1. Recording Revenue Too Soon or of Questionable Quality This may be the most common technique because many opportunities arise to accomplish it, including recording revenue before the earnings process has been completed or before an unconditional exchange has occurred. Examples of this shenanigan include: Recording revenue before shipment or before the customers unconditional acceptance. Recording revenue even though the customer is not obligated to pay. The Xerox case discussed later in this chapter illustrates how a company can move earnings into an earlier period by allocating more of the revenue in a multiyear contract to earlier years than justified given continuing servicing under the contract. 2. Recording Bogus Revenue Typically, bogus revenue transactions lead to fictitious revenue. Examples include: Recording sales that lack economic substance. Recording as revenue supplier rebates that are tied to future required purchases. Releasing revenue that was held back improperly before a merger. The ZZZZ Best case assignment in Chapter 5 illustrates how a master of deception like Barry Minkow can create nonexistent revenue by creating fictitious invoices for unperformed work. 3. Boosting Income with One-Time Gains The gains (and losses) from the sale of operating and investment assets that should be recorded in another (e.g., miscellaneous) income account can be classified in other ways if the intent is to boost operating income. These include: Boosting profits by selling undervalued assets. Including investment income or gains as part of operating revenue. Including investment income or gains as a reduction in operating expenses. IBM used the net proceeds from the sale of an operating unit ($300 million) to lower its operating costs, rather than accounting for it as a nonrecurring, one-time gain. We consider it fraud because it is a deliberate attempt to mislead users of the financial statements into thinking that operating income is larger than it really is. Financial analysts tend to put more emphasis on operating income than net income because of the miscellaneous, non-operating items recorded below the line of operating income to get net income. 4. Shifting Current Expenses to a Later or Earlier Period A common approach to shifting expenses to a later period is by capitalizing a cost in the current period and expensing it over a period of time, rather than expensing the item completely in the current period. This was the technique used by WorldCom to inflate earnings by between $11 billion and $13 billion. Additional examples include: Changing accounting policies and shifting current expenses to an earlier period. Failing to write down or write off impaired assets. Reducing asset reserves. WorldCom capitalized its line costs that provided telecommunications capacity on other companies systems rather than expense those costs as they were incurred. The effects on reported income were dramatic and illustrate how earnings management techniques can lead to reporting earnings when a loss Recording revenue when future services remain to be provided. has actually occurred. The following table illustrates just how that was done. 5. Failing to Record or Improperly Reducing Liabilities The liability account is often used to manipulate earnings because when liabilities that should be recorded are not, the expenses also are understated. When liabilities are reduced improperly, the same effect on expenses occurs. The result is to overstate earnings. Some examples include: Failing to record expenses and related liabilities when future obligations remain. Releasing questionable reserves (cookie-jar reserves) into income. Recording revenue when cash is received, even though future obligations remain. The recording of discretionary accruals that was previously discussed is one application of the technique. The Lucent Technologies example discussed later in this chapter illustrates a variety of these techniques. 6. Shifting Current Revenue to a Later Period Some companies act to delay the recording of revenue when the amount is relatively high in a given year. In a sense, this action sets up a rainy day reserve that can be used to restore earnings in low-earnings years. One way to accomplish this is to create a cookie-jar reserve with the excess revenues and release it back into the income stream at a later date, when it can do more good for the bottom line. Another method is through the use of deferred revenue. Examples include: Deliberately overstating the allowance for uncollectible accounts thereby understating current revenue and adjusting the allowance downward in future years to increase revenue. Deferring revenue recognition on a year-end service transaction that was completed by December 31 and then transferring it to earned revenue in subsequent years. Deliberately overstating the estimated sales returns account and adjusting it downward in future years.

As previously mentioned, in the 1990s the SEC brought a lawsuit against W. R. Grace & Co. for manipulating earnings to meet Wall Streets expectations. The SEC alleged that senior Grace executives deferred reporting some 1991 and 1992 income from National Medical Care, then the main Grace health-care unit. Grace assigned $10 million to $20 million of this unexpected profit to corporate reserves, which it then used to increase the reported earnings of both the health-care unit and the company between 1993 and 1995, the SEC said.70 The actual earnings of the unit and its parent company sometimes fell short of analysts expectations during this period, the suit alleged. Thus, Grace misled shareholders by reporting results buttressed by the reserves. The only problem was that Grace deferring reporting income by increasing or establishing reserves was not in conformity with GAAP. In fact, it smacks of using secret reserves to achieve a cookie-jar reserve effect. 7. Shifting Future Expenses to the Current Period as a Special Charge A company might choose to accelerate discretionary expenses, such as repairs and maintenance, into the current period if the current years revenue is relatively high in relation to expected future revenue or if future expenses are expected to be relatively high. The motivation to shift future expenses to the current period might be to smooth net income over time. The delay in recording repairs and maintenance is a technique that McKee would probably categorize as appropriate, given the goal of providing smooth and predictable earnings. Recall that in the reported studies on earnings management, the idea of managing earnings through operating decisions was not perceived to be as big a problem as altering revenue amounts. However, the decision to delay needed repairs raises several ethical issues with respect to the companys operating decisions because it creates a risk that assets such as machinery and equipment may break down prematurely. The ethical issues and consequences are (1) the quality of product may suffer, leading to extra quality control and rework costs; (2) production slows and fails to meet deadlines, thereby risking customer goodwill; and (3) the costs to repair the machines can be greater than they would have been had maintenance been completed on a timely basis. Imagine, for example, that you fail to change the oil in your car on a regular basis. The result may be serious, costly repairs to the engine later on.

For your initial post, provide a detailed explanation of the type of earnings management technique that you have chosen to research. Include the following in your explanation: What are some reasons a company might employ your selected method? Provide an example of how this particular fraudulent method might occur. What are the ethical considerations of your selection? Why is this method misleading to the stakeholders who count on the veracity of financial reporting? Your initial response should be 200 to 300 words in length, include at least two academic sources that are properly cited,