UNIVERSITY OF ZAMBIA

GRADUATE SCHOOL OF BUSINESS

Financial Reporting and Analysis Course - Evening

Goodwill

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KEY MESSAGES

S/N Activity
1 What is earnings management?
2 Earnings Management Strategies
3 Earnings Management and ownership structures
4 Earnings Management Continuum
5 Conclusion
6 Other Issues

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KEY Questions

S/N Question
1 Identify the factors that motivate earnings
Management.

2 List the common techniques used to manage

earnings.

3 Critically discuss whether a company should

manage its earnings.

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1.0 What is earnings management?

Earnings Management Defined

A company's number one goal is to make money. Not only do
the company owners want to have a profit at the end of every
accounting period, but they also want the company financial
statements to look as good as they can. After all, the financial
statements are what potential investors and creditors look at
when they make the decision whether or not to lend the
company money or to become an investor. This is where the
concept of earnings management comes into play. Earnings
management, in a nutshell, is the creative use of different
accounting techniques to make financial statements look
better.

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Why Earnings Management?

Because of pressure from stakeholders and shareholders

expectations. Stakeholders and shareholders want to see
better results. Management can feel pressure to manage
earnings by manipulating the company's accounting practices
to meet financial expectations and keep the company's stock
price up. Many executives receive bonuses based on earnings
performance, and others may be eligible for stock
options when the stock price increases. Many forms of
earnings manipulation are eventually uncovered either by a
CPA firm performing an audit or through required SEC
(Securities and Exchange Commission) disclosures.

Because of The best way to answer this question is to use the

acronym WISE. WISE stands for: Window dressing, Internal
targets, income Smoothing, External Expectations.

Window dressing refers to the company's decision to dress

up the financial statements for potential investors and
creditors. The goal of this is to attract new supporters by
having financial statements that look like the company's doing
great. The company needs to appear to have a history of
being profitable, even if it means lowering profits in one
accounting period to increase profits in another. Even though
this seems fraudulent, it isn't. Overall, the company is still
reporting the same amount of profits, but is spreading the
amount evenly over a specific time period.

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Internal targets are another reason that a company may
choose to use earnings management techniques. Often times,
the company has set its own internal goals, such as
departmental budgeting, and wants to be sure to meet those
goals. No department wants to be the one to blow the
proposed budget, so earnings management techniques are
used to balance this out.

Income smoothing comes into play here because of the fact

that potential investors generally like to invest in companies
that have a continuous growth pattern. Smoothing out income
generated, when there may be spikes at certain times and
drops at others, allows it to appear like the company has that
smooth growth pattern.

External expectations comes into play when the company

has already made projections as to what their profits will be
and investors now expect that exact amount of profits or
more. Management may feel the need to shift revenue from
one accounting period to another in order to meet the
projected goal. Earnings management, quite simply, takes
advantage of the different ways that accounting policies and
procedures can be applied to financial reporting.

Understanding Earnings Management

Earnings refers to a company's net income or profit for a

certain period, such as a fiscal quarter or year. Companies use

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 earnings management to smooth out fluctuations in earnings
and present more consistent profits each month, quarter, or
year. Large fluctuations in income and expenses may be a
normal part of a company's operations, but the changes may
alarm investors who prefer to see stability and growth. A
company's stock price often rises or falls after an earnings
announcement, depending on whether the earnings meet or
fall short of analysts' expectations.

The Securities and Exchange Commission (SEC) has pressed

charges against managers who engaged in fraudulent
earnings management. The SEC also requires that the
financial statements of publicly traded companies be certified
by the Chief Executive Officer (CEO) or Chief Financial Officer
(CFO).

2.0 Earnings Management Techniques

There are a number of techniques that are used to manage

earnings. The top five are as follows;

2.1 The big bath - This technique is often called a 1-time event.
What happens with the big bath technique is that an out of
the ordinary, or non-recurring, event occurs in a company,
and expenses associated with that event are actually inflated.
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 So, how can they inflate expenses and still be within GAAP
guidelines? Easily! The company reports all of its expenses,
but instead of attributing them to the correct accounts, they're
all attributed to the 1-time event. The big bath is especially
common when a new CEO takes over. The new CEO can
blame the old CEO for the current mess and then predict a
better future, knowing well that some future expenses have
already been taken. An example will help bring out the point;

2.2 Cookie jar reserves - This technique is also an income

smoothing technique. A cookie jar generally happens in a
good year and the big bath happens in a bad year. Both serve
to increase profits in future years. The name cookie jar
implies that earnings are being stored away to be used in the
future when the sweet tooth kicks in and needs it. The big
bath can include the over accruing of liability. It occurs when
expenses are based on estimates. If the company over
estimated expenses, then it may choose to use a portion of
the expenses in one accounting period and save the other for
future accounting periods.

2.3 INVENTORY VALUATION - LIFO/FIFO

One method of manipulation when managing earnings is to

change an accounting policy that generates higher earnings in
the short term. For example, assume a furniture retailer uses
the last-in, first-out (LIFO) method to account for the cost of
inventory items sold. Under LIFO, the newest units purchased

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 are considered to be sold first. Since inventory costs typically
increase over time, the newer units are more expensive, and
this creates a higher cost of sales and a lower profit. If the
retailer switches to the first-in, first-out (FIFO) method of
recognizing inventory costs, the company considers the older,
less-expensive units to be sold first. FIFO creates a lower cost
of goods sold expense and, therefore, higher profit so the
company can post higher net income in the current period.

2.4 Asset Capitalization

Another form of earnings management is to change company

policy so more costs are capitalized rather than expensed
immediately. Capitalizing costs as assets delays the
recognition of expenses and increases profits in the short
term. Assume, for example, company policy dictates that
every item purchased under K5,000 is immediately expensed
and costs over K5,000 may be capitalized as assets. If the firm
changes the policy and starts to capitalize all items over
K1,000, expenses decrease in the short-term and profits
increase.

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2.5 Materiality Rule

Materiality – This topic may not be a big deal to small

companies since nearly everything is material and, hence,
should be accounted for. But for large, publicly traded
companies with revenues and assets in the billions of
kwachas, they can potentially get away with millions of
kwachas worth of misstatements and merely write them off
as being “nonmaterial” in nature. Auditors are primarily
concerned with material misstatements. Materiality has the
potential to allow companies to slightly fudge their numbers,
just enough to get them to where the analysts forecasted.

2.6 Revenue Recognition

Revenue recognition – Sort of the flip-side of cookie jar

reserves, improper revenue (or expense) recognition can lead
to inflated financial statements now at the expense of future
earnings. Some companies that have dabbled with this
earnings management technique then have to inflate
revenue in the next period even more to make up for
the shortfall caused by the prior period’s acceleration
of revenue. It becomes a never-ending game of covering up
for the previously improperly recorded revenue and can fairly
easily lead to outright fraud. Several of the bigger scandals of
the past few years have been the result of companies
improperly, and or prematurely, recording revenues in order
to meet or exceed forecasts, only to have the house of cards
eventually come tumbling down, resulting in massive

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 restatements to the prior financial statements, new
management, new auditors, and very low stock prices (if not
bankruptcy).

3.0 Earnings Management Accounting

Earnings management is the use of accounting techniques

to produce financial reports that present an overly positive
view of a company's business activities and financial position.
Many accounting rules and principles require company
management to make judgments following these principles.
Related party transactions, write downs, revenue recognition,
off balance sheet finance, hidden reserves and bad debts.

5.0 Earnings Management and ownership structures.

In a world characterised by imperfect people with different

divergent needs, a divergence of interests between
shareholders and management can lead to suboptimal
management decisions. Such decisions are possible
because the actions of managers are largely unobservable and
the goals of the managers and their shareholders are not
necessarily aligned. Managers are posited to opportunistically
manage earnings to maximise their utility at the expense of
other stakeholders. Agency theory suggests that the
monitoring mechanisms can improve the alignment. A
conflict of interests has potential agency cost such as
management decisions that do not maximize shareholder’s
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 interests. Managers may manage reported earnings to justify
their actions. Earnings management may lead to an agency
cost where investors make non-optimal investment decisions
from reported earnings. In a situation where a company has
a high free cash flow, the manager may be engaged in
earnings management to show better performance of the
company. This relation can be explained by using agency
theory. In this contractual context, characterized by the
conflict of interests between shareholders and managers,
corporate governance involves the design series mechanisms
that reconcile the interests of shareholders and managers.

The ownership structure is defined by the distribution

of equity with regard to votes and capital but also by
the identity of the equity owners. Ownership structure
concerns the internal organization of a business entity
and the rights and duties of the individuals holding a
legal or equitable interest in that business. As owner
of the business entity, it is important to understand
how the ownership structure of a particular business
entity is organized and what that means for the
owner’s rights.
o Example: A shareholder, as owner of a corporation,
has certain rights. These rights are distinct from those
of members of a limited liability company. Further,
within the corporation, a holder of preferred
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stock may have different rights than the holder
of common stock. Discussion: Why do you think
different types of business entity allow for unique
ownership structures? Why do you think ownership
structure is so important for business owners?

While there are a few conventions which are best

followed to avoid any misunderstandings a company
can call shares by whatever name it likes. That said,
you cannot simply assume that shares called ordinary
in one company will have exactly the same rights as
the ordinary shares in another company. Indeed the
only way to ascertain what rights go with a particular
share class is to read the articles of association of that
company. The reasons why a company would want to
have different share classes will generally fall into one
of the below categories;

 To attract investment

 To push dividend income in a certain direction

 To remove (or enhance) voting powers of certain

individuals

 To motivate staff (to remain as employees)

Provided it follows due process, and subject to

any restrictions in its articles of association, a
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 company can create a new share class at any
time. When it needs a new share class a
company can choose to either create a new share
class in addition to an existing class or convert an
existing share class into one or more new share
classes.

It is the articles of association which set out the

division of shares into their different classes. The
articles will also detail the precise rights attaching
to each class. Most classes of share will fall into
one of the below categories of types of share:

6.0 Classes of shares- Ownership Structure

1.0 Ordinary Shares

These carry no special rights or restrictions. They rank after
preference shares as regards dividends and return of capital
but carry voting rights (usually one vote per share) not normally
given to holders of preference shares (unless their preferential
dividend is in arrears).

Some companies create more than one class of ordinary shares

– e.g. “A Ordinary Shares”, “B Ordinary shares” etc. This gives
flexibility for different dividends to be paid to different
shareholders or, for example, for pre-emption rights to apply to
some shares but not others.
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In some cases, different classes of ordinary share may be of
different nominal values – for example, there may be £1
Ordinary shares and £0.01 Ordinary shares. If each share had
the right to one vote (and assuming the shares were issued at
their nominal value), then the £0.01 Ordinary shareholders
would get 100 votes per £1 paid while the £1 Ordinary
shareholders would get 1 vote for paying the same amount.

2.0 Deferred Ordinary shares

A company can issue shares which will not pay a
dividend until all other classes of shares have received
a minimum dividend. Thereafter they will usually be fully
participating. On a winding up they will only receive
something once every other entitlement has been met.

3.0 Non-voting ordinary shares

Voting rights on ordinary shares may be restricted in
some way – e.g. they only carry voting rights if certain
conditions are met. Alternatively, they may carry no
voting rights at all. They may also preclude the
shareholder even attending a General Meeting. In all
other respects they will have the same rights as ordinary
shares.

4.0 Redeemable shares

The terms of redeemable shares give the company the
option to buy them back in the future; occasionally, the
shareholder may (also) have the option to sell them

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 back to the company, although that’s much less
common.

The option may arise at or after a specific date, between

two dates or be effective at any time the shares are in
issue. The redemption price is usually the same as the
issue price, but can be set differently. A company can
only redeem shares out of profits or the proceeds of a
new share issue, which may restrict its ability to redeem
shares even if the directors would like to exercise the
option.

If a company chooses to have redeemable shares, it

must also have non-redeemable shares in issue. At no
point can all of its share capital be made up of
redeemable shares. We’ve written a dedicated article
covering the features and processes related
to redeemable shares.

5.0 Preference shares

These shares are called preference or preferred since
they have a right to receive a fixed amount
of dividend every year. This is received ahead of
ordinary shareholders. The amount of the dividend is
usually expressed as a percentage of the nominal
value. So, a £1, 5% preference share will pay an annual
dividend of 5p. The full entitlement will be paid every
year unless the distributable reserves are insufficient to
pay all or even some of it. On a winding up, the holders

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 of preference shares are usually entitled to any arrears
of dividends and their capital ahead of ordinary
shareholders. Preference shares are usually non-
voting (or only have a vote only when their dividend is
in arrears).

6.0 Cumulative preference shares

If the dividend is missed or not paid in full then the
shortfall will be made good when the company next has
sufficient distributable reserves. It follows that ordinary
shareholders will not receive any dividends until all the
arrears on cumulative preference shares have been
paid. By default, preference shares are cumulative but
many companies also issue non-cumulative preference
shares.

7.0 Redeemable preference shares

Redeemable preference shares combine the features of
preference shares and redeemable shares. The
shareholder therefore benefits from the preferential
right to dividends (which may be cumulative or non-
cumulative) while the company retains the ability to
redeem the shares on pre-agreed terms in the future.

Most companies start by just having one type of shares

in the form of an ordinary share class. These will
typically carry equal rights to voting, capital and
dividends. The issue of new shares after company
incorporation will generally be allotments of these

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 ordinary shares, unless circumstances suggest a need
for flexibility or varied rights.

Just as a company may issue shares in multiple share

classes, there’s also nothing to stop a shareholder
holding more than one class of share in the same
company and thereby benefiting from the differing
rights (e.g. voting or dividend entitlement) that each
class offers.

7.0 Earnings Management Continuum

There is a continuous argument in the audit circle on whether

earnings management is another form of fraud. Fraudulent
financial reporting engages deliberate misstatements or
exclusion of figures or dissemination in financial statements
as a part of a design to “manage earnings.”… With this
therefor the debate is whether earning management is
Legitimate or whether earnings management is a
Fraud

Chia (2006), agued that Earnings Management is another kind

of financial reporting fraud.
(Jiraporn, Diana and Madaline (2007) argued that since it is
within the periphery of GAAP earnings management is not a
fraud.

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