Grice1
Running head: EARNINGS MANAGEMENT
Research Case 5-1: Earnings management with respect to revenues
Michael Grice
Liberty University
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Running head: EARNINGS MANAGEMENT
Despite the long list of generally accepted accounting principles and various other
regulations that have been set in place to standardize financial reporting of all companies,
regardless of size, industry, etc., there are still ways in which these companies can skew numbers
on their financial reports. One aspect that this financial misrepresentation applies to is revenue
reporting and how entities may or may not report accurate revenue recognition, which is truly
misleading, as many investors and/or stakeholders use revenue recognition as an indicator of an
entity’s financial health. According to the article, ‘How are Earnings Managed? Evidence from
Auditors”, there are four very common methods by which revenue recognition is abused or
misrepresented. These revenue recognition abuses consist of; the right of return sale, deferring
too much or too little, bill and hold, and cut off manipulation. The practice of cut off
manipulation is very straight forward and self-explanatory and occurs when an entity ends their
accounting period either earlier or later than traditionally expected. This practice can either push
revenue into the next accounting cycle OR include revenue in the currently cycle that should
traditionally be included in a later cycle. Bill and hold is the next abuse mentioned and occurs
when an entity recognizes the revenue of a sale before the sale is finalized, which can inflate
revenues that are reported should pending sales fall through. Deferring too much or too little is
another abuse that is carried out much like it sounds – an entity can either defer too much
revenue or defer too little revenue, which ultimately impacts revenue accounted for in the current
period for services to be rendered at a future date. The last, more hard to quantify method of
abuse is the rights of return sales. This revolves around the concept of how many returns an
entity can budget for or expect in a particular accounting period (Nelson, 2003). Given the
exampes from the article, it becomes evident that all financial reporting must be examined and
audited with a keen eye to ensure financial data is being reported accurately and honestly.
Grice3
Running head: EARNINGS MANAGEMENT
In “How are Earnings Managed? Evidence from Auditors”, Nelson explains the
percentage of completion method and how it is used to monitor and give insight into a project
and more explicitly the costs, status of completion, and revenue associated with the particular
project. Nelson indicates that this percentage of completion method and it’s data as reported can
be manipulated by the implementation of the bill and hold abuse. This method and the respective
abuse both hold the central concept that revenue is not recognized until a sale (or in this case a
particular project) is finished. This method provides a general overview and glimpse into the
progress being made on a project but doesn’t recognize the revenue until the project has been
concluded and posted as completed. The percentage of completion should ALWAYS be recorded
as accurately as possible to avoid data, such as gross profit recognition, being reported
inaccurately.
Given the information presented in the article by Nelson, once can see why an entity may
be inclined to ‘innocently’ utilize one of the previously mentioned four revenue recognition
abuses. In his article, Nelson not only presented data that indicated these abuses could inflate the
net income for the year they occurred, but could do so by roughly 75%! Initially, it may seem
that altering the revenue recognition data for one or two accounting cycles is an innocent act and
may not have far reaching effects, but the date reported by Nelson indicated the opposite.
Looking outside of the data presented by Nelson, one who walks in faith should realize that fraud
is NOT acceptable, regardless of how innocent it may seem. Proverbs 10:9 offers a firm warning
against fraud and explicitly states, “…but he who makes his ways crooked will be found out.”
And even offers security to those who work with integrity in ALL aspects of their life. 1 Timothy
6:10 takes it a step further to describe money as the root of all evil and reinforces that the lust for
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Running head: EARNINGS MANAGEMENT
more money is what causes many to wander from their faith. Given these Biblical warnings, all
business entities should strive to report their revenue recognition as transparently as possible.
The mere fact that these revenue recognition abuses exist is a reason why it is imperative
for our accounting system to have well trained and truly independent auditors in place who can
identify and bring to light misrepresentations in financial reporting. Outside of the auditors
recognizing inconsistencies in financial reports, the business entities are still held responsible for
correcting their reporting to accurately reflect their financial standing. Nelson ascertains in his
article that the majority (greater than half) of the entities who were presented with claims of
misrepresentation did in fact reevaluate and adjust their financial reporting to more accurately
reflect their true recognition of revenue. Not only is this a wise business decision, but this is an
very good practice to follow to avoid a public relations scandal that could cause serious harm to
an entity’s reputation.
