Scott Chapter 11 - Earning Mangements (English Ver)

Instructor’s Manual—Chapter 11

CHAPTER 11 Earni Earni ngs Management Management 11.1

Overview

11.2

Patterns of Earnings Management

11.3

Evidence of Earnings Management for Bonus Purposes

11.4

Other Motivations for Earnings Management 11.4.1 Other Contracting Motivations 11.4.2 To Meet Investors’ Earnings Expectations and Maintain Reputation 11.4.3 Initial Public Offerings

11.5

The Good Side of Earnings Management 11.5.1 Blocked Communication 11.5.2 Theory and Empirical Evidence of Good Earnings Management

11.6

The Bad Side of Earnings Management 11.6.1 Opportunistic Earnings Management 11.6.2 Do Managers Accept Securities Market Efficiency? 11.6.3 Implications for Accountants

11.7

Conclusions on Earnings Management

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L EARNING OBJECTIVES AND SUGGESTED TEACHING A PPROACHES 1.

To Outline Reasons Reasons for Earni Earni ngs Management Management

I recommend introducing students to the topic of earnings management by discussing Healy’s seminal 1985 bonus plan paper. Healy’s evidence that bonus plans motivate earnings management helps students to take contracting theory seriously. It opens up a whole new set of considerations in accounting policy choice beyond the disclosure of useful information to investors. While it is somewhat cynical, I sometimes ask the question whether management would admit to the behaviour documented by Healy, and whether the auditor would assist or oppose the manager in this type of earnings management. For those interested in research methodology, Healy’s paper can be used to point out the desirability in accounting research areas such as this of using empirical analysis of hard data, with good experimental design and statistical analysis, in order to more fully understand management’s accounting policy choices. Having said this, it is important that the Healy results not be “oversold,” since Healy faced substantial methodological problems, particularly with respect to separating discretionary and non-discretionary accruals. The text contains discussions of some of these problems, and the results of some subsequent papers, in Section 11.3. The Jones’ (1991) methodology which, with some variants, is still the state of the art in this area is reviewed in Section 8.5.3. I do not spend much class time on these methodological issues, other than a brief review of the Holthausen, Larcker and Sloan (1995) paper. This paper, with better data and different methodology, supports Healy’s results for firms with above-cap earnings, even though Healy’s below-bogey results seem to disappear in their study. Since it now appears that meeting earnings expectations drove at least some of the financial reporting scandals of the early 2000s, such as WorldCom, I also suggest class discussion of the material in Section 11.4.2. This sets up the point that earnings management relates to reporting to investors as well as contracting.


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2.

To Appr eciate the Good Side of Earni Earni ngs Management Management

I begin by asking if the earnings management behaviour documented by Healy is good or bad. I usually take the role of arguing it is good, from an efficient contracting perspective. This argument assumes, however, that the earnings management was anticipated by the principal when the bonus contract was being negotiated, so that it is allowed for in setting the bonus rate. While most people probably view earnings management with suspicion, I suggest 2 good sides. One, as just mentioned, is to lower contracting costs in the face of rigid and incomplete contracts. A second, and more controversial, side is that earnings management can reveal inside information to investors. A provocative discussion question here is to ask if earnings management can be thought of as an extension of the accrual process. That is, if accruals smooth out lumpy cash flows to produce a more useful measure of quarterly and annual performance, why can’t earnings management be used to smooth out annual accrual-based earnings to produce a more useful multi-year measure measure of persistent earning power? Such a measure may help investors better predict future firm performance, which is a major goal of financial reporting. To pursue the argument that earnings management as a vehicle to release inside information can be “good,” the case of General Electric Co. (Problem 9 of this chapter) works well to get the point across. The steady increase in GE’s reported earnings over the years is quite impressive. I point out the complexity of GE to the point where even financial analysts have difficulty in understanding the whole company. As a result, it is very difficult to estimate GE’s persistent earning power. I also point out that a simple announcement by GE of its persistent future earnings is ‘blocked.” Such an announcement lacks credibility since, for such a complex company, the market has little ability to verify it. This sets up the role of “good” earnings management as a credible way to reveal this information. An argument that GE does engage in earnings management for this purpose is supported by both the variety of earnings management devices available to it and the steadily increasing pattern of its earnings over time.


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It is interesting to note that GE’s earnings management came under suspicion in the market in the early 2000s, due to the severe apprehension of post-Enron investors about earnings management in general. According to an article “General Electric: Big game hunting” in The Economist (March 14, 2002) investors may have interpreted GE’s increased reported

earnings for 2001 as evidence of bad earnings management, since poor economic conditions during 2001 suggest that earnings should have declined. In addition, GE appointed a new CEO in late 2001. The Economist suggests that the market may have less trust in the new CEO than in Jack Welch, the highly regarded former CEO, simply because he is less of a known quantity. As a result, the market may have felt that there is a higher likelihood that GE will use its considerable potential for earnings management for bad purposes rather than good. GE’s response to these market concerns is worth noting. It started to release considerably more information. Further discussion of how GE worked to overcome investor scepticism is given in Problem 21 of Chapter 12. Theoretical and empirical evidence in favour of good earnings management is given in Section 11.5.2, which I have marked as optional reading for those that wish to pursue good earnings management in greater depth. Suffice it to say that there is considerable evidence in this regard. 3.

To Appr eciate the Bad Side of Earni Earni ngs Management Management

Despite the above arguments, most people would likely regard earnings management with suspicion, reinforced by revelation of serious abuses of earnings management by Enron and WorldCom and numerous other corporations in the early 2000s. Consequently, students should not be left with the impression that it is necessarily good. A useful place to start is Hanna’s 1999 article in CA Magazine, which is well worth assigning and discussing. The important point to get across from this article is that management is tempted to provide excessive unusual, non-recurring and extraordinary charges, to put future earnings in the bank. Furthermore, these future earnings are buried in operations. This makes it difficult for investors to diagnose the reasons for subsequent earnings increases. Nortel Networks’ reversals of its excess accruals (see Theory in Practice vignette11.1 in Section 11.6.1) provide a vivid example of Hanna’s argument. Also, the effect on future profits of putting


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earnings in the bank has been recognized by an article in The Economist (“A world awash with profits, Business is booming almost everywhere,” February 18, 2005, pp. 62-63). This article states that one reason for the dramatic increase in firm profits during 2002-2004 is that they are an “accounting fiction,” which apparently means that they are a consequence of earlier writeoffs. I find that to drive home these various considerations, an example of how earnings management can go too far is instructive. An excellent case in point is the downfall of “Chainsaw Al” Dunlap at Sunbeam Corp. Jonathan Laing’s 1998 article in Forbes is reproduced in Question 10. Laing demonstrates that Sunbeam’s 1997 reported earnings were almost completely manufactured by means of discretionary accruals. The substantial first quarter, 1998, loss reported by Sunbeam supports Laing’s analysis, and the “iron law” of accrual reversal. I think that Laing’s analysis of the effects of the $17.2 million drop in Sunbeam’s prepaid expenses for 1997 is backwards–see part a of Question 10. If I am not correct in this, presumably other instructors will let me know. However, even taking this error into account does not substantially alter Laing’s conclusion that 1997 earnings were manufactured. 4.

Do Managers Acc ept Securiti es Market Efficienc y?

Evidence of good earnings management is consistent with managers’ beliefs that markets are reasonably efficient. Why use earnings management to reveal inside information if the market cannot interpret it? However, evidence of bad earnings management may or may not be consistent with efficiency. On the one hand, managers may feel that they can fool the market by managing their earnings, which seems to have been the case with Sunbeam management. Emphasizing proforma earnings (Section 7.4.2) is another tactic that seems inconsistent with acceptance of efficiency. It is hard to believe that managers would continue to attempt to manipulate investors’ beliefs if an efficient market immediately detected and penalized such behaviour. On the other hand, bad earnings management may hide behind poor disclosure. If the market is not aware that reported earnings are being managed, it can hardly be concluded that the market is inefficient. Rather, the question is whether the market will react once it Copyright © 2009 Pearson Education Canada

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suspects or becomes aware of the earnings management. The market’s negative reaction to the frequency of non-recurring charges as an indicator of possible earnings management, as documented by Elliott and Hanna (1996) (see Section 5.5) suggests considerable efficiency, for example. Also, the market’s post-Enron suspicion of GE’s earnings management, discussed above, is also consistent with efficiency. The text concludes that at least some managers do not accept market efficiency. However, it also concludes that markets are sufficiently close to full efficiency that improved disclosure will reduce bad earnings management. 5.

To Summarize the Strategic Aspects of Accoun ting Policy Choice

I end my discussion of earnings management with two main points: (i)

I emphasize the concept of strategic accounting policy choice, whereby

managers choose accounting policies to achieve certain objectives. These objectives may include efficient contracting, such as avoiding excess earnings volatility for compensation and debt covenant reasons, which may conflict with accounting policies that are most useful to investors. This greatly expands the role of financial reporting, since we now formally recognize two main roles of financial reporting– reporting to investors and reporting on manager performance. Both roles matter since the quality of manager effort and the well-working of managerial labour markets is as important to society as the quality of investor decisions and the well-working of securities markets. The conflict between these two roles, I hope, validates to the class the time spent on basic game and agency-theoretic concepts of conflict in Chapter 9. (ii)

I emphasize that managers have a legitimate interest in accounting policy

choice, since their operating and financing policies, and even their livelihoods, are at stake. This view is in contrast to many discussions of standard-setting where management seems to be the “bad guys,” opposing every new standard that comes along. The theory provides several legitimate reasons why managers will be concerned about changes to GAAP.


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SUGGESTED SOLUTIONS TO QUESTIONS AND PROBLEMS 1.

Some reasons why a firm’s management might both believe in securities market efficiency and engage in earnings management are: •

Income taxation. The firm may be able to postpone payment of taxes if it can minimize its reported income, for example by managing accruals, or using LIFO (if allowed by the tax authority).

•

Managerial bonus plan. As Healy documents, managers have incentives to maximize their bonuses, consistent with the bonus plan hypothesis of positive accounting theory. Consequently, they may adopt accounting policies to increase reported net income, or to reduce reported net income if it is below the bogey or above the cap of the bonus plan.

•

Covenants in lending agreements. Managers may adopt policies to increase reported net income, or other financial statement variables, to avoid covenant violation or even to avoid being too close to violation. Lending agreements may also induce income-smoothing behaviour. A smooth sequence of reported net incomes will reduce the probability of covenant violation.

•

A smooth earnings sequence may increase the willingness of lenders and suppliers to grant short-term credit. This is particularly so if the firm has implicit contracts with these stakeholders.

•

Political visibility. By reducing its reported net income the firm may forestall government intervention which might ensue if the public felt the firm was earning excessive profits. Question 10 of Chapter 8 illustrates this point.

•

Earnings management can be a credible way to communicate the firm’s inside information about its longer-term expected profitability to the market.

•

Poor disclosure. The manager may feel he/she can manage earnings opportunistically but hide behind poor disclosure to prevent the efficient market from detecting it. Copyright © 2009 Pearson Education Canada

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2.

Taking a bath involves writing off assets against the current year’s operations and/or providing currently for future costs. As a result, future years’ reported earnings are relieved of amortization, and provisions for future costs can absorb items that would otherwise be charged against current earnings. Furthermore, if provisions for future costs are excessive, reversal of the excess will increase current earnings. Consequently, future years’ reported earnings will be higher (or losses lower) than they would otherwise be, and the probability of the manager receiving a bonus correspondingly increases.

3.

Next year’s earnings will be reduced by $1,300 due to the “iron law” of accruals reversal. With respect to credit losses, there is a $500 lower cushion to absorb credit losses in the following year. Consequently, next year’s credit losses expense will be $500 higher, other things equal. With respect to warranty costs, a similar argument applies. The lower the accrued liability for these costs, the lower the cushion to absorb payments for warranty costs in the following year. Consequently, next year’s warranty cost expense will be $800 higher, other things equal.


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4.

a.

You would react negatively to the extent that the charge to record the liabilities

reduced net income for bonus purposes. However, the Compensation Committee may base the bonus on net income before deducting the charge, particularly if it was accounted for as an extraordinary item. (See Question 13 of Chapter 10 re BCE Inc. on this point. See also the evidence of Gaver and Gaver (1998) in Section 10.6, who report that extraordinary gains tend to be included in the determination of cash bonuses but not extraordinary losses.) A counter argument is based on the evidence of Healy (1985). If your net income before the charge is below the bogey or above the cap of your bonus plan, you may prefer that the charge be included in net income for bonus purposes. b.

You would react negatively. A reason is that the increased volatility would

increase the chance that reported net income would fall below the bogey or above the cap of the bonus plan. If this happens, it would require you to either manipulate accruals or forego your bonus. c.

You would react negatively because your expected bonus would be lowered,

with no compensating decrease in bonus volatility. d.

You would react negatively to a reduction in your ability to choose from different

accounting policies, because your freedom to manipulate discretionary accruals, such as choice of inventory costing method, for bonus, debt covenant or political reasons would be reduced. Also, your ability to communicate inside information about long-term earning power to the market would be reduced for the same reason. This could adversely affect cost of capital, hence future earnings.


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5.

The following points should be made: •

Generally speaking, fair value accounting for financial instruments eliminates the ability to manage earnings through gains trading, since the amounts and timing of the resulting unrealized gains and losses are no longer under management control.

•

Some earnings management potential may exist under IAS 39 and SFAS 115 by transferring financial assets between categories, such as from held-to-maturity to trading or available-for-sale. This triggers an unrealized gain or loss on the transferred items. However, a sale or transfer out of the held-to-maturity category is inconsistent with an intent to hold securities in this category to maturity. Thus, these standards contain provisions to severely limit such possibilities. For example, if such a transfer is made, IAS 39 prevents use of the held-to-maturity category for two years. This eliminates the ability to manage earnings on future transfers of this nature.

•

However, under IAS 39 and SFAS 115, unrealized gains and losses on available-for-sale securities are excluded from net income. Then, there may be a potential for earnings management by actual sale of financial instruments, since any realized gains and losses on these instruments will then be transferred into net income.

•

Where market values for financial instruments are not available, some ability to manage unrealized gains and losses remains, since fair values will then have to be estimated. Management may influence unrealized and realized earnings by managing the fair value estimates.

We may conclude that while managing earnings for bonus purposes will be reduced under fair value accounting for financial instruments, some ability to manage earnings remains.


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6.

a.

The various accruals for JSA Ltd. are as follows: Ad d b ack to net income - Depreciation and amortization.

Dedu ct fr om net income

$14

Mainly non-discretionary, since method of amortization and useful lives fixed by policy. However, manager has some discretion to change policy on occasion. - Reduction of liability for future income tax

$6

Non-discretionary, except to extent that manager controls depreciation and amortization policy. - Provision for reorganization

12

Discretionary, since manager controls amount and timing. - Increase in accounts receivable

16

May be driven by increased level of business activity. However, manager has considerable discretion over allowance for doubtful accounts and some discretion over credit and collection policy. - Decrease in inventories.

18

May be driven by lower level of business activity, but seems unlikely since accounts receivable have increased. Manager has considerable discretion over valuation of obsolete, used or damaged items. Also, under lower of cost or market rule, manager has discretion over amounts of writedowns. - Increase in prepaid expenses.

1

Considerable discretionary component Copyright © 2009 Pearson Education Canada

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since manager controls capitalization policy for many of these. - Decrease in accounts payable.

7

May be driven by lower level of business activity. However, manager controls amounts and timing of purchases and payment policy. Also, considerable discretion to extent accounts payable includes accrued liabilities. - Increase in customer advances.

5

Largely non-discretionary, although manager may influence number and amounts of advances. - Decrease in current portion of long term debt.

1

Non-discretionary, since fixed by contract. -

Increase in current portion of future income tax liability.

1

Non-discretionary, since income tax act specifies. $50

$31

31 Net income-decreasing accruals

$19

Check: Net income

$(12)

Net income-decreasing accruals

19

Cash flow from operations

$7

Note: Students often deduct from net income a $1 accrual for the increase in deferred development costs on the balance sheet. This throws them out of balance. There is not enough information on the income statement to know if deferred development costs are being amortized. It appears not. The most likely explanation for the increase


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in this item is that it results from a non-operating transaction, such as cash paid out for some capitalized development cost. b.

i)

Pick a specific account for which it is relatively easy to estimate the

discretionary component, such as net accounts receivable. Here, based on past collection and bad debts history, it is relatively easy to determine what the balance of the allowance for doubtful accounts should be. The discretionary accrual is then the difference between what the balance should be and the actual balance. ii)

Use the Jones model, which is a regression equation to estimate non-

discretionary accruals after allowing for the levels of business activity and capital investment. Discretionary accruals are then taken as the difference between this estimate and total accruals. c.

The manager may take a bath, by writing off investments in capital assets and

setting up provisions for future costs such as reorganization and layoffs. This will reduce reported net income this year, but the probability of high net income in future years is increased, since future amortization charges will be lower and future costs can be charged against the provisions rather than against net income. Furthermore, if the provisions turn out to be higher than actually needed, the excess amounts can be reversed into future years’ operations. Alternatively, the manager may income maximize, so as to increase net income above the bogey. However, this tactic is unlikely to be used unless pre-bonus earnings are only slightly below the bogey. Obviously, the most suitable accruals are those with the greatest discretion, and relative invisibility. These include maximization of prepaid expenses, and minimization of the allowance for doubtful accounts and accrued liabilities. Changes in amortization policy and useful life estimates of capital assets are possibilities. However, they are quite visible and could not be used very often.


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7.

a.

Reasons to resort to extreme earnings management tactics:

•

To meet analysts’ forecasts. As stated in the question, this was the apparent reason in BMS’ case.

•

Contractual reasons. To increase bonuses and/or to avoid debt covenant violations.

•

Implicit contracts. To increase earnings so as to receive better terms from suppliers. In BMS’ case, this seems unlikely since wholesalers were pressed to accept excess inventory.

•

IPO. The firm may have wanted to increase and/or smooth earnings so as to increase proceeds from a planned IPO.

b.

From the standpoint of a single year, stuffing the channels seems effective.

This is because it is hard to detect. Such behaviour may possibly be detected through full disclosure, such as sales by product, segment, or region. Then, careful analysis may reveal unusual sales patterns. However, the company has little motivation to provide full disclosure unless required by GAAP and/or insisted upon by the auditor. Wholesalers may object if too much inventory is forced upon them. Since wholesalers are not formally BMS employees, it may be more difficult to keep them from complaining to regulators or the media. However, in BMS’ case, paying their carrying charges may have been a device to avoid such complaints. Over a series of years, stuffing the channels is likely to be less effective, for the following reasons: •

Accruals reverse. Product stuffed into the channels this year will reduce sales next year. Ever more stuffing is needed if the strategy is to be maintained.

•

Physical limitations. There may be limits on wholesalers’ storage space.

•

Cost. It seems that paying the wholesalers’ carrying costs for their excess inventory became quite costly for BMS. Copyright © 2009 Pearson Education Canada

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We conclude that while stuffing the channels may be reasonably effective in the short run, it loses effectiveness to the extent it is used over multiple periods. c.

Cookie jar accounting seems reasonably effective as an earnings management device since it can be hard to detect. The firm has some flexibility about the

extent of disclosure of gains and losses from asset disposals (see discussion re unusual, non-recurring, and extraordinary items in Section 5.5.). Furthermore, overprovision for losses puts future earnings (i.e., cookies) in the bank (jar), and GAAP does not require separate disclosure of the effect on operating earnings when these accruals reverse. Full disclosure of unusual, non-recurring, and extraordinary items may tip off an efficient market as to the possibility of cookie jar accounting. This effect was documented by Elliott and Hanna (1996)—see Sections 5.5 and 11.6.1. While even an efficient market will not really know the actual extent of such accounting without full disclosure, suspicions may lead to SEC investigation. This seems to have happened to BMS. Effectiveness of cookie jar accounting can be increased if it is used responsibly to reveal management’s estimate of persistent earning power (i.e., good earnings management). It seems unlikely that BMS was using it in this manner, however. We conclude that while cookie jar accounting can be reasonably effective, and has the potential to be good, its continuing and excessive misuse may lead to its discovery and subsequent penalties. BMS appears to have been using cookie jar accounting to smooth reported earnings.


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8.

a.

In the short-run, capitalizing expenses to manage earnings is of moderate

effectiveness. On the one hand, the reduction in current reported expenses is considerably greater than the increase in amortization, so that there is scope for a considerable increase in reported profits. Furthermore, capitalizing expenses does not reduce current operating cash flows (since they are included in the investing, not the operating, section of the funds statement). As a result, techniques that attempt to identify earnings management by estimating discretionary accruals, such as the Jones model, will not work. On the other hand, effectiveness is reduced because capitalization of expenses is contrary to GAAP. As a result, unless the capitalizations can be concealed from the auditor, they will have to be reversed or the firm will receive a qualified audit report. The ability to conceal becomes more difficult the larger the amounts capitalized. In the longer run, the scope for increasing reported profits and the lack of effect on operating cash flows continues. However, as amounts capitalized continue to accumulate, it becomes more likely that this earnings management will be discovered. We conclude that effectiveness is only moderate in the short run and declines over time. b.

The importance of meeting earnings targets derives from securities market

efficiency and rational investor behaviour. A firm’s share price will incorporate the market’s expectations of future firm performance. Earnings targets, for example those laid down by management forecasts and/ or by analysts, are an important indicator of future performance. If these targets are not met, investors’ expectations of future firm performance will fall and share price will quickly fall with them. This is likely to be the case even if earnings are just short of target, since the market will suspect that if the firm could not manage earnings upwards by a small additional amount, its future must be bleak and/or management is unable to predict the firm’s future operations. As a result, managers’ compensations, including the value of share holdings, ESOs, and other share price-based compensation will fall. The manager’s reputation, tenure, and the firm’s cost of capital will all be negatively affected. To avoid these consequences, managers strive to meet earnings targets.


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c.

Large public companies may discontinue earnings forecasts to avoid the

negative consequences of failing to meet them. Forecasts provide an incentive for the manager to exert effort to attain them. However, if it appears the forecast will not be met in the normal course of business, the manager may attempt to meet them through dysfunctional behaviour such as bad earnings management, excessive cost-cutting, and/or deferral of maintenance. In effect, meeting forecasts encourages short-run behaviour at the expense of longer-term firm interests.

9.

a.

Restructuring charges are an effective earnings management device. They are

an unusual and non-recurring item, hence of low persistence. As a result, they may be ignored by investors in evaluating operating earnings, and by compensation committees for bonus purposes. However, the reasonableness of the amount of the restructuring charge is difficult for investors and compensation committees to evaluate. Consequently, as Hanna (1999) argues, management may overstate the amount, thereby putting earnings in the bank. These future earnings increases are also difficult to detect, since they become buried in lower amortization and/or used to absorb costs that would otherwise be charged to future earnings. Thus management can have it both ways—little penalty when the charge is reported, and reward for increased future operating earnings. In effect, Hanna’s argument is that restructuring charges are too effective an earnings management device since they create temptations for opportunistic manager behaviour. With respect to GE, it seems that restructuring charges are used in conjunction with other earnings management devices to manage current reported earnings. GE’s goal seems to be to report steadily increasing earnings. This goal rules out reporting huge increases in earnings currently, such as earnings from large extraordinary gains, since it may be hard to top these earnings in future years. Then, restructuring charges serve a role of reducing current reported earnings to a desired level. Given the variety of other earnings management devices at its disposal, it seems unnecessary for GE to overstate restructuring charges. If it did, it is unlikely that it could sustain the pattern of steadily increasing earnings it has reported. Overall, GE’s use of restructuring charges Copyright © 2009 Pearson Education Canada

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seems quite effective as part of an overall earnings management strategy that avoids reporting large, unsustainable earnings increases. b.

It seems unlikely that GE’s share price always fully reflects all publicly available

information. Costs of fully analyzing all information, and idiosyncratic risk, contribute to lack of full market efficiency. In GE’s case, costs of analysis are particularly high, since the firm’s complexity makes it difficult even for analysts to fully interpret GE. Also, investors who wish to eliminate idiosyncratic risk would find it difficult to find similar firms to invest in. Thus, any anomalies and resultant mispricing of GE shares are likely to persist. However, any mispricing will be reduced, if not eliminated, if GE’s management uses earnings management responsibly to reveal its expected persistent earning power, since share prices are based to a considerable extent on expected future earnings. If management’s inside information about expected earning power is accurate, GE’s share price should trade at a price similar to its price if the market had fully digested all publicly available information. c.

The answer follows from part b. It seems that GE is using earnings

management responsibly to convey inside information about expected earning power. This stands in for the difficulty analysts and investors face in fully evaluating all available information themselves. As a result, GE’s share price should reasonably reflect its future performance. We conclude that, in this case, GE’s earnings management is good. Note: This is an excellent article for class discussion. I begin by discussing the various earnings management devices that the question refers to, each of which can be discussed as to its effectiveness. The important point to bring out, however, is that GE apparently uses these devices in concert, as part of a strategy to generate a smooth, growing earnings series. It is also worth reminding the class that the accrual basis of accounting involves smoothing of annual or quarterly cash flows. Indeed, this is the reason the FASB gives in SFAC 1 for favouring accrual accounting over cash flow accounting as an indicator of “an enterprise’s present and continuing ability to generate favorable cash flows....” Copyright © 2009 Pearson Education Canada

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See Question 7 of Chapter 3. I then suggest that GE’s use of earnings management is a multi-period version of the same argument. I also ask the class whether they would go along with GE’s use of earnings management if they were its auditor. Usually, the answer is yes, since nothing GE does seems inconsistent with GAAP. Then, I point out that, in effect, management can “drive a truck” through GAAP, and ask what prevents a firm from reporting just about any net income it wants. The answer is very important– accruals reverse. This is what puts discipline on the earnings management process, and is food for thought for any budding accountant/auditor/manager. This point is illustrated with a vengeance in Question 10 re Sunbeam Corp. Instructors may wish to follow up on GE subsequent to the Enron collapse. GE’s impressive earnings sequence continuing to at least 2006 tends to validate its preEnron earnings management activities. That is, if GE had been excessively pumping up its reported earnings pre-Enron, it could hardly have continued to report earnings increases in subsequent years—the iron law would have caught up with it sooner or later. The decline in investor confidence in financial reporting following Enron led to severe share price declines for many firms for which there was even a faint suspicion of reporting irregularities and lack of transparency. As a well-known practitioner of earnings management, GE was no exception. GE’s response is interesting. One response was to greatly increase its disclosure, including for its GE Capital subsidiary. See the discussion in point 3 of the Learning Objectives and Suggested Teaching Approaches above, including problem 21 of Chapter 12. Also, according to an article in The Globe and Mail by Elizabeth Church (April 1, 2002, p. B6), GE expanded the

number of pages in its 2001 annual report by 30%. See also, “GE changing its reports to provide more details,” in The Globe and Mail , February 20, 2002, p. B11 (reprinted from The Wall Street Journal). The Globe also reported on GE’s 1st quarter, 2002 results (“GE reports profit up, revenue flat,” by Stephen Singer, April 12, 2002, p.B6). GE’s reported net income for the quarter was $3.5 billion (before accounting changes), compared to $2.57 billion for the same quarter of 2001. However, its revenues were almost the same as for the 1 st quarter, 2001. Its share price fell by 9% on the day it Copyright © 2009 Pearson Education Canada

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released its results. Obviously, the market is suspicious about how its quarterly earnings increased when revenues were flat. Another GE response was to amend its manager compensation plan, to reduce the use of ESOs. See Problem 10 of Chapter 10 for an account of restricted stock units awarded to its CEO in 2003, in place of ESOs. See also a reference to its policy of not repricing ESOs in Problem 14.c of Chapter 10. 10.

a.

Laing reports a $23.2 million dollar drop in prepaid expenses in 1997. The

offsetting debit in 1997 was, presumably, to expense (Dr. Expense $23.2, Cr. Prepaid Expense $23.2). If so, the drop in prepaid expenses has decreased 1997 net income, not increased it as Laing asserts. Laing notes that 1996 was “a lost year anyway,” so the company prepaid everything it could. He seems to imply that prepaying everything served to decrease 1996 net income, which, of course, is incorrect since prepaid expenses are assets. He then states that costs for 1997 were “reduced markedly.” In fact, 1997 costs would be increased, as the 1996 prepaid expense accruals were used up in 1997. Note: An alternative interpretation of what Laing meant is that the company prepaid everything it could in 1996 but charged the prepayments to expense in 1996. This would have the effect of decreasing 1996 earnings and increasing those of 1997, as he asserts. But, if this is what Sunbeam did, the decline in prepaid expense from 1996 to 1997 does not measure the amount by which earnings were affected.


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b.

List of impacts on 1997 net income of the various earnings management

devices described in article. Amounts are estimated net of tax: Effect on 1997 Net Income ($ million) (Net of tax) Increase •

Decrease

Inventory written down to zero in 1996, sold at 50¢ on the dollar in 1997

•

$36.5

Decline in prepaid expense from $40.4 in 1996 to $ 17.2 in 1997

•

$15

Decrease in other current liabilities ($18.1) and other long-term liabilities ($19), attributed mainly to reduction in product warranty provisions

•

$25

Reduction in 1997 amortization, due to 1996 writedown of property, plant and equipment, and trademarks

•

$6

Capitalization of product development, advertising, etc. into property, plant and equipment in 1997

•

$10

Decrease in allowance for Copyright © 2009 Pearson Education Canada

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doubtful accounts from $23.4 to $8.4 during 1997 •

$10

Manufacturing for stock in 1997, evidenced by 40% increase in inventories

•

$10

“Early buy” and “bill and hold” sales of $50

$8

$105.5 Less total of Decrease column Net discretionary accruals

___

$15

15 $90.5

Total accruals can be determined as the difference between net income and operating cash flow: $109.4 - (-$8.2) = $117.6 We may conclude that $90.5 million of the total accruals of $117.6 million were discretionary, income-increasing. It thus appears on the basis of Laing’s analysis that Sunbeam’s 1997 reported earnings were largely manufactured. c.

The article implies that the restructuring charges of $390 million were

excessive. This puts earnings in the bank, which can be drawn down in future years through reduced amortization and charging of operating costs to the restructuring reserves. d.

Sunbeam’s reported first quarter, 1998 earnings were a loss of $44.6 million,

compared with a profit of $6.9 million for the first quarter of 1997. Sales were reported as $244.5 million, a decrease of $9 million from the first quarter of 1997. While a decline in actual sales may be at least partly responsible for the first quarter loss, the reported sales would have been pulled down by the reversal of the


360


$50 million of “early buy” sales accruals recorded in 1997. It appears that the efforts to “pump up” first quarter sales (additional “buy now, pay later” sales, extending quarter by 3 days) fell short of overcoming the reversal of the sales prematurely recorded in 1997. With respect to expenses, some of the expense reductions, such as amortization, noted for 1997 would continue in 1998. However, many others would reverse, such as warranty expense, allowance for doubtful accounts, and manufacturing for stock (which would lower 1998 production, hence the amounts of absorbed overhead). In sum, the early recording of sales in 1997, together with the reversal of discretionary, income-increasing 1997 accruals, seems to have “come home to roost” in 1998, consistent with the iron law of accruals reversal. Note: Subsequent articles relating to Sunbeam’s accounting problems include: •

“Troubled Sunbeam ousts CEO Al Dunlap,” The Globe and Mail , June 15, 1998, p. B6 (reprinted from The Wall Street Journal).

•

“Teary-eyed Chainsaw Al defends record at Sunbeam,” The Globe and Mail, July 10, 1998, p. B8 (reprinted from The Wall Street Journal).

•

“Sunbeam audit finds mirage, no turnaround,” The Globe and Mail , October 20, 1998, p. B15 (reprinted from The Wall Street Journal).

•

“Despite Recovery Efforts, Sunbeam Files for Chapter 11,” The Wall Street Journal, February 7, 2001.

•

“S.E.C. Accuses Former Sunbeam Official of Fraud,” The Wall Street Journal, May 16, 2001. Arthur Andersen partner Philip E. Harlow was

also charged. •

“Sunbeam’s ex-CEO settles SEC probe,” The Globe and Mail , September 5, 2002, p. B6. The article reports that Mr. Dunlap will pay $500,000 (U.S.) to settle charges he used inappropriate accounting


361


techniques that hid Sunbeam’s financial problems. Former CFO Russell Kersh will pay $200,000. Both men were barred from ever serving as officers or directors of any public company. Mr. Dunlap has also paid $15 million and Mr. Kersh $250,000 to settle a class action lawsuit over misrepresentation of Sunbeam’s results of operations. •

“Morgan Stanley duped financier Perelman in ‘fraudulent deal’,” Financial Times, April 7, 2005, page 16. The Laing article mentions Sunbeam’s

acquisition of Coleman Co., a maker of camping equipment. The Financial Times article reports that Ronald Perelman, a wealthy financier

and chairman of cosmetics firm Revlon, is suing Morgan Stanley, a large investment bank. Perelman had owned 82% of Coleman, and accepted Sunbeam shares as payment. The lawsuit claims that Morgan Stanley helped Sunbeam “dupe” Perelman about the value of Sunbeam shares, which collapsed in value when the earnings management described in the Laing article was revealed. 11.

a.

Managers may want to smooth earnings for the following reasons: •

They may feel that the market rewards share prices of firms that report steadily increasing earnings, consistent with the findings of Barth, Elliott, and Finn (1999).

•

They may want to keep earnings for bonus purposes between the bogey and cap of their bonus plan.

•

They may want to reduce the probability of violation of debt covenants.

•

They may want to convey inside information about persistent earning power by smoothing reported earnings to an amount they feel can be sustained.

•

They may smooth earnings because of implicit contracts, consistent with the findings of Bowen, Ducharme, and Shores (1995). The firm Copyright © 2009 Pearson Education Canada

362


may be able to secure better terms from suppliers and other stakeholders with which it has a continuing relationship if it reports steady earnings. b.

Costs of smoothing earnings by means of opportunistic discretionary accruals

derive primarily from negative investor reaction should the firm’s usage of such discretionary accruals to manipulate earnings be discovered by the market. Investors may then lose confidence in the integrity and transparency of the firm’s reporting (i.e., their perception of estimation risk increases), leading to a fall in its share price. Costs of smoothing earnings by means of derivatives include the commissions and other costs paid in order to acquire and sell the derivative instruments. Also, if the firm excessively smooths its earnings in this manner, this reduces the manager’s incentive to exert effort, since agency theory tells us that if he/she is to work hard, the manager must bear risk. Another potential cost is that hedging by derivatives reduces upside risk. The firm will not benefit if underlying prices move opposite to the direction hedged. Smoothing by accruals does not have this effect. Managers will trade off these 2 earnings management devices in order to minimize costs. Smoothing by means of derivatives involves the use of real variables to manage earnings, with costs as given in the previous paragraphs. Smoothing by means of accruals also creates costs, deriving from increased investor estimation risk should opportunistic earnings management be revealed. Also, firms may differ in the amounts of discretionary accruals available. For example, firms that operate in a risky environment, or that are continually buying and selling other companies and engaging in costly restructurings, have more accruals-based earnings management potential than a stable firm in a stable industry where, for example, there may be relatively few large unusual and non-recurring items with earnings management potential. Stable firms would find it less costly to smooth by means of derivatives.


363


Other firms may already be heavy derivatives users and may be concerned that further usage could turn into speculation, which could increase, rather than reduce, volatility of earnings . Alternatively, firms may be in a business for which a derivatives market does not exist or is very costly. For example, a firm with operations very subject to the weather may find weather derivatives to be too costly. Other firms may wish to protect themselves against large credit losses but my find that credit derivatives are not available or are too costly. Such firms would find it less costly to smooth earnings by means of discretionary accruals. c.

Barton’s results are more consistent with the efficient contracting version of

positive accounting theory. If managers were not concerned about the costs to the firm of smoothing activity, they would not trade off the use of discretionary accruals and derivatives so as to find the lowest-cost way to smooth. 12.

a.

Nortel appeared to be using a policy of big bath in 2001 and 2002, to put

earnings in the bank. In 2003, the company appeared to be using a policy of income maximization, to enable bonuses to be paid. b.

One impact would be to increase manager effort directed towards increasing

sales and profitability. Presumably, this was the intention of the tying of bonuses to a return to profitability. Nortel’s compensation committee may have felt that defining profitability in terms of pro-forma income would contribute to this goal by eliminating from the profit calculation expenses that were not informative about current sales and profitability-oriented effort. However, another impact would be to encourage dysfunctional, short-run manager behaviour, particularly if it seemed that increasing sales and profitability was more difficult and lengthy than originally hoped. This behaviour apparently took the form of reversing previous years’ excess accruals into current (pro-forma) earnings. Dysfunctional behaviour could also be encouraged by defining profitability in terms of pro-forma income. Since there are no rules laid down to define items that can be excluded from pro-forma income, management may have been tempted to omit loss items that were informative about effort. Copyright © 2009 Pearson Education Canada

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c.

Nortel went wrong because of poor disclosure. It credited the reversals of

excessive accruals into 2003 operating (and pro-forma) income without disclosing their source. This created the impression that the increased 2003 earnings were due to current manager effort (hence persistent) rather than simply a restatement of past over-provisions. Matters were made worse by payment of bonuses. These were intended to encourage current effort but seem to have had the opposite effect of diverting effort into misleading financial reporting.

13.

a.

The current financial report shows GN. Two points should be mentioned. First,

the persistence of the non-recurring item is low by definition. Thus, it is unlikely to have much effect on future earnings. This suggests future earnings will be high since the current non-recurring item will likely reduce future amortization charges and/or provide a cushion against which future charges that would otherwise be debited to future earnings can be made. Second, it appears that CG manages its earnings so as to report a smooth and growing sequence over time. Thus, the role of the current non-recurring loss seems to be to reduce reported earnings for the quarter to an amount management expects to persist. This means that the current increase in earnings will be maintained and likely increased. Note: Answers that argue BN on the grounds that the analysts’ consensus forecast was only met, not exceeded, are not acceptable. Under the circumstances (increased earnings, despite a large non-recurring loss) it seems hard to interpret current earnings as BN. b.

By Bayes’ theorem, the posterior probability of the high state, based on GN in

earnings, is:


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P( High) P(GN / High)

P ( High / GN ) =

P (GN / High) P( High) + P (GN / Low) P( Low)

=

=

0.7 × 0.9 0.9 × 0.7 + 0.2 × 0.3

=

0.63 0.63 + 0.06

=

63 69

0.91

P ( Low / GN ) = (1 − 0.91) = 0.09

Then, denoting holding the shares by a 1:

EU ( a1 )

=

0.91 × 100

=

0.91 × 10 + 0.09 × 6

=

EU ( a 2 )

+

0.09 × 36

9.1 + .54 = 9.64

=

81 = 9

The decision is to hold. Note: If the answer to a is BN, an answer that correctly evaluates the resulting decision is acceptable: P(High/BN) = 0.23 EU(a1) = 6.3 EU(a2) = 9 c.

Yes, your evaluation of the earnings report should now be BN. Managers know

that the market price of their shares will be severely affected if earnings expectations Copyright © 2009 Pearson Education Canada

366


are not met. If the manager cannot find enough earnings management to raise reported earnings by 1 cent per share, the firm’s earnings outlook must be bleak.

14.

a.

The revenue deferral will decrease relevance, since there is now a greater

recognition lag for contract revenue. This reduces the ability of investors to revise state probabilities and predict future cash flows of the firm. However, reliability will increase, since there is now less chance of error or bias in revenue recognition. b.

Nortel appears to be following a pattern of big bath for 2005. The shareholder

litigation expense item creates a large loss for the year. Nortel may feel that this would be a good time to defer revenue, since there is a large loss anyway, and, since accruals reverse, deferral now will increase revenue to be recognized in future periods. c.

Abnormal return is the difference between expected and actual share return for

the day. From the market model, the expected return for Nortel for t = March 10/06 was: R jt = α j + β j RMt, where α j = Rf (1 – β j) = .0001(1 – 1.96) + 1.96 × .0058 = -.0001 + .0114 = .0113 The actual return on Nortel shares for this day was - .0305. Abnormal return was thus (-.0305 – .0113) = - .0418, or - 4.18%. The abnormal share return likely arose because of the revenue deferral, since the market would have been aware of the shareholder litigation and would have incorporated the expected settlement amount into Nortel’s share price prior to March Copyright © 2009 Pearson Education Canada

367


10. The news of the deferral would cause investors to lose confidence in Nortel’s accounting, increasing estimation risk. An opposite answer can also be supported, for either of 2 reasons:

•

If the amount of the settlement exceeded the market’s expectation, the news of the settlement amount could have caused the negative abnormal return.

•

If markets are not fully efficient, the market may not have incorporated an expected settlement amount into Nortel’s share price prior to the news of March 10.

d. Inclusion in operations seems questionable. Presumably, shareholder litigation resulting from accounting restatements will not occur frequently over several years. Also, such lawsuits do not typify the normal business activities of Nortel. In addition, the amount or timing of the expense does not seem to depend on decisions or determination by managers or owners. Thus, the 3 requirements for an extraordinary item are met. Nortel may have intentionally overestimated its litigation settlement costs charged to current operations, in order to put earnings in the bank. If so, this is consistent with the argument of Hanna (1999). To the extent actual litigation costs are less than $2.474 billion, the difference can be transferred back to earnings from continuing operations at some future date.


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15.

a.

Revenue recognition is an effective earnings management device because

recognition criteria under GAAP are vague and general. A company can speed up, or slow down, revenue recognition but disguise the change through vague wording of its revenue recognition accounting policy disclosure. Also, as in the case of Coca-Cola, revenue recognition can be speeded up by stuffing the channels to unconsolidated subsidiaries or customers, without any formal change in revenue recognition policy. Stuffing the channels can be difficult for investors, or even auditors, to detect. A superior answer will point out that revenue recognition is an accruals-based earnings management policy, whereas, stuffing the channels involves real variables. A disadvantage of revenue recognition as an earnings management device is that accruals reverse. Consequently, it is difficult to maintain increased reported revenue over time. Also, stuffing the channels becomes quite costly if it is necessary to compensate the subsidiary or customer for carrying costs, as Coca-Cola did. Possible reasons why Coca-Cola managed its reported earnings upwards: •

Contractual. To smooth or otherwise manage executive compensation where this is based on reported earnings, and to reduce the probability of violation of debt covenants.

•

To meet analysts’ earnings projections, thereby avoiding a fall in share price. This seems to be the most likely reason in Coca-Cola’s case.

•

To maintain or increase management’s reputation.

•

Income taxes. To reduce or otherwise manage income taxes payable.

•

Changes in CEO. CEOs may manage earnings to reduce the probability of being fired, to reduce the probability of a successful takeover bid, or because they are approaching retirement.

•

IPOs. Firms may manage earnings upwards prior to a stock offering so as to increase the issue price.


369


•

Implicit contracts. To maintain good relations and credit terms from suppliers.

•

Communicate inside information to investors, providing the upward management is not to an amount higher than can be sustained.

b.

Since gallons shipped in one quarter correspondingly reduce amounts shipped

in future quarters, an increase in EPS this quarter will create a corresponding decrease in EPS next quarter. Consequently, even more gallonage must be pushed in each successive quarter to maintain an EPS increase. c.

The reason appears to be to avoid a reduction of future core earnings when

bottlers’ inventories cannot be further increased and reported sales fall off. The inventory reduction program could be accounted for as an unusual and non-recurring component of operating income. This would have the appearance of low persistence, reducing negative investor reaction to the inventory reduction and to lower sales and earnings in 2000. 16.

a.

Reasons why Deutsche Bank shares rose on October 3: •

Reduction of uncertainty. Given the market meltdown of asset-backed securities, the market had little idea of their fair value, hence little idea of the losses faced by firms holding these securities. The EUR 2.2 billion writedown gave investors at least a ballpark figure of Deutsche Bank’s losses. The result is to lower estimation risk and/or lower Deutsche Bank’s beta (since Deutsche Bank’s loss provides some information about losses of other bank’s—see Section 4.5), both of which raise stock price.

•

The amount of the writedown may have been less than the market expected.

•

Cleaning house. The market may have felt that the writedown signals that Deutsche Bank has put its losses behind it and will now turn its full attention to increased future profitability.

•

Optimistic earnings forecast. The market may have felt that the CEO’s reaffirmation of Deutsche Bank’s 2008 profit forecast indicated that he felt that the


370


company’s asset-backed securities losses were now behind it and that he felt securities markets will return to normal functioning. b.

Reasons why the bank may have wanted to take a bath: •

Investors feared the worst. Consequently they would not penalize Deutsche Bank unduly if the writedown was inflated.

•

Cookie Jar. Since the company reiterated its 2008 profit forecast, it would be anxious to avoid the consequences of not meeting it. Putting earnings in the bank by means of a cookie jar increases the likelihood that it will meet its forecast.

c.

Reasons why the bank may want to understate its writedown: •

Investor unease. Investors were concerned about the consequences for the economy of major losses by financial institutions. If investor concerns led to recession, this would reduce future bank profits. High reported writedowns would increase investor concerns.

•

Regulatory concerns. As a financial institution, Deutsche Bank may have been concerned about violation of capital adequacy requirements if writedowns were sufficiemtly high.

•

Debt covenant hypothesis. Excessive writedowns may lead to violations of debt covenants.

•

Management compensation. Managers whose bonuses are tied to earnings or stock price may fear reduced compensation if high writedowns lead to lower values of these performance measures.

d.

Reclassification would lead to valuing the reclassified securities at cost, not fair

value. If so, a writedown would be avoided. You would object to this suggestion, for the following reasons: •

Reclassification suggests opportunistic behaviour by management. Accepting such behaviour violates ethical behaviour and professional responsibility. Copyright © 2009 Pearson Education Canada

371


•

If the reclassification becomes public knowledge, this will adversely affect management’s reputation and market value, and could lead to legal liabilities and penalties for the firm and its managers.

•

Once reclassified, the securities could not be sold until maturity. Situations could arise such that it would be desirable to sell prior to maturity, but, if sold, the consequences under IAS 39 would be that use of the held-to-maturity classification is denied for all securities for 2 years.

•

Ceiling test. Reclassification would be unlikely to avoid writedowns in any case, since held-to-maturity securities are subject to a ceiling test.

Ad di ti on al Pr ob lem s 11A-1. This problem is based on the paper by Elliott, Hanna, and Shaw (EHS), “The Evaluation by the Financial Markets of Changes in Bank Loan Loss Reserve Levels,” The Accounting Review (October, 1991), pp. 847-861. While the main research

interest of this article is information transfer (the impact of a firm’s financial statements on the share prices of other firms)–a topic not covered in this book, the evidence in the paper also provides an interesting and persuasive illustration of how earnings management (in this case, the establishment of loan loss reserves) can reveal inside information. During 1987, many United States banks faced severe problems with respect to loans to “lesser developed countries” (LDCs). For example, on February 20, 1987, Brazil declared a moratorium on interest payments on $67 billion of its debt. This led to problems of how to account for the LDC loans by the banks that were affected. On May 19, 1987 (4.45 pm), Citicorp (a money-center bank and, at the time, the largest U.S. bank) announced a $3 billion increase in its loan loss reserve for LDC loans. This amount equalled 25% of the book value of its LDC loans. In the 2 days following the announcement, Citicorp’s share price rose by 10.1%, after falling by 3.1% on the day of the 4.45 pm announcement. Copyright © 2009 Pearson Education Canada

372


EHS also examined the share price behaviour of 45 other U.S. banks with foreign loans in excess of $100,000 and which announced increases in their loan loss provisions during 1987. Of these banks, 11 (excluding Citicorp) were money-center banks (with major LDC exposure) and 34 other, regional banks (with lower LDC exposure). For a 3-day window surrounding the May 19, 1987 Citicorp announcement, EHS report the following abnormal returns: 11 money-center banks: 34 other banks

1.14% -.054%

On December 14, 1987 (4.15 pm), the Bank of Boston (not a money-center bank) announced a $200 million increase in its LDC loan loss reserve, classified $470 million of LDC loans as non-accrual of interest status, and wrote off $200 million of LDC loans. In the 3-day window centred on 15 December, 1987, its share price rose by 9.9%. Banks were required to maintain a capital adequacy ratio (see note) of at least 5% for regulatory purposes. The Bank of Boston’s capital adequacy ratio remained strong (8%) after the writeoff. Note: The capital adequacy ratio is calculated as the ratio of shareholders’ equity plus loan loss reserves to total assets. Thus, a provision for loan losses does not affect the ratio, while a writeoff of loans does. For a 3-day window centred around 15 December, 1987, EHS report the following abnormal returns: 12 money-center banks

-7.26%

33 other banks

- 1.14%


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Required a.

Why did Citicorp’s share price fall by 3.1% on May 19, 1987 and rebound by

10% over the next two days? b.

Why did the abnormal 3-day return for 11 money-center banks exceed the

return for the 34 other banks for the same period? c.

Why did the Bank of Boston’s share price rise by 9.9% over a 3-day window

surrounding December 15, 1987? d.

Why was the average abnormal return of 12 money-center banks significantly

lower (-7.26%) than the abnormal return of 33 other banks (-1.14%) over the 3-day window surrounding December 15, 1987?

11A-2.Shown below are the income statement and comparative balance sheets of ACR Ltd., from its 2008 annual report. The 2008 cash flow statement of ACR Ltd. (not shown) reports operating cash flow as $2,386. ACR Ltd. Income Statement Year Ended December 31, 2008 Contract income

$11,684

Cost of contracts

9,073

Gross profit

2,611

General and administrative expenses

1,346

Amortization

276

Interest

16 1,638

Operating profit

973

Equity income from affiliates

165

Other income

52 217 Copyright © 2009 Pearson Education Canada

374


Income before income taxes and extraordinary items

1,190

Income taxes: Current

584

Future

59 643

Income before extraordinary items

547

Extraordinary items

—

Net income for year

$547


375


ACR Ltd. Balance Sheets As at December 31 2008

2007

Assets Current assets: Cash

$

693

Trade accounts receivable Income taxes recoverable

$

2,107 —

— 3,464

506

Inventories

810

410

61

99

3,671

4,479

405

203

1,532

1,632

$5,608

$6,314

$

—

$1,291

Accounts payable and accrued liabilities

398

497

Income taxes payable

282

34

83

64

763

1,886

62

22

825

1,908

2,268

2,268

80

80

3,895

3,275

1,175

1,307

7,418

6,930

Prepaid expenses Investments in affiliated companies Machinery and equipment Liabilities Current liabilities: Bank indebtedness

Liability for future income taxes Future income tax liability

Shareholders’ Equity Share capital Capital contributed on issue of warrants Retained earnings Excess of appraised value of fixed assets over amortized cost


376


Less: Cost of shares purchased

2,635

2,524

4,783

4,406

$5,608

$6,314

Required a.

What is the amount of net accruals included in ACR Ltd.’s year 2008 net income?

b.

Use the information in the income statement and balance sheets of ACR Ltd. to calculate the various individual accruals and reconcile to the net total in part a.

c.

Upon comparing operating cash flow and net income, we see that the accruals have substantially lowered the reported income for the year. Give reasons why management may want to manage income downwards in this manner.

11A-3.

A way to manage earnings is to manipulate the point in the operating cycle at which revenue is regarded as earned. An article entitled “Bausch & Lomb Posts 4thQuarter Loss, Says SEC Has Begun Accounting Probe” appeared in The Wall Street Journal on January 26, 1995.

The article reports on questions raised by the SEC about Bausch & Lomb Inc.’s premature recording of revenue from products shipped to distributors in 1993. “Bausch & Lomb oversupplied distributors with contact lenses and sunglasses at the end of 1993 through an aggressive marketing plan, and was forced to buy back a large portion of the inventory [in 1994] when consumer demand didn’t meet expectations.” The oversupply amounted to around $10 million, which Bausch & Lomb claimed was not “material.” In addition, the article points out that in the fourth quarter of 1994 Bausch & Lomb had incurred $20 million in “one-time expenses,” which included expenses from “previously announced staff cuts of about 2,000.” Also, in the fourth quarter Bausch & Lomb took a $75 million charge in its oral-care division in order “to reduce unamortized goodwill


377


that it recorded when Bausch & Lomb bought the business in 1988.” Many analysts are saying that Bausch & Lomb are looking to sell the oral-care division, and this reduction of unamortized goodwill will make the division look better. Required a.

What earnings management policy did Bausch & Lomb appear to be following in 1993?

b.

Evaluate revenue recognition policy as an earnings management device.

c.

The article refers to a $20 million writeoff in 1994 relating to staff cuts, and another $75 million writeoff in Bausch & Lomb’s oral-care division. What earnings management strategy does the firm appear to have followed in 1994? Why?

d.

Do Bausch & Lomb’s 1993 and 1994 earnings management strategies suggest that its management does not accept efficient securities market theory? Explain why or why not.

11A-4. Note: The 5th edition of this text has removed discussion of push-down accounting. Earnings management extends into the realm of new share offerings (IPOs), since the prospectus for a new offering includes current and recent financial statements. An article entitled “RJR Nabisco’s Use of Accounting Technique Dealing with Goodwill Is Getting a Hard Look,” which appeared in The Wall Street Journal on April 8, 1993, describes some earnings management considerations surrounding a $1.5 billion new share offering of Nabisco, a food subsidiary of RJR Nabisco Holdings. According to the article, the parent, RJR Nabisco Holdings, has substantial goodwill on its books arising from its acquisition of Nabisco, which is being amortized at a rate of $607 million annually (at the time, both the CICA Handbook, and, in the United States, APB 17 required that goodwill from acquisitions be amortized over a period of up to 40 years). However, this goodwill amortization appears only on the books of the parent— not on those of Nabisco. Copyright © 2009 Pearson Education Canada

378


According to the article, “What RJR is doing is presenting Nabisco’s annual earnings without the burden of $206 million of 1992 ‘goodwill,’ leaving this earnings-depressing item with the parent company instead.” This resulted in Nabisco increasing its 1992 after-tax profit from $179 million to $345 million or from 48 cents a share to 93 cents a share. The article goes on to state “Nabisco executives indicated the food company could generate 1993 earnings of as much as $1.30 a share. That earnings level might justify the proposed selling price of $17 to $19 a share for the new Nabisco shares, analysts say.” The article questions whether RJR is managing the reported net income of its Nabisco subsidiary by not “pushing down” goodwill to Nabisco. Required a.

What pattern of earnings management is RJR following? Why?

b.

Without considering any strategic issues surrounding the pricing of the new shares, do you think that goodwill should be pushed down to the subsidiary company?

c.

Do you think the strategy of not pushing down the goodwill will be successful in raising the issue price of the new shares? Explain why or why not.


379


Suggested Solutions to Additio nal Problems 11A-1 a.

The 3.1% fall could have been due to a fall in the stock market index (i.e.,

economy-wide risk) on that day. (EHS investigated this possibility, and concluded that the fall was not “the outcome of general macroeconomic events.”) The fall could have been due to investors anticipating the announcement and “fearing the worst.” If so, the subsequent rise could have been because the actual loan loss provision turned out to be less than the market had expected. However, this does not seem to explain why the subsequent share price increase was so high–much greater than the 3.1% drop. The most likely reason for the initial fall is that the announcement was made quite late in the day and even rational investors did not have time to analyze the reasons for the loan loss reserve announcement. They then sold quickly to protect themselves in case the announcement turned out to be bad news. Over the next 2 days, however, it became apparent that the loan loss provision was a signal that Citicorp had a strategy to deal with its LDC loan problems. Consequently, the bank’s share price rebounded by more than the initial decline. b.

The most likely reason follows from part a, namely that Citibank’s

announcement was taken by the market to indicate that all exposed banks were taking steps to deal with the problem. That is, the ”good news” from Citibank carried over. However, the less exposed a bank was, the less it would be affected by the good news--it had less to lose in LDC loans in the first place, so information suggesting that it was taking steps to deal with the problem would have a smaller effect on its share price. Thus the most-exposed bank (Citibank) enjoyed the greatest share price increase (10.1% - 3.1% = 7%), followed by the 11 other exposed money-center banks (1.14%) and the 34 least-exposed other banks (0.54%). The reason the return is negative for these latter banks is likely because the good news was not good enough to outweigh the losses from writeoffs per se.


380


c.

The same reasons as for part a apply here. In addition, the Bank of

Boston’s capital adequacy ratio was still well above the regulatory minimum, even after its $200 million writeoff. This seems to have been interpreted by the market as an indication of the bank’s financial strength. d.

The answer seems to lie in the fact that the Bank of Boston, in addition to

increasing its loan loss provision, actually wrote off $200 million of LDC debt, thereby taking a “hit” to its capital adequacy ratio. The market apparently interpreted this as an indication that actual writeoffs were generally needed, but that other banks were reluctant to do this, creating fears that these other banks were concerned about their own capital adequacy ratios, or they would have recorded writeoffs too. This argument is consistent with the negative returns for all sample banks around December 15. It is also consistent with the much larger negative abnormal returns for the money-center banks, which were much more exposed.


381


11A2 . a.

Net accruals are the difference between operating cash flows and reported net

income. Here, net accruals for 2005 are $2,386 - 547 = $1,839. b.

The individual 2008 accruals of ACR Ltd. can be calculated and reconciled as

follows: Cash flow from operations Less: Amortization expense Future income taxes expense Decrease in net accounts receivable

$2,386 $276 59 1,357

Decrease in income taxes recoverable

506

Increase in income taxes payable

248

Decrease in prepaid expenses

38

Increase in current liability for future income taxes

19 2,503 (117)

Add: Equity income from affiliates Increase in inventories

$165 400

Decrease in accounts payable and accrued liabilities

99

Net income as per income statement


664 $ 547

382


c.

Reasons why management may want to manage income downwards by means

of accruals: •

Political cost hypothesis of positive accounting theory. If ACR is very large, it is very much in the public eye. It may fear political repercussions if it reports earnings that are perceived as too high.

•

Bonus plan hypothesis. If it appears that ACR’s earnings for bonus purposes will be above the cap of the bonus plan, management may wish to lower reported earnings. Otherwise, bonus will be permanently lost on above-cap earnings.

•

Taxation. If firms in the United States use the LIFO inventory method for income tax purposes, they must also use LIFO in their financial statements. On a rising market, LIFO reports a lower net income than other methods, such as FIFO. The firm then reports a lower net income in order to save taxes. ACR does not indicate which inventory method it uses, however.

•

Taking a bath. The firm may want to increase the probability of high future earnings by writing assets down currently and/or providing for future costs, such as for downsizing or reorganization. This motivation may be present when a new management takes over, or when earnings are below the bogey of the bonus plan. In the case of ACR, however, no unusual, non-recurring or extraordinary items appear on its income statement. Unless these are buried in larger totals, it seems this motivation does not apply to ACR in 2008.

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To communicate inside information to investors. If current year’s operations have led to higher earnings than ACR’s management thinks will persist, it may wish to manage reported earnings downwards so as to credibly inform investors of its best estimate of sustainable earnings.


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11A-3 a.

Bausch & Lomb appears to have followed a policy of income maximization in

1993. b.

Bausch & Lomb appears to have used revenue recognition policy as a device to

manage annual (1993) earnings. Such a policy is reasonably effective, at least in the short-run, since revenue recognition criteria under GAAP are vague. This gives the firm some room to manoeuvre in terms of timing of when it regards revenue as earned. In particular, current earnings can be increased by recogizing revenue on excess shipments to distributors. In the longer run, however, a disadvantage of Bausch & Lomb’s early revenue recognition policy is that it involved physical shipment of product to distributors. There may be limits to distributors’ storage capacity and ability to carry the additional inventory, rendering the policy potentially quite costly. Indeed, it was this aspect of Bausch & Lomb’s 1993 policy that seemed to come back to haunt it in 1994, namely, the need for buybacks. Another longer run disadvantage of early revenue recognition is that accruals reverse. Thus, higher revenue recognized in 1993 means lower revenue in 1994. Then, even more shipments to distributors are needed in subsequent years if the policy is to be maintained. We conclude that revenue recognition policy is reasonably effective in the short run but its effectiveness decreases over the longer term. c.

Bausch & Lomb appears to be taking a bath in 1994. Presumably, this is to

increase earnings in subsequent years by “clearing the decks,” possibly to make its oral-care division appear more attractive for a sale, or to “bank” earnings so as to increase the probability of substantial earnings increases in future years. d.

Arguments that Bausch & Lomb’s management does not accept securities

market efficiency depend on the extent to which its earnings management strategies are visible to investors. If these strategies are visible, there would be little point in trying to fool an efficient market. Consequently, visible earnings management strategies suggest management does not accept efficiency. Copyright © 2009 Pearson Education Canada

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At least some of the firm’s earnings management strategies are visible. These include the staff cuts and the $75 million charge in its oral care division. Visibility of other strategies, such as “stuffing the channels” in 1993 is less clear. To the extent that Bausch & Lomb felt the market would not find this strategy out, it is consistent with acceptance of efficiency. That is, management could both accept efficiency and feel that it could fool the market through lack of disclosure. However, it is also consistent with not accepting efficiency. Management may feel that even if stuffing the channels was visible, the market would still react favourably to higher reported 1993 earnings. Additional arguments can be made based on contracting theory. The bath strategy may be for bonus purposes, consistent with Healy’s findings for earnings below the bogey. Management may both accept securities market efficiency and manage earnings for contractual reasons. Bausch & Lomb management may feel that with these 1994 writeoffs behind them, the firm’s persistent earning power will be revealed, consistent with a desire to convey inside information to an efficient market. Yet another possibility may be that management is signalling to the efficient market that it has its problems in hand and has a well-worked-out strategy to deal with them. This argument is consistent with the findings of Liu, Ryan, and Whalen (1997) with respect to banks (see Section 11.5.2).


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11A-4. a.

RJR is following an income maximization policy with respect to Nabisco. A

possible reason is that RJR is planning a new Nabisco share offering. It seems to believe that higher reported earnings will enhance the offering price. Friedlan (1994) found evidence that firms use earnings management to increase reported net income prior to an IPO (Section 11.4.3). b.

According to the information approach, it should not matter whether goodwill is

pushed down as long as the amount is disclosed, since the efficient securities market will put the same values on shares of parent and subsidiary regardless. Certainly, the amounts involved here have been disclosed, since they are reported in the article. According to the measurement approach, goodwill should be pushed down since this results in more relevant values on the books of the subsidiary. Furthermore, the value of goodwill should be reliably determined since it resulted from an arms-length acquisition transaction. Note: While it predates SFAS 141 and 142 and Sections 3062 and 1581 of the CICA Handbook, effective July, 2001, this question can also be discussed in relation to

these standards. They eliminate amortization of purchased goodwill (see discussion in Section 7.4.2). Then, pushing down goodwill to Nabisco is of less immediate concern to RJR management since, even if it was pushed down, there would be no goodwill amortization and resulting lower reported earnings, on Nabisco’s books. However, purchased goodwill is subject to the ceiling test under the above new standards. If goodwill on Nabisco’s books should hit the ceiling, a writedown may be required. Then, Nabisco’s reported earnings would be reduced if the goodwill had been pushed down. Consequently, RJR management may still wish to avoid this possibility, by not pushing down. Of course, if Nabisco’s goodwill should hit the ceiling, it would have to be written down on the parent’s (RJR Nabisco Holdings) consolidated financial statements, whether or not it was pushed down.


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Scott Chapter 11 - Earning Mangements (English Ver)

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