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Motivation For Fraudulent Financial Reporting

Chapter 06

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Learning Objectives

L O 6-1: Describe the characteristics of earnings management.

L O 6-2: Explain the purpose of providing earnings guidance and motivation for making false and misleading disclosures.

L O 6-3: Explain how an auditor might look for red flags that indicate fraud may exist in the financial statements.

L O 6-4: Explain the working of financial shenanigans and its effect on reported earnings.

L O 6-5: Describe the makeup of non-GAAP amounts and whether they can distort reported earnings.

Questions for Consideration

What motivates fraudulent financial reporting?

How are financial statements manipulated to achieve a desired goal?

What are the red flags to look out for in spotting techniques that can lead to material misstatements of the financial statements?

Why do companies provide non-G A A P earnings?

Ethics Reflections 1

Financial statements must be relevant and reliable. Relevance means the information being reported is meaningful. Reliability refers to the accuracy with which financial data is reported so that users know that information can be trusted.

An important quality of useful information is representational faithfulness. To represent the transactions and events faithfully in the financial statements, the effects of transactions and events should be reported on the basis of economic substance of the transactions instead of legal form of the transaction.

Fraudulent financial reporting occurs for a variety of reasons including to make the company look like it’s doing better than it really is. Some companies manipulate G A A P to achieve a higher level of earnings and mislead investors and creditors about the company’s current and expected future earnings.

Ethics Reflections 2

Companies use a variety of techniques to produce fraudulent financial reports including accelerating the reporting of revenues and delaying the reporting of expenses, oftentimes by manipulating accrual amounts. These are called financial shenanigans.

Companies seem to look for an any advantage when they report G A A P earnings results. One approach that has caught on with virtually all public companies is to report non-G A A P earnings.

Motivation to Manage Earnings

Companies manage earnings when they ask, “How can we best report desired results?” rather than “How can we best report economic reality?”

Pressure to “make the numbers”.

Emerged during 1990s and early 2000s.

Stock market awards firms that meet or beat analysts’ forecasts and punishes firms that miss earnings targets.

Management may also use earnings management to maximize bonuses and the value of stock options.

Another objective can be avoiding consequences of violation of debt covenants.

Board of Directors should focus on long term strategic goals and shield managers from short-term pressure.

Nonfinancial Measures of Earnings

Constant pressure to report favorable earnings performance motivates many companies to report income numbers that exclude unusual events that almost always seem to be costly and depress earnings.

These non-G A A P numbers put a positive spin on what otherwise might not be such good results under G A A P.

Regulation G requires public companies that disclose or release non-G A A P financial measures to include a presentation of the most directly comparable G A A P financial measure and a reconciliation of the non-G A A P measure to the comparable G A A P measure.

Auditors should be tasked with at least reviewing non-G A A P measures as part of their annual audit requirements.

Characteristics of Earnings Management

Gaa and Dunmore denote two basic possible earnings managements.

Alter the numbers in the financial records by using discretionary accruals and other adjustments.

Create or structure transactions to alter reported numbers.

Another perspective is to divide the techniques into two categories.

Operating earnings management – altering operating decisions to affect cash flows and net income for a period.

Accounting earnings management – using the flexibility in accounting standards to alter earnings numbers.

The end result of earnings management is to distort the application of G A A P, bringing into question the quality of earnings.

Earnings manipulation is a form of earnings management and can be legitimate, marginally ethical, unethical, or illegal.

Income Smoothing

Motivation to smooth net income over time.

Steady increase each year over a period of time is ideal.

Investors are willing to pay premium for stocks with steady and predictable earnings streams.

These practices lead to erosion in quality of earnings.

Accelerate recognition of revenue.

Delay recognition of expenses.

“Cookie jar reserves”

Set aside reserves in good years.

Used to prop up earnings in bad years.

HealthSouth case.

Banks more aggressive using loan-loss reserves.

Companies also smooth tax liability over years.

Definition of Earnings Management

Schipper defines it in a negative light- “purposeful intervention in the external reporting process, with the intent of obtaining some private gain”.

Healy and Wahlen define it as “when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company, or to influence contractual outcomes that depend on reported accounting numbers”.

Dechow and Skinner believe that a distinction should be made between making choices in determining earnings that may comprise aggressive, but acceptable, accounting estimates and judgments, as compared to fraudulent accounting practices that are clearly intended to deceive others.

McKee characterizes it as “reasonable and legal management decision making and reporting intended to achieve stable and predictable financial results”.

How Do Managers and Accountants Perceive Earnings Management? 1

Akers, Giacomino, and Bellovary Survey.

Accounting manipulation is much less ethically acceptable than operating decision manipulation.

Practitioners have few ethical qualms about operating decision manipulation.

Operating decisions that influenced expenses were more suspect than those that influenced revenues.

How Do Managers and Accountants Perceive Earnings Management? 2

Survey by Elias:

Accountants in organizations with high ethical values perceive earnings management as more unethical.

Accountants in industry significantly less likely than C P As in public practice to perceive high ethical values in their organizations.

Survey by Bruns and Merchant:

Managers disagree about ethics of earnings management.

Manipulation of operating decisions was more ethical than manipulation by accounting method.

Survey by Rosenzweig and Fischer:

Accounting manipulation.

Changing accounting methods.

Recording expense in wrong year.

Changing inventory valuation.

Operating decisions.

Deferring necessary expenditures to subsequent year.

Attracting customers at year-end to draw sales into current year.

Ethics of Earnings Management 1

Use ethics framework to judge acceptability.

Virtue ethics examines reasons for the actions taken by decision maker AND the action itself.

McKee’s explanation is merely a rationalization.

Doesn’t hold true to virtues of honesty and dependability.

Ignores rights of shareholders and stakeholders to receive fair and accurate information.

Masks true performance.

Hopwood says ethics issue can be mitigated by disclosing aggressive accounting assumptions.

Nothing more than rationalization for unethical behavior: disclosure should not be used to cure ills of earnings management.

Ethics of Earnings Management 2

Act Utilitarian

A decision made by weighing benefits of management/company to smooth net income versus. costs of providing false information to shareholders.

Rule Utilitarian.

Financial statements should never be manipulated for personal gain.

The problem is there is no clear limit between what is ethical and what isn’t.

Needles Continuum of Earnings Management

Needles points out that the difference between an ethical and an unethical accounting choice is often merely the degree to which the choice is carried out.

The problem with many accounting judgments is that there is no clear limit beyond which a choice is obviously unethical.

A perfectly routine accounting decision, such as expense estimation, may be illegal if the estimated amount is extreme, but it is perfectly ethical if it is reasonable.

Needles provides an interesting example of how a manager might use the concept of an earnings continuum to decide whether to record the expense amount at the conservative end or aggressive end.

Earnings Guidance

Earnings guidance reflects the comments management makes about what it expects the company will do in the future.

Earnings guidance is given by management to provide investors and financial analysts with data that indicates expected future earnings and earnings per share. These comments are known broadly as forward-looking statements.

Earnings guidance can be given in conference calls with investors and analysts and in press releases available to the public.

One concern with earnings guidance statements is they represent management’s subjective view of the company’s future financial performance, which is exposed to uncertainties and risks.

Forward-looking Statements

“Forward-looking” statements focus on sales revenues or earnings expectations in light of industry and macro-economic trends.

Guidance to investors and financial analysts about the company’s earnings potential.

Can create liability for issuers, underwriters, officers and directors if material misstatements of fact or omissions are made for public offerings.

P S L R A enacted safe harbor provisions if forward-looking statements are identified as such and accompanied by meaningful cautionary statements that could cause actual results to differ from the statements.

Green Mountain Coffee Roasters

Green Mountain used conference calls that provided earnings guidance to shareholders and analysts to mask a financial fraud.

Manufacturer of the Keurig brewing system and K-Cup portion packs.

Represented to investors that it was straining to meet consumer demand without accumulating excess inventory.

Deceived P w C auditors on inventory levels by hiding bags and bags of coffee loaded on trucks, and blocking parts of the plant from auditor access.

Hedge fund manager, David Einhorn, and Sam Antar, former C F O of Crazy Eddie, used analytical procedures to spot and warn of the red flags on inventory.

Should auditors monitor conference calls with investors, analysts, and the financial press to determine whether something is said that could be false, fraudulent, or deceptive?

Using Social Media to Report Earnings Guidance and Financial Results

The S E C said in April 2013, that postings on sites such as Facebook and Twitter are just as good as news releases and company Web sites as long as the companies have told investors which outlets they intend to use.

The S E C guidelines on these matters are under the fair disclosure rule (Regulation F D) that requires companies to disseminate information in a way that wouldn’t be expected to give an advantage to one group of investors over another.

Filing an 8-K form or holding an earnings call are both ways to ensure compliance with the regulation.

Audit Committee Responsibilities

Audit committee oversight of forward-looking guidance is part of the board of directors' overall ongoing risk assessment process.

The audit committee should understand management's processes for (1) developing assumptions and estimates, (2) accumulating guidance information, and (3) ensuring management judgment's are reasonable. The audit committee should also inquire of possible earnings management to meet the guidance.

Pull-in Sales

One technique used to meet earnings guidance is accelerating (or "pulling-in") sales from a future quarter to the present in order to close the gap between actual and forecasted revenue.

Typically, this earnings management technique is triggered by offering various incentives, such as price rebates, discounted prices, and extended payment terms to entice customers to accept products in the current quarter that they would not need until next quarter.

Efforts to pull-in sales from a future quarter to a current one only delays the bad news and can create a more spectacular market disappointment when, after a few quarters, there were no more future sales to cannibalize.

Sunbeam Corporation learned this lesson the hard way by using the pull-in revenue technique known as “channel stuffing”.

Red Flags

Auditors need to be attuned to the red flags that fraud may exist because of overly aggressive accounting and outright manipulation of earnings.

There are many examples of red flags including:

One-time sources of income.

Unexpected increase in accounts receivable.

Slowdown of inventory turnover.

Reduction in reserves.

Reduction in discretionary costs at year-end (i.e., advertising; R&D).

Earnings Quality

Another way to spot potential fraud in the financial statements is through an assessment of earnings quality.

Dichev et al. conducted a survey in 2016 that examined the views of 375 C F Os on the prevalence and identification of earnings misrepresentation.

The C F Os were asked to rank order specific characteristics of earnings quality.

The leading answers were consistent reporting choices through time and the absence of long-term estimates, both features of sustainable earnings.

Financial Statement Analysis

Financial analysis can be used to identify red flags that the numbers in the financial statements may not make sense considering the relationship between selected items on the balance sheet and income statements.

Comparative statements over two or more years based on reported numbers can be converted into percentages to enhance the analysis. These are known as common size statements.

Ratios can be used to compare relationships between financial statement items or indicate trends over time.

Accruals and Earnings Management

Accruals are needed because of matching and timing problems that can give wrong financial picture of company.

Earnings are sum of a period’s change in accruals and its cash flows.

Revenue recognition and matching principles.

Can manage earnings through aggressive estimations or more conservative ones.

Discretionary accruals (items that management has full control over and is able to delay or eliminate)

Nondiscretionary accruals (management has no control over)

Earnings Management: One More Thing

It is unethical if the primary motive for managing earnings is to deceive users of the true results of operations or reflect the economic substance.

Often earnings management is carried out by otherwise honest people who tell the company’s side of the story rather than adhere to G A A P.

Cycle of earnings manipulation.

Often a company begins with a track record of success.

It is becoming more difficult to maintain the sales and earnings growth expected.

Management runs special incentives to accelerate sales and uses overtime to ship product out.

Steps are repeated in the next quarter(s), as expectations are higher, only now the company may not accrue all of its expenses, and to keep the stock prices increasing.

One aggressive interpretation leads to another until the quality of the financial information is in doubt.

The company has gone from aggressive operating practices to financial fraud.

Financial Shenanigans

Actions or omissions intended to hide or distort real financial performance or financial condition of an entity.

Overstate revenues and profits to enhance reported earnings and E P S.

Understate revenues and profits to smooth net income/decrease volatility.

Schilit’s 7 Common Financial Statement Shenanigans:

Recording Revenue too soon or of questionable quality.

Recording bogus revenue.

Boosting income with one-time gains.

Shifting current expenses to a later or earlier period.

Failing to record or improperly reducing liabilities.

Shifting current revenue to a later period.

Shifting future expenses to the current period as a special charge.

Red Flags of Earnings Management

Auditors need to be attuned to red flags or signs of aggressive accounting and fraud:

Growth in the market share that seems unbelievable.

Frequent acquisitions of businesses.

Management growth strategy and emphasis on earnings and/or E P S.

Reliance on income sources other than core business.

One-time sources of income.

Growth in revenue that doesn’t line up well with receivables or inventory.

Unexpected increase in accounts receivable.

Slowdown of inventory turnover.

Reduction in reserves:

Not reserving for possible future losses.

Reduction in discretionary costs at year-end (i.e., advertising; R&D)

Unusual increase in borrowings; short-term borrowing at year-end.

Extension of trade payables longer than normal credit.

Change in members of top management, especially the C F O.

Change in auditors.

Changes in accounting policies toward more liberal applications.

One forensic accountant is needed on each audit to help identify the signs.

Non-G A A P Financial Metrics

Most companies disclose non-G A A P financial metrics.

An Audit Analytics study shown in Exhibit 6.7 found the top five non-G A A P metrics were:

Income-related (including adjusted operating income)

Earnings-per-share (E P S)

Cash flow.

E B I T D A.

Funds from operations.

S E C Regulations and Non-G A A P Amounts

S E C Regulation G and Item 10(e) of Regulation S-K define a “non-G A A P financial measure” as a numerical measure of historical or future financial performance, financial position, or cash flows, that:

Excludes amounts that are included in the most directly comparable measure calculated and presented in accordance with G A A P; or,

Includes amounts that are excluded from the most directly comparable measure so calculated and presented.

EBITDA

One common non-G A A P measure is EBITDA (earnings before interest, taxes, depreciation, and amortization). Other variations include EBIT, EBITA, EBITD, EBITDAR (earnings before interests, taxes, depreciation, amortization, and restructuring costs), adjusted EBITDA, and so on. A joke making the rounds is perhaps the best measure is EBBS (earnings before the bad stuff)

SEC Regulation S-K

Applies to non-G A A P financial measures that are included in S E C filings.

They should be presented with equal or greater prominence, of the most directly comparable financial measure or measures calculated and presented in accordance with G A A P.

A non-G A A P measure should be presented in proximity to the G A A P measure with an appropriate balance of discussion.

A quantitative reconciliation of the differences between the non-G A A P financial measure and the most directly comparable G A A P financial measure should be shown.

Reconciliation of G A A P and Non-G A A P

The reconciliation should be presented with each adjustment clearly labeled and separately quantified;

A statement disclosing why the registrant’s management believes that presentation of the non-G A A P financial measure provides useful information to investors regarding the registrant’s financial condition and results of operations; and,

To the extent material, a statement disclosing the additional purposes, if any, for which the registrants management uses the non-G A A P financial measure.

Concluding Thoughts

Earnings management is typically motivated by a desire to meet or exceed forecasted results, meet financial analysts’ earnings estimates, inflate share price to make stock options more lucrative, and enhance bonuses.

Financial reporting needs to focus more on representational faithfulness, there should be agreement between the accounting measures or descriptions in financial reports and the economic events they purport to represent.

Financial shenanigans have been used for years to manage earnings by choosing how and when to report and disclose financial information.

The motivation oftentimes is to smooth net income over time. These artificial maneuvers mislead investors and financial analysts about the true state of earnings in two or more years.

Auditors should look for the red flags that something is not right with the reported earnings.

case 6

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