Professional Documents
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Earnings Management and Earnings Quality (2010)
Earnings Management and Earnings Quality (2010)
Earnings Management and Earnings Quality (2010)
Test 2:
An 80% chance to lose $4,000, 20% to lose nothing
A certain loss of $3,000
Loss Gain
Implications for the Prospect
Theory:
People seem to respond to perceived gains
or losses rather than to their hypothetical
final wealth positions, the latter of which is
assumed by expected utility theory.
There is a diminishing marginal sensitivity
to changes, regardless of the sign of the
changes; and
Loss looms larger than gains.
What is Earnings Management?
Arthur Levitt: “practices by which earnings
reports reflect the desires of management
rather than the underlying financial
performance of the company.”
Earnings management (or income smoothing)
is often defined as the planned timing of
revenues, expenses, gains and losses to
smooth out bumps in earnings. In most cases,
earnings management is used to increase
income in the current year at the expense of
income in future years. Earnings management
can also be used to decrease current earnings
in order to increase income in the future.
The Public Perception of Earnings
Management
Earnings management has a negative effect on the
quality of earnings if it distorts the information in a
way that it less useful for predicting future cash
flows. The term quality of earnings refers to the
credibility of the earnings number reported. Earnings
management reduces the reliability of income.
The investing public does not necessarily view minor
earnings management as unethical, but in fact as a
common and necessary practice in the everyday
business world. It is only when the impact of
earnings management is great enough to affect the
investors’ portfolio that they feel fraud has been
committed.
How company smoothes earnings Check list
a. Cendant
b. Manhattan Bagel
c. Sunbeam
d. Tyco
e. Sensormatic
f. 3Com
g. W.R. Grace
h. MicroStrategy
i. Lucent
Cendant
Cendant was created in 1997 by merge of equals
between CUC and HFS.
HFS later found CUC recorded 500M phony profit
before merger.
This is driven by management’s determination to meet
Wall Street analysts’ expectations.
CUC management maintained an annual schedule
setting forth opportunities that were available to inflate
operating income.
Top down approach. Top management allocate the
amount that each subsidiary needs to come up with the
earnings. Then the management make additional
adjustment to ensure the earnings and expenses ratios
are similar to that of previous year.
Cendant
1996 CUC established merger reserve that is double its
cost, simply view as opportunity the viability of future
earnings at CUC.
1997 CUC used merger with HFS as another chance to
cover up its shortfall of earnings.
In April 1998, Cendant suited 7 former CUC executives
for accounting fraud. SEC brought similar charges in
June 1998.
The day after fraudulent financial reporting was
announced in April 1998, Cendant’s stock price drop
46.5%, eliminating $14 billion in market capitalization.
1998 December, Ernst and Young, CUC’s auditors
agreed to pay $335M to Cendant stockholders.
MicroStrategy
MicroStrategy's reporting failures were primarily the
result of premature recognition of revenue.
Management did not sign contracts received near the
end of quarters until after it determined how much
revenue was required to achieve desired quarterly
results.
MicroStrategy engage in complex transactions
involving the sale of software as well as extensive
software application development and consulting
services. The nature of the multiple element deals at
MicroStrategy gave rise to accounting practices that
were not in accordance with GAAP.
MicroStrategy
SEC documents detail a transaction in which
MicroStrategy negotiated a $4.5 million
transaction to provide software licenses and
extensive consulting and development services.
The majority of the software licenses were to be
used in conjunction with to-be developed
applications, indicating that the product and
service elements were interdependent.
However, MicroStrategy recognized the entire
$4.5 million received in the transaction as
software product license revenue, allocating no
revenue to the extensive service obligations.
MicroStrategy
MicroStrategy also entered into an agreement
in which it agreed to provide software licenses,
maintenance and services to a large retailer. In
a side letter to the agreement, MicroStrategy's
sales staff promised the retailer future product
at no cost, although the product had not yet
been developed.
Under GAAP, the revenue should have been
deferred because the value of the future
product could not be determined.
MicroStrategy
MicroStrategy announced that it would restate
earnings for three years to comply with GAAP. After
the announcement, MicroStrategy stock fell 62
percent in one day. Its stock price dropped from a
high of $333 per share to $33 per share.
In April 2001, the company settled a class action suit
alleging fraud arising from its accounting practices.
Three of its executive officers at the time of the
restatement agreed to fraud injunctions and paid
penalties of $350,000 each.
The company agreed to undertake corporate
governance changes and implement a system of
internal controls.
Lucent
Lucent Technologies, an AT&T spin-off, started trading
publicly in 1996 with an initial public offering that was,
at the time, the largest in domestic history.
In December 1999, Lucent's stock was selling at
$77.78 and was the nation's fourth most widely held
stock. However, by July 2001, Lucent's stock was
trading at $6.43, the SEC was investigating its
accounting practices and several former, high-level
managers.
The decline in Lucent's stock value has been
attributed to a Nov. 21, 2000 announcement in which
Lucent said it had voluntarily reported accounting
irregularities to the SEC. As a result of its own internal
investigation, Lucent restated its Sept. 30, 2000
financial statements, reducing revenue by $679
million.
Lucent
According to a January 2000 Wall Street Journal
article, Lucent had used "a whole myriad of aggressive
accounting moves to boost its growth." One analyst
estimated that Lucent added about 27 cents a share to
its earnings through "deft accounting moves," including
creative acquisition accounting.
In October 1998, Business Week reported that Lucent
avoided some goodwill amortization by writing off $2.3
billion of in-process research and development as
companies were acquired. Lucent's earnings also
benefited from a $2.8 billion reserve for "big bath"
restructuring charges that were recorded as part of
Lucent's spin-off from AT&T. Some analysts believe
Lucent put aside far more than was needed to cover
restructuring expenses and used the excess reserves
to smooth earnings .
Lucent
Although revenue and accounts receivable increased in
fiscal 1999, Lucent lowered its bad-debt reserves. In
addition, some observers believe that Lucent improperly
lowered its reserves for obsolete inventory in 1999.
Lucent's December 2000 restatement in which revenues
were reduced by $679 million, created doubt. Two-thirds of
the $679 million reduction in revenue, or $452 million, was
attributed to "channel stuffing" sales, in which transfers of
products to distributors are recorded as sales although the
products are not yet sold to end-users.
The restatement also reduced revenues by $199 million
because customers were promised discounts, credits and
rights of return.
Lucent also nullified $28 million in revenue recognized on a
partial shipment of equipment.
The Cendant, MicroStrategy and Lucent cases
share several common characteristics
1. The earnings management activities took place over extended
periods of time, escalating from questionable and improper
revenue recognition practices to other forms of earnings
management;
2. The earnings management practices were initiated "at the
top," but eventually involved high-level managers and their
subordinates; and
3. The earnings management practices were not uncovered by
external auditors or audit committees.