Download Earnings_Management

(EM)
Earnings Management
June 28, 2006
Group Members
Alfred D’Souza
Aman Gill
Eric Lindsay
Mary Guo
Michael Flaman
Ranbir Khangura
Tammy Cheung
Agenda
What is Earnings Management?
What motivates Earnings Management?
Common Approaches
Example – Krispy Kreme
Consequences
What is Earnings Management?
Healy and Wahlen, 1999
“Earnings management occurs when managers
use judgment in financial reporting and in
structuring transactions to alter financial reports
to either mislead some stakeholders about the
underlying economic performance of the
company or to influence contractual outcomes
that depend on reported accounting numbers.”
What is Earnings Management?
Schipper (1989)
“… a purposeful intervention in the
external financial reporting process, with
the intent of obtaining some private gain
(as opposed to merely facilitating the
neutral operation of the process”
EM – Recent Examples
• Worldcom (1999 –2002)
– $ 9 billion overstatement through release of improper reserves
• Xerox (1997 –2000)
–
–
–
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$ 3 billion accelerated revenue recognition
$ 500 million though ‘cushion’ reserves
SEC levied $ 10 mm in fines
No admission of guilt
• Lucent Technologies, Cendant, MicroStrategy (2000)
– Stock market lost 34 billion in three days
Fraud vs. Earnings
Management
“Conservative”
Accounting
• Aggressive recognition of provisions and
reserves
• Overvaluation of R&D purchase acquisitions
• Overstate asset write-offs
Earnings
Management
“Aggressive”
Accounting
“Fraudulent”
Accounting
Within GAAP
• Understate provision for bad debts
• Drawing down provisions/reserves in an overly
aggressive manner
• Recording sales before realizable; recording
fictitious sales
• Backdating sales invoices
• Overstating inventory
Violates GAAP
When is EM Fraudulent?
EM and accrual methods are fraudulent under
the following circumstances:
–
1. When they are used to satisfy analysts’ expectations.
–
2. When they are used to realize bonuses.
–
3. When transactions are structured or carried out to alter
financial reports.
–
4. Whenever they are used for reasons other than to provide
accurate financial information to investors and stakeholders
Determined by motive.
Is Accrual Accounting a form of EM?
• Accrual accounting uses accrual, deferral, and allocation
to reflect an entity’s performance during a period
• Managers use GAAP to make reporting decisions
• Enables its investors to assess the entity’s economic
performance more accurately than from just cash flows
Manipulate the company’s earnings so the
figures match a pre-determined target
Qualitative vs Quantitative
Earnings
•
Size matters. Most investors look at
cents per share when analyzing earnings
•
Quality earnings have 3 basic qualities:
– Repeatable
– Controllable
– Bankable
Repeatable
In the 3rd quarter of 2001, Motorola
posted earnings per share of 4 cents,
beating analysts’ expectations, but the
stock fell 15% soon after.
–
The reason? Sales had shrunk, and the
economy was soft. Most of the earnings
growth came by way of job cuts and the sale
of investments
Controllable
Some U.S companies with European
subsidiaries are reporting earnings that
are better than expected.
–
The Reason? The falling U.S dollar has
improved earnings via the exchange rate.
Inflation can also affect earnings through the
prices of inputs and outputs.
Bankable
In 2002, Circuit City’s stock price fell over
40% even though both sales and earnings
showed sizable increases.
–
The Reason? The size of the company’s
Accounts Receivable had more than doubled
creating concerns around their collectibility
Why is EM not acceptable?
• Misallocation of Investment Resources
• Undue improvement in management
credibility
• MD&A provides room to explain variance
in performance
• Sign of Compromised Collusive Auditing
Agenda
What is Earnings Management?
What motivates Earnings Management?
Common Approaches
Example – Krispy Kreme
Consequences
Why does EM occur?
Three main reasons:
• Capital Market Expectations and
Valuation (Earnings Shock)
•
Contracting Motives
•
Anti-trust and Government Regulations
Capital Market Motivations
• Sample motives:
• Short term stock price performance
• Valuation prior to management buyouts
• E.M. to meet the expectations of financial
analysts
Capital Market Motivations
Sample methods:
• Income increasing depreciation methods
and allowances in year prior to IPO
• Income smoothing
But… studies show investors “see through”
such E.M. and instead rely on long term
strategy when allocating resources
Earnings Shock
• Positive earnings surprises usually aren’t
significantly rewarded by the market.
• Negative earnings surprises are penalized
harshly
The Reason
• Earnings targets are usually conservative.
• Every subsequent positive shock has less of an
impact.
Earnings Shock cont’d…
• Positive earnings surprises tend to be
more frequent than negative earnings
surprises as companies try to ‘beat down’
expectations
• Interim Reports are not audited, thus
creating more opportunity to manage
earnings
Contracting Motivations
• 1. Lending Contracts
• Managers manage earnings to ensure
compliance with existing lending
covenants (i.e. debt service coverage or
debt equity ratios)
But… Study showed only 5 of 22 firms
delayed default through E.M.
Contracting Motivations
1. Management Compensation Contracts
•
Managers use judgment to increase earnings
based bonus awards
•
Managers manage earnings when job security
is threatened
But… study shows personally motivated
E.M. has little effect on asset allocation
Regulatory Motivations
Industry Regulations
• Banks required to satisfy capital adequacy
requirements
• Insurance companies must meet conditions for
minimum financial health
• Utilities companies have been historically permitted
to earn normal return on invested assets
Strong evidence that E.M occurs when
companies are on verge of violating
regulatory provisions.
Regulatory Motivations
Anti-Trust Regulations
Companies on verge of investigation may
manage earnings to appear less profitable
Study: Companies being investigated for antitrust violations report income decreasing
accruals
Agenda
What is Earnings Management?
What motivates Earnings Management?
Common Approaches
Example – Krispy Kreme
Consequences
How are Earnings Managed?
• ‘Big Bath’ Restructuring
• Cookie Jar Reserve Accounting
• Premature Revenue Recognition
–
–
–
–
Camouflage of ‘Hold and Sale’ transactions
Transporter picks up risk of loss
Uncertainty at cut off date
Inflating standard orders
• Expected lives of long term assets
• Obligations for pension benefits
• Deferred Taxes
Typical Stages of EM
1) Tuck awaycreate the
Cookie Jar
2) Dip into the
Cookie Jar –
reversal of
accruals
3) Can’t manage
growing market
expectation
4) No real cash
flow - Scraping
the bottom
How are Earnings Managed?
Cont..
• Deference of Asset Impairment
• FIFO vs LIFO methods of accounting (e.g.hyper
inflationary countries)
• Accelerated Declining method of Amortization
• Working Capital Management – delayed shipments
• Timing of capital gains
Other Sophisticated methods
• Off Balance Sheet reporting in subsidiaries
• Synthetic Leases
• Pro-forma Estimates
• Inter-company transactions
Some Special Cases
• Banks – Loan Loss Reserves
• Insurance Companies – Claim Provisions
• Large Petrol Chemical Projects – Deferred Tax
Allowances
• Business Combos – creative acquisition accounting
• Equity structuring to avoid / require consolidation
How auditors detect EM
• Cash flows that are not correlated with earnings
• Receivables that are not correlated with revenues
• Allowances for uncollectible accounts that are not correlated with
receivables
• Reserves that are not correlated with revenue growth or balance
sheet items
• Questionable acquisition reserves
– restructuring charges or reserves set aside for disposals
• Earnings that consistently and precisely meet analysts’ expectations
S&P’s Core Earnings Metric
• Attempts to provide consistency and
transparency related to earnings
• Created with the input of the investment
community
• Clearly defines what can and cannot be included
as Revenues and Expenses
S&P Core Earnings





What’s In
Employee stock option
expenses
Restructuring charges
Pension fund costs
Purchased R&D
expenses
Write-downs and
depreciable operating
assets





What’s Out
Goodwill impairment
Gains/losses from asset
sales
Pension gains
Litigation costs/proceeds
Unrealized gains from
hedging activities
Critique – S&P’s Core Earnings
• Can option expenses be fairly priced?
– Black-Scholes produces highly subjective
results; especially with volatile stocks
• Pension plan gains are excluded, but
losses are included.
– If returns are down in a given year, earnings
will be penalized even if the plan is flush
Agenda
What is Earnings Management?
What motivates Earnings Management?
Common Approaches
Example – Krispy Kreme
Consequences
Krispy Kreme - What Went Wrong?
Background Information
• KKD began in 1937 in the southeast U.S.
• Began going national in 1996, opening stores in
Manhattan, L.A, Los Vegas
• Declared “Hottest Brand in the Land” by Fortune
Magazine
• IPO took place in 2000
KKD: Initial Public Offering
• IPO in 2000, just after the tech bubble burst
• Investor’s were eager for a business they could
understand
• Considered one of the best IPO’s of that year
• IPO price: $21…. by August 2003: $50
•
2004: $665.6 MM in sales, $94.7 MM in profit, 400 total
stores (Australia, Canada, Korea)
KKD: Canadian Rights
• Owned by KremeKo Inc. under exclusive
franchising and licensing arrangement
(2000)
• KremeKo required to open 32 stores within
7 years ($US 40,000 pre store plus
royalties)
What happened?
•
May 2004: First ever missed quarter and first loss as a public
company (CEO blames low carb diets)
•
July 2004: SEC makes an informal inquiry into KKD buybacks of
several franchises
•
Stock price plunges, shareholders file suit
•
Oct. 2004: SEC inquiry upgraded to “formal”
•
KKD continued to add stores, though sales were falling
•
Jan.2005: KKD decides to restate financials; CEO replaced by
Stephen Cooper, who kept his other job as interim CEO of Enron.
How KKD Managed Earnings?
• Getting Greedy
• KKD required franchisee’s to buy equipment and
ingredients at marked up prices
• 31% of 2003 came from selling ingredients and
equipment
• KKD concentrated on growing parent company sales
instead of franchisee profits
Management’s decision to include ingredient
and equipment sales does not accurately reflect
overall health of company = E.M.
How KKD Managed Earnings?
Synthetic Lease
• KKD financed a $35 MM mixing plant with an off-balance
sheet synthetic lease
• Permissible only when lessee has no intention of
acquiring leased property at term end
• “Mixing Plant” should be technically an asset to the
company and should be recorded on balance sheet
• KKD scuttled this plan in Feb.2002 after Enron
How KKD Managed Earnings?
Fudging the Numbers
• Oct. 2003: Company acquired seven Michigan based
franchises for $32.1 MM
• Purchase price recorded as intangible asset (Reacquired
Franchise Rights), which it did not amortize
• Purchase price was inflated so seller could make interest
payments so vendor could pay interest for past due
loans
• Interest was recorded as income
How KKD Managed Earnings?
Additional Items
• KKD rolled store closing costs, consulting fees into
intangible capital asset account
• KKD bought California based franchises at inflated
prices which were owned by CEO’s ex-wife
• KKD bought Dallas based stores at inflated prices that
were partly owned by former director and board member
• KKD employed 3 different CFO’s from 2000-2004
KKD’s Motives
•
Extreme pressure to satisfy expectations of
public market
•
Personal benefit by paying excess amounts for
franchises
•
Company faced S.E.C. inquiries
•
CFO’s jobs were not secure
Agenda
What is Earnings Management?
What motivates Earnings Management?
Common Approaches
Example – Krispy Kreme
Consequences
Reaction from Stake HoldersExtreme Distrust
• Dump stock on news of Managed Earnings
• Increased reliance on non financial information
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Investment bankers
Financial analysts
Bond Rating Agencies
Financial Press
• Class action suits – Nortel
Debatable Over Reactions
• Stop earnings guidance
– Coca-Cola
• Reward share-holders with trustworthy
book-keeping not earnings
• Class action suits against auditors
Reality
• The markets are still more reliant on
earnings reports than on cash flows
• Management judgment better indicator of
future earnings than fluctuating cash flows
• Almost every one does it in some way
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