Lecture #4

Chapter covered Mintz & Morris 7.

“Increasingly, I have become concerned
that the motivation to meet Wall Street
earnings expectations may be overriding
common sense business practices……In
the zeal to satisfy consensus earnings
estimates and project a smooth earnings
path, wishful thinking may be winning the
day over faithful representation.”
Arthur Levitt, 1998
“Earnings can be pliable as putty
when a charlatan heads the
company reporting them.”
--Warren Buffet
 Integrity a Must!
Financial statements must be
Accurate
Reliable
Quality of financial information is harmed if
Information is omitted
Information is materially misstated
To address above, must have integrity in
Accountants
Auditors
Motivation to Manage Earnings
Sources of pressure:
• Pressure on company to make numbers for Wall
Street
• Pressure on Manager to have
• Smooth upward trend of earnings
• Bonus on earnings
• Pressures on Auditors
• Retain clients by firm
• Not to be in the way by management
Incentives/Pressures to Commit Fraud
Self-serving
 Pressures to meet financial numbers
 Financial distress
 Home Problems
Leads to erosion of
 Quality of earnings
 Quality of financial reporting
Fraud Triangle
Incentives/Pressures

Opportunity Rationalization
Opportunity to Commit Fraud
Employees who have access to assets such as cash and
inventory
Internal controls to help safeguard assets
Segregation of duties
Backdating stock options
Rationalization for Fraud
Perpetrators are often in denial
A good person may get caught up in the fraud
Rationalization
Company had to make numbers
Fear losing job
I’m entitled since I’m underpaid
Defining Earnings Management
Distortion in application of GAAP
Due to choices in application?
If a conscious effort to manipulate –
THEN FRAUD!

Fine line between

Aggressive but acceptable
Deception of others
Practices of Earnings Management
Most common practices used to “smooth earnings”
Accelerating revenue recognition
Delaying recognition of expense
Creating “cookie jar reserves”
Some Techniques Used to Falsify
Financial Information
Lengthening estimated useful lives
Special Purpose Entities (SPE)
Bogus invoices to record revenue
Backdated sales agreements
Misapplication of GAAP
Bill and Hold
Channel Stuffing
Misappropriation of Assets
Theft of company assets
Understates cash or other assets
Overstates expenses
“Bury” the expenses in an innocuous account
Lapping of accounts receivable
Theft of inventory
“Positive” Earnings Management
From executive’s perceptive, earnings management:
Is reasonable and legal; and,
Provides stable and predictable financial results

In fact, it is illegal and not fair to all stakeholders!!!

Ethics of Earnings Management
Virtue Ethics
Examines reason for actions
Action itself
Reason and Action of earnings management
Self interest
Perceived interests of company
Stakeholders
Left out or
Deceived
 Virtue and McKee’s View
Does not reflect what is wanted or needed by
stakeholders
Masks true performance
Rationalization for unethical act
Thus, from virtue viewpoint
Unethical
Rights and Earnings Management
From a Rights perspective
Ignores/does not consider stakeholders
Ethics of accounting profession places public
interest first
Unethical
 Rights and McKee
Right of management placed first
Moral point of view of accounting
Rights of others first
Unethical
 Utilitarian and Earnings
Management
Cost/benefit analysis
Costs
False and misleading financial information
Negative affect on investors and creditors
Benefits
Increase in share price
Managers and company and shareholders
Costs outweigh benefits
Rationalizing falls victim to fraud triangle
 Fraud Triangle and Earnings
Management
Pressure -- falsify earnings
Opportunity – top management can override
internal controls
Rationalization – a temporary fix to a problem
The Acceptability of Earnings Management
from a Materiality Perspective

SEC Staff Accounting Bulletin No. 99 –

Materiality, 1999
Reaction to rationalization for not reporting
misstatements based on materiality
Use of numerical threshold provides basis for
assumption an amount less than that basis is not
material
Both qualitative and quantitative factors must be
considered when assessing materiality
Gemstar TV Guide International
SEC Enforcement Release 2125

2000 – 2002 KPMG audits of Gemstar TV

Overstated revenue from licensing and

advertising
 Gemstar’s Misstatements
Recorded revenue from expired, disputed or non-
existent agreements
Accelerated revenue from a long-term agreement
Inflated advertising revenue
Engaged in “round trip” transactions
Created “cookie jar reserves”
Recorded barter transactions as advertising
revenue
 Qualitative Considerations of
Misstatement Materiality
Potential effect on trends
Misstatement that changes loss into income or
vice versa
Potential effect on compliance with loan
covenants or other contracts
Existence of statutory or regulatory requirements
Sensitivity of circumstances
 Comparison of Financial
Restatements: 2000 through 2004

Year Financial restatements

Amount Percentage
(millions) change
2000 $233 ------
2001 $270 16%
2002 $330 22%
2003 $323 (2%)
2004 $414 28%
 Earnings Management
Techniques
1. Recording revenue too soon or of questionable
quality
2. Recording bogus revenue
3. Boosting income with one-time gains
4. Shifting current expenses to a later or earlier
period
 Earnings Management
Techniques
5. Failing to record or improperly reducing
liabilities
6. Shifting current revenue to a later period
7. Shifting future expenses to the current period as
a special charge
 Descriptions of Financial
Shenanigans
Waste Management
Xerox
Lucent
Sunbeam
 The Case of Waste Management
Aggressive accounting practices
Understated operating expenses
Delayed recognition of expenses to another accounting
period
Andersen gave unqualified opinions as amounts
were not material
 The Case of Xerox
Aggressive accounting practices
Fraudulent least accounting
“Cushion” reserves
Tone at the top
Meeting short term earnings target
KPMG failed to exercise
Due care
Professional skepticism
Adhere to GAAS
 The Case of Lucent
Technologies
Aggressive accounting practices
Recorded revenue too soon
Boosted income with one-time gains
Failed to write down impaired assets
Shifted current expenses
Reduced liabilities by changing assumptions
Released reserves into income
Created new reserves from acquisitions
 Sunbeam Corporation
Tone at the top
Chainsaw Al
Aggressive accounting
Cookie jar reserves
Channel stuffing
Bill and Hold sales
 The Story of Enron
Recorded anticipated revenue immediately
Getting deeply in debt
Treadmill of: keep growing, book bigger deals
Special Purpose Entity (SPE)
3% ownership to keep off books
Borrowed money from bank, backed by Enron stock
Enron sold assets to the SPEs and arranged loans
Money
 Growth of SPEs
Arrangements hid debt
No transfer of risk to the SPE
 Culture at Enron
Rank and Yank system
Rewarded loyalists and punished dissenters
Lack of internal controls
Executive compensation and stock options
 Whistleblowing at Enron
Sherron Watkins was dubious on why Jeff Skilling
resigned from Enron
Anonymous letter to Ken Lay
Vinson & Elkins investigated and reported no
reason for concern
 Lay-Skilling Trial
May 2006 unanimous jury verdict of guilt
Lay
6 counts of fraud and conspiracy
Passed away before sentencing and declared innocent
Skilling
19 counts of fraud and conspiracy
Sentenced to 24 years and 4 months and fines of $185.2
M
 Enron: A Review of Important
Accounting Issues
Failure to consolidate dependent SPEs
Failure to disclose related party relationships of
SPEs
Overstatement of earnings from mark-to market
Quality of reports was poor due to above
Earnings management
Lack of controls and tone at the top
 FASB Rules on SPEs
Revised in December 2003
No percentage ownership test
Dispersion of risk determines the consolidation
status
 Sarbanes-Oxley Act of 2002
PCAOB relieves the AICPA of its authority over
establishing
Independence
Ethics
Quality control
Auditing standards for public companies
PCAOB assumes peer review functions over
registered CPA firms
 Enron Impact on SOX Reform
Prohibits internal audit services for audit clients
Off-balance sheet financing must be disclosed
Related-party transactions require disclosure
Stronger corporate governance
 Lessons to be Learned from
Enron
Weak internal controls equates possible fraud
Ethical tone at the top to help prevent fraud
 Back to the Future
We end where we began
A strong ethic base is needed