solution manual intermediate 1

8/10/2019 solution manual intermediate 1

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CHAPTER 6

QUESTIONS

1. The four factors that might motivate amanager to attempt to manageearnings are as follows:

(a) Meet internal targets(b) Meet external expectations(c) Provide income smoothing(d) Provide window dressing for an

IPO or a loan

2. (a) Internal earnings targets are animportant tool in motivatingmanagers to increase sales efforts,control costs, and use resourcesmore efficiently.

(b) The risk with internal earningstargets is that the person eingevaluated will forget the underlyingpurpose of the measurement andinstead focus on the measurednumer itself.

3. !cademic research has demonstratedthat managers su"ect to an earnings#ased onus plan are more likely tomanage earnings upward if they areclose enough to reach the onusthreshold and are more likely tomanage earnings downward, savingthe earnings for a rainy day, if reportedearnings sustantially exceed themaximum onus level.

4. $ecause the existence of an earnings#ased onus plan increases theincentive of managers to manipulatethe reported numers, auditorsconsider such plans to e a risk factoras they plan the nature and extent oftheir audit work. !s a result, it ispossile that the existence of such aplan might increase the amount of audit

work performed.5. The figure in %xhiit &' displays a

trough "ust elow (ero, indicating thatthe numer of companies with earnings

"ust elow (ero is significantly lowerthan expected. In addition, there is alump on the distriution "ust aove(ero, indicating that the numer ofcompanies with earnings "ust aove

(ero is significantly greater thanexpected. This suggests thatcompanies that compute a preliminaryearnings numer that is slightly lessthan (ero make more favorale accrualassumptions to get earnings to epositive.

6. If analysts) earnings forecasts aremerely a mathematical forecast of amechanically generated numer, theforecasts should e less than actualearnings half the time and more thanactual earnings half the time. The fact

that many companies meet or exceedanalysts) forecasts for many *uarters ina row strongly suggests that theprocess is eing managed in someway. The figure in %xhiit &'demonstrates that managers do indeedmanage reported earnings. There isalso evidence that managers provide+guidance to analysts to try to ensurethat the analysts) forecasts are not toohigh to reach. -o, companies canconsistently meet or eat analysts)forecasts ecause they manage

earnings and they also manage theforecasts.

7. Income smoothing is the practice ofcarefully timing the recognition ofrevenues and expenses to even out theamount of reported earnings from oneyear to the next.

8. !s descried in the text of the chapter,eneral %lectric)s usiness structure isparticularly well suited to incomesmoothing ecause of the company)slarge numer of diverse operating units/e.g., financial services, heavymanufacturing, home appliances0. !large one#time loss reported y oneusiness unit can fre*uently ematched with an offsetting gainreported y another unit. $y carefullytiming the recognition of these gainsand losses, % can avoid reportingearnings that ounce up and downfrom year to year. Perhaps more

237


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important, % has had very successfulunderlying operations over the past '1years. $ecause of this, any incomesmoothing undertaken y % has eenmerely the carefully timing of therecognition of income, not a desperateattempt to create earnings out of thinair.

9. Many studies have demonstrated thetendency of managers in 2.-.companies to oost their reportedearnings using accounting assumptionsin the period efore an initial pulicoffering /IPO0. 3esearch has alsoshown that socialist managers in4hinese state#owned enterprises/-O%s0 do exactly the same thing inadvance of selling shares of the -O% tothe pulic.

10. !n important piece of evidence that2.-. companies can sumit to the 2.-.International Trade 4ommission /IT40when petitioning for import arriers isfinancial statements showing areduction in profitaility correspondingto an increase in the import ofcompeting foreign products. 3esearchsuggests that, at least in the past, 2.-.companies may have managedearnings downward in advance of filinga petition with the IT4.

11. !ccountants, using the concepts ofaccrual accounting and the accountingstandards that have een patientlydeveloped over the course of the past511 years, add information value yusing estimates and assumptions toconvert the raw cash flow data intoaccrual data. 6et income is a ettermeasure of a company)s economicperformance for a period than isoperating cash flow. Thus, even thoughthe flexiility of accrual accounting

opens the door to some ause, theasic system provides usefulinformation for financial statementusers.

12. The five laels in the earningsmanagement continuum, and thegeneral types of actions associatedwith each, are as follows:

ab!" T#$!% &' Ac&*%

7 -avvyTransactionTiming

-trategic matching

' !ggressive!ccounting

4hange in methodsor estimates with full

disclosure8 9eceptive

!ccounting4hange in methodsor estimates with littleor no disclosure

;raudulent3eporting

6on#!!Paccounting

5 ;raud ;ictitioustransactions

13. 4hanging accounting estimates toreflect the most current informationavailale is an essential part of accrualaccounting.


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16. The five techni*ues of accountinghocus#pocus identified y !rthur =evittare as follows:(a) $ig ath charges(b) 4reative ac*uisition accounting(c) 4ookie "ar reserves(d) Materiality(!) 3evenue recognition

17. If a company expects to have a series oflosses or large expenses in future years,the notion of a ig ath is that it is etterto try to recogni(e all of the ad news inone year, leaving future years unspoiledy continuing losses. !ccording to thisnotion, after a year or two financialstatement users will have forgottenaout the horrile ath year and insteadwill e impressed that no additionalpieces of ad news have hit the financial

statements.

18. -ince 7>>?, the ;!-$ has limited theflexiility companies have to recogni(eig ath restructuring charges yadopting SFAS No. 144 on impairmentlosses and SFAS No. 146on the timingof the recognition of restructuringoligations.

19. ! company can +take a ath whenrecording the ac*uisition of anothercompany y allocating a large amount ofthe purchase price to +purchased in#

process 3@9. Purchased in#process3@9 is expensed immediately inaccordance with the mandated 2.-.!!P treatment of all 3@9expenditures. The net result is similar toa ig ath in that a large 3@9 expenseis recorded in the ac*uisition year, andexpenses in suse*uent years are lowerthan they would have een had thepurchase price een allocated to adepreciale asset.

20. Ahen a company estalishes a cookie

"ar reserve, it overreports expenses orunderreports revenues during thecurrent year in the anticipation thatthese deferred earnings can than erecogni(ed as needed in a future year.Thus, the most likely candidate for acompany to e tempted to estalish acookie "ar reserve is one that has etter#than#expected performance in the

current year ut with concern aoutfuture years.

239


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'1 4hapter &

21. The traditional concept of materiality isased on straightforward numericalthresholds such as 7B of sales, 5B ofoperating income, or 71B of stockholders) e*uity. The concept ofmateriality in SAB 99re*uires that onelook at the context to decide whether anamount is material. ;or example, if aC711,111 expense is "ust 'B ofoperating income ut the nonrecognitionof this expense would result in acompany having earnings high enoughto meet analysts) expectations, the itemis material.

22. In order to limit the ause of revenuerecognition to manage earnings, the-%4 has released SAB 101, identifyingmore carefully the circumstances inwhich it is appropriate for a company to

recogni(e revenue.23. ! pro forma earnings number is the

regular !!P earnings numer withsome revenues, expenses, gains, orlosses excluded. In a general sense,+pro forma results are those that wouldhave happened or will happen undercertain defined circumstances. Thus, proforma numers offer a +what#ifscenario. The controversy aout proforma earnings numers is that theexclusions from !!P earnings aresometimes made merely to make the

earnings numer look etter, notnecessarily to provide a etter picture ofthe company.

24. ! trustworthy manager can reveal evenetter information aout the underlyingeconomics of the usiness throughappropriate ad"ustments to !!Pincome in computing pro formaearnings. The danger with pro formaearnings is that a desperate managerseeking to hide operating prolemsmight try to use the flexiility of proforma reporting to report deceptively

positive pro forma results.

25. The -%4 endorsed the recommendationmade y the ;inancial %xecutivesInternational /;%I0 and the 6ationalInvestor 3elations Institute that firmsgive a reconciliation to !!P netincome whenever reporting pro formanumers. This reconciliation highlights

the ad"ustments made y managementin reporting pro forma earnings.

26. The financial statements are one of alarge numer of vehicles used y themanagers of a company tocommunicate information aout the

company to the pulic. In this sense,financial reporting is part of a company)sgeneral pulic relations effort.

27. (a) Point % represents the highestearnings of the five points includedin %xhiit &DE Point 4 representsthe second highest earnings.


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C+a$!, 6 '7

(-) Massive loss of reputation

31. !nother way to respond to the pressurecaused y poor operating performanceis to seek to fix the underlying usinessprolems through etter operations andetter marketing.

32. Ahen signing an audit opinion, theauditor is alancing the multiyear futurerevenues from continuing as acompany)s auditor with the potentialcosts of eing swept up in an accountingscandal, losing valuale reputation, andperhaps losing a large lawsuit.

33. -ome financial analysts work forrokerage houses that also doinvestment anking work for clients. If afinancial analyst releases a report on acompany that is very unfavorale, that

company may e less likely to use thatanalyst)s rokerage house forinvestment anking work.

34. !fter finding evidence of misleadingfinancial reporting, the most commonpunishment y the -%4 is a cease anddesist order that instructs a company tostop its misleading practices and not torepeat them. The -%4 also chargesfines such as the C71 million fine leviedagainst Ferox for misleading financialreporting.

35. !n earnings management meltdowndoes not ecome pulic knowledge untilstage &, the regulatory investigation.$efore that, the usiness downturn andresulting earnings management coverupare "ust a secret earnings managementmeltdown waiting to happen.

36. The cost of capital is the cost ofotaining the external financingnecessary to fund a company)soperations and expansion. The cost ofdet capital is the after#tax interest costassociated with orrowing the money.

The cost of e*uity financing is theexpected return /oth as dividends andas an increase in the market value of theinvestment0 necessary to induceinvestors to provide e*uity capital.

37. ! company produces financialstatements to etter inform lenders andinvestors aout the performance of thecompany. 4onse*uently, good financial

statements reduce the uncertainty oflenders and investors. Aith loweruncertainty, the information risksurrounding the company is lower, andthe company)s cost of capital is lower.

38. $y increasing the *uality of financialreporting, good accounting standardsare ale to reduce information risk.Thus, the overall cost of capital is lowerwhen accounting standards are ofhigher *uality.

39. !ccording to the !I4P! 4ode ofProfessional 4onduct, the guidingprecept in


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'' 4hapter &

alancing conflicting pressures amongclients) interests and the pulic)s interestis that acting ethically and in the pulicinterest is also in the est long#runinterest of the client.

40. The est long#run usiness practice isethical ehavior.


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'8 4hapter &

ISCUSSION CASES

%c/%%&* Ca%! 61

The advantage of an earnings#ased onus plan is clear: %mployees are unified and directly

interested in the overall performance of the company.


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' 4hapter &

%c/%%&* Ca%! 64

Over the past three years, 4lark 4ompany has had a more stale, predictale earnings series. !sa result, an analyst would typically feel more comfortale making a forecast aout sustainalefuture earnings for 4lark 4ompany than for 9urfee 4ompany. The earnings series makes 9urfeeappear to e a more volatile and risky investment. Thus, in the asence of any conflicting

evidence, an investor would proaly e willing to pay more for a share of 4lark 4ompany thanfor a share of 9urfee 4ompany.

The chapter information discussed the possiility that a company could time its transactions anduse ad"ustments in accounting estimates to smooth the reported amount of earnings from oneyear to the next. !n analyst would want to look at the reported operating cash flow numers forthese two companies to determine whether the underlying cash#flow#generating aility of 4lark4ompany is as stale as its apparent earnings#generating aility. !n analyst would also want tolook carefully at the notes to 4lark)s financial statements for the past three years to find whetherany accounting changes have een made that might have contriuted to the smooth earningsstream. !n analyst also would like to see the *uarterly earnings amountsE one would esuspicious of 4lark)s reported annual amounts if the *uarterly earnings in the first three *uarterswere widely variale ut the fourth *uarter results consistently led to steady overall incomegrowth for the year. ;inally, an analyst would like to get a sense for the character of the managersof oth companies. ;or example, if the managers of 4lark 4ompany are people of high personalintegrity, the analyst can place much more reliance on the smooth reported earnings series.

%c/%%&* Ca%! 65

Mr. Ghang has several motives for releasing very honest, straightforward financial statements.;irst, he has his own personal integrity to consider. -econd, he is aware of the enefits ofestalishing the crediility of the company with investors. This reputation for crediility will eparticularly valuale if a decision to sell more shares of 9alian to the pulic is made in the future.

Mr. Ghang also has some incentives to push for the issuance of very positive, perhaps overlypositive, financial statements. Aith stronger financial statements, the IPO price likely will e

higher and more funds will flow into the udget of the ministry of which Mr. Ghang is an employee.This additional cash inflow will e good for the people of 4hina. In addition, the more funds thatare raised through the IPO, the etter Mr. Ghang looks to his superiors. Thus, Mr. Ghang)s futurecareer may e impacted y the type of financial statements released in connection with this IPO.

!s mentioned in the chapter, there is some evidence that the financial statements of 4hinesestate#owned enterprises are su"ect to some earnings management efforts in advance of an IPO.

%c/%%&* Ca%! 66

The primary issue that should e weighing upon your mind is the pulic relations disaster that willresult if ;lame 4ontrol reports record earnings ecause of the fires that have destroyed the

state)s forests. The financial statements could very well e used as evidence in the statelegislature as laws are considered that would punish profiteering from natural calamities such asforest fires. %ven in the asence of direct punishment from such legislation, ;lame 4ontrol willhave lost a large amount of pulic goodwill y seeming to profit from the misfortunes of the rest ofthe state. !s a result, you as ;lame 4ontrol)s 4;O will feel a strong incentive to make pessimistic,income#decreasing assumptions as you supervise the preparation of the financial statements.Hou may consider decreasing depreciation life assumptions, increasing ad det estimates, andso forth.


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C+a$!, 6 '5

%c/%%&* Ca%! 66 (C&*c"/d!d)

3ather than rely on accounting assumptions to lower your reported earnings and conceal the factthat, from a usiness standpoint, you had a record year at the expense of the rest of the state,you might convince the oard of directors to address the issue head on. Hes, ;lame 4ontrolmakes more money when there are more fires. That also means, however, that ;lame 4ontrol

suffers financially in years that are relatively fire free. Perhaps in recent years ;lame 4ontrol hashad to lay off workers ecause of slowdowns at its factories associated with a low incidence offorest fires. ;lame 4ontrol might also e advised to use some of its windfall profits to reuild thecommunities harmed y the fires. In summary, the reported earnings of ;lame 4ontrol are goingto provide politically sensitive information this year. 3ather than trying to cover over its financialsuccess with accounting assumptions, ;lame 4ontrol might consider more direct ways to placatepulic anger.

Note:arious industries in the 2nited -tates have faced this exact issue in the past. In the mid#7>D1s, soaring oil prices generated windfall profits for the ig oil companies. 4ongress evenpassed a +Aindfall Profits Tax to try to extract some of the oil profits that appeared to have eengenerated through the suffering of the !merican people. In the mid#7>>1s, pulic scrutiny focusedon the profits generated y pharmaceutical companies.

%c/%%&* Ca%! 67

The frustration of your finance professor is understandale.


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'& 4hapter &

%c/%%&* Ca%! 69

!ccounting assumptions can e used to improve


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C+a$!, 6 'D

reveal the misstatements, the audit firm recklessly designed it. The -%4 formally sanctioned!rthur !ndersen in this case.%c/%%&* Ca%! 612

It may e possile for you to assemle enough evidence to get an indictment against Kohn andMary. It is reported that -ol Aachtler, the former 4hief Kudge of the 6ew Hork -tate 4ourt of

!ppeals, oserved, %ven a modestly competent district attorney can get a grand "ury to indict aham sandwich. etting a conviction won)t e so easy. Ahat %arnings Management, Inc., is doingcertainly appears to e slea(y and unethical.


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'? 4hapter &

%c/%%&* Ca%! 615

-cenario 7. %arnings this year are high, ut earnings in future years are in dout. If =ily4ompany)s oard wants to estalish a cookie "ar reserve that can e used to olster earnings infuture years, a B ad det expense should e used this year. This will allow for the reporting oflower ad det expense in future years if earnings are low.

-cenario '. %arnings this year are low, ut those in future years are expected to e strong. If =ily4ompany)s oard wants to show consistent, steady income growth, a 7B ad det expenseshould e used this year. This low expense will increase reported income this year. In futureyears, experience may necessitate a higher ad det percentage estimate, ut that can ealanced against the expected future profit improvements.

$y using the ad det percentage estimate to create a cookie "ar reserve to smooth earnings, =ily4ompany runs the risk of reducing the crediility of its financial reports. ;inancial statement userswill e ale to detect the fluctuating ad det estimates. If changes in usiness conditions do not

"ustify these changes, =ily will e suspected of eing an earnings manager. This will causefinancial statement users to e more skeptical of future financial reports and perhaps other claimsy =ily)s oard or managers.

%c/%%&* Ca%! 616

$y making his comment, 3ex has informed the assistant controller that no *uestionale itemsless than C'51,111 in amount will e actively investigated. If the accounting staff at Jirtland4ompany wanted to hide anything from the auditor, they now know that they can hide *uite a it

"ust y making sure that the amounts of the items are less than C'51,111. On the other hand, 3exproaly hasn)t revealed any crucial state secrets. It is likely that some of the people on Jirtland4ompany)s accounting team have previously worked for the same audit firm that is now doing theaudit. !s such, they are familiar with the way the audit firm computes its materiality thresholdsand could proaly deduce the numer if they desired.

!ny numerical threshold is dangerous if the auditor focuses only on the dollar amount of thethreshold ut doesn)t put the audit evidence in a roader context. ;or example, the nature of anapparent error in the client ooks might e more important than the dollar amount, such as aC51,111 cash payment to a vendor that is not on the approved list and is identified only y a post

office ox numer. In addition, as mentioned in the text of the chapter, an audit difference thatresults in a company reporting a profit instead of a loss should e considered to e material nomatter what the amount.

%c/%%&* Ca%! 617

3evenue cannot e recogni(ed until the company has sustantially completed its performance.!lthough the memership fees are nonrefundale, the memership is for the person)s lifetime.Thus, the revenue should e spread over the estimated time that a memer will use the facilities.In attempting to secure a new loan, Jristen and her partners wish to portray the performance oftheir health clu in the est light possile. If a potential lender is nervous aout the clu)seconomic viaility, the loan may e offered on very unfavorale terms. Thus, Jristen and herpartners would like to recogni(e as much revenue as possile. Timing is very important since the

loan is eing sought nowE revenue recogni(ed next year or the year after won)t improve thefinancial statements given to a potential lender now. On the other hand, Jristen and her partnersdo have an economic incentive for maintaining, or increasing, their crediility with their lender. Ifthe revenue recognition rules are stretched and extra revenue is reported, the lender could verywell ignore the financial statement numers and focus instead on the negative connotation thatthis earnings management has with respect to the character of Jristen and her partners. Throughstraightforward financial reporting and revenue recognition, Jristen and her partners mightincrease their crediility and lower their cost of orrowing.


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C+a$!, 6 '>

%c/%%&* Ca%! 618

The Aorthington 4ompany pro forma disclosure is an example of how pro forma reporting canhelp financial statement users etter understand a company)s earnings. $y removing the effectsof one#time items, the Aorthington pro forma numer gives the financial statement user a ettermeasure of the sustainale or permanent component of the company)s earnings. In contrast, the

Millward 4ompany pro forma earnings numer is an illustration of the ause of the flexiility of proforma reporting. One can make an argument that the costs of the strategic initiative and theemployee training are economically e*uivalent to long#term capital investments.


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'51 4hapter &

%c/%%&* Ca%! 620 (C&*c"/d!d)

Thus, the purpose of the presentation is to show the shareholders what earnings would e ifother sets of acceptale estimates had een used.

This is not to say that this range of possile earnings numers was examined and the mostfavorale numer chosen to e reported. Instead, a set of estimates, consistent with the

estimates that have een made in prior years, was applied to the facts, resulting in thereported earnings numer.

%c/%%&* Ca%! 621

Jara thinks that the time she spends explaining *uarterly earnings to the usiness communitycould e much more productively spent in developing long#run initiatives to improve her usiness,initiatives that might not ear fruit within the current reporting period ut which are in the estlong#run interest of the company.

!s descried in 4hapter 7?, the $usiness 3oundtale /an organi(ation of '11 4%Os of top 2.-.corporations0 has claimed that *uarterly earnings reports are very costly in terms of preparationand are counterproductive ecause they cause management to focus on short#term earningsrather than long#term growth. This concern aout the counterproductivity of *uarterly reportingwas echoed y Peter !. Magowan, then#4%O of -afeway, the large supermarket chain ased inOakland, 4alifornia. In 6ovemer 7>?&, -afeway was taken private in a C5.8 illion leverageduyout /=$O0. In looking ack on the success of the restructuring that followed the =$O,Magowan reported that one of the key advantages en"oyed y -afeway was that as a privatecompany, it was no longer locked into the cycle of fixation on reported *uarterly earnings.

!ccording to Magowan, this freedom from pressure to report ever#increasing *uarterly profitsmade it possile for -afeway to institute aggressive pricing, store expansion, and increasedspending for training and technologyall actions that would hurt reported profits in the short runut were for the company)s long#term good.

%c/%%&* Ca%! 622

It is important to rememer that every audit involves a calculated risk. It is impossile for an auditfirm to take the time and incur the expense to check every transaction a client entered into duringa year. !ccordingly, the final issuance of the audit opinion is an act of faith that the auditprocedures have een designed properly to detect all material misstatements. Aith riskier clients,the possiility of an undetected material misstatement increases.


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C+a$!, 6 '57

%c/%%&* Ca%! 624

Aith no financial statements availale from any of the 711 companies in Tara(ania, the est aninvestor can do is estimate a company)s average profitaility and financial soundness andassume that each company is aout average. !ccordingly, when it ecomes legal to releasefinancial statements, the company with the greatest incentive to release financial statements is

the one with profitaility and financial soundness most aove average. In fact, all companies thatare aove average have an incentive to release financial statements. Once this happens, theottom 51 companies will e left, and the est that investors can do is assume that each of thesecompanies has profitaility and financial soundness e*ual to the average of the ottom 51companies. -o, the companies that are in the top half of the ottom 51 will have an incentive torelease financial statements to differentiate themselves from the ottom half of the ottom 51.This process will repeat itself until >> companies have released financial statements to reveal toinvestors that they are not the worst of the 711 companies. !t that point, the 711th companymight as well release its financial statements. -o, even with voluntary reporting, it is proale thatall, or almost all, companies would release their financial statements to the pulic.

This analysis is ased on the following well#known article: eorge !. !kerlof, The Market for=emons): Quality 2ncertainty and the Market Mechanism, #uarterl$ %ournal of &conomics'

!ugust l>D1. Professor !kerlof was the co#winner of the '117 6oel Pri(e for %conomics.

%c/%%&* Ca%! 625

The reporting choice that 4ompanies ! and $ face is similar to the famous prisoners) dilemma.The standard way to analy(e a prisoners) dilemma is using a payoff matrix. %ach cell contains theamount of investment funds that you receive, given the comination of your action and the othercompany)s action, as follows:

T+! O+!, C&$a*#% Ac&*

Hour !ctionTransparent3eporting

9eceptive3eporting

Transparent reporting C5 million C1

9eceptive reporting C? million C7 million

=ook at the columns Transparent 3eporting and 9eceptive 3eporting. These are the two optionsopen to the other company. In the first column, which assumes that the other company reportstransparently, you see that you can increase the investment amount that you receive from C5million to C? million y issuing a deceptive rather than a transparent report. In the second column,which assumes that the other company will report deceptively, you can increase the amount ofthe investment funds that you receive from C1 to C7 million. -o, no matter what you expect theother company to do, you can increase the amount of investment funds that you will receive yreporting deceptively rather than transparently. Hour only rational choice, given these conditions,is to report deceptively.

The other company will construct this same matrix and come to the same conclusion.


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'5' 4hapter &

The more you think aout this 6ash e*uilirium, the more unsettling it ecomes ecause the twocompanies could oth e etter off if they were to report transparently and receive C5 million eachin investment funds. The 6ash e*uilirium of dual deceptive reporting is, however, the only stalesolution.

! key part of the prolem of this prisoners) dilemma is that deceptive reporting has no long#run

conse*uences. If this scenario were played out each year over the course of many years, thecompanies might reali(e that they could oth improve their long#run positions y reportingtransparently. The est long#run solution is for oth companies to report transparently each periodso that each gets C5 million in investment funds each period. This illustrates that perverseehavior sometimes arises ecause a company or an individual does not properly evaluate thelong#run conse*uences of actions that may have short#term enefit.


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C+a$!, 6 '58

SOUTIONS TO OE ITES

c,&%&' C+a,-!d + E%ab"%+*- C&&! a, R!%!,!% ($$. 328329)

1. The second revenue recognition criterion is that the revenue has een earned throughsustantial completion of the activities involved in the earnings process. Microsoft reports

that sustantial completion of its earnings process is not accomplished until technicalsupport has een provided over the product life cycle. This approach makes theoreticalsense ut also introduces a practical difficulty in determining how much of the revenueshould e recogni(ed immediately and over what period the remaining revenue should edeferred.

2. ! company)s management would desire to report smooth earnings to give the impression ofstaility and predictale growth. =enders in particular are made nervous y companies withvolatile earnings.

3. ! simple definition of conservatism is that revenues and gains are deferred until certain,whereas expenses and losses are recogni(ed immediately. $y this definition, the Microsoftrevenue deferral practice is conservative.


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'5 4hapter &

SOUTION TO STOP ; RESEARCH

Stop & Research (p. 338): One reason for the very harsh treatment of !rthur !ndersen in the%nron case in '11' is that the audit firm had een severely reprimanded y the -%4 in '117 forits actions in the audit of Aaste Management. This reprimand can e found athttp:RRwww.sec.govRlitigationRadminR8#.htm.!ccess this document and determine how the

!ndersen partners "ustified the issuance of an un*ualified opinion in connection with the 7>>8audit of Aaste Management.

The following comes from -ection 9.8 of the -%4 censure of !rthur !ndersen:

+!ndersen audited Aaste ManagementLs 7>>8 financial statements. $y ;eruary 7, 7>>, theengagement team *uantified current and prior period misstatements totaling C7'? million, which,if recorded, would have reduced net income efore special items y 7'B. The engagement teamprepared Proposed !d"usting Kournal %ntries /P!K%s0 in that amount for the 4ompany to recordin 7>>8. The engagement team also identified accounting practices that gave rise to other knownand likely misstatements involving understatements of operating expenses for which it did notprepare P!K%s. The engagement team informed Maier of the P!K%s and accounting practicesgiving rise to the other known and likely misstatements. The 4ompany refused to record theP!K%s or to correct the accounting practices giving rise to the P!K%s and other misstatements

and likely misstatements.

+!ndersenLs !udit O"ectives and Procedures Manual /the !OP Manual)0 re*uired that !llgyerconsult with partners having firmwide responsiilities when cumulative P!K%s exceeded ?B ofnet income from continuing operations. !s a result, on ;eruary 7, 7>>, !llgyer and Maierconsulted with the Practice 9irector and the !udit 9ivision >8 financial statements. !pplying an analytical procedure for evaluatingthe materiality of audit findings referred to as the roll#forward method, these partnersdetermined that, ecause the ma"ority of P!K%s concerned prior period misstatements, theimpact of the P!K%s relating to current period misstatements on the 4ompanyLs 7>>8 incomestatement was not material. They instructed !llgyer to inform the 4ompany that !ndersen wouldissue an un*ualified audit report. In addition, they instructed !llgyer to emphasi(e that !ndersenexpected the 4ompany to change its accounting practices and to reduce the cumulative amountof the P!K%s in the future.

Stop & Research (p. 341): The !I4P! 4ode of Professional 4onduct can e found at thefollowing Ae address: http:RRwww.aicpa.orgRaoutRcodeRindex.htm. !ccess this site, and find-ection 71' on Integrity and O"ectivity. Ahat constitutes a knowing misrepresentation in thepreparation of financial statementsN

+.1' 71'#7Jnowing misrepresentations in the preparation of financial statements or records. !memer shall e considered to have knowingly misrepresented facts in violation of rule 71' S%Tsection 71'.17 when he or she knowingly

a. Makes, or permits or directs another to make, materially false and misleading entries in anentityLs financial statements or recordsE or

. ;ails to correct an entityLs financial statements or records that are materially false andmisleading when he or she has the authority to record an entryE or

c. -igns, or permits or directs another to sign, a document containing materially false andmisleading information.
http://www.sec.gov/litigation/admin/34-44444.htmhttp://www.aicpa.org/about/code/index.htmhttp://www.sec.gov/litigation/admin/34-44444.htmhttp://www.aicpa.org/about/code/index.htm


19/23

C+a$!, 6 '55

COPETENC< ENHANCEENT OPPORTUNITIES

!c$+!,*- 61 (T+! =a" %*!# C&$a*#)

In its 6ovemer ?, '117 press release, 9isney reported pro forma net income for fiscal '117 ofC7,5'5 million, compared to a !!P net loss of C75? million. ! close estimate of this amount can

e generated as follows:

/in millions06et loss for '117 according to !!P C /75?0

!dd restructuring and impairment charges 7,5-utract gain on sale of usinesses /''0

!dd cumulative effect of accounting changes 'D?+%stimated pro forma net income for '117 C 7,55'

This estimate of C7,55' million is close to the actual pro forma earnings, ut only ecause itignores two offsetting factors. ;irst, in its computation of pro forma earnings, 9isney only addedack C?D? million of the restructuring and impairment charges. The remainder of the restructuringcharge was considered to e sufficiently integral to normal operations to re*uire that it e

included in the computation of pro forma earnings. -econd, increasing the amount of reportedpretax earnings will change the reported income tax expenseE that factor is ignored in the simplecalculation presented aove.

!c$+!,*- 62 (!,&>)

!s discussed in the text of 4hapter &, the peak period of earnings management at Ferox was in7>>?. The following gross profit percentage numers confirm that Ferox was ale to maintain itsapparent operating profitaility until 7>>>:

'111 7>>> 7>>? 7>>Dross profit percentage 1.&B &.?B >.8B >.?B/ross profitR3evenues0

Most informative are the operating cash flow numers. If the cash generated y the selling of thefinance receivales is removed from the 7>>> operating cash flow, the trend for the years is asfollows:

/in millions0 '111 7>>> 7>>? 7>>D6et income /loss0 C/'5D0 C7,' C 8>5 C7,5'Operating cash flow /&&80 /'D70 /7,7&50 D'

The negative operating cash flow numers indicate that Ferox was having serious operatingprolems at least as early at 7>>?, and those prolems continued through '111. This exampleconfirms that one must look at oth net income and operating cash flow in order to get a completepicture of a company)s performance. In addition, the finance receivales securiti(ation in 7>>>

demonstrates that there are actions that a company can take to manage reported operating cashflow.


20/23

'5& 4hapter &

=,*- A%%-*!*

=+# dd ! a*a-! !a,**-%?

To: 9ee!nn Martine(, -enior ice President, Hosef $ank;rom: Hour 6ame, 4ontroller, 4am#3y Industries-u"ect: Poor Kudgment and %arnings Management

Thank you for agreeing to meet with me next week. !s the new management team at 4am#3yguides the company out of the mess that we are in, we will need the support of our long#timecustomers, suppliers, employees, and you, our anker.

I personally apologi(e for my part in providing you with misleading financial statements for thepast two years. I wish I could say that the entire earnings management scheme took placewithout my knowledge, ut that would not e true. I knew what our former 4%O was up to, and Ifailed to act to stop the release of the deceptive financial statements. !long with our 4%O, I gotcaught up in working for our final o"ective, a successful e*uity offering next year, and Ioverlooked the unethical means /misleading financial reports0 that were used to try to reach thato"ective. 9on)t think that I have escaped punishmentE even though I have kept my "o, myusiness reputation is now in tatters and it will take me years to restore it.

Our new 4%O has placed a high priority on restoring good relations with Hosef $ank. If you havelost confidence in me personally, then the new 4%O will appoint someone from the newmanagement team at 4am#3y to represent us in our dealings with your ank. In addition to a newmanagement team, we also have a new auditor, new financial reporting controls, and a newethical attitude in the company. Please don)t let your disappointment in my personal ehavior getin the way of working with this new management team.

!gain, thanks for agreeing to meet with me next week. If you think it would e appropriate for adifferent memer of the new senior management team at 4am#3y to come in my place, please letme know.

R!%!a,c+ P,&@!c

Q/a"# &' !a,**-%

In the case, +! 4ontroller)s 4hallenge, the controller Kim Aoodruff is reluctant to order theacceleration of the C' million shipment ecause to complete the goods early will re*uire thecompany to spend an extra C711,111 in overtime charges. Kim wonders: +Ahy would I endorsespending real money to move profits a few weeks aheadN Other earnings management issuesintroduced in this case are the li*uidation of =I;O layers, the potential capitali(ation ofexperimental development costs that would normally e expensed, delaying the initiation ofdepreciation on a new facility that is "ust eginning to e used, and so forth. The pressure tomanage the ottom line is illustrated in a *uote from the company president in the case: +3unninga usiness means having to alance out the ups and downs on the ottom line. Ae can get asi(ale chunk of it from Saccelerating the SC' million Imperial order. The rest is mostly accountingissues. The target is a millionsee if you can get it.

The !I4P!)s Quality of %arnings 4ase -tudy 4ollection contains over a do(en cases that exploreearnings management issues. In addition, there are many other sources of information aout*uality of earnings accessile through the !!!)s Quality of %arnings Pro"ect.


21/23

C+a$!, 6 '5D

T+! !ba!

I% c&*%!,a! acc&/**- -&&d acc&/**-?

The two teams in the deate might make some of the following points:

C&*%!,a%

!s mentioned in the text of 4hapter &, financial reporting is part of the roader pulic relationseffort of a company. !s such, accountants feel a natural loyalty to their company and, thus,tend to make estimates and "udgments that would present the performance of the company inthe est possile light. ! strict policy of conservatism would counteract this natural tendency.

Managers are naturally optimistic aout the prospects of their usiness, perhaps even overlyoptimistic. If they did not elieve in their usiness, they would not e ale to unreservedlydevote their efforts to making the usiness successful. This predictale overoptimism willinevitaly manifest itself in the form of overoptimistic accounting estimates, "udgments, andassumptions. 4onservatism is a counteralance to this tendency.

In addition to the factors mentioned aove, managers also have strong economic incentivesto ias the financial statements to report good news. These incentives include managementonuses, favorale ank loan agreements, a rising stock price, and so forth. !ccountingconservatism helps mitigate the positive ias in financial statements introduced ecause of

these economic incentives. !ccounting conservatism imposes greater discipline upon a company)s financial reporting.

The practice of conservatism removes a large amount of the freedom that companies have tomanage earnings y insisting that ad news e reported as soon as it is suspected and thatgood news not e reported until it has een concretely reali(ed.

,!!d& ',& a%

Misleading financial statements are misleading whether they paint an overly optimistic pictureor an overly pessimistic picture. ;inancial reports should fairly reflect a company)sperformance and should not e conservatively iased to intentionally present a worst#casescenario.

4onservatively iased financial statements harm those investors and creditors who wouldhave invested in or lent to a company if they had received accurate information. Those

investors and creditors have een deceived and have had to put their capital to use in lessproductive ways. 4onservatively iased financial statements make the overall economy lessefficient ecause the misleading information prevents capital from flowing to its most efficientuse.

2sing a conservative ias in financial statements to counteract overoptimism amongmanagers follows the faulty old +two wrongs make a right argument.

;inancial reporting should not e used to impose discipline in a corporate structure. If thereare concerns aout management)s ehavior, then those concerns should e addresseddirectly. The financial reporting system should e designed to provide uniased information.

E+ca" "!a

=+a %+&/"d #&/ d& + /*$"!a%a* a*d /*!"c&! a/d !d!*c!?

Hou are in a difficult situation ecause you owe loyalty to a numer of different parties whoseinterests may e somewhat at odds with one another. These parties are as follows: Hour audit team: !n important part of your responsiility as an audit manager is to train the

staff who work for you. Ahat type of professional training will you e giving them y sweepingthe channel stuffing evidence under the rugN

iff 6ielsen, the partner in charge: Hou might e tempted to go around 6ielsen and talk toother partners at 9oman @ 9etmer. Hou should only do this if you are convinced that 6ielsenwill never act on the channel stuffing evidence. $y going around 6ielsen, you run the risk of


22/23

'5? 4hapter &

harming his career, perhaps unfairly. %veryone will e etter off if you can convince 6ielsen totake this evidence seriously and act on it.

9oman @ 9etmer: The entire audit firm of !rthur !ndersen ceased to exist ecause of theconduct of a small group of professionals on the %nron audit. -urely, some of thoseprofessionals sensed that the conduct advocated y the partner in charge of the engagementwas wrong. If one of those professionals had acted *uickly and decisively, !rthur !ndersen

would still e a strong international audit firm today. The pulic /users of McMahon)s financial statements0: !s mentioned near the end of 4hapter

&, the !I4P! 4ode of Professional 4onduct says the following aout resolving conflictingloyalties:

+In discharging their professional responsiilities, memers may encounterconflicting pressures. In resolving those conflicts, memers should act withintegrity, guided y the precept that when memers fulfill their responsiilityto the pulic, clientsL and employersL interests are est served.

Hourself: Hour personal reputation is at stake. If you ac*uiesce and ury this channel stuffingevidence, everyone in the firm of 9oman @ 9etmer will soon know that you will not stand onprinciple. Hour audit team will look on you with less respect. Other partners in the firm may ereluctant to work with you on future engagements.

Hour est option in this situation is to prepare a etter case and return to iff 6ielsen to convincehim of the importance of following up on this channel stuffing evidence. Hou should provide6ielsen with the arguments he will need to convince the other partners of 9oman @ 9etmer thatthe additional audit work is necessary to ensure that the firm is not caught up in a catastrophicaudit failure. Hou should help 6ielsen prepare a presentation to the oard of directors ofMcMahon showing the impact of the apparent channel stuffing and the financial reporting risk thatthe company is running y insisting on reporting these shipments as sales in the current period.

I*!,*! S!a,c+

1. The following is from the -%4)s civil action complaint against Ferox, dated !pril 77, '11':

Paragraph 7&. FeroxLs senior management was informed of the most material of theseaccounting actions and the fact that they were taken for the purpose of what the company calledclosing the gap to meet performance targets. These accounting actions were directed orapproved y senior Ferox management, sometimes over protests from managers in the field whoknew the actions distorted their operational results.

2. The following is from the -%4)s civil action complaint against Michael K. Jopper, dated!ugust '7, '11':

Paragraph '. ;rom 9ecemer 7>>D through 9ecemer '111, Jopper received variouspayments relating to 4hewco, which he secretly shared with %nronLs 4;O. Jopper receivedapproximately C7.5 million in management fees relating to 4hewco, which he shared with%nronLs 4;O mainly through checks payale to memers of the 4;OLs family. In 9ecemer 7>>?,

%nronLs 4;O caused %nron to pay a C11,111 nuisance fee to 4hewco as compensation foragreeing to amend K%9ILs partnership agreement. Jopper transferred approximately C&D,'' ofthe nuisance fee ack to %nronLs 4;O, again through checks written to the 4;O or memers ofhis family. In addition, Jopper paid the 4;OLs wife approximately C5,111 for acting as a 4hewcoadministrative assistant.


23/23

C+a$!, 6 '5>

3. The following is from the -%4)s initial complaint against Aorld4om, dated Kune '&, '11':

Paragraph 5. -tarting at least in '117, Aorld4om engaged in an improper accounting schemeintended to manipulate its earnings to keep them in line with Aall -treetLs expectations, and tosupport Aorld4omLs stock price. One of Aorld4omLs ma"or operating expenses was its so#calledline costs. In general, line costs represent fees Aorld4om paid to third partytelecommunication network providers for the right to access the third partiesL networks. 2nder!!P, these fees must e expensed and may not e capitali(ed. 6evertheless, eginning atleast as early as the first *uarter of '117, Aorld4omLs senior management improperly directedthe transfer of line costs to Aorld4omLs capital accounts in amounts sufficient to keepAorld4omLs earnings in line with the analystsL consensus on Aorld4omLs earnings. Thus, in thismanner, Aorld4om materially understated its expenses, and materially overstated its earnings,therey defrauding investors.

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