Introduction
Earnings or Net Income is the single most important figure in a company’s financial statement for the average investor. Even a small fall in the reported earnings can result in the loss of millions of dollars in stock value and subjects company managements to scrutiny by investors and financial analysts. Corporate executives are under therefore under pressure to meet market expectations resulting in “earnings management”. Earnings manipulations can range from minor adjustments within the law and the accounting standards to the outright fraud of showing non-existing profits (Carruth, 2011).
The Sarbanes- Oxley (SOX) Act of 2002 was enacted in response to the high profile accounting scandals in large companies such as Enron and WorldCom. Section 404 of this act requires effective internal controls over financial reports with false statements facing severe penalties including jail time (Verschoor, 2012). The SOX act has resulted in better compliance in company financial reports but earnings management practices continue in a substantial number of listed companies. This paper examines certain specific questions relating to why managers resort to earnings management and the methods they adopt.
Question 1 – Incentives for Managers to Manipulate Earnings
The various reasons for earnings manipulation include:
One reason for earnings manipulation is performance linked compensation. A substantial portion of executive compensation in large companies is tied to reaching performance targets such as revenue growth or EPS. An article in Forbes says that performance linked compensation leads to practices such as “channel stuffing” where inventory is pushed to retailers to boost revenue, lowering reserves to increase EPS and lumping regular operating expenses into one-time “restructuring” costs (Trainer, 2015).
In 2015, the Japanese conglomerate Toshiba admitted to overstating its profits by $ 1.2 billion over a 7 year period. Three different CEOs over this period pressurized executives to show high quarterly profits which resulted in multiple actions such as booking future profits early and pushing back expenses that cumulated to the staggering figure (Carpenter, 2015). In this example it was the company culture and perhaps fears of job loss that led to earnings management.
A second reason is what is called “Cookie Jar” accounting. Some one-third of the cases of earnings misrepresentations come from under-reporting profits in a quarter, as a means of income smoothing over the subsequent quarters. The Forbes article says that major corporations such as Capital One, Caterpillar and Walgreen added substantially to their reserves in 2012 causing lower reported earnings and wrote-back some of those reserves the following year (Trainer, 2015).
In 2010, Dell Computers admitted to a different form of cookie jar accounting. Dell had an agreement for using Intel microchips exclusively, in return for certain payments. These payments were used to inflate Dell’s quarterly earnings, presenting a misleading picture of its quarterly operating margins between 2002 and 2005 (Adkins, 2011).
Another reason is termed “big bath” accounting. Most large companies have multiple business units and / or overseas subsidiaries which periodically come up for restructuring. Costs of such restructuring are shown as one-time costs in the financial reports. Managers often write-off costs and expenses unrelated to the restructured operation to clean-up their books.
The HP – Autonomy accounting scandal includes allegations of illegal earnings inflation by Autonomy followed by a big-bath cleansing by HP. The UK software company Autonomy was acquired by HP in 2011 for over $ 10 billion. In 2012, HP claimed that Autonomy had inflated its earnings and wrote off $ 8.8 billion of the value paid for the acquisition (Kompella, 2015). It is inconceivable that HP’s due diligence of Autonomy accounts before acquisition failed to uncover such a scale of financial manipulation. The UK Serious Fraud Office investigated HPs allegations and found no evidence of fraud by Autonomy.
Question 2 – Real Activities Manipulation and Accrual-based Earnings Management
Real Activities Manipulation (REM) and Accrual Earnings Management (AEM) are the two most common methods of earnings management. AEM practices inflate earnings without impacting the reported cash flow. Examples include delaying the write-off of bad debts and the write-down of asset values. In real activities manipulation, both earnings and cash flows change (Roychowdhury, 2006).
Real Activity Manipulation (REM)
Some of the methods of real activity manipulation are as discussed below.
Sales manipulation is the process where managers temporarily boost sales by offering price discounts or increased credit. Any increases in sales volumes result in lower net margins and reduced cash inflow. Increased credit also results in lower prices to the extent of the interest cost, lower net margins and lower operating cash flow (Roychowdhury, 2006)
Managers can also resort to reduction in discretionary expenditure. Managers can reduce spending on activities such as R&D, Advertising, Employee Training or Maintenance to reduce expenses in a reporting period. This will lead to an increase in earnings and an increase in the operating cash flow (Roychowdhury, 2006)
Managers may also do overproduction. In manufacturing companies, managers can increase production beyond projected demand adding to finished goods inventory. The allocation of fixed overhead over the larger volume results in lower unit cost and better operating margins (Roychowdhury, 2006).
Another tactic is financial manipulation. Managers can grant stock options to reduce reported EPS or resort to share buyback to boost reported EPS. Stock options have no impact on cash flow but share buyback will reduce cash flow. Debt-to-equity swaps may be used and the swap gains used to inflate reported income (Joosten, 2012).
Accrual-based Earnings Management (AEM)
Accruals are defined as the difference between cash flow from operations and net income. The common AEM strategies are discussed below (Dharan, 2003).
Adjustment of accounting accruals is the most common AEM strategy. Accruals such as accounts receivable, inventory, accounts payable, deferred revenue, accrued liabilities and prepaid interest can be adjusted up or down to manage earnings (Dharan, 2003).
Certain interpretations can be favorably used. For example, money spent on a marketing campaign would normally be treated as an expense. The manager can capitalize this amount by classifying this as an exercise in brand-building which would result in future economic benefits (Dharan, 2003).
Valuation of Goodwill and Intangible Assets which make up over 50% of assets in large companies are a frequent target for AEM. These intangibles are tested each year for impairment. The management has absolute discretion in deciding the impairment loss under GAAP, which is then charged to the earnings (Jahmani, et al, 2012).
Question 3- Trade-offs between Real Activities Manipulation and Accruals Management
The choice whether a company would use manipulation of real activities or accruals management would depend upon the costs involved and the circumstances in each company (Joosten, 2012). Some of the factors that influence the decision include:
The extent of auditor scrutiny. The Public Company Accounting Oversight Board (PCAOB) reviews audit firms for mistakes in their reports. In 2015, for example, the PCAOB found deficiencies in 24% of the audits performed by Deloitte and in 22% of the audits performed by PwC (Heller, 2016). This close scrutiny by the PCAOB has led to greater vigilance of company financials by the audit firms. The scrutiny is likely to be more intense in large companies with wide public shareholding than in smaller companies. In general, independent auditors are more likely to detect AEM attempts than REM practices.
Real activity management has to on-going throughout the year to make a significant difference. Changes made in any one quarter in a year become easy to detect. A company or business unit that has a marginal shortfall in performance can make that up through REM but the overall impact on the company earnings would be small.
The extent of competition in the industry is also a factor. Financial analysts constantly compare data from competitors in the same industry. Real activity manipulation could result in the company being shown in an adverse light and adverse comments by analysts could send wrong signals to the company’s creditors, customers, suppliers and other stakeholders. AEM would be under less scrutiny than REM.
The counterpoint to this argument is that company managers also track financial data from competitors and are often well-qualified to suspect earnings management practices in these reports. That could cause managers to adopt similar earnings management measures in their own business units.
Question 4 – Whether Earnings Management is Rife
A report published by Audit Analytics in April 2015 says that financial report restatements by US corporations peaked in 2006 with 1842 disclosures which declined to a figure around 800 in 2009 and has then leveled off. The severity of the restatements has become lower compared to earlier years (Whalen, et al, 2015).
The report says that negative impact on net income has been lower than in earlier years. The dollar value of the highest adjustment in 2014 was $ 154 million by KBR, Inc., compared adjustments of $ 6.3 billion by Fannie May in 2004 and $ 5.2 billion by AIG in 2005. The average cumulative impact on net income per restatement has also been lower at only $ 1.9 million in 2014 compared to $ 21.3 million in 2005 and $ 17.8 million in 2006. In addition, 59.13% of the restatements in 2014 had no impact on earnings. In the 2007 to 2011 period, only around 36% of restatements had no earnings impact.
The message from the Audit Analytics report is that earnings management is present but not rife in US companies and the impact is low.
A very different picture emerges from a survey of CFOs of US Corporations that was conducted in 2012. Dr. Vincent Papa quotes from this survey which says: (Papa, 2013)
Around 20% of firms engage in earnings management in any reporting period.
Earnings management affects around 10% of the reported EPS.
The survey quotes some CFOs to say that earnings management is rife through acquisition accounting. During an acquisition, mangers would create numerous provisions in the balance sheet against which they take charges in later years to manage their P&L over the next two to three years. The article suggests that there is the need for SEC to devise and use analytics tools in its review of company reports to detect earnings management (Papa, 2013).
The conclusion perhaps is that it would be difficult to agree with the statement that earnings management is rife and occurs virtually for every firm, in every quarter and for enormous amounts. The practice is however prevalent as is shown by the big names such as Dell Computers, Toshiba and HP which have been involved in allegations of earnings management. The prevalence of this practice requires the average investor to be vigilant and to compare the company’s financial metrics with its competitors. Special care needs to be taken when the company is in financial stress, is involved in a merger or acquisition or when there is any major restructuring in its operations.
Summary and Conclusions
Stock market scrutiny of listed companies focuses on quarterly earnings and there is enormous pressure on company managers to meet earnings forecasts. The pressure could arise either from their compensation being linked to key operating results or from fear of job loss or reputation damage. The two major forms of earnings management are the real activities manipulation and accruals management. Real activities manipulation methods include sales manipulation, deferment of discretionary expenditure, overproduction and financial manipulation. Accrual management strategies include adjustment of current assets and current liabilities, classifying revenue expenses as capital expenses and impairment of intangible assets.
The choice between real activity manipulation and accruals management in a company depends on the relative costs and the circumstances in the company. The degree of auditor scrutiny for the company, the magnitude of earnings adjustment needed and the resulting distortion of the company financial data in relation to competitors in the same industry.
While it is difficult to conclude that earnings management is rife, there is evidence that it is quite prevalent and is especially likely when the company is in financial stress or when there is a merger or acquisition or major restructuring of operations.
References
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