09/14/2006

Dalkkon Hurtt

Article Review: An Analysis of Earnings Management & Cookie Jar Reserves

This article review will define and discuss one of the techniques used by management that could prove misleading to a financial statement user, specifically, the use of Cookie Jar reserves. The trade-off between relevance and reliability will be explored within the accounting principles, as well as how broad macro-economic concerns should be taken into consideration when justifying certain account balances. This earnings management technique will be discussed from both the investors and managements perspective. Finally, a compelling case is made regarding the importance of understanding how an earnings management technique can impact the valuation of a company. To begin, a good analyst seeks additional insight into the financial position, profitability, and risks not readily apparent on the face of a companys financial statements or within the accompanying disclosures. According to the Financial Accounting Standards Board (FASB), a fundamental objective of financial reporting is to help investors, creditors, and others, assess the amounts, timing, and uncertainty of future net cash inflows.1 In order to accomplish this task, FASB has produced concept statements that serve to guide the authoritative literature to meet this fundamental objective. In some cases, the guidance must make trade-offs between its principles and pronouncements as will be seen below. Many of the qualitative characteristics of good financial reporting stem from the characteristics of relevance and reliability, subject to cost and materiality constraints as outlined in FASB Concept Statement 2. FASB defines relevance as, The capacity of information to make a difference in a decision by helping users to form predictions about the outcomes of past, present, and future events or to confirm or correct prior expectations.2 Reliability tends to be more historical in nature (i.e. property, unless impaired, is stated at its historical or acquisition cost even though property usually increases in value over time). The reliability of a measure rests on the faithfulness with which it represents what it purports to represent, coupled with an assurance for the user that it has that representational quality.3 Therefore, a judgment must be made whether the relevance of the results of one method is superior to the reliability of the results of the other. Given that managers can choose accounting policies from a set (e.g. GAAP), it is natural to expect that they will choose policies so as to maximize their own utility and/or the market value of the firm.4 Thus, preparers of financial statements have opportunities to mislead potential investors, creditors, and others through many means, one of which is broadly classified as earnings management techniques. An earnings management technique is the active manipulation of accounting results for the purpose of creating an altered impression of business performance.5 The rest of this article review is concerned with defining and discussing one such earnings management technique: The use of Cookie Jar reserves. Specifically, the assigned articles concentrate on reserves associated with accounts receivable (A/R), very often, a materially significant asset. The A/R balance is stated at net realizable value, a figure intended to reflect the companys best estimate of the collectable amount. As suspected, this estimate of collectable amount is subject to interpretation, management policies, and judgment calls. The assigned articles discuss General Motors and Fords use of cookie jar reserves and highlight the risks and rewards of employing such a strategy. First, the use of cookie jar reserves can artificially boost earnings to offset losses in an accounting period. This practice can be identified when management reduces the allowance for doubtful accounts balance relative to their historical reserve position. Initially, when the reserve is set up, the contra-asset account, allowance for doubtful accounts, is credited and the bad debts expense account is debited based on a good faith estimate of uncollectable accounts. This initial entry reduces net income. As certain accounts are deemed uncollectible, conventional accounting practice is to adjust the reserve position during the month end close in order to reflect an accurate forecast of doubtful collections. This standard practice limits a companys exposure to unexpected expenses from hitting the
1 2

http://www.fasb.org/pdf/con1.pdf. Retrieved 09/09/2006. http://www.fasb.org/pdf/con2.pdf. Retrieved 09/09/2006. 3 Ibid. 4 W. Scott, Financial Accounting Theory. Englewood Cliffs, NJ: Prentice-Hall, 1997, p. 295. 5 C. Mulford and E. Comiskey, Financial Warnings. New York: John Wiley & Sons, 1996, p. 360.

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income statement. Provided that management can reasonably justify such a reduction, then the earnings management misnomer is unjustified. If management chooses not to increase the reserve, decreases the reserve, or lets it remain the same, then earnings management may have occurred. In his article, Jeffrey McCracken contends that General Motors and Ford are manipulating earnings by reducing their expenses required to maintain previous reserve balances.6 Furthermore, he suggests that although the steady decline in reserves boosted earnings in recent reporting periods, investors should be aware that expenses associated with restocking these reserves may be imminent (future bad debts are not currently being reserved for while current and planned write-offs eat into the reserve balance). McCracken cites several analysts who comment on the quality of GM and Fords receivables. The reader is led to infer that the receivable balances are overstated because current period expenses are not matching historical reserve positions. The risk is that uncollectible receivables are not fully reserved for, thereby overstating assets (A/R) and understating expenses. An understatement in expenses is equivalent to an overstatement or boost to net income. If McCraken is right, then future net income is adversely impacted when the reserves are brought back in line with historical requirements (assuming those estimates were accurate at the time). Moreover, in good times, management may decide to increase the reserve position by expensing more in the near term in preparation for bad times in the future (more of an income-smoothing approach). In essence, despite what the analysts or management believes, earnings can be altered to the extent that management decides the timing of the expense and estimates what proportion of receivables are deemed uncollectible On the other hand, management may disagree that they are attempting to artificially boost earnings. They may argue that at the time, given the available information, their estimate accurately reflected the conditions. They may also argue that the historical reserve positions were initially too high, thereby necessitating the need to revise their estimates and lower their current reserve positions rather than raise them. As we will see, management of Ford and GM will suggest that events justify a less aggressive reserve position based on internal and/or external information. McCracken supports his position that management is manipulating earnings through his analysis of the companys internal and external environment. From an internal and industry perspective, he argues that the immediate term calls for even more conservative reserve positions (higher reserves) and tighter credit policies than historically maintained. As evidence, McCracken points out that GMs bad loans increased by more than $1billion from 2004 to a total of $6 billion in 2005. Furthermore, auto loan related bankruptcies increased by over 10,000 filings in the same period. During this time, GM reduced its reserve balance to $915 million in the first 9 months of 2005, down 36% from $1.44 billion in 2004. The $525 million difference helped boost GMACs pretax profit by nearly 20% for the year.7 Similarly, although Ford cites an improvement in the quality of their receivables, McCracken points out that Ford has been even more aggressive in reducing its reserve. Specifically, at one point in 2001, Ford had a loan loss provision of $3.2 billion. Even though McCracken incorrectly stated that Fords reserve had declined to $78 million as of the third quarter 2005 (the real reserve was $1.8 billion as tersely refuted by CFO Don Leclair in his reply to McCrackens article), the decline still represents a reduction of $1.4 billion in expense over the 2001-2005 period. Was a 56 percent reduction in the reserve position over the time period justified? Was the result really a managed 26 percent boost to earnings as claimed in the article? The facts were that both Ford and GM pursued more aggressive reserve positions and looser credit policies in an economic environment that appeared to justify the reverse of those strategies: The increase in industry wide auto-loan bankruptcies, and GMs rapid increase in bad loans. McCracken points to other macro-economic environment reasons for concern as well. Specifically, rising interest rates, increasing energy prices, and the looming housing market bubble. These signals did not reflect well on forecasts of consumer spending or the consumers ability to meet debt obligations. Glenn Reynolds (chief executive of Credit Sights) stated, What theyve done is defensible, but its also
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7

McCracken, Jeffrey (2005, Nov 22). General Motors, Ford Offset Losses By Dipping Into Cookie-Jar Funds. Wall Street Journal. New York, NY. Nov 22, 2005. p. C.3

Ibid.

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aggressive and allowed them to bolster their earnings.8 So the central theme of McCrackens article is that given the broader economic realities coupled with the use of aggressive reserve policies, investors, creditors, and other users of financial statements should be concerned and carefully scrutinize these strategies. Despite these seemingly obvious concerns, certain management disagreed. For example, Don Leclairs reply in the assigned Wall Street Journal article, noted that management believed their reserve positions accurately reflected the environment.9 Leclair, the Executive VP and CFO of Ford, first pointed out McCrackens material misstatement of Fords third quarter reserve position (the correct amount was $1.8 billion, not $78 million). Secondly, Leclair stated that Fords managed receivables have actually declined from over $199 billion to approximately $149 billion. Thirdly, he contends that the quality of those receivables has improved. As part of Fords strategy, Leclair wrote, the decline reflects our wellpublicized strategy to reduce significantly the amount of used and non-Ford business we write, and to divest certain non-core operationsall this information is readily available and regularly disclosed in a straight-forward manner in our public disclosure10 However, the question of what is an adequate reserve related to the $149 billion in Fords receivables remains unanswered. It should be noted that LeClair didnt specifically state whether or not the corrected $1.8 billion reserve figure (or 1% of net credit sales) was an adequate reserve, nor did he address the aggressive strategy in light of the broader economic situation. A review of the companys disclosures did not include an aged receivable balance either so it is not entirely true that all the information is readily available and regularly disclosed in a straight-forward manner In valuing a company, a good analyst has to perform due diligence and understand his/her company inside and out. The analyst must know the macro-environment, the industry, and the competition. One piece of the puzzle is to assess what an adequate reserve should be. To do this, one must consider the amount and quality of a companys receivables within the broader macro-economic environment similar to the other components of the balance sheet, income statement, and statement of cash flows. This can be a difficult task given the inadequate disclosure requirements surrounding the aging and quality of a companys receivables. Management may have very valid and defensible estimates. With respect to Ford and GM the question is, did these seemingly aggressive policies artificially boost earnings to meet short-term earnings expectations? It doesnt appear that management was justified in reducing their reserve positions given the increase in bankruptcies, bad loans, and the macro environment. Therefore, I would agree with McCrackens interpretation, that GM and Fords management has used Cookie Jar reserves to boost short-term earnings. It appears likely that the confluence of aggressive reserve policies and macro-economic concerns will adversely and materially impact the future cash flows of both GM and Ford? In conclusion, this article review assignment defined, analyzed, and discussed the risks and rewards of using cookie jar reserves from both the financial statement users and managements perspective. As can be seen, both an asset and an expense can be over or understated as a result of this technique. This could have a material impact on the valuation of a company. It is therefore up to the investor, creditor, or other analyst to determine the adequacy of the reserve and assess its relevance or reliability as part of their due diligence.

McCracken, Jeffrey (2005, Nov 22). General Motors, Ford Offset Losses By Dipping Into Cookie-Jar Funds. Wall Street Journal. New York, NY. Nov 22, 2005. p. C.3 9 LeClair, Don (2005, Dec 6). Ford Credit-Loss Reserves Now Stand at $1.8 Billion. Wall Street Journal. (Eastern Edition). New York, NY. Dec 6, 2005. p. A.21
10

Ibid.

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