Ethics in Financial Reporting: Cooking the Books

Sudha KrishnanDepartment of Accountancy

California State University, Long Beach

Definition – Earnings Management (EM)

• Purposeful intervention in the external reporting process with the intent of obtaining some private gain (Schipper)

• When managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholder about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers (Healy & Wahlen)

Intent of Management

Is all EM unethical? –depends on management intent.•Management intent unobservable•Distinction between aggressive accounting choices including acceptable GAAP based estimates / judgments vs. fraudulent accounting practices intended to deceive others

Howard Schilit – Financial Shenanigans• Revenue recognition– Recording revenue too soon

• Revenue is recorded before service is fully provided

– Recording revenue of questionable quality• Revenue is recorded before customer’s unconditional

acceptance

– Recording made up revenue• Revenue is recorded even if it lacks economic substance

– Shifting revenue to a future period• Purposely over-estimating sales returns and adjusting

downward in future years

Howard Schilit – Financial Shenanigans

• Shifting expenses– Capitalizing current costs– Shifting current expenses to later or earlier period • Changing accounting policies and shifting expenses to

later period

– Expensing future expenses as current• Accelerating discretionary expenses

Aggressive Accounting ChoicesExamples of accounting choices allowed by FASB•Changing life of assets affecting depreciation•Changing estimate of allowance for doubtful accounts affecting bad debt expense•Changing estimate of sales return allowances affecting net revenue•Choosing inventory valuation methods thus affecting cost of goods sold•Estimating higher restructuring charges than required affecting earnings before interest & taxes

Numbers Game

Arthur Levitt Speech (1998) on accounting hocus-pocus•Big bath– Large estimates of restructuring charges that are

deducted from revenues to show lower income in one quarter/year and then revised few quarters/years later to show higher income

Note: 1/1/2003 onwards, restructuring charges to be actual – no more estimates allowed (ASC para 420)

Numbers Game

Arthur Levitt Speech (1998) on accounting hocus-pocus•Creative acquisition accounting– Classifying large portions of acquisition price as in-

process research & development and then written off immediately after the merger. That reduces future drag on income

Note: all IPR&D to be capitalized and checked for impairment like goodwill (EITF09-2, FASB141(R), ASC para 805)

Numbers Game

Arthur Levitt Speech (1998) on accounting hocus-pocus•Cookie jar reserves– Use unrealistic assumptions to estimate sales

returns, loan losses or warranty costs, thus stashing accruals in cookie jars during the good times and reach into them when needed in the bad times.

Numbers Game

Arthur Levitt Speech (1998) on accounting hocus-pocus•Materiality– Intentionally record errors with specified ceiling

and then argue that the errors are not material

Note: Staff Accounting Bulletin Codification Topic I para M for guidance on materiality

Numbers Game

Arthur Levitt Speech (1998) on accounting hocus-pocus•Revenue recognition– Recognize a sale before it is complete, before the

product is delivered to a customer, or at a time when the customer still has options to terminate, void or delay the sale.

Note: Staff Accounting Bulletin 101 & 104 for guidance

Pressures to Manage EarningsWhy does management manage earnings?•External pressures– Analysts’ forecasts– Access to debt markets– Competition– Contractual agreements & debt covenants– Roaring stock market– Emerging financial instruments– Market disregard for big charges

Pressures to Manage Earnings

• Pressures within the company– Merger attractiveness– Management compensation– Short term focus– Unrealistic budgets and plans– Excessive profits followed by decline– Personal factors – bonus, promotions, job

retention

Signals in Current YearSignals that should be checked in company reportsRead the audit reportReduction in managed costs such as advertising in relation to salesChanges in accounting policies towards more liberal applicationsUnexpected increase in accounts receivableExtension of trade payables longer than normal creditUnusual increase in intangible assetsOne time sources of incomeDecline in gross margins

Signals in Current Year (Cont’d) Reduction in reserves Reliance on income sources other than core business Nor reserving for future probable losses Unusual increase in borrowings Increase in deferred taxes Increase in unfunded pension liability Low cash and marketable securities at year end Peak short borrowings at year end Slowdown of inventory turnover ratio

Red FlagsWhen should you pay more attention to the company?

•Company has achieved significant market share and isgrowing faster than the industry

•Frequent acquisitions of business•Management history•Firing of auditors•Rapid growth of company -- internal control issues•Company doing too well •Management growth strategy and emphasis on EPS goals

Cases• Worldcom (expense capitalization)• Satyam Computers (bogus revenue)• Tyco (executive loans, merger magic)• Adelphia (borrowing from company)• Waste Management (materiality)• SunBeam (channel stuffing, cookie jar

reserves)• Healthsouth (false earnings)

Teaching Notes – Worldcom & Adelphia

• Assign the citations at the end of the case for readings• Go over signals/red flags and pressures to manage earnings (earlier slides)

with the class before assigning the case• Assign one case in class discussion and the second as homework

(assessment). • Emphasize the importance of reading the SEC complaint and the AAERs• Ask the students to read the articles from general media such as WSJ,

Business Week etc.• Use the opportunity to talk about SOX Act, corporate governance and the

importance of independent auditors and audit committee• To make the discussion interesting, talk about the CEO/CFO involved in

the scandal and what is their current status (that information is in the general media articles as well as the case)

WorldCom answers

• How did WorldCom cook the books? – They capitalized the leasing expenses on the balance sheet instead of

expensing them.

• What is the impact on the income statement and the balance sheet and ratios of such actions taken by WorldCom? Provide examples.– The capitalizations of leasing expenses increased income and

increased assets on the balance sheet. So ratios with income in the numerator looked better than before managing earnings. Also, the leased assets on the balance sheet gets depreciated over the estimated life, thus spreading the cost over many income statements

WorldCom numbers

Form FiledWith theCommission

Reported LineCost Expenses

Reported Income(before Taxesand MinorityInterests)

Actual LineCost Expenses

Actual Income(before Taxesand MinorityInterests)

10-Q, 3rd Q. 2000 $3.867 billion $1.736 billion $4.695 billion $908 million

10-K, 2000 $15.462 billion $7.568 billion $16.697 billion $6.333 billion10-Q, 1st Q. 2001 $4.108 billion $988 million $4.879 billion $217 million

10-Q, 2nd Q. 2001 $3.73 billion $159 million $4.29 billion $401 million loss

10-Q, 3rd Q. 2001 $3.745 billion $845 million $4.488 billion $102 million

10-K, 2001 $14.739 billion $2.393 billion $17.754 billion $622 million loss

10-Q, 1st Q. 2002 $3.479 billion $240 million $4.297 billion $578 million loss

WorldCom answers (cont’d)

• Read the article “Twenty pressures to manage earnings” mentioned in the citations. Identify some of the pressures that caused the management to cook the books.– Meeting analyst forecast– Excessive profits in an environment where competitors were not

doing as well.– Management greed and compensation

• Almost all the red flags (as per the slide before)

Adelphia answers

• Read the complaint on the SEC website. How did the management cook the books? – Borrowed funds along with other entities that were closely held but

did not show the loans on the books of Adelphia. Liabilities were thus understated.

– Rejected auditor recommendation that at least a footnote disclosure needs to be made re the loans

– Equity was overstated by doing sham stock transactions (A=L+SE)– Inflated number of cable subscribers (criteria used in the industry to

analyze cable companies)– Identified source of revenue – management fees (did not exist)– Recorded kickbacks from converter box sellers as income– Shifted Adelphia expenses to other entities run by the family

Adelphia answers (cont’d)• Who were the auditors of Adelphia during the fraud period? What were

they accused of doing? How were they punished?– Deloitte & Touche– “Deloitte engaged in improper professional conduct and caused

certain of Adelphia's books and records violations by failing to detect a massive fraud perpetrated by Adelphia and certain members of the Rigas family. Even though Deloitte identified Adelphia as one of its highest risk clients, Deloitte failed to design an audit appropriately tailored to address audit risk areas that Deloitte had explicitly identified”

– Deloitte settled the case with the SEC by paying a penalty of $50 million

Contributions

• This class material introduces students to ethical issues in financial reporting. It should be taught at the level of Intermediate Accounting I.

• It uses cases to teach students some critical reasoning skills.• It gets them to read articles from the general business media

such as Wall Street Journal, Fortune, Business Week etc. • It allows them to access the SEC website and read the

Accounting & Auditing Enforcement Releases (AAER) & the Litigation Releases (LR)

• It gives them exposure to unethical behavior – what not to do when reporting to investors.