminate extraordinary items from the income
statement.
2
(Source: Guidance: The Good Riddance: http://fortune.com/2009/02/06/guidance-good-riddance/).
Ethical Obligations and Decision Making in Accounting, 4/e 1

© 2017 by McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
meet those targets within the penny.” Back in the early 2000s, “the practice had become
so enshrined in the culture of Wall Street that the men and women running public
companies often thought of little else. They become preoccupied with short-term
“success,” a mindset that can hamper or even destroy long-term performance for
shareholders. I call this the tyranny of quarterly earnings…
Tyranny is a slippery thing. Rarely does it make itself known for what it is right from the
start. Once you get under the domination of making the quarter -- even unwittingly -- you
start to compromise in the gray areas of your business, that wide swath of terrain between
the top and bottom lines. Perhaps you’ll begin to sacrifice things (such as funding a
promising research-and-development project, incremental improvements to your
products, customer service, employee training, expansion into new markets, and yes,
community outreach) that are important and that may be vital for your company over the
long term…”
A consensus forecast number is normally an average or median of all the forecasts from
individual analysts tracking a particular stock. So, when you hear that a company is
expected to earn $1.50 per-share this year, that number could be the average of 30
different forecasts. On the other hand, if it's a smaller company, the estimate could be the
average of just one or two stock analyst forecasts.
A few companies, such as Thomson First Call, Reuters and Zacks Investment Research,
compile estimates and compute the average or consensus. Consensus numbers can also be
found at a number of financial websites, including Yahoo! Finance and MSN
MoneyCentral. Some of these sites also show how estimates get revised upwards or
downwards.
Consensus estimates of quarterly earnings are published for the current quarter, the next
quarter and so on for about eight quarters. In some cases, forecasts are available beyond
the first few quarters. Forecasts are also compiled for the current and next 12 month
periods.
A consensus forecast for the current year is reported once actual results for the previous
year are released. As actual numbers are made available, analysts typically revise their
projections within the quarter or year they are forecasting.
Even the most sophisticated investors - such as mutual fund and pension fund managers -
rely heavily on consensus estimates. Most of them do not have the resources to track
thousands of publicly-listed companies in detail - or even to keep tabs on a fraction of
them, for that matter.3
2. Are the use of non-GAAP financial measures ethical?
3
Source: Everything You Need To Know About Earnings.: http://m.kiplinger.com/article/investing/T052-C000-
S001-everything-you-need-to-know-about-earnings.html).

One of the objectives of the Sarbanes-Oxley Act of 2002 (SOX) was to “eliminate the
manipulative or misleading use of non-GAAP financial measures and, at the same time,
enhance the comparability associated with the use of that information.” Consequently, the
SEC issued Regulation G, “Conditions for Use of Non-GAAP Financial Measures,” in
January 2003. It requires companies using a non- GAAP measure to disclose that the
measure isn’t misleading and to provide a reconciliation between their measure and the
most directly comparable GAAP measure. The GAAP presentation must have equal or
greater prominence. Management must disclose the reasons why the non-GAAP measure
provides useful information to investors and offer a statement of additional purposes for
which the non-GAAP measure is used. Only GAAP financial information can be
presented directly on the face of a company’s financial statements, to highlight the fact
that the independent audit opinion doesn’t cover such information.
Several conclusions can be made about the relevance and usability of the current
financial reporting system. Even considering the imprecise nature of current accounting
standards, it’s too easy for companies to turn poor GAAP earnings into great non-GAAP
earnings by simply designing their own performance measures that can readily be
adjusted to unethically report successful accomplishment of the goals created using those
same measures. Consequently, non-GAAP earnings reporting should be strictly limited
and permitted only in extraordinary circumstances -- that is, in cases where current
GAAP doesn’t clearly reflect economic reality. Companies should have to demonstrate a
real necessity and communicate meaningful, unique reasons why they believe using a
non-GAAP measure is mandatory to avoid misleading investors and others, not just to
portray better short-term profits, earn bigger bonuses, and cash in on stock options. The
widespread use of non- GAAP performance measures seems to provide conclusive
evidence that the current financial reporting system may be broken.4
3. Relevance and faithful representation are the qualitative characteristics of useful

information under SFAC 8. Evaluate these characteristics from an ethical
perspective. That is, how does ethical reasoning enter into making determinations
about the relevance and faithful representation of financial information?
Relevance relates to the usefulness of financial information and whether all necessary
information has been made available for stakeholders to be able to make informed
decisions. Faithful representation addresses the honesty and integrity of the information.
Is it biased or slanted to be misleading? Relevance and faithful representation requires the
accountant to display the values of trustworthiness, honesty, integrity, reliability, respect,
fairness, and responsibility. Representational faithfulness refers to the requirement for
consistency between claims made in financial statements and economic reports and the
actual financial state of the company. Accounting reports should reflect accurate, reliable
and verifiable financial position including debt, cash flow and company performance.
Relevance and representational faithfulness can be judged using Rights Theory. In other
4
(Source: Curtis Verschoor, “Is Non-GAAP Reporting Unethical? http://www.imanet.org/docs/default-
source/sf/04_2014_ethics-pdf.pdf?sfvrsn=0.)

words, would I want others to report this item of financial information the way I am
about to do? If the answer is yes, objectivity exists and the reporting reflects what it
should from a reliability perspective.
Relevance and faithful representation are values of financial reporting. As such they
embody ethical determinations of how best to show the economic substance of
transactions and not just legal form. This links to ethical legalism since even though the
method of financial reporting appears to comply with GAAP, the result may not be
enough to reflect open and transparent financial information.
4. Evaluate earnings management from a utilitarian perspective. Can earnings

management be an ethical practice? Discuss why or why not.
From a utilitarian perspective, the market, shareholders, investors, and other stakeholders
want a company to be profitable over the long-run. Quarterly financial reporting
introduces variability into earnings and other trends. Earnings management can smooth
the short term earnings and have little effect on the long-term earnings. Accrual
accounting is a form of earnings management for the short-term. Examples of accrual
accounting that manage earnings in the short term are accrued liabilities including
warranties at period end. These accrual adjustments enable the financial statements to be
reported more smoothly in the short-term without changing the long term results. Accrual
accounting provides smoothed short term financial reporting while not distorting the
long-term effects; it aids the greatest number of shareholder, investors, creditors, and the
market. A utilitarian perspective might rationalize earnings management by saying the
benefits of smooth earnings outweigh the costs. This is an argument made by Thomas
McKee to support the ethical acceptability of earnings management. However, this is act
utilitarianism and ignores the basic tenet of rule utilitarianism that certain rules should
never be violated, such as managing earnings through manipulations rather than natural
reporting measure.
Earnings management may be considered unethical from a virtue perspective if when

earnings do not meet financial analysts’ earnings expectations or goals established for
earnings, the company purposefully manipulates those amounts, an action that lacks
honesty, reliability, and the resulting loss of trust in the financial reporting process.
Earnings management may either ignore or not adequately consider the rights of the
investors and creditors to receive accurate, reliable and transparent financial statements.
Earnings management might be rationalized from an ends justifies the means approach to
ethical reasoning. However, the analysis misses the point that the means are not
accomplishing what is in the best interest of the shareholders (principals); instead it
emphasizes the interest of management (agents).
To illustrate the potential distortion effects of earnings management, ask students about
the scandal at Volkswagen in 2015 when it was determined that VW sold hundreds of
thousands of diesel cars in the U.S. with software specifically designed to evade
government pollution tests. The company disclosed that the irregularities on diesel-

emission readings extended to some 11 million vehicles globally. The company had
admitted that it rigged diesel vehicles using a "defeat device" to pass lab tests, even
though they emitted as much as 40 times the legal limit of pollutants on the road.
Proper accounting requires VW to accrue a liability to cover the cost to fix the affected
cars. According to the following estimates, VW should accrue at least $1.8 billion and
that’s just the base cost price of $2,700 for the street price of a used late model
Volkswagen replacement engine. The cost of 482,000 engine replacements on the open
market would therefore be $1.3 billion, just for parts. If we assume an additional $1,000
per vehicle for independent repair shop labor, we're up to $1.8 billion. You can adjust
these estimates on your own for new original equipment manufacturer parts and dealer
labor rates. And you can adjust the estimates up or down based on whether you think the
replacements will run on diesel or gasoline.
That's the estimate of the maximum warranty cost for the U.S. portion of the installed
base: $1.8 billion. And that's actually quite significantly smaller than the $2.5 billion
allocation General Motors made in the first half of 2014 for its massive ignition switch
recall, which had a much larger frequency but a much smaller severity than VW's current
problem.
The $1.8 billion estimate doesn’t include the potential liability from a class action lawsuit
The point is that VW will estimate its future liability which, obviously, is not easy to do.
What if its 2015 earnings were extremely low? It could under-estimate the liability and
make adjustments as needed later on when and if it recovers from the scandal. On the
other hand, the company might over-estimate the loss based on the belief that the public
expects it to be quite high in 2015, and then take back into income the over-reserved
amount in the future to make up for what is expected to be losses for some time. Thus, by
using earnings management VW distorts the financial results over a period of time and
misleads the users of financial statements about the true earnings (or losses).
5. Evaluate the following statements from an ethical perspective:

“Earnings management in a narrow sense is the behavior of management to play
with the discretionary accrual component to determine high or low earnings.”
“Earnings are potentially managed, because financial accounting standards still
provide alternative methods.”
Refer to the discussion above about the use of accruals to manage earnings. The example
of VW illustrates how management can play with the numbers to reflect earnings based
on what it wants rather than what it should be.
The statements reflect that earnings management is a means to an end, that being
increasing earnings. The methods of managing earnings may either be ethical or
unethical. Using ethical means would lead to staying in the middle of the continuum as
Needles noted (and that was discussed in the chapter); reporting the honest earnings
reflecting economic transactions and being transparent in the disclosures of policies.

Earnings can be managed through the choice of accounting techniques as pointed out by
Dechow and Skinner.
Accounting allows for alternative ways to record transactions. If the choices are designed
to best reflect the financial results within the context of GAAP, then the techniques used
are acceptable. However, if those techniques are chosen to achieve a desired level of
earnings and not to reflect representational faithfulness, then they are unethical. Unethical
means would reflect the outer areas of Needles’ continuum and can produce unreliable
numbers.
6. Comment on the statement that materiality is in the eye of the beholder. How does
this statement relate to the discussion in the chapter of how to gauge materiality in
assessing financial statement restatements? Is materiality inconsistent with the
notion of representational faithfulness?
One of the definitions of materiality is that it is the amount that would cause an investor
to change his mind about investing in a company. Normally, a rule of thumb for
materiality is the amount that would change a net income to a loss or vice versa, or 5% of
revenue. However, many investors have their own definition.
Ask students what their definition of materiality is. One student in a class said that
materiality is the amount of money that he would not care about if his check book was
out of balance (i.e., $1). One student claimed that it was the amount that students were
making per hour on one of their jobs. Another student said it was the amount of money,
in aggregate, that would mean that he could complete his college education without
having to work. In other words, the amount to pay for his remaining tuition, books, and
living expenses so he could graduate without student loans. We pointed out that it could
be viewed as the amount of money that one’s paycheck could be reduced by without
influencing life style.
Materiality and financial restatements goes hand in hand. If the amount involved does not
materially affect a reasonable user’s view of the earnings, regardless of how such
materiality judgments are made, then a restatement is not required. The ironic point is the
difference may affect representational faithfulness but not require adjustment so that the
statements are not 100% accurate. This is a compromise accountants and auditors make
in the process of auditing because there may be several items of difference with a client
and the auditor can’t debate each and every issue, but instead should focus on the more
important items.
In late 2008, the SEC Final Report of the Advisory Committee on Improvements to
Financial Reporting recommended moving away from the professional judgment and
“reasonable person” standard of materiality in restatements. The committee also
encouraged disclosures surrounding restatements, including how and why the restatement
occurred, was discovered, and corrective actions to prevent future errors.
7. Needles talks about the use of a continuum ranging from questionable or highly
conservative to fraud to assess the amount to be recorded from for an estimated
expense. Discuss his concept of a continuum and the choices within a range from an

ethical perspective. That is, how might a decision about the selection of one or
another amount in the continuum relate to it being an ethical position to take?
In Needles’s continuum, a neutral treatment is in the middle of the continuum reflecting

the mid-ground between high and low misstatements of GAAP. The continuum shows a
highly conservative amount on one end and fraudulent on the other. This continuum may
be thought of as a road with the two extremes being the curbs on either side of the road.
The idea is to stay between the two curbs. The two extremes distort the financial
statements and disclosures. These extremes do not reflect the virtues of honesty, full
disclosure (transparency), dependability, and reliability that shareholders, investors and
other stakeholders require to trust that the financial statements are fair and accurate.
The best way to discuss the continuum from an ethical perspective is to examine what
Aristotle meant by the “Golden Mean.” The golden mean is the desirable middle between
two extremes, one of excess and the other of deficiency. For example, in the Aristotelian
view, courage is a virtue, but if taken to excess would manifest as recklessness, and, in
deficiency, cowardice.
Aristotle conceived of the golden mean as being the result of practical knowledge and
wisdom. Thus, we might say that a wise accountant finds a middle ground to stake out a
position when debating differences of opinion with management on an earnings issue. If
the accountant goes too far to one extreme or the other, either the earnings will be
materially misstated or overly-conservative.
Critics of Aristotle’s golden mean point out that the theory doesn’t actually help in
finding virtue. Think about it: when you’re trying to find out what the virtuous amount of
a characteristic is, all the golden mean offers is a tautological claim that the right amount
is not too much and not too little (tautological because the good amount of a
characteristic is defined as being the good amount of the characteristic). In accounting,
however, the right amount is that which fairly represents underlying economic
characteristics and leads to a fair presentation of operating results. The golden mean does
neither; rather it seems to be a compromise position albeit one that auditors take all the
time on materiality positions.
8. In 2010 LinkedIn reported trade payable obligations totaling $10.8 million in other
accrued expenses within accrued liabilities instead of accounts payable. In 2011,
note 2 in the 10-K financial statements described the use of accrued liabilities
instead of accounts payable as a classification. Do you believe LinkedIn’s accounting
qualifies as a financial shenanigan? Why or why not?
Accounts payable is a liability account; normally it is considered a current liability or

payable in one year or less. Using the term “liabilities” instead of “payable” does not rise
to a financial shenanigan in and of itself. If all the accounts payable or accrued liabilities
that should be recorded are not recorded, then it might rise to a financial shenanigan.

The most important point is accounts payable denote trade amounts so the reader believes
these liabilities occurred as a result of purchase and other operating decisions. Accrued
liabilities are seen as adjustments to expenses to conform to the matching principle.
While the use of the accrued liability classification instead of accounts payable may not
in and of itself constitute a shenanigan, it does reflect improper account classification and
may affect the judgment of the user.
9. Comment on the statement that what a company’s income statement reveals is
interesting but what it conceals is vital.
Here are some examples of where the earnings on the income statement revealed
information but concealed important facts about the true nature of the amount thereby
bringing into question the quality of earnings.
Revenue Gross-Up: Revenue Gross-Up is a practice that many internet firms used in the
early part of this decade. The companies would report the entire sales price a customer
paid at their site when in reality the companies kept only a small percentage of the
amount they collected. Priceline.com was criticized for this strategy because about 72%
of amount the customers paid to Priceline.com went to airlines, hotels, or other vendors.
Although the SEC in 2005 accepted Priceline.com’s practice of revenue gross-up, other
companies have not received acceptance of this practice.
Right to Return. When a company sells a product to another company and the contract
gives the company buying the product a right to return it, the selling company may have a
financial accounting duty not to recognize the revenue from the sale of the product until
the right to return the product has elapsed. Companies like Delphi Corp. had problems in
2005 with this right to return issue when senior executives recorded sales of inventory to
outside companies despite an agreement with that company to buy back those same assets
at a later date.
Related Service Agreements. Related service agreements may cause revenue
recognition problems. So for example, if a computer system is sold on a bundled basis at
$125 million at the time of installation and $25 million per year for each of the three
years of service, then the company should book $125 million at the time of installation
and $25 million per year for the length of the service contract. Xerox received one of the
largest civil penalties of the time for its leasing arrangements when it bundled the sale,
financing, and service elements of its equipment together and recognized revenue all at
once.
Sale of Franchises. When a franchisor collects a high front-end fee in return for
exclusive rights to a territory the franchisers may book the fee as revenue. However, this
practice could make the growth rate in early years look spectacular but significantly drop
in later years. Jiffy Lube International ran into this problem and while misstating its
revenue, the stock price jumped from $78 per share in 1986 to $250 share in 1997. The
price run up was directly related to reported revenue growth. When the growth tapered
off and investors looked at royalty revenues instead of the front-end fees, the stock price
fell to $3.50 a share in 1990.

10. Maines and Wahlen state in their research paper on the reliability of accounting
information: “Accrual estimates require judgment and discretion, which some firms
under certain incentive conditions will exploit to report non-neutral accruals
estimates within GAAP. Accounting standards can enhance the information in
accrual estimates by linking them to the underlying economic constructs they
portray.” Explain what the authors meant by this statement with respect to the
possible existence of earnings management.
The authors note that accrual estimates may be skewed under the right circumstances.
These accruals can be adjusted up or down to reflect desired results (earnings
management) rather than portray economic reality. For example, the bonuses payable to
top managers might be increased or decreased based on reported earnings with reference
to the earnings desired by management rather than to show the true liability agreed-to by
the CEO.
The authors go further to note that accounting standards could be enhanced by tying the
estimates to the underlying economic constructs they portray. This is what is desired from
a representational faithfulness perspective. For example, in accounting for leases if one of
four capital lease criteria exist (i.e., transfer of ownership to lessee, bargain purchase
option, lease equals 75%+ of economic life, and present value equals 90%+ of the
estimated fair value of the lease including any guaranteed residual value) the transaction
is treated as if the lessee (user of property) bought the asset from the lessor (owner) rather
than is just using it for a period of time as one might with a leased automobile. The result
is an asset and liability is recorded on the books of the lessee, rather than operating
expenses, and the transaction reflects economic reality because for all intents and
purposes if any of the criteria are met, then the lessee has, in reality, purchased the asset.
This is a good time to point out to students how the “bright-line” rule standards in leases
can be manipulated thereby distorting economic reality. For example, if a company
desires to record the lease as operating rather than capital, and none of the first three
criteria are met, then the “guaranteed” residual value might be purposefully lessened to
fail that criteria as well. Management choice takes center stage rather than to reflect the
economic substance of the transaction.
Accounting information is widely used in many contexts, implying financial statements
users consider it to be sufficiently reliable; however, Maines and Wahlen found that
accounting information reliability is difficult to determine because of difficulties
observing the underlying economic construct. Thus, accounting information reliability is
jointly determined by accounting standards that match the underlying economic
constructs and preparers and auditors that appropriately apply such standards to the
financial reporting process.
11. Krispy Kreme was involved in an accounting fraud where the company reported
false quarterly and annual earnings and falsely claimed that, as a result of those
earnings, it had achieved what had become a prime benchmark of its historical
performance, that is, reporting quarterly earnings per share that exceeded its
previously announced EPS guidance by 1¢. One method used to report higher

earnings was to ship two or three times more doughnuts to franchisees than ordered
in order to meet monthly quotas. Would you characterize what Krispy Kreme did as
earnings management? Explain.
There are a variety of definitions of earnings management. Schipper defines it as a

“purposeful intervention in the external reporting process, with the intent of obtaining
some private gain (as opposed to, say, merely facilitating the neutral operation of the
process).” Healy and Wahlen define it as “when managers use judgment in financial
reporting and in structuring transactions to alter financial reports to either mislead some
stakeholders about the underlying economic performance of the company, or to influence
contractual outcomes that depend on reported accounting numbers.” Both of these
definitions coincide with the intent of Krispy Kreme’s management when it shipped
excessive inventory to meet financial projections. Management intervened in the
financial reporting process and structured revenue-earning transactions to achieve a
desired goal -- to report operating results that met or exceeded financial analysts’
earnings expectations rather than to portray the underlying economic reality of Krispy
Kreme’s business. The company struggled as competition in its product space increased
and made decisions that compromised ethical values for the sake of non-ethical ones.
12. Safety-Kleen issued a major financial restatement in 2001. The next year, the
company restated (reduced) previously reported net income by $534 million for the
period 1997–1999. PwC withdrew its financial statement audit reports for those
years. Do you believe that financial restatements and withdrawing an audit report
are prima facie indicators that a failed audit has occurred? Explain.
Audit failure occurs when the auditor issues an incorrect audit opinion because it failed to
comply with the requirements of auditing standards. How does one decide if the audit is a
failure when the audit is properly planned and performed to detect material misstatements
but there was financial statement fraud by top management? It is possible to have a
proper audit and a misstatement goes undetected. It is also possible to have a problematic
audit and the financial statements are accurate. Because the financial statements are
accurate, it did not matter if the (Safety Kleen) audit was perfect or problematic.
Likewise, if there is a misstatement in the financial statements it may not be possible for
the audit to identify the amount and existence if management goes to such lengths that it
hides information from the auditors, deceives it when questioned about the matter,
manipulates the books to support the improper treatment or takes other measures to
thwart diligent audit attempts to identify all material misstatements.
Financial statement restatements and withdrawing an audit report are indicators that the
auditors failed to catch a material misstatement until after the financials were issued. It
may indicate a failed audit if the auditors did not follow GAAS, failed to exercise due
care, failed to approach the audit with the requisite professional skepticism, allowed its
relationship with top management and the company to influence professional judgment,
or exhibited other features of an audit that did not adhere to quality measures.

The reality is the public typically expects the audit to identify all such problems while the
profession’s view is it can only be expected to catch financial fraud (and avoid the need
for restatements and opinion withdrawal) through GAAS and a careful, diligent audit.
This is the reason for the expectations gap discussed in chapter 5.
13. Revenue recognition in the Xerox case called for determining the stand-alone selling
price for each of the deliverables and using it to separate out the revenue amounts.
Why do you think it is important to separate out the selling prices of each element of
a bundled transaction? How do these considerations relate to what Xerox did to
manage its earnings? Do you think the new revenue recognition standard will
change the criteria in accounting for transactions like at Xerox?
Vendors often provide multiple products or services to their customers as part of a single
arrangement or a series of related arrangements. These deliverables may be provided at
different points in time or over different time periods. As a simple example, a vendor
may enter into an arrangement with a customer to deliver and install a tangible product
along with providing one year of maintenance services. In this arrangement, there are
three deliverables: (1) the product, (2) installation, and (3) maintenance services. Issues
often arise regarding how and whether to separate these deliverables and how to allocate
the overall arrangement consideration. Subtopic 605-25, Revenue Recognition—Multiple-
Element Arrangements, of the Financial Accounting Standards Board’s Accounting
Standards Codification (ASC) provides the guidance that should be followed in
accounting for this and many other revenue arrangements with multiple deliverables.
Bundled transactions may have two or more components that require different accounting
methods (or treatments). An example might be the lease of equipment under an operating
lease, the maintenance of the leased equipment throughout the lease term, and the sale of
addition equipment unrelated to the leased equipment. The maintenance of the leased
equipment would be accounted for as executory (future contingency) costs. Another
example would be a cell phone company that offers a free phone as a reward for signing a
two-year service contract with the cell phone company. The same monthly service fee is
charged whether the customer receives a free phone or not. The phone may also be sold
separately. In the cell phone example, one component is recognized as revenue when the
service or product is activated. The second component is recognized over the
maintenance or service term.
Xerox used different methods to increase the amount of lease revenues at the inception of
the lease and reduced the amount it recognized over the life of the lease. Xerox would
bundle the lease of copiers, pre-sale copier supplies, and maintenance service all into the
same contract; it would then minimize any financing, the supplies and maintenance
portions so that more revenue was recognized at the time of the contract. The practice
violated basic matching requirements which dictate earnings should be matched with
effort and not based on earnings management objectives.
In May 2014, the Financial Accounting Standards Board (FASB) and the International
Accounting Standards Board (IASB) jointly issued a new revenue recognition standard,

Revenue from Contracts with Customers, to converge the revenue recognition rules of
both bodies. The new standard is effective for public companies for annual and interim
periods beginning after December 15, 2016, and December 15, 2017 for nonpublic
companies. The new standard provides guidance for helping companies recognize
revenue under both U.S. GAAP and IFRS. The new standard provides a single,
comprehensive accounting model for revenue recognition. The standard is complex so we
limit the discussion to the very basics here.
Under the new standard, companies under contract to provide goods or services to a
customer will be required to follow a five-step process to recognize revenue:
1. Identify contract(s) with a customer.

2. Identify the separate performance obligations in the contract.
3. Determine the transaction price.
4. Allocate the transaction price to the separate performance obligations.
5. Recognize revenue when the entity satisfies each performance obligation.
The new revenue recognition standard is more principles-based and may result in
financial reporting that, in some cases, is more reflective of the underlying economics.
The rule’s expanded disclosure requirements will help financial statement users
understand the nature, amount, timing, and uncertainty of revenue and cash flows arising
from contracts with customers.
The new standard tightens up revenue recognition criteria and provides better guidance
for companies like Xerox. The new standard requires extensive disclosures including
disaggregation of total revenue; information about performance obligations; changes in
contract asset and liability account balances between periods; and key judgments and
estimates.
[We’ll reserve final comment until the standard goes into effect and any “tweaking” that
is necessary is made. This question provides an opportunity to review the new standard
with students and any amendments to the original standard that have occurred since the
original one discussed in the text.]
14. Tinseltown Construction just received a $2 billion contract to construct a modern

football stadium in the City of Industry, located in southern California, for a new
National Football League (NFL) team called the Los Angeles Devils of Industry. The
company estimates that it will cost $1.5 billion to construct the stadium. Explain
how Tinseltown can make revenue recognition decisions each year that enable it to
manage earnings over the three-year duration of the contract.
Tinseltown should follow the percentage-of-completion method and recognize revenue

over the life of the contract based on a ratio of costs incurred to date to total estimated
costs on the contract. Using this approach leads to a proper matching of costs and
revenues based on stage of completion. The alternative of using the completed contract
method would delay the recording of revenue until the contract is complete. The problem

here is no matching occurs and generally this method should not be used unless
uncertainty exists about the accuracy of the estimates.
Since the percentage-of-completion method involves costs estimates, it allows for

manipulation of the numbers and earnings management. For example, if the company
legitimately incurs $500 million in costs the first year, then 1/3 of the revenue
($666,666,667) should be recognized assuming the estimate of total costs remains at $1.5
billion. The net income is $166,667. However, what if the company lowers the estimate
of future costs to $1.25 billion? Then 40% of the revenue ($800 million) can be
recognized. The net income is $300,000. Each year the estimate can be adjusted to meet
earnings goals rather than show economic reality. Earnings management is the technique
used to accomplish the company’s objectives with revenue recognition on the contract.
The use of percentage-of-completion accounting to manage earnings distorts the quality
of earnings.
15. Explain how a company might use the accounting rules for impairment of long-lived
assets to manage earnings.
The accounting for impairment of long-lived assets to be held and used depends on
judgments of fair value. Generally, if the fair value of the asset is less than the carrying
amount of an asset, an impairment loss is recognized. Under U.S. GAAP (Statement of
Financial Accounting Standards No. 144: Accounting for the Impairment or Disposal of
Long-Lived Assets), an impairment loss exists when the financial statement carrying
amount exceeds its fair value and is not recoverable. A carrying amount is not
recoverable if it is greater than the sum of the undiscounted cash flows expected from the
asset’s value and eventual disposal. FASB defines impairment loss as the amount by
which the carrying value exceeds an asset’s fair value. Thus, the impairment loss
calculation is a two-part process. The first thing to do is to determine if impairment exists
(carrying value greater than undiscounted cash flows). The second step is to determine
the loss as the difference between carrying value and fair value. Under SFAS 144, once
an impairment loss is recognized, future increases in fair value are not recognized as a
recapture of the loss. Finally, asset depreciation is based on the lower fair value amount
after the loss is determined.
The FASB rules require judgment in estimating future cash flows and fair value, thereby
providing an opportunity to manage the estimates and affect current and future earnings.
The amount of discretionary choice available to management in a decision to charge an
impairment loss is an important point in terms of whether management uses this
discretion in order to manipulate the published financial results.5
Extended Discussion
5
Discretionary choice forms an important part of the seminal work by Watts and Zimmerman (1978) in the area of
Positive Accounting Theory and management choice in discretionary accounting policy. Central to the issue of
discretionary choice is the measurement and valuation method applied by management in the determination of an
asset impairment loss.

This question provides an opportunity to incorporate a discussion of International
Financial Reporting Standards (IFRS) and provide students with one example of how
FASB and IFRS differ. IFRS provides (International Accounting Standard No. 36:
Impairment of Assets) that an impairment loss is recognized when the carrying amount is
greater than the “recoverable amount.” The recoverable amount is the greater of the fair
value minus costs to sell and the value in use (i.e., the present value of future cash flows
to be derived from the asset). The impairment loss is the excess of the carrying amount of
the asset over its recoverable amount. Unlike FASB standards, under IFRS impairment
losses already recognized are subject to reversal if the recoverable amount increases –
and it is limited up to the carrying amount. Depreciation is taken on the higher or
adjusted values.
Example:
Carrying amount $50,000

Selling price 40,000
Costs of disposal 1,000
Expected future cash flows 55,000
Presented value of expected future cash flows 46,000
IAS 36:
Net selling price (40,000-1,000) $39,000

Value in use 46,000
Recoverable amount (greater) $46,000

Less: Recoverable amount 46,000
Impairment loss $4,000
FASB 144:
Undiscounted cash flows $48,000
Fair value 47,0006
Less: Undiscounted cash flows 48,000
Asset is impaired 2,000
6
Fair value is defined as the price that would be received in selling an asset or paid to transfer a liability in an
orderly transaction between market participants at the measurement date.

Calculation of loss:
Estimated fair value 47,000
Impairment loss $ 3,000
16. The SEC’s new rules on posting financial information on social media sites such as
Twitter means that companies can now tweet their earnings in 140 characters or
less. What are the problems that may arise in using a social media platform to
report key financial data including the potential effects on shareholders and the
company?
On April 2, 2013, the Securities and Exchange Commission issued a report that makes
clear that companies can use social media outlets like Facebook and Twitter to announce
key information in compliance with Regulation Fair Disclosure (Regulation FD) so long
as investors have been alerted about which social media will be used to disseminate such
information.
The SEC confirms that Regulation FD applies to social media and other emerging means
of communication used by public companies the same way it applies to company
websites. The SEC issued guidance in 2008 clarifying that websites can serve as an
effective means for disseminating information to investors if they’ve been made aware
that’s where to look for it.
The SEC’s report clarifies that company communications made through social media
channels could constitute selective disclosures and, therefore, require careful Regulation
FD analysis. “One set of shareholders should not be able to get a jump on other
shareholders just because the company is selectively disclosing important information,”
said George Canellos, Acting Director of the SEC’s Division of Enforcement. “Most
social media are perfectly suitable methods for communicating with investors, but not if
the access is restricted or if investors don’t know that’s where they need to turn to get the
latest news.”
Regulation FD requires companies to distribute material information in a manner

reasonably designed to get that information out to the general public broadly and non-
exclusively. It is intended to ensure that all investors have the ability to gain access to
material information at the same time.
The SEC’s report stems from an inquiry the Division of Enforcement launched into a post
by Netflix CEO Reed Hastings on his personal Facebook page stating that Netflix’s
monthly online viewing had exceeded one billion hours for the first time. Netflix did not
report this information to investors through a press release or Form 8-K filing, and a
subsequent company press release later that day did not include this information. Neither
Hastings nor Netflix had previously used his Facebook page to announce company

metrics, and they had never before taken steps to alert investors that Hastings’ personal
Facebook page might be used as a medium for communicating information about Netflix.
Netflix’s stock price had begun rising before the posting, and increased from $70.45 at
the time of the Facebook post to $81.72 at the close of the following trading day. The
SEC did not initiate an enforcement action or allege wrongdoing by Hastings or Netflix.
Recognizing that there has been market uncertainty about the application of Regulation
FD to social media, the SEC issued the report of investigation pursuant to Section 21(a)
of the Securities Exchange Act of 1934.7
The report of the investigation explains that although every case must be evaluated on its
own facts, disclosure of material, nonpublic information on the personal social media site
of an individual corporate officer -- without advance notice to investors that the site may
be used for this purpose -- is unlikely to qualify as an acceptable method of disclosure
under the securities laws. Personal social media sites of individuals employed by a public
company would not ordinarily be assumed to be channels through which the company
would disclose material corporate information.
Several large companies, including computer-maker Dell Inc. and eBay Inc., use Twitter
to announce financial and other key information to investors. Many simultaneously send
out news releases or report the information in filings to the SEC. The SEC’s
announcement of the new policy will allow them to use social media more. Only 14.4%
of companies communicate with shareholders via social media, according to a 2012
survey by the Conference Board and Stanford University. Yet more than three-quarters of
the companies in the survey said they used social media to interact with customers.
Controls on the release of financial data using social media have been set by the SEC.
One concern is whether a hacker (i.e., disgruntled employee) can gain access to the
financial information on the web site and alter its information content. Given the newness
of the SEC pronouncement, there may be unintended consequences that potentially harm
shareholder interests. The accounting profession also has to consider whether the
information should be reviewed to ensure consistency with the published financial
information in 10-Q and 10-K reports to the SEC. The possibility of selective release of
financial information potentially threatens shareholder needs and might mislead them into
making decisions based on incomplete or faulty data.
17. Do you agree with each of the following statements? Explain.
• EBITDA makes companies with asset-heavy balance sheets look healthier than they
may actually be.
• EBITDA portrays a company’s debt service ability— but only some types of debt.
• EBITDA isn’t a determinant of cash flow at all.
7
(Source: http://www.sec.gov/News/PressRelease/Detail/PressRelease/1365171513574).

Fortune magazine had an informative story on the abuses of EBITDA as a measure of
true earnings on December 28, 2011. Top Five Reasons Why EBITDA Is A Great Big Lie.
The following is a summary of the key points made in that article.8
EBITDA, is a widely-touted measure of company performance and indicator of value

otherwise known as earnings before interest, taxes, depreciation, and amortization.
EBITDA purports to indicate a company’s pure operating performance, free of such
esoteric characteristics as debt cost, tax burden, depreciation and amortization. In reality,
EBITDA is akin to a blender, into which go normal financial statements and out of which
comes a number that always seems to make the subject company look better than it did
when the numbers went into said blender.
Here is why relying on EBITDA is misleading to shareholders and other users of

financial reports.
EBITDA makes companies with asset-heavy balance sheets look healthier than they
may actually be.
Understanding the amount of asset depreciation is of limited value in determining the

present viability of a company; instead, it’s a measure of what the company has spent, in
the past, on capital expenditures. However, a company in distress needs cash. EBITDA
ignores the company’s future asset needs. EBITDA leaves the viewer blind as to both
short- and long-term asset replacement needs -- and those require cash, debt, or both.
EBITDA portrays a company’s debt service ability – but only some types of debt.
EBITDA is a measure created by investment bankers to answer the question “How much
debt can a buyer put on this company after it’s acquired?” And, for that, EBITDA does a
fine job, depending upon which spot in the debt structure a creditor occupies. The type of
debt held by a given creditor may leave that creditor in a position that is either
advantageous or highly precarious. Consider a hypothetical company that generates
$10M in EBITDA this year –what this doesn’t show is a hypothetical $12 M of interest
payments on its senior secured credit facility that the company has to make between now
and then. Simple math tells us that the company is now on the wrong side of a $2 M cash
shortfall. Unless you’re the senior secured lender and the EBITDA number is in excess of
your debt service for the period projected, EBITDA is of little practical value.
EBITDA ignores working capital requirements (isn’t a determinant of cash flow at

all).
A positive EBITDA does not necessarily reflect that a retail store has to start ordering for
the holiday season, which means cash is going to be tied up in inventory. This means that
the company is going to need cash, which it may not have. So either it has to borrow
8
(Source: http://www.forbes.com/sites/tedgavin/2011/12/28/top-five-reasons-why-ebitda-is-a-great-big-lie/print/).

more, which increases debt service costs, or it has to “stretch payables”. Either way,
EBITDA doesn’t reflect changes in working capital requirements or cash needs.
Also, the traditional criticism of EBITDA is it doesn’t adhere to GAAP. EBITDA is

essentially a tool that shows what a company would look like if it ignored certain items
because they don’t reflect cash or are non-operating. The problem is these numbers can
be easily manipulated. EBITDA doesn’t provide any consistency check for a company’s
accounting practices as to how it arrives at its cash flow reporting.
18. Critics of IFRS argue that the more principles-based standards are not as precise as,
and therefore easier to manipulate than, the more rules-based GAAP. The reason
for this is that IFRS requires more professional judgment from both auditors and
corporate accountants with regard to the practical application of the rules. The
application of professional judgment opens the door to increased opportunities for
earnings management. Do you agree with these concerns expressed about
principles-based IFRS? Relate your discussion to the research results discussed in
this chapter.
IFRS are considered principles-based and allow for professional judgment to be applied.
The standards are more flexible in dealing with all economic and business situations.
Some might argue that allowing that much judgment introduces bias. U.S. GAAP is
considered rules-based or more prescriptive. Many feel that this tightens up accounting
and introduces consistency into the system. An argument against rules-based system is
that a rule is needed for every situation and the system later becomes unwieldy in size
and complexity. Although more guidance may give some comfort, it often becomes
difficult to ensure that standards are all consistent. It does not matter whether the
standards model is labeled as principles-or rules-based; the bottom line is that the model
selected needs to be robust, consistent, and manageable.
To determine if there was a difference in the magnitude of earnings management in a
principles-based versus rules-based environment, Mergenthaler examined the factors that
executives consider when deciding to manage earnings. He contends that the probability
of being penalized for earnings management and the penalty imposed on executives who
manage are factors that influence executives’ estimate of the expected cost of earnings
management. Mergenthaler found a positive association between rules-based
characteristics and the dollar magnitude of earnings management. He argues that this is
because the expected cost of managing earnings is lower in a rules-based environment.
The SEC study of principles-based standards seems to support Mergenthaler’s
contention. The commission expressed its concern that in a principles-based system, there
may be “a greater difficulty in seeking remedies against ‘bad actors’ either through
enforcement or litigation.”
French authors Thomas Jeanjean and Herve Stolowy examined the effect of IFRS
conversion on earnings quality -- specifically on management manipulation of earnings to
avoid recognition of losses. Their work examined more than 1,100 firms in three
countries to determine whether the earnings management appeared to increase or decrease
after implementation of IFRS. The authors measured financial reporting quality as a

reduction in earnings management. Earnings management was assessed as the frequency
of small profits compared to small losses, a technique used in past studies. Australia,
France, and the United Kingdom were selected for examination, as these three countries
were unable to adopt IFRS before the 2005 mandatory transition date, thus eliminating any
early adoption benefits. According to their research, earnings management remained
consistent in Australia and the United Kingdom after IFRS adoption. However, in France,
earnings management appeared to increase, suggesting that earnings quality was not
improved overall by adopting IFRS.
A frequent question asked is whether principles-based accounting standards increase or
decrease earnings informativeness. As outlined in the SEC study and the FASB report on
the principles-based approach, some argue that earnings are more informative when
standards are principles based. They contend that principles-based standards do not have
bright-line thresholds or exceptions that allow managers to structure transactions that
technically comply with a standard while circumventing its intent. On the other hand,
some argue (e.g., Herz) that principles-based standards provide more opportunities for
managers to use their discretion to obfuscate earnings, thereby reducing earnings
informativeness. This argument suggests that rules-based standards provide guidelines
that prevent management from abusing GAAP to manipulate earnings.
In a study of principles-based standards and earnings effects, Folsom et al. examined
whether the reliance on principles-based standards affects the informativeness of
earnings. They defined principles-based standards as standards that have fewer rules-
based characteristics than rules-based standards, as evidenced by fewer bright-line
thresholds, scope and legacy exceptions, large volumes of implementation guidance, and
high levels of detail. The authors found that firms that rely more on principles-based
standards better predict one-year-ahead future cash flows. Overall, these findings suggest
that managers use the discretion provided by principles-based standards to convey
information better to investors.
19. In the Enron case, the company eventually turned to “back-door” guaranteeing of
the debt of Chewco, one of its SPEs, to satisfy equity investors. Assume that a $16
million loan agreement required that Enron stock should not fall below $40 per
share. If the share price did decline below that trigger amount, either the loan would
be called by the bank or the bank could choose to increase the guaranteed number
of Enron shares based on the new price (assume $32). If the bank decides to increase
the number of shares guaranteed, what would be (1) the original number of shares
in the guarantee and (2) the new number of shares? Why would it be important
from an accounting and ethical perspective for Enron to disclose information about
the guarantee in its financial statements?
By guaranteeing the SPE’s debt, Enron was still at risk for repayment of the SPE’s debt
thereby failing to transfer the risk. At a minimum, the situation should have been fully
disclosed in the financial statements. When the price of Enron stock fell so low that banks
had to request additional stock or cash from the SPE, Enron had to adjust the guarantee to
accurately reflect the change.

In the example originally given, Enron would have pledged 400,000 shares of stock at
$40 per share to collateralize the $16 million loan. When the share price was reset to $32
per share, Enron had to collateralize with 500,000 shares or a 25% increase in the number
of shares. It would be important for Enron or any company to disclose all guaranteed
loans for the off chance that the guarantor may have to make good on the loan. These
amounts are contingent liabilities that must be paid by Enron if the SPEs defaulted on
their debt.
20. In the study of earnings quality by Dichev et al., CFOs stated that “current earnings
are considered to be high quality if they serve as a good guide to the long-run profits
of the firm.” Discuss how and why current earnings may not be a good barometer of
the long-term profits of the firm.
Current earnings of a firm may not be a good barometer of the long-term profits of a
firm if those earnings are fraudulent. Examples of firms like Enron and WorldCom are
firms that had profitable currents earnings based upon fraud. When earnings are
manipulated in a given year, the shareholders may believe future earnings will show a
similar trend. However, if a technique such as channel stuffing is used, then the
company simply borrows from the future an amount of earnings to inflate current
earnings and it is not clear whether future earnings will show the same trend. In fact,
such a technique builds a culture of finding new ways to hype the numbers or
continuing the charade of stuffing the channel with product on a long-term basis. The
bubble eventually bursts as occurred in the Sunbeam fraud.
Extended Discussion
Individuals, institutional investors and the financial press often make much of earnings
estimates from the big Wall Street firms. Are these estimates good indicators of the
future or can they be much ado about nothing?
A McKinsey on the accuracy of earnings estimates produced results that are surprising to
many.9
9
(Source: http://www.sjmfiduciary.com/are-wall-street-earnings-estimates-good-barometers-of-the-future/.)

What the chart above highlights, and the McKinsey study has twice observed, is that Wall
Street analysts can be herd animals and get somewhat anchored on a trend. They tend to
be late to revise earnings up, to be late to revise earnings down and to move in
groups. Beyond anchoring, we believe this is also due to pain avoidance. It is painful to
be right early on for Wall Street. If an analyst is out in front and seems to be wrong for a
quarter or two, the pain in terms of job security and reduced bonus potential might be
high.
With all of this, it is questionable whether we should follow information being published
by top analysts. Perhaps caution is the approach so that we do not get overly anchored on
estimates of the future. Many factors beyond Wall Street estimates affect the market and
the prices of individual securities.
21. The auditor of Beastie Company is reviewing the following client information for
the prior year ended December 31, 2015, and all four quarters of 2016.

Estimated Accruals in pretax earnings (in millions)
December Quarter Quarter Quarter

Quarter ended Total
ended ended ended
12/31/16 s
12/31/15 3/31/16 6/30/16 9/30/16
Accruals relating to
employee (2.0) (0.4) (0.5) (0.6) (0.6) (4.1)
vacation pay
Accruals for
charitable (0.6) (0.1) (0.2) (0.2) (0.3) (1.4)
contributions
Characterize the accruals as discretionary or nondiscretionary. What are the potential

issues that the auditors should address given these numbers?
Accruals related to employee vacation pay are nondiscretionary because a company has
an obligation to pay employees when on vacation so it is a mandatory payment. Accruals
for charitable contributions are discretionary. The company is under no obligation to
make payments to charities, although there may be an agreement in effect to the contrary.
For example, a company might agree to make payments to a university to help fund its
scholarships. It may be able to get out of the agreements but not without cost to its
reputation if nothing else.
The auditor normally examines documentation to test the existence of accrued liabilities
and other payables and to understand the nature and purpose of the accounts. For some
accounts it is necessary to further test by recomputation that amounts have been allocated
to the proper period or to establish their reasonableness by performing analytical
procedures.
For example, the auditor may:
a. Compare real estate tax notices with properties held.
b. Examine payroll records, payroll tax filings and subsequent cash payments;
recomputed accrued payroll amounts to determine allocation to the proper period; and
review the reasonableness of relationships among the payroll accounts when testing
accrued payroll and payroll taxes payable.
c. Review warranty agreements and prior experience and perform analytical

procedures, such as applying formulas or percentages from prior periods to current-period
revenues from products subject to warranties, to determine the reasonableness of
warranty accruals.

In judging the reasonableness of accrued liabilities and other payables the auditor should
consider the nature of the entity’s business and take account of unusual conditions. This
step requires a decision on the extent of tests. The auditor should use judgment in
determining levels of tests after considering information gathered or updated about the
entity, including the reliability of the division's accounting procedures, the type and
frequency of errors in prior periods and the nature and materiality of the account balance.
22. Explain the meaning of the following two statements and why each may be true:
a. Where management does not try to manipulate earnings, there is a positive effect on
earnings quality.
When management does not try to manipulate earnings, then the earnings are reliable,
assuming it has been properly recorded in conformity with GAAP, and earnings quality is
high. However, even though management does not manage earnings it does not mean the
earnings quality is high because errors may exist in the financial statements or important
disclosures omitted that affects the quality of earnings in future years. Also,
discretionary accruals can be used to manage earnings in one period or another. Thus, by
not managing earnings the company increases the likelihood of quality earnings but other
factors exist so that earnings quality is not guaranteed.
b. The absence of earnings management does not, however, guarantee high earnings
quality.
Where management does not try to manipulate earnings, there is a positive effect on
earnings quality. The earnings data is more reliable because management is not
influencing or manipulating earnings by changing accounting methods, recognizing one-
time items, or deferring expenses or accelerating revenues to bring about desired short-
term earnings results. The absence of earnings management does not guarantee high
earnings quality. This is true because some information or events that affect future
earnings may not (and cannot) be disclosed in the financial statements.
Studies have shown that there are two different perspectives regarding the effect of
earnings management on the quality of accounting information. The first perspective
states that management tries to manipulate accounting information with the purpose of
transferring its private information. In such condition, management's intervention in the
reporting process must increase the quality of reported information. According to the
second perspective which is more commonly accepted, earnings management is
opportunistic by nature and is done consistent with managements' personal motives and
interests. Therefore, we must expect that earnings management decrease the quality of
accounting information, because managed information is does not reflect the economic
content of events anymore.
Earnings management and earnings quality have many things in common. Higher
earnings management will lead to lower earnings quality. However, lack of earnings
management (low earnings management) does not guarantee high earnings quality (or
accounting figures high quality in general), because there are other factors that affect the

earnings quality in a company. For example, accountants strictly follow a set of weak
standards which lead to financial reports with low quality. If we suppose other influential
factors to be constant, then we can draw a closer relationship between earnings
management and earnings quality.
Results of researchers' studies show that by increasing the number of discretionary

accruals, the desirable values of earnings features would decrease. Quality of accruals is
affected by earnings management more than any other feature does. Moreover, increase
in the values of discretionary accruals is related to decrease in the rate of companies'
earning quality. These results support the theory that states earnings management is
opportunistic and show that earnings management distorts accounting information
content.
23. Big Pharma has been criticized for making deals that may bring harm to
shareholder interests. Evaluate the following transaction from earnings
management and ethical perspectives: A pharmaceutical drug company agreed to
make payments to wholesalers if they bought drugs they did not need. The company
paid $66 million to wholesalers who then “bought” $720 million of the company’s
drugs for which no customers existed.
Deals made to have wholesalers buy drugs they don’t need in return for payments by
pharmaceutical companies are designed to inflate revenues that probably will never be
collected and in amounts that are far in excess of the payments made to the wholesalers to
agree to the arrangements. These deals distort earnings and can be used to manage
earnings by deciding when and how much the agreed payments should be, but only after
assessing the level of earnings for a period of time. These arrangements are unethical and
violate GAAP because they lack economic substance. There is no doubt that shareholder
interests are harmed as false results are reported upon which decisions may be made to
buy stock, sell it, or hold on given the reported positive results.
24. In well-governed companies, a sense of accountability and ethical leadership create

a culture that places organizational ethics above all else. What role does
organizational culture play in preventing financial shenanigans from being used to
manage earnings?
Organizational culture is the underpinnings of an ethical environment that sets a positive

ethical tone with leaders who are committed to ethical behavior. In organizations that live
by ethical values, employees are more likely to identify with those values and commit to
carry them out. Even employees who may lack the ethical foundation can be swayed by
social forces within the organization to act ethically.
Managers must acknowledge their role in shaping organizational ethics and seize this
opportunity to create a climate that can strengthen the relationships and reputations on
which their companies’ success depends. From the perspective of integrity, the task of
ethics management is to define and give life to an organization’s guiding values, to create
an environment that supports ethically sound behavior, and to instill a sense of shared

accountability among employees. The need to obey the law is viewed as a positive aspect
of organizational life, rather than an unwelcome constraint imposed by external
authorities.
An integrity strategy is characterized by a conception of ethics as a driving force of an

enterprise. Ethical values shape the search for opportunities, the design of organizational
systems, and the decision-making process used by individuals and groups. They provide a
common frame of reference and serve as a unifying force across different functions, lines
of business, and employee groups. Organizational ethics helps define what a company is
and what it stands for.
A strong organizational culture backed by ethical leadership makes it much less likely
that financial shenanigans will exist and/or be tolerated if they do. An ethical leader
would not stand for such abuse and would not want to be held accountable for unethical
actions to manipulate reported earnings through the use of shenanigans.
25. Evaluate the following statement: Do the ends of positive organizational

consequences justify the means of earnings management?
In a paper titled “Managers’ Ethical Evaluations of Earnings Management and Its

Consequences,” (2011), Johnson, Fleischman, Valentine and Walker studied the ethics of
earnings management by examining the specific ethical dilemma that arises when a
choice to engage in earnings management results in positive organizational
consequences. This study focuses on the consequences of earnings management behavior
in response to the question: Do the ends of positive organizational consequences justify
the means of earnings management?10
The authors investigate manager evaluations of, and reactions to, a scenario in which a
hypothetical employee makes a choice whether or not to engage in earnings management
behavior, with consequences that are either favorable or unfavorable to the organization.
Two hundred and sixty-four experienced managers provided responses to the scenario in
a controlled experimental research design.
The results indicate that managers may be motivated to discount the ethical impact of
earnings management behavior when the consequence has a favorable impact on the
organization -- implying that the ends justify the means. This finding, in turn, suggests
that incrementalism, or the ethical -- slippery slope of overlooking seemingly minor
ethical breaches, can undermine efforts to establish a strong ethical tone throughout the
organization. The ethical dilemma of incrementalism where an initial minor unethical
behavior ultimately leads to large-scale negative consequences, is a key element of
rationalization. The authors’ found that managers tend to behave as if the ends justify the
means thereby raising the issue of rationalization of unethical conduct through the
discounting of earnings management behavior when organizational consequences are
favorable. Specifically, managers acted as if they rationalized that the greater good to the
organization of favorable consequences offset the questionable ethicality of the behavior.
10
(Source: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1898266).

The question of means versus ends in an ethical context has significant leadership and
organizational governance implications as will be discussed in Chapter 8.
Extraordinary Items
I was recently reviewing the FASB website for Accounting Standard Updates and I came
across the following update to be implemented for fiscal years ending after 12/15/15:
http://www.fasb.org/cs/ContentServer?c=FASBContent_C&pagename=FASB%2FFASB
Content_C%2FProjectUpdatePage&cid=1176164211686
It looks like the FASB intends to eliminate "extraordinary items" from the income
statement, citing that it detracts from the overall understandability of the financial reports
and that it drains valuable time and energy from preparers and auditors to determine what
is truly "extraordinary". That seems really surprising since the "extraordinary items"
section is meant to report more transient, temporary items that a financial statement user
may not want lumped in with "ordinary income".
I also came across a discussion by Sarah McVay's (currently at University of

Washington) dissertation.
McVay, S. 2006. "Earnings Management Using Classification Shifting: An Examination

of Core Earnings and Special Items". The Accounting Review, Vol 81, 501-531.
In this paper, she finds evidence that managers will reclassify certain expenses from
ordinary income (more permanent income) to extraordinary items (more temporary
income) in order to beat the market's expectations (since the market is focused on
permanent earnings). A conclusion from this paper could be that having "extraordinary
items" actually reduces the decision-usefulness of financial reporting and it seems
reasonable to add that it will be costly to companies and auditors to disentangle what is
truly extraordinary.

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Suggested Discussion and Solutions

What are Consensus Earnings?

Novartis CEO Dan Vasella told Fortune magazine that:2

Ethical Obligations and Decision Making in Accounting, 4/e 1

2. Are the use of non-GAAP financial measures ethical?

Ethical Obligations and Decision Making in Accounting, 4/e 2

3. Relevance and faithful representation are the qualitative characteristics of useful

Ethical Obligations and Decision Making in Accounting, 4/e 3

4. Evaluate earnings management from a utilitarian perspective. Can earnings

Earnings management may be considered unethical from a virtue perspective if when

Ethical Obligations and Decision Making in Accounting, 4/e 4

5. Evaluate the following statements from an ethical perspective:

Ethical Obligations and Decision Making in Accounting, 4/e 5

Ethical Obligations and Decision Making in Accounting, 4/e 6

In Needles’s continuum, a neutral treatment is in the middle of the continuum reflecting

Accounts payable is a liability account; normally it is considered a current liability or

Ethical Obligations and Decision Making in Accounting, 4/e 7

Ethical Obligations and Decision Making in Accounting, 4/e 8

Ethical Obligations and Decision Making in Accounting, 4/e 9

There are a variety of definitions of earnings management. Schipper defines it as a

Ethical Obligations and Decision Making in Accounting, 4/e 10

Ethical Obligations and Decision Making in Accounting, 4/e 11

1. Identify contract(s) with a customer.

14. Tinseltown Construction just received a $2 billion contract to construct a modern

Tinseltown should follow the percentage-of-completion method and recognize revenue

Ethical Obligations and Decision Making in Accounting, 4/e 12

Since the percentage-of-completion method involves costs estimates, it allows for

Ethical Obligations and Decision Making in Accounting, 4/e 13

Carrying amount $50,000

Net selling price (40,000-1,000) $39,000

Recoverable amount (greater) $46,000

Carrying amount $50,000

Impairment loss $4,000

Undiscounted cash flows $48,000

Fair value 47,0006

Carrying amount $50,000

Less: Undiscounted cash flows 48,000

Asset is impaired 2,000

Ethical Obligations and Decision Making in Accounting, 4/e 14

Carrying amount $50,000

Estimated fair value 47,000

Impairment loss $ 3,000

Regulation FD requires companies to distribute material information in a manner

Ethical Obligations and Decision Making in Accounting, 4/e 15

17. Do you agree with each of the following statements? Explain.

Ethical Obligations and Decision Making in Accounting, 4/e 16

EBITDA, is a widely-touted measure of company performance and indicator of value

Here is why relying on EBITDA is misleading to shareholders and other users of

Understanding the amount of asset depreciation is of limited value in determining the

EBITDA ignores working capital requirements (isn’t a determinant of cash flow at

Ethical Obligations and Decision Making in Accounting, 4/e 17

Also, the traditional criticism of EBITDA is it doesn’t adhere to GAAP. EBITDA is

Ethical Obligations and Decision Making in Accounting, 4/e 18