3. 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
4. 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)
5. Definition given by Kamal Naser :
Creative accounting is the transformation of
financial accounting figures from what they
actually are to what preparers desire by taking
advantage of the existing rules and/or
ignoring some or all of them.
6. 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.
7. 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
8. METHODS
1. Choosing between different accounting
methods
2. By estimation, judgement and prediction
3. Artificial transactions
4. Timing of genuine transactions
9. 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
10. EXAMPLE
Estimation of warrranty cost
Revenue : $30.00
Warranty 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.
11. 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”
12. The Earnings Management – Fraud Continuum
We assume that there is evidence that quality
control improvements could lower warranty
costs to $2.25
13. 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.
14. 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
15. It is a measure against the 'short-termism'
Avoids raising expectations so high in good
years
'big bath' accounting
16. 2- Manipulating profit to tie in to forecasts
3- Maintain or boost the share price
- by reducing the apparent levels of borrowing
- makes company appear subject to less risk
- 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
17. 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
18. HOW IS EARNINGS M DETECTED?
By looking at the Revenue Recognition
- Read the footnotes
- Look for the ways in which companies
recognize their revenues
- Is there any recent changes in the policies?
19. Delivering the product / performing the service
- try to find details in the notes to the financial
statements
20. By monitoring Accounts Receivable
- Follows customers who buy on credit
- Compare the turnover ratio
- Check the percentage rate of change
21. By Checking the Capacity
- Revenue per employee
- Revenue per dollar value of property, plant,
and equipment
- Revenue per dollar value of total assets
22. 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.
23. 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
24. 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.»
24
25. 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.
26. 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.
