EM

Question 1

What is EM?

Answer 1

The use of accounting policies to make your FS look better or worse.

Question 2

Why is Earnings management is undertaken by managers?

Answer 2

1. To increase remuneration packages 

   
   1. So for example remuneration package may be determined by a growth in the share price and if you don’t hit the share price growth you won’t get the remuneration.
2. To meet market expectations 

   
   1. This would be in order to protect the share price and the shareholders.
3. To ensure the share price is not too volatile 

   
   1. When you are investing in equity you don’t like volatility if you are a long term investor. It makes your investment more risky and increases your required return and the companies cost of capital as a result, and everyone loses out.
   2. So this is an important issue where it would be seen as important to try and smooth out.
   3. But just remember volatility = risk/uncertainty = higher return for shareholders = **higher cost of capital for firms.**
4. To protect their employment 

   
   1. If they feel their jobs are under pressure due to underperformance for e.g.
5. To enhance their credentials 


Question 3

What is EM not?

Answer 3

Fraudulent. EM is used to cover up fraud, though.

Question 4

If you are performing EM one year what does it make it difficult to do?

Answer 4

To manage earnings in the next year.

Question 5

All accountants want quality financial reporting, when is financial reporting quality high?

Answer 5

1. Reporting is compliant with IFRS.
   
   1. However even though you are compliant with IFRS you could be exercising judgement in a creative way to manage earnings.
2. Information is relevant, neutral, complete, free from errors, and decision-useful 

   
   1. Decision useful is a key point. If you are publishing a set of FS that are not very useful for decision making, then what’s the point? People don’t review FS for no reason, they review them in order to make decisions and the higher the quality they are the more decision useful they are.
3. Statements faithfully represent economic reality of activities and financial position.
   
   1. This is what gives rise to things on leasing and how the leasing standard has recently changed. This is an example of economic reality taking precedence over legal form as with a legal form you don’t own it and its not yours but from an economic substance point of view it is all yours. You have got it, you are generating revenue from it, you are insuring it… Essentially it is your asset and therefore you place it on the BS as an asset with its corresponding liability to show you haven’t paid for it yet.
   2. Economic reality is sometimes forced on companies by IFRS and other times companies have to make a judgement as to showing the economic reality of a transaction.

Question 6

Where will EM tend to take place?

Answer 6

Judgement surrounding the accounting polices.

Question 7

When is earnings quality high?

Answer 7

1. Earning are sustainable.
   
   • i.e. you can repeat them year on year.
2. Earning provide an adequate return to investors.

Question 8

when are financial reports most decision useful?

Answer 8

When they are unbias.

Bias exists and sometime we are required to exercise bias through the FS.

Question 9

What is aggressive accounting??

Answer 9

Aggressive accounting choices increase current period earnings and financial position.


Question 10

What is conservative accounting?

Answer 10

Conservative accounting choices decrease current period earnings and financial position.

Question 11

what is an example of conservative bias and why?

Answer 11

Contingent reporting:

A contingency represents something that has not been resolved, and you should a accrue for a contingent liability/loss if it is more likely than not to happen (so if >50% chance it happens you should accrue for it). And you should accrue for a contingent gain when it is virtually certain. CONTINGENICES ARE IMPORTANT FOR EM AS WHO KNOWS WHAT IS GOING TO HAPPEN IN THE FUTURE. IT IS UNCERTAIN AND GIVES MANAGEMENT GREAT POTENTIAL TO MANAGE EARNINGS. There is also bias in the ruleset of contingencies, e.g. you accrue a contingent gain when you are 100% sure? This is conservative bias! Which is imposed on us by accounting standards.

Question 12

what is the most common form of EM and how is this done?

Answer 12

Smoothing profits.

Profits will be smoothed by performing conservative accounting when profits are high and aggressive accounting when profits are low.

Question 13

Why do management smooth profits?

Answer 13

Essentially what management like to do is to report a smooth profile of earnings overtime. The smoother it is the less volatile and the less volatile the less risk.

But there is volatility as co.’s operates within economies and economies go through cycles so there is likely to be volatility. Also layer on to this the fact that industries go through cycles too and this would then add a different burden. So an example of an industry in trouble would be the food retail industry has gone through an overextended price competition and over supply which has resulted in a lower profitability, hence why Sainsbury’s tried to take over Asda to produce synergies. An example of reasons a specific company being in trouble would be as they are going through an investment cycle to increase capacity and \ denting profits, investing in R&D as they have reached the end of the current product cycle and \have to develop profits which would impact profits, or even partaking in M&A which again impacts profits.

Question 14

problem with the management narratives in the FS?

Answer 14

They are not audited, only the numbers themselves. So the narrative is an opportunity for the companies to ‘big up’ the good news for e.g. Management can introduce bias this way by presenting reports that emphasize good news and/or obscure bad news.

Question 15

When would companies want to perform EM (low quality reporting)?

Answer 15

1. To meet or exceed benchmark EPS (e.g., prior year EPS, analyst expectations) 

   
   1. EPS is close measure of co.’s performance but it is a profit measure. And profit can be manipulated. And lots of stuff goes in to earnings as EPS is earnings after tax so includes revenues, operating costs, interest income and cost, tax charge and profits after tax. Any one of these figures can be manipulated as there is judgement involved in all of them.
2. To increase remuneration and reputation of the directors
3. To increase share price 

4. To avoid violating debt covenants (highly leveraged, unprofitable companies) 

   
   1. There is currently a lot of companies battling with a high level of debt. And when in this situation, every time you take out more debt there will be a legal agreement with the debt provider, and in this legal agreement is a series of covenants that you are required to maintain or avoid going in to. These covenant will say “you will do this or you will not do this”. If for example you have a covenant that says your interest cover must stay at four times (i.e. your profit before interest cost must be always at least 4 times your interest cost), and you will do anything you can to stay within these covenants as if you breach the covenant the implication is that the debt can be recalled, and If the debt can be recalled and you can’t pay for it your company will be gone and you will be put in to liquidation.
5. To improve view of company by investors, suppliers, customers 

   
   1. So If you are working for a co. that is highly leveraged you will be under intense pressure to manipulate the earnings figure, and improve the view of the company for the stakeholder groups.
   2. Retailers are having bad time at the moment. So if you are auditing these high street retailers you know that they are struggling at the moment and may try to perform EM to make their profit levels look better, and make it look like their profitability hasn’t dropped too much. So if you know EM may be taking place you know that there may be EM being performed.

Question 16

WHat are the opportunties that allow companies to use EM?

Answer 16

1. Weak internal controls
2. inadequate board oversight
3. range of acceptable treatment within IFRS
4. Minimal consequences for innapropriate choices.

Question 17

What are the compliance mechanisms that exist for comapnies?

Answer 17

1. Gov and market regulation
2. Auditors provide opinion on the FS
3. Private contracts.

Question 18

What does “Gov and market regulation” include for the compliance mechanism?

Answer 18

1. Listing rules
2. Listing disclosure requirements
3. Auditing requirements
4. Management responsibility
5. Enforcement: fines, suspension and prosecution.
6. Management commentaries, review of business, principle risks and uncertanties.

Question 19

Explain the “Auditors provide opinion on the FS” compliance mechanism? what is the problem with this mechanism of compliance?

Answer 19

They come in and check internal controls.

Problem is they dont guarantee absense of errors/fraud. They are selected and paid for by the company.

Grant thornton head - “our job is not to id fraud but to give a view on the FS.”

Question 20

what would the “private contracts” compliance mechanism include?

Answer 20

i.e. private contracts in form of loan covenants, specific methods for accounting measures etc,

Question 21

what is the most important compliance mechanism?

Answer 21

Government and market regulation

Question 22

what may companies tend to do to influence analysts earning expectations and valuations?

Answer 22

Present non-IFRS statements.

• This is done as there are things that IFRS require you to do that may distort your underlying earnings.
• Non-IFRS presentation is an attempt to get back to what the underlying profit figures are if you ignore all the one off non-recurring items, unusual things etc. that have affected the problems.

Question 23

When does non IFRS reporting tend to be used by companies

Answer 23

Non-IFRS measures often remove negative items, and therefore end up showing more profitable figures and higher levels of profitability etc.

Question 24

Non-IFRS measures rules include that they

Answer 24

• Must be defined 

• Require an explanation for their use 

• Must be reconciled with closest IFRS measure 

• stick with it as it should be consistent every year

Question 25

What are the main ways EM can be performed through accounting policies and estimates?

Answer 25

1. Revenue recognition choices for EM 2. Management of accruals 3. Depreciation methods 4. Depreciation estimates 5. Capatalisation versus expensing 6. Impairments 7. Related party transactions 8. Managing operating cash flows

Question 26

How can EM be performed through revenues recognition?

Answer 26

1. **Split of bundled revenue between goods and service** 
 * This is a requirement of IAS20 revenue standard that came out recently asking you to split bundled revenue. Before that standard came out there was no definitive guidance on how you split the two items. There was however an incentive for companies to allocate a greater proportion of bundled revenue to goods and a lower proportion to services. This is because they can generate the revenue for goods straight away whereas the service has to be time apportioned. **So before the standard there was a greater potential for manipulation but this has reduced as a result of the new standard, as there are rules governing how you allocate the split of the bundled revenue.** 2. **Discounts to increase orders in current period** 
 * This is robbing transactions from the following period for the current. People may not order more products they may just order them quicker so they come in to the current accounting period. **This is poor quality however as it is not sustainable as they won’t then make that order in the following year.** 3. **Delaying shipments to future periods to defer revenue to later period** 
 * So you are trying to delay shipment of goods till after the YE so you can recognise the revenue in a future period rather than in the current. * This may be done as you know sales for January are set to be a lot lower than they were for December. 4. **Increase shipments to distributors (“channel stuffing”)** * Car manufacturers do this when they want to hit their targets. They throw a lot of cars at dealerships and tell them to make space to put it in showroom as it will allow them to generate a greater amount of revenue. cars must be registered in order to recognise the revenue, so you can \ buy pre-registered cars that are cheaper that non-registered cars. 5. **Bill-and-hold transactions: Recognise revenue for goods that have not been shipped** 


Question 27

How can EM be performed through management of accruals?

Answer 27

1. Allowances for doubtful debts 2. Warranty Expense * When company’s sell products with a warranty, you don’t know how much you will have to pay out a warranty claim as you don’t know how many goods will be returned. This is a classic area for companies to exercise their judgement in order to manipulate the warranty provision.

Question 28

How can EM be performed through depreciation method?

Answer 28

SL or RB? HOWEVER, **In areas in which companies can exercise judgement, if the judgement requires an ongoing choice (e.g. dep’n method) companies will be required to make a decision on what approach to take and this approach will become their stated accounting policy. And these policies can only be changed if you believe that the one you are changing to gives more meaningful and decision useful information, or if the rules change.**

Question 29

How can EM be performed through accounting estimates?

Answer 29

changing estimates of economic life or scrap value of an asset, therefore changing depn expense

Question 30

how can EM be performed through 'capitalising versus expensing'?

Answer 30

if you can capatalise a cost (add to assets) you dont have to expense it as an asset is a deffered expense, therefore improving your overall profit figures.

Question 31

How can you perform EM through impairments?

Answer 31

Can impair assets which will write down the value of the asset, and therefore the depreciatation charge that can be attached to it. This is often done by new management coming in to a firm.

Question 32

How can EM be performed through related party transactions?

Answer 32

e.g. joint control of a company? can move earning in and out of the company through these related party transactions.

Question 33

How can EM be performed through managing operating cash flows?

Answer 33

1. **Capitalising purchases** 
 * So you treat purchases as capital items rather than expense so they don’t hit the operating CF and hit the investing CF instead. **Remember, the operating CF is very closely watched by analysts.** 2. **Stretching payables** 
 * For e.g. when you pay suppliers with cheques. Companies used to print them and put them in the drawer, and when people called up they said the finance director was out the office and couldn’t sign the cheque. * **You will sit on these payables (via bank transfers or cheques) in order to delay the cash flow as you know it is struggling.** 3. **Capitalising cash interest costs** 
 4. **Classifying interest and dividends paid as cash flow from financing (rather than cash flow from operations)** 
 * **There are ways in which you can make choices on how CF’s are classified. For e.g. classifying interest cost as financing cash flows rather operating cash flows which makes your operating cash flows (which are closely watched by analysts) look better.** 5. **Classifying dividends and interest received as operating cash flow (rather than cash from investing)** 
 * **You can classify interest rec’d as operating cash flow instead of investment cash flow which again makes your cash flows better. So there are ways of managing operating cash flow, but it is more to do with classification. The figures wont effect the fundamental cash balances, they are what they are, but the way they are classified makes a difference as remember operating profit is more closely looked at by analysts.**

Question 34

what is the hardest thing to maniuplate

Answer 34

Cash flow statement. as this shows cash going in and out as and when it happens

Question 35

WHat are the ways to spot EM? Explain.

Answer 35

1. Accounting policy notes * The accounting policies are note one of the FS. They tell you the choices the company has made in areas where the companies have been given choice by the accounting standards. * i.e. how they depreciate or recognise revenue etc. * A lot of EM takes place here 2. Emphasis on non-IFRS presentation? * Can maybe indicate something. 3. Profit v Cash flows * needs to be a correlation between the two, shouldnt differ massively. * Enron and Arthur anderson going bust. Losing so much cash but they looked good on the BS. 4. Excessively smooth trends over time * Excessively smooth trends could suggest EM if you are in a volatile industry. 5. Unexplained increase/derease in margins 6. Peer group comparison anomolies. * You differ so much to your peer group? why? * Patisserie valerie was massively out of line with its peers. This shows EM?

Question 36

WHat is the obvious way of spotting EM?

Answer 36

If there are warning signs that have not been explained or justified in the FS. Where there is judgement it needs to be explained!

Question 37

How could you spot EM through revenue recognition?

Answer 37

1. **Have they changed the revenue recognition method?** 2. **Lack of clarity in the revenue recognition method?** 3. **Bundled products/services that require judgement on split** 
 * Under the new IFRS for e.g. if they sell a bundled product or service they should tell you how they split the product and service element for revenue recognition. Is there a judgement required on bundled products and how you split revenue? 4. **Revenue growth out of line with peer companies** 5. **Bill-and-hold transactions** 
 * **Are there any? These are when you bill a customer but you hold on to the good yourself. So** **\** **don’t recognise revenue till the receive** 6. **Receivables turnover, total asset turnover, are they decreasing over time?** * **If they are decreasing over time it indicates that something is happening out of trend.** * Trend analysis is a powerful tool when it comes to earnings management. Trends over time. for e.g. an unexplained change in asset turnover. 7. **Non-operating or one-time items included in revenue?** * **They would have to disclose this but these could also be for the purpose of manipulating revenues.**

Question 38

How could you spot EM through depreciation?

Answer 38

1. **Unusual depreciation methods relative to peer group** 
 * Why would they be doing this? Is there a good reason that this company adopts a different accounting policy? Or something sinister? 2. **Useful lives appear excessively long (or short)** 
 3. **Salvage values appear excessively high (or low)** 
 * **Salvage values are not disclosed in a set of financial statements. THIS MAKES IT EVEN EASIER TO RECLASSIFY YOUR DEP’N CHARGES** * Only people in the company will see the salvage value figure on the NCA spreadsheets.

Question 39

How can you sport EM through capitalisation of costs?

Answer 39

Capitalisation of costs that industry peers do not capitalize.

Question 40

How do you spot EM through the operating cash flow?

Answer 40

**Ratio of operating cash flow to net income is consistently less than one or declining over time.** * **They should be relatively consistent with another, not exactly 1:1 but movements in cash should affect the movement in profit. See point above on this.**