Tut 7 Solutions - HOMEWORK HELPS PDF

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Tutorial 7 1. What is meant by the term ‘earning management’? What are the incentives for managers to manage earnings? (from Godfrey)

Earnings management occurs when managers use judgment or discretion within GAAP, or structure transactions, to affect the information in financial reports. The purpose of earnings management is to influence users’ perceptions of financial statements about the firm’s underlying economic performance or to influence outcomes that contractually depend on reported accounting numbers. For example, if financial information is used in determining bonus payments as part of executive remuneration, managers may have an incentive to arrive at the financial results necessary to achieve the bonus. Another example relates to debt covenants. A firm at risk of breaching a loan covenant has an incentive to manipulate financial information to avoid the breach and thus avoid cost of refinancing the loan. Earnings management may be undertaken so that a firm reports a smooth income stream rather than a volatile one. The practice of earnings management may potentially affect transparency of the underlying economic reality of a firm’s financial performance or position. Consequently, investors’ decisions with respect to the allocation of resources may be affected, with adverse consequences. The authors note that earnings management may be used to disguise declining operating performance to protect share price to ‘ensure their stock based compensation remains valuable’ and to allow capital raising on favourable terms. 2. Do you consider earnings mangement to be good or bad? Why? Earnings management is defined as a ‘manager’s use of accounting discretion through accounting policy choices to portray a desired level of earnings in a particular reporting period’. Whether it is considered good or bad will depend on the acceptance of the arguments of Macintosh et al. 2000 or those of Parfet, 2000. Because the measure of corporate success has become whether a corporation has reached its earnings predictions, the temptation for management is to ‘manage’ earnings to match analysts’ forecasts. In this process, as outlined by Macintosh et al., accounting earnings do not reflect the outcomes of an enterprise’s strategic decisions. Instead, analysts’ predicted earnings determine the strategy of an enterprise to satisfy the prediction. This means management may take predictions about earnings as targets and select investments that are likely to produce reported income equal to or exceeding the analysts’ forecasts. Meanwhile, the market incorporates analysts’ earnings forecasts into share prices. In this way, share prices, analysts’ forecasts and reported income all relate to each other but not to ‘true’ or underlying income. Parfet, a representative of preparers of financial reports, defends earnings management by differentiating ‘bad’ from ‘good’ earnings management. The bad involves intervening to hide true operating performance by creating artificial accounting entries or by stretching the estimates required in preparing financial statements beyond reasonableness. This, he points out, is the realm of hidden reserves, improper revenue (income) recognition and overly aggressive or conservative accounting judgements.

Good earnings management, on the other hand, involves management taking actions to try to create stable financial performance by acceptable, voluntary business decisions in the context of competition and market developments. The market tends to reward corporations that achieve stable trends of growing income. Good earnings management involves spotting the most beneficial use for the corporation’s resources and quickly reacting to unforeseen circumstances. Parfet declares earnings management not to be a bad thing but a reflection of expectations and demands, both inside and outside a business, on the part of all stakeholders in the capital market. 3. Outline the five methods discussed in this chapter that entities can use to manage earnings. Discuss the circumstances in which entities are likely to use each method. The five methods entities can use to manage earnings include: Accounting policy choice – where managers have flexibility in making accounting choices, they can chose policies that manage timing differences and the amounts of expense recognition and asset valuation, for example. Entities may choose to alter change accounting policies at a time when they change an accounting estimate (for example extending the useful life of an asset) or changing the use pattern of an asset (e.g. changing form straight line to reducing balance depreciation). If a company changes accounting policies they will need to provide the auditor with documentation to justify the decision. As such, it is more costly than accrual accounting or income smoothing. Accrual accounting – Accrual accounting techniques generally have no direct cash flow consequences. They can include recalculating impairment of accounts receivables (provisioning for bad debts), delaying asset impairment, adjusting inventory valuations, amending depreciation and amortization estimates, including expected useful life and residual values. Companies will manage accruals to generate consistent revenue and earnings growth. Income smoothing – relates to managing fluctuations in income by shifting earnings from peak periods to less successful periods. This is also related to accrual management. It can include such activities as early recognition of sales revenues, variations in bad debts or warranty provisions, or delaying asset impairments. Income smoothing is used to present the appearance of constant growth, and limit volatility in earnings. companies will manage accruals to generate consistent revenue and earnings growth. Real activities management – earnings are managed through operational decisions. This could include accelerating sales, offering price discounts, reducing discretionary expenditures, altering shipment schedules or delaying R&D or maintenance expenditures. Real activities management tends to occur throughout the year, whereas accruals management occurs at the end of the fiscal or financial year. Real activities management is less likely to draw the attention of auditors.

Big bath write-offs – relates to large losses reported against income as a result of significant restructuring. This would involve selling or writing down assets. It often occurs when a new management team moves in, or when a business sells off a poor performing subsidiary or business unit. 4. Table 9.1 presents examples of some common accounting decisions, and how companies following a conservative, moderate, aggressive or fraudulent strategy might use these to manage earnings. Prepare a similar table and complete it in relation to the following accounting decisions: (a) Revenue recognition from services (b) Intangible assets (c) Impairment of non-current assets (d) Revaluation of non-current assets (K, J) Conservative

Moderate

Aggressive

Fraud

Revenue recognition from services

Services are prepaid and performed in full

Services prepaid and partially performed

Services are agreed to but not yet performed

Fraudulent scheme

Intangible assets

Regularly impair, do not revalue even in an active market

Slow to record impairment losses

Revalue intangibles even when no active market

Overstate intangibles where nonexistent intangibles are recognised

Impairment of non-current assets

Conservative impairment policy used

Slow to record impairment losses

Non-current assets are impaired but no impairment loss recorded

Fictitious noncurrent assets recorded to bolster asset balances

Record revaluations annually using generous valuations

Revalue noncurrent assets when no change in fair value

Upwardly Revalue impaired noncurrent assets estimates to meet earnings targets

Revaluation of Use cost basis of accounting non-current assets

5. You have recently been appointed as a researcher for a firm of share analysts. As one of your first roles you are required to prepare a report for your manager

to outline common techniques used to manage or manipulate earnings. From your prior accounting knowledge you would have gained an understanding of techniques you can use to examine entity performance and profitability, including trend analysis. Document what strategies you might use as an analyst to detect earnings management using accounting information. Outline common techniques used to manage or manipulate earnings: see Q3. There is a range of techniques analysts can use to examine financial data to detect earnings management. A number of these are outlined in Contemporary Issue 9.1. These can include: Examine trend in profit results – the analyst should be able to determine if profits are consistent, and growing gradually over time, or if they vary significantly from one year to the next. Analysts can also access half yearly, and sometimes quarterly data that can assist in this assessment. Is the company subject to seasonal variations? Are they meeting forecasts on a half yearly basis? Operating/non-operating mix – analysts need to determine which part of the business is generating profits. If earnings are being generated through non-recurring items such as gain on sale of fixed assets, rather than current operations, it may indicate a problem with meeting earnings forecasts and continued increases in earnings. Earnings base – analysts should examine from where the company sources earnings. If they are spread across a number of operations or sectors there is a higher likelihood of longer-term success than if the company relies on only one operation, or even one major customer. Analysts should also look at the change in debt arrangements in place, and leverage ratios. This may give an indication of earnings management being used to avoid breaches of covenants etc. Similarly, executive compensation arrangements and performance hurdles managers are required to meet to obtain bonuses are going to provide an indication of the extent to which earnings management is likely, if they are heavily based on earnings targets.

Case study 9.1: The ethics of earnings management 1.

Why would the NZSO wish to smooth income?

The NZSO would wish to smooth income because it needs to assure government (which provides grants) and sponsors that it is using the funds provided to it on an annual basis, and does not have a significant surplus over the medium term. This is important to ensure the continued support of these bodies for the NZSO. It is also important that the NZSO does not show large deficits in any year, as this can mean the management of the body will be questioned. 2.

Were the earnings management techniques the NZSO used ethical? Explain your answer.

The earnings management techniques were not used to mislead users, by presenting financial data that was entirely inaccurate. The difficulty with having the end of the financial year finishing in the middle of a concert season means the total costs and income for the entire season are going to be spread over two financial periods. The NZSO is not using methods to hide costs or overstate profits, they are merely using methods to smooth out costs and income over the medium term in order to ensure there are no periods with a large surplus followed by another with a large deficit. As such it would appear the management techniques are ethical. 3.

What factors would you consider when determining whether such a decision was ethical?

Some of the factors you would consider are:  Are the decisions designed to mislead stakeholders?  Is the management of the NZSO using funds for alternative purposes?  Do costs and income align over the medium term – e.g. over two or three reporting periods?  What are the reasons behind the decision to smooth income?...