1. Outline why management may be motivated to manage the earnings of their company.

2. Outline the evidence provided by Dunmore to support his argument regarding earnings management, particularly around the division between accounting losses and accounting profits.

3. Identify the options that firms use to manage earnings.

4. Discuss whether earnings management is an ethical practice.

Forensic Accounting Earnings management: good, bad or downright ugly? By Paul Dunmore But why 100 years? Several NZ universities use buildings older than that; New College, Oxford, still uses 600-year-old buildings. There is no correct depreciation expense. Even if we could travel far into the future and discover that a Paul Dunmore is research professor of accounting at Massey University, particular building will last 143 years, there would Wellington. still be no way of knowing the true depreciation of E that building in 2008 because there is no way to arnings management - arranging measure how much really belongs to that year. All matters to achieve a predetermined we can do is to assume a reasonable value. result - is usually regarded as a bad thing, to be stamped out if possible. I Incentives to report a particular result argue that not only is stamping it out impossible, This example shows that EM is not confined but that there are good reasons for accepting that to business. It may occur whenever managers it will always occur. control the accounting system and have Earnings management (EM) occurs for two incentives to report particular results. Research reasons. First, managers and directors have has found a number of self-interest incentives: strong incentives to report particular results. managers whose pay is related to earnings or Second, there is no true figure against which to the share price have incentives to increase reported results can be tested. earnings, to meet earnings expectations to raise For example, some years ago a NZ university the share price, and to smoothe earnings to changed the depreciation life estimate for its understate the volatility of the business. EM, some major buildings from 60 years to 100 years, of it quite subtle, has been found in each of these bringing it in line with the other universities. There situations. was one data point: the original building had been Managers also have an obligation to protect closed as an earthquake hazard after 70 years, the firm's interests. In particular, they must and newer buildings were presumably better manage the risk that arises from reporting a engineered. So the change was easily justified particular profit. There are risks of driving down as giving a fairer presentation of the university's the share price to the detriment of current performance. shareholders; triggering technical default under This reduced depreciation expense by some debt covenants; drawing unwelcome attention $900,000. Universities budget for a small surplus. So if the new estimate was better, students had ammunition to unions, suppliers and customers in previously been overcharged by $900,000 a year. negotiations; losing donations and sponsorships; The estimate matters to management as well as to and more. Researchers have looked at several of students: it is easier and more pleasant to achieve these risks and found that they do in fact increase a target surplus by improving an accounting the incidence of EM. Fraudulent reporting of estimate than by fighting with Deans about their results is unacceptable; but when several different budgets. Changing the estimate, then, was partly fair reports are possible, managers would be a convenient way of achieving a desired surplus derelict in their duty if they did not consider the figure. 32 from competition and tax authorities; giving consequences of the alternatives. Chartered Accountants Journal April 2008 Forensic Accounting Finally, managers have private information about the firm and its prospects. By modifying the reported earnings, managers may there would be no need for accounting standards at all. To summarise: the absence of a \"real\" share information about their medium-term earnings figure creates the opportunity for EM, expectations. They do this by altering earnings and the incentives to report a particular result because, despite the enormous and increasing create the motivation. detail of disclosure in the financial statements, the So how common is EM, bottom-line profit is still the figure that attracts and how effective are most attention. current arrangements for preventing it? There is no \"real\" earnings figure The distance between Auckland and Wellington is a real figure . . . But there is no real figure against which reported earnings can be tested The distance between Auckland and Wellington EM in practice is a real figure, which can be measured fairly Figure 1 shows earnings accurately. But there is no real figure against before interest and tax which reported earnings can be tested. It is (EBIT) divided by total not possible to demonstrate that one allowed assets for over 16,500 accounting method (e g historical cost or global companies from 2006 and 2007. The revaluation of fixed assets) gives the \"true\" profit division by assets is purely for scaling; the year- and the other a \"false\" profit, nor which is the end figure is used for convenience. The number correct estimate of depreciation, collectability of of firms is shown for each 1%-wide group (e g debts and so on. If we could measure the true one column is the number of firms with EBIT of at earnings figure, we could simply report it, and least zero but less than 1% of ending assets). The Solution 1: Meeting the Challenges of Charities and Not-for-Profits Trust Investments is the only signicant investment fund manager catering exclusively to the needs of charities and not-for-prot organisations. We currently manage over 50 clients with assets in excess of $700m. Trust Investments has created Solution1, a purpose-designed investment and accounting service for charities and trusts that effective and professional way for trusts with assets between $1m and $5m to benet from best practice procedures and superior investment experience. To find out more contact Matthew Laing. Email: mlaing@trustinvestments.co.nz or freephone 0800 306 2530 www.trustinve stments.co.nz OUT NOW! News, views and insights . Contact us fo r your free co py P29/12919CAJ rely on income generated by investments. Solution1 is the www.trustinvestments.co.nz Chartered Accountants Journal April 2008 33 Forensic Accounting distribution of firms by EBIT is a bit skewed and than what analysts have been forecasting, etc. rather long-tailed, but unremarkable. The equivalent chart to Figure 2 for over 7,200 Figure 2 presents a histogram of net income US-listed firms shows an even greater jump for the same firms, again scaled by ending total between the number of firms reporting small assets. This distribution shows a remarkable losses and small profits, suggesting that not jump at zero profit. The number of firms making even the vigorous oversight of the SEC and the profits of 0-1% of assets is over 3.5 times the requirements of the Sarbanes-Oxley Act have had number making losses of the same size. (Only much effect on EM. five firms reported a profit of exactly zero; they Accounting adjustments for EM involve were included in the positive-profit group, but it making suitable estimates of necessary accruals, particularly inventory valuation, receivables valuation, depreciation and amortisation, impairments, and provisions. If there is nothing to accrue, this form of EM is impossible. When the meat company Fortex failed in 1994, its inventory and, therefore, its past earnings turned out to be grossly overstated. Had the amount of inventory been negligible, as Fortex's just-in-time business strategy called for, material overstatement would have been impossible. But I am not suggesting that such EM typically constitutes fraud. It is Figure 1. Histogram of EBIT divided by total assets for 16,514 firms. Each bar is the use of various estimates, judgements, and 1% wide. Data sourced from Compustat Global Vantage. accounting policies, all of which must be made by management and all of which are individually reasonable, in such a way that their combined effect is to report a preferred outcome. The avoidance of expected losses requires action before the end of the period when the outcome is still somewhat uncertain. It involves reduction or deferral of expenses such as advertising, training and maintenance, and actions such as year-end sales to boost revenues. By simply advancing or delaying the planning for an expected restructuring, management can ensure Figure 2. Histogram of net income divided by total assets for the same firms as in that the critical moment at which the provision Figure 1. and expense must be recognised will occur late in one financial year or early in the next. would make no material difference how they were treated.) Figure 2 implies either that many firms have Public sector bodies also engage in EM, using the same techniques. Swedish municipalities accrue more depreciation and impairment tuned their accounting to turn small actual losses write-offs in years when their surpluses are into small reported profits, or that firms coming high (thus smoothing surpluses and creating to the end of the year and expecting small losses hidden reserves which can be drawn down in have taken real actions before the year end to future years), and also in \"big bath\" situations ensure that the outcome will be a profit. There is (Stalebrink, 2007). In 1996, the New Zealand no evidence in Figure 1 that firms took any such Symphony Orchestra (NZSO) adopted a action to prevent their EBIT being negative. revaluation policy for the building whose value Much research has found similar patterns had declined since it was purchased, and around important thresholds: not reporting revenue. These changes reduced its surplus from previous year, and not reporting a worse result 34 changed the timing of recognition of sponsorship a loss, not reporting a smaller profit than the $645,000 to a reported amount of $79,000. In Chartered Accountants Journal April 2008 Forensic Accounting 1998, the building value had increased again and Considering ethics as right behaviour, rather the NZSO brought into income some previously than compliance with a code, the ethics of EM deferred income which it decided no longer met depends on both the management's intention and the definition of a liability. These items turned a on the way in which it is carried out. EM that is deficit of $753,000 into a surplus of $3,000. The intended to benefit managers personally is clearly effect of the adjustments was to smooth reported unethical, a breach surpluses to within a medium-term range of about of the duty owed $150,000 surplus or deficit (Gaa and Dunmore, to an employer. EM 2007). intended to protect the company's interests or Is EM ethical? to give readers a better Accounting codes of ethics have little to say understanding of the about EM, although they are properly very hostile company's performance to fraudulent reporting. It seems unlikely that can be defended, ethical rules could be drafted that would offer provided it is carried much help in deciding which reasonable estimate Running a sale just before yearend . . . may permanently lower customers' expectations of what they should pay out in an ethical way. to choose, which acceptable accounting policy Much EM is carried out secretly, without to adopt or how quickly to advance plans for disclosure of the fact of the management, the a possible restructuring. And an ethical code methods used, or the amount. The secrecy should certainly not tell managers to ignore their seems to be driven by the social attitude that responsibility to manage accounting risks facing EM is a bad thing. If a US-listed company were their firm. to say \"we estimated this year's provision for AMERICAN EXPRESS RIGHT BEHIND THE INSTITUTE THAT'S RIGHT BEHIND YOU. 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AM0904 NZICA Ad v8.indd 1 12/3/08 12:50:57 PM Chartered Accountants Journal April 2008 35 Forensic Accounting doubtful debts at the low end of the But in a situation where disclosure of year boosts earnings under full-cost range of reasonable estimates and the EM would lead it to being reversed accounting, but the unsold goods may thereby changed our result from a loss by regulators, deception of the readers be in excess of requirements (and extra of $1 million to a profit of $2.5 million\