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
o Recognize revenue before product is delivered – aggressive.
o Recognize revenue after product is delivered – moderate.
o Recognize revenue after cash is collected – conservative.
o Policy records old inventory at a lower value (market) –
o Policy ignores worthless inventory and leaves on balance
sheet – aggressive.
o Company creates fake inventory – fraud.
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 –
1. Cost is used up in generating revenue.
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
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
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.
Research is always expensed
Development can be capitalized if 5 criteria:
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,
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
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
EPS = Net income–preferred dividends total / # of
AP = CGS [sales if not available] / avg accounts
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
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.