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Earnings Management .docx

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Management Core
MGCR 211
Karen Zajdman- Borden

Earnings Management 4/16/2012 6:08:00 AM I. What are examples of policies to be used in earnings management A. Revenue Recognition policy (revenue is largest # on income statement) o Recognize revenue before product is delivered – aggressive. o Recognize revenue after product is delivered – moderate. o Recognize revenue after cash is collected – conservative. B. Inventory o Policy records old inventory at a lower value (market) – moderate. o Policy ignores worthless inventory and leaves on balance sheet – aggressive. o Company creates fake inventory – fraud. C. Amortization o Amortize cost over expected life – moderate o Amortize over a much longer life – aggressive o Amortize over a short-life – conservative. D. Capitalize Expenses o Show costs as an asset rather than expensing the cost, when in fact cost does not provide a future benefit – Aggressive/fraud. o Expense 1. Cost is used up in generating revenue. o Asset 1. Provides future benefit. o To maximize net income -> capitalize the asset. E. Accounts Receivable o Selecting low rates or high rates to estimate bad debt expense, depending on objective F. Warranty Expense o Underestimating or overestimating warranty expense depending on the objective. II. Earnings Management Part II A. Detection of Earnings Management o Overall Earnings Management Detection strategy. 1. Evaluate business strategy 2. Evaluate economic benefits o Review Balance Sheet 1. Ratio analysis, trends, quarterly F/S, compare to previous years, compare to industry average. 2. General review of balance sheet, looking for unusual items. What’s there this year that wasn’t before? Is the growth slowly rising? Has there been a big drop? 3. Review working capital – indicates if there are liquidity problems 4. Leverage ratio (debt-equity ratio) – highly leveraged company could indicate cash flow problem. Are they in trouble, trying to hide it? Too much debt? 5. Review assets/liabilities that are titles “other”. 6. Look at Cash account – big decrease? 7. Look at inventory – it could have obsolete or worthless items: ratio analysis, notes to F/S. Is company using inventory to engage in EM? Big loss? 8. Look at A/R – review notes for factoring, look at Allowance For Doubtful Accounts policy, is it too lose? Trying to max/min net income? 9. Look at Accounts payable – watch out for understated liabilities, look at notes, compare to last year, is there unrecorded debt? 10. Fixed Assets – look at amortization policy, ratio analysis, look at timing of purchase and sales of assets. Amortization policy. DDB = big bath. 11. Intangible assets – look at capitalizing vs expense policy. Advertising, goodwill, R&D, warranty.  R&D  Research is always expensed  Development can be capitalized if 5 criteria: o Feasible o Definable o Funds to pursue o Intent to market product o There is a market for product  Goodwill  Excess paid for a company’s shares.  Excess represents the intangible assets such as reputation, patents, good management, etc.  Show goodwill in our capital assets.  Reevaluate goodwill every year.  If value has gone down, we write the value down as “asset impairment”:  Dr Impairment Loss (SE) $50,000  Cr Goodwill (A) $50,000 12. Warranties Payable, are they underestimated. 13. Commitments, review notes and description, what is the company’s future liabilities. 14. Contingencies, is there a large potential loss in the future? Income smoothing using cookie jar (push revenues to next year). 15. General comparison to other companies in same industry. o Review Income Statement 1. Ratio analysis, trends, quarterly f/s, compare to previous years, compare to industry average. 2. General revie of income statement – looking for unsuaul items, large $ amounts, item never appeared before. 3. Look at Net income, compare to previous years. Negative should worry us. 4. Look at EPs, look at trend. Big drop should worry. EM taking place?  EPS = Net income–preferred dividends total / # of common shares.  AP = CGS [sales if not available] / avg accounts payable 5. Revenues – look at revenue recognition policy, notes to F/S, look at trends. This area is the most vulnerable to earnings management and fraud. 6. Look at expenses, ratios, trends, compare, revie policies for recognizing expenses. 7. Look at nonrecurring items on income statements, investigate “other” expenses. 8. Net loss is always a red flag indicating need to review further. B. Signs to indicate EM taking place: o Small net income or net loss – it is better to show a small net income than a small net loss. Small net loss might indicate a larger net loss?????? o Earnings slightly below last year, a slight decrease may indicate the loss was larger. o Net income very close to analyst’s forecast – not meeting forecast is very negative. o Bonus structured based on net income.
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