Berat BAŞAT

Mert KESKİ

DefinitionsMethodsAccounting ChoicesReasonsDetection and PreventionAn opposing viewSurveyFinal Notes

EARNINGS

Bottom Line or Net Income

It shows value added activities

The value of a company’s stock = the present value of its future earnings

EARNINGS MANAGEMENT

- Reasonable and legal management decision making and reporting intended to achieve stable and predictable financial results.

- not to be confused with illegal activities (Cooking the books)

Definition given by Kamal Naser :

Creative accounting is the transformation of financial accounting figures from what theyactually are to what preparers desire by taking advantage of the existing rules and/orignoring some or all of them.

The definition of earnings management does not rely on any particular item in the income statement.

Earnings management can also occur in supplementary disclosures and may target financial ratios instead of earnings.

OTHER NAMES

- Account hocus-pocus- Financial statement management- The numbers game- Aggressive accounting- Juggling the books- Financial Statement Manipulation- Accounting Magic- Borrowing income from the future- Banking income for the future- Window Dressing

METHODS

1. Choosing between different accounting methods

2. By estimation, judgement and prediction

3. Artificial transactions

4. Timing of genuine transactions

ACCOUNTING CHOICES

Accounting choices should be made within the framework of GAAP.

Everyday accounting choice may be either legal or illegal

There is no clear posted limit beyond which a choice is obviously illegal

EXAMPLE

Estimation of warrranty cost

Revenue : $30.00Warranty Expense : (2.75)

Income : $27.25

Past five years: ranged from $2.50 to $2.80

$2.50 and $2.25 would be justified, but $1.25 would be crossing the line to financial fraud.

Fraud“the intentional, deliberate misstatement or omission of material facts, or accounting data, which is misleading and, when considered with all the information made available, would cause the reader to change or alter his or her judgement or decision.”

Earnings management is at the legal end of a continuum.

Financial fraud is at the illegal end.

GAAP may also be violated by “overly aggressive accounting”

The Earnings Management – Fraud Continuum

We assume that there is evidence that quality control improvements could lower warranty costs to $2.25

Now we assume that there is absolutely no evidence that quality control changes can lower future warranty costs under the historical $2.50 - $2.80 range.

The $2.25 figure is now “overly aggresive” and beyond the bounds of GAAP.

REASONS

1- Income smoothing

Reporting a steady growth in profit rather than to show volatile profits

Making unnecessarily high provisions for liabilities and against asset values in good years

It is a measure against the 'short-termism'

Avoids raising expectations so high in good years

'big bath' accounting

2- Manipulating profit to tie in to forecasts

3- Maintain or boost the share price

- by reducing the apparent levels of borrowing

- by creating the appearance of a good profit trend

- to raise capital from new share issues

- offer their own shares in takeover bids

- resist takeover by other companies

- makes company appear subject to less risk

4-

Delaying the release of information for the market

Enhancing opportunity to benefit from inside knowledge

Companies are subject to various forms of contractual rights, obligations and constraints

Example

HOW IS EARNINGS M DETECTED?

By looking at the Revenue Recognition

- Is there any recent changes in the policies?

- Read the footnotes

- Look for the ways in which companies recognize their revenues

- try to find details in the notes to the financial statements

Delivering the product / performing the service

By monitoring Accounts Receivable

- Follows customers who buy on credit

- Compare the turnover ratio

- Check the percentage rate of change

By Checking the Capacity

- Revenue per employee - Revenue per dollar value of property, plant, and equipment - Revenue per dollar value of total assets

HOW IS E M DETECTED?

BY CASH FLOWS

Recent academic research found that we could detect accounting tricks by comparing net income to operating cash flow.

But the occurrence of rising earnings combined with falling cash flow doesn't necessarily imply accounting tricks.

HOW TO PREVENT ?

1. Focus on cash flow rather than income numbers

2. Put more than one person in charge of the accounting

3. Don’t let investors and partners mix company business with personal investments

4. Have an independent auditor go over the statements

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AN OPPOSING VIEW

Even when earnings management conceals information, it can still be beneficial to shareholders. Arya, Glover, and Sunder state:

« A managed earnings stream can convey more information than an unmanaged earnings stream. A smooth car ride is not only comfortable, but it also reassures the passenger about the driver’s expertise.»

Two Surveys on Creative Accounting

A substantial minority in each country takes a tolerant view of creative accounting.

More optimism in Spain on resolving the problem.

FINAL NOTES

Creative accounting offers a challenge to the accounting profession. Accountants need to be aware of the scope for both abuse of accounting policy choice and manipulation of transactions.

The problem is an international one, with accounting policy choice being a particular problem in the Anglo- American tradition and transaction manipulation a particular problem in the continental European tradition.