AA102 Group Report TG14/Team4

Analysis of Earnings Management

Contents Page

Overview Page

1. Abstract

1.1. Key Definition ------------------------------------------------------- 4

1.2. Identified Company and two Accounts -------------------------- 4

2. Justification for Choice of Company

2.1. Company Background ---------------------------------------------- 5

2.2. Volatility of Property Sector --------------------------------------- 5

2.3. Funding for Projects ------------------------------------------------ 6

2.4. Motivating Employees-Annual Performance Incentives ------- 6

2.5. Motivating Employees-Employee Share Option Scheme ------ 7

3. Justification for Choice of Accounts

3.1. Revenue Recognition ------------------------------------------------ 8

3.1.1. Ambiguity and Significance --------------------------------- 8

3.1.2. Managing earnings through Revenue account ------------ 9

3.2. Impairment of Financial Assets ------------------------------------ 9

3.2.1. Ambiguity and Significance -------------------------------- 9

3.2.2. Relative ease of manipulation ------------------------------ 10

3.2.3. Managing earnings through Impairment account -------- 10

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4. Integrating Corporate Governance Mechanism

4.1. Board of Directors ---------------------------------------------------- 11

4.2. Internal Controls and Audit ----------------------------------------- 13

5. Conclusion/Insights -------------------------------------------------------- 14

6. References ------------------------------------------------------------------- 15

7. Appendix 1 to 6 ------------------------------------------------------------- 17 to 23

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1. Abstract

1.1 What is Earnings management is defined as the active manipulation of the

Earnings accounting results for the purpose of creating an altered impression of

Management? business performance. 1 Earnings management, which often reflects the

unethical side of management, has always been viewed negatively.

However, it might be notable that traces of earnings management might

be constructive when a managed earnings number is a better indicator

of expected future earnings and reflects a more realistic index of

financial risk.

Nevertheless, management‟s behavior and self interest still portray the

harmful side of earnings management. For instance, managing earnings

to reach earnings target to earn incentive compensation, or simply

complying with the financial covenant are often the reasons to play the

financial numbers game.

1.2 Identified With that, we chose Keppel Land to study the possibilities of managing

Company and earnings through two accounts identified: Revenue Recognition and

Accounts Impairment of Financial Assets.

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2. Justification for Choice of Company

2.1 Company Keppel Land (KepLand), Singapore‟s third-largest listed property

Background company, conducts key businesses in offshore and marine,

infrastructure and property, having strategic focus on two core

businesses of property development and fund management.

2.2 Volatility of KepLand being part of the property sector is badly hit by the financial

Property sector meltdown and the fair value gain on investment properties have also

dropped drastically due to its cyclical as seen below. As such, managers

might potentially recognize more revenue to beef up its KepLand‟s

reported income, possibly to save their reputation and jobs.

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2.3 Funding for Although KepLand has recently announced rights issue to raise funds, it

Projects is reckoned by analysts that more gearing is expected to fund

KepLand‟s projects and other strategic opportunities.

To further undertake projects, KepLand is likely to increase its financial

resources through borrowings, thereby raising its gearing level. This

presents a “justification” for the management to employ earnings

management to keep financial ratios healthy, so as to secure funding

from banks.

2.4 Motivating KepLand‟s remuneration mix comprises of annual performance

employees: incentive which is tied to manager‟s performance. Hence, management

Annual benefits maximum emoluments if the company is able to keep earnings

Performance rising smoothly by planning ahead or changing accruals over a period.

Incentives Hence, the presence of management incentives in KepLand is likely to

support Healy and Wahlen‟s (1999) study3 that management

compensation is one of the principal factors motivating earnings

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management.

2.5 Motivating Employee incentives such as share options, which are highly correlated

employees: with the firm‟s performance, may increase the risk of earnings

Employee Share management. In the short run, employees will be encouraged to enhance

Option Scheme the reported earnings of the firm to maximize their rewards. Raising

(Appendix 1) public‟s confidence in KepLand will lead to an increase in market

capitalization and a higher share price. Thus, employees might be

motivated to manage earnings in an attempt to exercise their share

option scheme when share price increases.

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3. Justification for Choice of Accounts

3.1. Revenue Revenue Recognition was chosen as it is a measure of a company‟s

Recognition financial performance. When there is ambiguity over how much

revenue should be recognized, whether and when revenue has been

earned, there is scope for opportunistic manipulation.

3.1.1 Ambiguity The trading of properties in KepLand accounts for 80.20% of the

and Significance revenue (Appendix 2). Due to this significant proportion, it presents one

of account of the greatest opportunities for KepLand to potentially manage

revenue, where an incremental percentage increase could substantially

boost the revenue. Next, it is important to focus how revenues on partly

completed projects are recognized. KepLand in particular uses the

percentage of completion (POC) method (Appendix 3). Although the

revenue account are often under stringent checks by auditors and

governing bodies due to its significance, assumptions are still required

to determine POC which is based on past experience and expertise,

making earnings management possible. In addition, there is no clear

conclusion of whether POC method or completion of construction

(COC) is more appropriate for property developers in FRS 18. Hence,

revenue recognition is still subjected to the company‟s choice of

method.

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3.1.2 Managing KepLand might potentially report a higher POC by recognizing a larger

earnings portion of total estimated project costs incurred, hence overstating POC.

through For example, the management can inflate revenue by recognizing a

Revenue larger portion of total cost incurred in the current Sixth Avenue

account Residences project to cushion the weak quarter.

3.2 Impairment Impairment of Financial Assets (IFA) was chosen because

of Financial management may have incentives to understate the estimate for the IFA,

Assets in order to present a higher reported net income. With regards to

KepLand, it is estimated based on historical loss experience and

judgment of the management under FRS 39 which might be another

grey area to determine, providing KepLand with another opportunity to

manage earnings.

3.2.1 Ambiguity Referring to the diagram below, KepLand estimated a relatively large

and Significance proportion of IFA, between 13-22% of total receivable from other

of account debtors, which is a significant amount to impact revenue and hence,

management might choose to manage earnings with this account.

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3.2.2 Relative As compared to non-financial assets such as long-lived PPE, the nature

ease of of financial assets is such that its fair value tends to fluctuate more. For

manipulation example, the fair value of available-for-sale financial assets is under the

influence of the quoted bid prices which can be volatile. Besides, the

duration of holding on to such assets is relatively shorter, meaning that

the composition is constantly changing. With this, IFA will hence be a

better avenue to manage earnings since there are more opportunities to

do so and detection is also harder given the difficulty of keeping track.

3.2.3. Managing To illustrate fictitiously, KepLand might have estimated a lower

earnings allowance for doubtful debts in 2008 than 2007 by potentially impairing

through lesser such that expenses are lower. This results in reported income

Impairment of which had taken a hit by the financial crisis to be higher.

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Financial Assets

account

4. Integration of Corporate Governance

4.1 Board of The Board, acting as “professional referees”, oversees the effectiveness

Directors of management with the utmost consideration for shareholders‟

interests. Eight of the twelve directors are Independent Directors (ID),

positively influencing the group‟s corporate strategies and directions,

risk taking, human resource requirements and overall firm performance

(Higgs, 2003). This is in line with Singapore Code of Corporate

Governance (SCCG), principle 2, guideline 2.1 (P2:G2.1).

This inclusion of IDs acts as a control mechanism as they have no ties

to the firm. This lowers the probability of collusion, thereby minimizing

agency problems. Also, high transparency and disclosure standards are

ensured to minimize earnings management often engaged by managers

who are aligned by incentives linked to earnings. Hence, it helps to

monitor any conflicts of interest and also improves on the quality of

reported information. Each committee has well-defined roles to align

with shareholders‟ interests and this enhances the competency aspect of

how the company is managed.

Board composition is also important to in determining the reported

earnings quality. The current size and diversity of expertise is also

deemed as appropriate and effective to lead KepLand because it allows

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perspectives from different experts while keeping the team nimble.

Regular meetings by the Board also reduce any incoming-increasing

earnings management by frequently reviewing reports and performance

objectively.

The Chairman and CEO are two separate persons to ensure impartiality

in their varied roles. Appropriate balance of power is also provided to

ensure increased accountability and more independent decision-making

for the Board as supported by the Sarbanes-Oxley Act 2002,

corresponding to SCCG, P3:G3.1.

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4.2. Internal The Audit Committee (AC) consists of three IDs and is guided by

Controls and written terms of reference. The AC reviews external auditors‟

Audit independent and objective findings to ensure they are sufficient to

assess the adequacy and effectiveness of internal controls. The AC also

provides internal audit and reviewing of key accounting principles

applied. Furthermore, under the company‟s whistle-blower protection

policy, the AC Chairman will assess and investigate any protected

report raised.

It is also found that independent AC members with financial expertise

are most effective in mitigating earnings management. 5 The autonomy

and objectivity of the AC serve as a check such that Keppel Land

complies with the accounting rules and makes proper judgements in the

estimation of financial figures.

The Group Internal Audit (GIA) serves as another control mechanism.

It assists the AC to ensure adequate internal control by frequent reviews

of material control and procedures.

This mechanism addresses the accountability aspect of how the

company is managed. The independent monitoring and inspection

increases level of transparency, leading to the AC and internal controls

being effective in improving quality of reported information which are

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in line with SCCG, P11:G11.1,G11.4, P12:G12.1, P13:G13.1.

5. Conclusion

Our group believes that the issue of earnings management deserves

greater emphasis given that there is an upward trend of such cases in

recent years. Through the appropriate incorporation of corporate

governance mechanisms, reported information can be enhanced but

total eradication of earnings management may still be impossible.

Moreover, an unconscious biasness in the assessment of KepLand‟s

performance may arise due to the close working relationship of the AC

with the company, which can limit the effectiveness of the above

control mechanism (Bazerman 1997)6. What can further be done would

be to instill corporate social responsibility into the workforce and

promote a transparent culture of doing business. With this, it would

allow for a fairer business environment with reliable information in

circulation.

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References

1) C. Mulford and E. Comiskey. (1996). Financial Warnings. John Wiley & Sons, Inc.

2) Aswath Damodaran. (2002). Investment Valuation: Tools and Techniques for

Determining the Value of Any Asset

3) Oliver Marnet. (2008). Behaviour and Rationality in Corporate Governance

4) Proforma Financial Statement Unaudited Results For The Year Ended 31 Dec 2008

5) Joseph V. Carcello, Carl W. Hollingsworth, April Klein, Terry L. Neal. (2006). Audit

Committee Financial Expertise, Competing Corporate Governance Mechanisms, and

Earnings Management

6) Max H. Bazerman. (1998). Judgment in managerial decision making.

7) Charles W. Mulford, Eugene E. Comiskey. (2002). The financial numbers game:

detecting creative accounting practices. John Wiley & Sons, Inc.

8) Keppel Land. (2008). Annual Report. Retrieved September 06 2009, from Keppel

Land Ltd official website: http://www.keppelland.com.sg/AR.asp

9) Lock MunYee. (23 Apr 2009). DBS Group Research: Keppel Land. Equity

10) Lock MunYee. (27 Apr 2009). DBS Group Research: Keppel Land. Equity

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APPENDIX

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Appendix 1

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Appendix 2

Appendix 3

Mechanics of Percentage-of-Completion Accounting

In the simplest sense, a ratio of the percentage of completion is determined and applied to
the expected gross profit on the contract to determine the gross profit and revenue to be
recognized in the financial statements.

Two typical methods of measuring the percentage of completion are:

 The cost-ratio method, which uses the ratio of actual contract costs incurred during
the reporting period to total estimated contract costs.

 The effort-expended method, which uses the ratio of some measure of the work input
during the reporting period, such as labor hours, machine hours or material
quantities, to the total units of that measure of work required to complete the
contract. This method assumes that profits on the contract are derived from the
contractor's efforts rather than from the acquisition of materials or other tangible
items.

From: http://www.housingzone.com/probuilder/article/CA462657.html

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Appendix 4

Keppel Land Annual Report 2008 Pg162

(y) Critical Accounting Estimates and Judgement

(i) Critical judgement made in applying the Group’s accounting policies

In the process of applying the Group‟s accounting policies, Management is of the opinion that
there is no instance of application of judgement which is expected to have a significant effect
on the amounts recognised in the financial statements, apart from those involving estimations
described below.

Revenue Recognition
The Group recognises revenue from partly completed projects based on the percentage of
completion method. The stage of completion is measured in accordance with the accounting
policy stated in paragraph II (k). Significant assumptions are required in determining the stage
of completion, the total estimated development costs and the estimated total revenue. In
making the assumptions, the Group evaluates them by relying on past experience and the work
of specialists. Revenue from partly completed projects is disclosed in Note 2.

Income Taxes
The Group has exposure to income taxes in numerous jurisdictions. Significant assumption is
required in determining the provision for income taxes. There are certain transactions and
computations for which the ultimate tax determination is uncertain during the ordinary course
of business. The Group recognises liabilities for expected tax issues based on estimates of
whether additional taxes will be due. Where the final tax outcome of these matters is different
from the amounts that were initially recognised, such differences will impact the income tax
and deferred tax provisions in the period in which such determination is made. The carrying
amount of taxation and deferred taxation is disclosed in the balance sheet.

(ii) Key sources of estimation uncertainty

The key assumptions concerning the future and other key sources of estimation uncertainty at
the balance sheet date that have a significant risk of causing a material adjustment to the
carrying amounts of assets and liabilities within the next financial year, are as follows:

Impairment of Non-Financial Assets

Determining whether or not the carrying values of non-financial assets are impaired requires
an estimation of the value in use of the CGU. This requires the Group to estimate the future
cash flows expected from the CGU and an appropriate discount rate in order to calculate the
present value of the future cash flows. The carrying amounts of fixed assets, investment
properties, properties held for development and properties held for sale at the balance sheet
date are disclosed in Notes 15, 16, 17 and 22 respectively.

Impairment of Financial Assets

The Group assesses at each balance sheet date whether there is any objective evidence that a

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financial asset is impaired. To determine whether there is objective evidence of impairment,

the Company considers factors such as the probability of insolvency or significant financial
difficulties of the debtor and default or significant delay in payments.

When there is objective evidence of impairment, the amount and timing of future cash flows
are estimated based on historical loss experience for assets with similar credit risk
characteristics. The carrying amounts of financial assets at the balance sheet date are disclosed
in Notes 18, 21, 24, 25 and 26 to the financial statements.

Appendix 5

2006 2007 2008

Revenue (million) 1155.00 1835.00 950.00

Net Profit (million) 96.00 209.00 157.00

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Appendix 6

Other Debtors 2008 2007

Allowance for doubtful debts(„000) 23,499 19,588

Total other debts („000) 180,839 90,217

Percentage changes (%) 13% 22%

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