Earnings Management and Manipulation
by Scott McGregor
Types of Earnings Management and Manipulation
Earnings manipulation is usually not the result of an intentional fraud, but the culmination of a series of aggressive interpretations of the accounting rules and aggressive operating activities. The end result is misstatement of the financial results perpetrated by people that had previously been considered honest and may not have realized the severity of their actions until it was too late.
The typical case of earnings manipulation begins with a track record of success. The company or division has posted significant sales and earnings growth over recent years. Their stock price trades at a high price earnings multiple as the market rewards its stellar growth. Unfortunately, it is becoming more difficult for the company to maintain the sales and earnings growth that analysts have grown to expect. Sales are behind target this quarter, so management runs special incentives for its sales force to accelerate sales and uses overtime to ship out its products. It works and the firm meets expectations.
The next quarter, the analyst expectations are higher. However, sales still have not picked up to the level required, so the firm provides additional incentives to its sales force, uses overtime to boost shipments but now has additional expenses to contend with (incentives and overtime), so it does not fully accrue all its consulting expenses. The following quarter rolls around and sales still haven't recovered, but the analysts keep raising the bar. This time the operating tactics are not enough, so management pressures the CFO to make the numbers. The CFO is aggressive in the interpretation of installment sales and expense accruals, and the company again meets expectations. The expectations keep rising, as does the firm's stock price. As the fourth quarter comes around, sales still are not at expectations. The CFO creates sales and under-accrues expenses all to meet expectations. The company has gone from aggressive operating practices to financial fraud.
Earnings management is the acceleration or deferral of expenses or revenue through operating or accounting practices with the objective to produce consistent growth in earnings. These earnings may not reflect the underlying economics of the enterprise for the time-period. Some of the principle means of managing earnings are "cookie jar" reserves, capitalization practices, "big bath losses", altering the timing of operations to speed recognition of revenues, aggressive merger and acquisition practices and revenue recognition practices.
In general, the practice of earnings management leads to pulling operating profits from subsequent periods creating even greater pressure on financial managers to create earnings in those following periods. The management of earnings can then lead to manipulation and misstatement taking management down the path from questionable ethical practices to blatant fraud.
Some of the techniques used to manage and manipulate earnings are discussed below:
a. "Cookie-jar" Reserves
The accrual of expenses is to reflect the period in which the expense was incurred. For example, if a firm hires a consultant to perform a particular activity, it should reflect the expense related to that activity in the period in which it is incurred, not when the bill is paid or invoice received. In many cases, the accrual of expenses, or reserves in particular industries such as insurance and banking, are based on estimates. As such, the estimates have varying degrees of accuracy.
During times of strong earnings, the firm establishes additional expense accruals and subsequently reduces the liability to generate earnings when needed in the future - pulling a "cookie from the jar".
b. Capitalization practices - intangible assets, software capitalization, research and development
In 1997, companies were allowed to capitalize the costs of internally developed software and amortize it over the useful life, generally three to five years. Capitalization is to represent the development costs. The capitalization process of companies has the potential for manipulation because these assets are often intangible and based on judgement. A firm may allocate more expenses to a project that can be capitalized to reduce current operating expenses.
c. "Big bath" one-time charges
Unusual or non-recurring charges have become one-technique used by firms to escape the maze of over aggressive accounting practices. Many believe and anecdotal evidence has shown that analysts overlook non-recurring charges because they are not part of the firms ongoing operations or operating income. Typical non-recurring charges include writing down assets, discontinuance of an operating division or product line and establishing restructuring reserves.
As discussed previously, firms practicing earnings management deplete the economic earnings from future periods. As their ability to sustain earnings growth diminishes, they may seek an event that can be characterized as one-time event and "overload" the expenses attributable to that event. The one-time charge may be discounted by analysts as not being part of operating earnings while the stock price does not suffer the consequences normally associated with missing earnings targets. To provide itself with more "cookie jar" reserves or mask its past sins, the firm may take other write-offs or create other accruals not directly tied to the event and attribute those expenses to the one-time event.
A study by Elliot and Hanna (1996) reported that reports of large, one-time items increased dramatically between 1975 and 1994. In 1975, less than 5% of companies reported a large negative write-off compared to 21% in 1994. The authors also showed that companies that had previously reported similar write-offs were more likely to do so.
d. Operating activities
Managers often have the ability to modify the timing of events such that the accounting system will record those activities in the period that is most advantageous to management. The activity does not alter the long-term economic value of the transaction, just the timing and thus, comparability of financial statements. For example, a company could accelerate its sales and delivery process such that it records sales in December that normally would have been reported in January. Thus, the company reports higher fourth quarter sales, revenue and profits. In the long-term, the company would ultimately report the same sales and profits; however, it has inflated its growth in the near term, and reduced profits in the future period.
e. Merger and acquisition activities
One type of significant event that may be used to mask other charge-off is mergers and acquisitions. In most cases, there is some form of restructuring involved creating the need for a large one-time charge along with other merger-related expenses. The event provides the acquirer with the opportunity to establish accruals for restructuring the transaction, possibly attribute more expense than necessary for the transaction. The company may also identify certain expenses that are revalued on the seller's balance sheet, increasing goodwill. If the conservative valuations prove to be excessive, the company is able to reduce its operating expenses in the near term by reducing its estimate for the liability. The additional goodwill created would be amortized over a long period of time and not have a significant impact on near term results.
There are two methods of accounting for mergers and acquisitions. Pooling of interests ("pooling") accounting and purchase accounting. Pooling recognizes the transaction as a merger of equals, thus the transaction is recorded as company A plus company B. Purchase accounting treats the transaction as a purchase. The fair value of the purchased company is assessed and compared to the purchase price. Any excess or premium paid above the fair value of the assets is recognized as goodwill. Goodwill is amortized over a period of time not to exceed forty years.
1. Pooling on interests
Abraham Brilloff, professor emeritus at Baruch College, in an article in the October 23, 2000 issue of Barron's entitled "Pooling and Fooling" brought attention to the use of pooling accounting by Cisco Systems to inflate its operating earnings. Cisco has been an active acquirer paying $16 billion for twelve companies in fiscal 2000 alone, but through the use of pooling accounting, Cisco only recognized only $133 million in cost in its capital accounts for these transactions. In addition, five of the acquisitions were deemed "too immaterial" to restate prior period financial statements. Brilloff contends that Cisco's earnings for 2000 should have been reduced by $2.5 billion reducing the $2.1 billion gain into a $.4 billion loss.
If a company pays a premium to acquire another firm, the premium, or goodwill, is amortized and reduces earnings going forward. Thus, companies seek transactions that will allow them to use pooling of interests. It has been contended that additional premiums have been paid in instances where pooling of interests will be allowed.
Criticism of pooling accounting has been significant and the FASB has reacted by announcing the elimination of the method. However, the effective date has been delayed as the FASB has received strong opposition from industry.
2. Purchase accounting and goodwill
Under the purchase method of accounting for acquisitions if the price paid by the acquiring firm exceeds the fair value of the company acquired, the difference is recorded as an intangible asset, goodwill. Goodwill is amortized over future periods, thus, the creation of goodwill causes future expenses, therefore reducing reported earnings. If the acquirer conservatively values assets (such as private placement or illiquid securities and real estate) or liabilities (reserves, accrued liabilities), the company may be able to recognize additional earnings in the near future as it estimates become less conservative.
Professor Brilloff has also been a critic of the accounting practices of Conseco, a financial services company. Mr. Brilloff contended that Conseco had manipulated its earnings through its acquisition practices. In summary, he argued that Conseco had inflated the loss or claim reserves of the insurance entities it acquired and recognized a corresponding asset of goodwill at the time of acquisition. It could then reduce the reserves over the near term to inflate earnings while amortizing the goodwill over a significantly longer period of time.
f. Revenue Recognition
The timing of the recognition of revenue is the most likely area to target for management and manipulation. From an operational standpoint, firms can take aggressive actions to boost revenues and sales in one period through providing incentives to their sales force, utilize overtime to push shipments out the door. They may also take aggressive accounting actions such as selling securities classified held for sales recognize gains in income versus stockholders equity, aggressive in the timing of the recognition of sales or aggressive in the application of broad or unclear accounting guidance.
g. Immaterial misapplication of accounting principles
Materiality is a concept that has been under fire from the SEC due to its misuse. As previously discussed. Errors, misstatements and misapplication of accounting principles have been overlooked if they fell below the materiality threshold. A company may knowingly misstate earnings by amounts that fall below the materiality threshold by not correcting known errors or other misstatements. If the practice continues for a number of periods, the balance sheet (retained earnings) may become significantly misstated.
h. Reserve one-time charges
The use of one-time charges, established in the form of a reserve, can be used to manage earnings. The company conservatively recognizes a one-time charge in the form of a contingency reserve for a possible future loss or future expense. They anticipate that analysts will discount the charge since it is not deemed to be part of operating income. Over time, the company changes its estimate (reduces) to recognize additional earnings.
Examples of cases of earnings manipulation
In April 1998, Cendant announced misstated financial statements at its CUC International unit, the announcement resulted in a loss of $14 billion in market capitalization within one day of trading. Cendant had been a darling of Wall Street until its announcement. It had produced a tremendous record of growth in revenues and earnings. By April of 1998, the company was an active acquirer of firms performing various services (Ramada, Coldwell Banker, Avis) and had recently made news by outbidding behemoth AIG for American Bankers Insurance Group, a deal that fell through following the accounting fraud announcement.
Cendant had acquired the CUC unit through a merger of equals. The firm had two headquarters, one in Stamford, Ct. for the former CUC and one in New Jersey. For the merger due diligence, Cendant had relied almost exclusively on the audited financial statements of CUC. Thus, they failed to uncover the $ 500 millions of fraudulent sales and receivables recorded between 1995 and 1997, and the million-plus of expenses charged by its CEO to the company.
The improprieties at the Cendant unit grew to the point where they could not be concealed in its annual audit, prompting the announcement. Although Cendant has survived, they sold 11 businesses and their stocks price and price earnings multiple has not recovered. Cendant eventually settled the largest shareholder lawsuit, $2.8 billion, in history.
b. Manhattan Bagel
From its initial public offering in 1994 to June 1996, the stock price of Manhattan Bagel rose from $5 per share to $29. The company grew to be the third largest bagel franchise in the United States with ambitious plans for substantial expansion. Sales and earnings were growing. The company began to expand through acquisition. In January 1996, the company acquired a West Coast bagel operation, however, the firm failed to perform the necessary due diligence and acquired millions of dollars of overstated revenues.
In June 1996, the firm announced accounting problems in its recently acquired West Coast operations, and its stock price was cut in half within days. The free-fall in its stock price continued and with the negative publicity and shareholder lawsuits that followed, the company was unable to sell franchises at anywhere near their previous pace. Eventually, the company was forced to seek bankruptcy protection.
Sunbeam, a maker of small consumer appliances such as Mr.Coffee, has drawn much attention in recent years for its disappointing financial results and cutthroat tactics of its former CEO, "Chainsaw Al" Dunlap. The nickname was given to Mr. Dunlap for the manner in which he cut the size of the employee base.
In mid-November 2000, the SEC concluded its investigation into accounting practices at Sunbeam. The SEC charged that Sunbeam recognized revenues prematurely from sales promotions with retailers in 1997. This activity was prior to the dismissal of Sunbeam's infamous CEO, who was terminated in 1998. Although not discussed in the SEC ruling, it would not be surprising if the stress of the environment contributed to the aggressive revenue recognition.
Recently, Tyco was forced to restate fiscal 1999 and the first quarter of 2000 due to certain merger, restructuring and other non-recurring charges, increasing 1999 earnings and decreasing earnings for the first quarter of 2000. Tyco is still under investigation for its usage of pooling of interest accounting in its merger and acquisition activities. Based on the SEC ruling, it appears that Tyco set aside "cookie jar reserves" in 1999 and began to reduce the liabilities in 2000, thus, increasing earnings.
Between 1994 and 1995, Sensormatic recognized out-of-period revenue, overstating earnings to meet analysts' expectations. The Chairman and CFO had to pay penalties of $50,000 and $40,000, respectively. Most likely, there were quite a few individual investors who incurred greater financial losses as a result of their actions.
3Com agreed in November 2000 to pay $259 million to settle shareholder lawsuits involving accounting irregularities following its 1997 acquisition of U.S. Robotics Corp. 3Com had allegedly concealed losses at U.S. Robotics when they combined the companies. Under pressure from the SEC, 3Com was forced to reduce it stated net income for 1997 by $111 million and reduce a purchase-related charge for 1998 by $158 million.
g. W.R. Grace
WR Grace & Co. was charged by the SEC with manipulation of its earnings through the use of "cookie jar" reserves used to smooth reported earnings in its National Medical Care Inc. unit.
The above cases are just a sample of some of the recent cases. These cases display some of the circumstances and ways in which earnings can be manipulated, including cases of blatant fraud, aggressive revenue recognition, cookie jar reserves and inadequate due diligence in mergers and acquisition practices.
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