Accounting Quality; Earnings Management Flashcards
3 factors influencing
Accounting Quality
Noise from accounting rules
Management forecast errors
Management choice of applying accounting principles
5 classes of Earnings Management
- Recognize premature revenue
- Aggressive capitalization of expenses or understating expenses
- Extended depreciation or amortization schedules
- Overvalued assets
- Undervaluing liabilities
- Recognizing Premature
Revenue
Taking sales that should be recognized in the future and recording in the current period.
Allocating sales from which services have yet to be rendered; done to boost net income.
Channel stuffing; recording sales before a customer’s acceptance or sales where the customer isn’t obligated to pay
- Aggressive Capitalization of expenses
Treating true expenses as CapEx expenses
- expenses not related to investments
- customer acquisition costs
- marketing and development costs
- Extended depreciation schedules
Depreciating and amortizing investments for longer than necessary
- Overvaluing Assets
Assets are carried above realizable amounts
- postponing write-downs
- allowances for bad debt are understated
- Undervaluing Liabilities
The portions of obligations are understated to boost current period earnings; they’ll be recognized at higher values in subsequent reporting periods
Why managers try to distort earnings?
Stock price: Higher earnings may correlate to investors feeling better about the firm’s stock price
Stock, Bonus Compensation
Higher earnings may result in executives getting paid more
Cost of debt
Higher earnings may link to higher credit ratings, then lower borrowing rates
Politics
Understating earnings may take heat off companies earning too much and scale back regulations
Image
Better earnings, better CEO?
Detection technique
High expenses after arrival of new management
Management may overstate expenses when it first arrives, as it’s a good look if expenses come down In subsequent periods.
If (AccEx / sales) rises y-y
Detection technique
Unexplained declines in allowances
Look at the ratio of
Allowance / AR
Detection technique
Understated expenses
Stock compensation is recorded in the footnotes, not on the IS as an expense
Detection technique
Operating cash is lower than Net income
Asset write-downs and expenses that boost cash may be understated leading to higher reported profits but lower add-backs to cash flow
