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Purposeful intervention in the external

reporting process with the intent of

obtaining some private gain (Schipper)
When managers use judgment in financial
reporting and in structuring transactions
to alter financial reports to either mislead
some stakeholder about the underlying
economic performance of the company or
to influence contractual outcomes that
depend on reported accounting numbers
(Healy & Wahlen)
Is all EM unethical? depends on
management intent.
Management intent unobservable
Distinction between aggressive
accounting choices including acceptable
GAAP based estimates / judgments vs.
fraudulent accounting practices intended
to deceive others
Revenue recognition
Recording revenue too soon
Revenue is recorded before service is fully provided
Recording revenue of questionable quality
Revenue is recorded before customers unconditional
Recording made up revenue
Revenue is recorded even if it lacks economic substance
Shifting revenue to a future period
Purposely over-estimating sales returns and adjusting
downward in future years
Shifting expenses
Capitalizing current costs
Shifting current expenses to later or earlier
Changing accounting policies and shifting
expenses to later period
Expensing future expenses as current
Accelerating discretionary expenses
Examples of accounting choices allowed
Changing life of assets affecting depreciation
Changing estimate of allowance for doubtful
accounts affecting bad debt expense
Changing estimate of sales return allowances
affecting net revenue
Choosing inventory valuation methods thus
affecting cost of goods sold
Estimating higher restructuring charges than
required affecting earnings before interest & taxes
Big bath
Large estimates of restructuring charges that
are deducted from revenues to show lower
income in one quarter/year and then revised
few quarters/years later to show higher income
Creative acquisition accounting
Classifying large portions of acquisition price as
in-process research & development and then
written off immediately after the merger. That
reduces future drag on income
Cookie jar reserves
Use unrealistic assumptions to estimate
sales returns, loan losses or warranty
costs, thus stashing accruals in cookie jars
during the good times and reach into them
when needed in the bad times.
Revenue recognition
Recognize a sale before it is complete,
before the product is delivered to a
customer, or at a time when the customer
still has options to terminate, void or delay
the sale.
Earnings Management Techniques
The Earnings
Earnings Management
Management Continuum
transaction Aggressive Deceptive
timing accounting accounting

General Delta Xerox

Electric Airlines

Change in Change in
Strategic methods or methods or
matching estimates with estimates but
full disclosure with little or no
Earnings Management Techniques
The Earnings
Earnings Management
Management Continuum

reporting Fraud

Non-GAAP Fictitious
accounting transactions

Enron ZZZZ
1. Shifting income between periods:
Revenues Expenses
Borrowing 1. Premature 2. Capitalization of
earnings from recognition of expenses
the future revenues Example: WorldCom
Example: Xerox
Postponing 3. Deferring 4. Exaggerating
earnings to the recognition of current
future revenues expenses/losses to
Example: Microsoft create cookie jar
Example: Microsoft

2. Classification of gains and losses:
Classifying one-time gains as earnings from
continuing operations
Classifying losses from continuing operations as one-
time items
3. Hiding Debt in unconsolidated subsidiaries
Example: Enron

Legitimate Earnings Violation of GAAP or

Management (Within SEC rules

The 2008 balance sheet comprised
faked and inflated figures of revenue,
profit, interest and debt. The list
includes Rs 5,040 crore of non-existent
cash and bank balances, non-existent
accrued interest, understated liability
of Rs 1,230 crore on account of funds
raised by Mr Raju and overstated
debtors position of Rs 490 crore (as
against Rs 2,651 crore).
Worldcom (expense capitalization)
Satyam Computers (bogus revenue)
Tyco (executive loans, merger magic)
Adelphia (borrowing from company)
Waste Management (materiality)
SunBeam (channel stuffing, cookie jar
Healthsouth (false earnings)
Why does management manage earnings?
External pressures
Analysts forecasts
Access to debt markets
Contractual agreements & debt covenants
Roaring stock market
Emerging financial instruments
Market disregard for big charges
Pressures within the company
Merger attractiveness
Management compensation
Short term focus
Unrealistic budgets and plans
Excessive profits followed by decline
Personal factors bonus, promotions, job
Signals that should be checked in company reports
Read the audit report
Reduction in managed costs such as advertising in relation to
Changes in accounting policies towards more liberal
Unexpected increase in accounts receivable
Extension of trade payables longer than normal credit
Unusual increase in intangible assets
One time sources of income
Decline in gross margins
Reduction in reserves
Reliance on income sources other than core business
Not reserving for future probable losses
Unusual increase in borrowings
Increase in deferred taxes
Increase in unfunded pension liability
Low cash and marketable securities at year end
Peak short borrowings at year end
Slowdown of inventory turnover ratio
When should you pay more attention to the company?

Company has achieved significant market share and is

growing faster than the industry
Frequent acquisitions of business
Management history
Firing of auditors
Rapid growth of company -- internal control issues
Company doing too well
Management growth strategy and emphasis on EPS goals
Important to understand: More often the problem
is not the flexibility of the reporting rules, but the
fact that the watchdogs are not doing their job!!!

Audit failure

Poor corporate governance

Shareholder involvement

SEC / SEBI enforcement