A common tactic to manage earnings is to stuff the channels, that is, to ship product prematurely to dealers and customers, thereby inflating sales for the period. A case in point is Bristol-Myers Squibb Co. (BMS), a multinational pharmaceutical company headquartered in New York. In August 2004, the SEC announced a $150 million penalty levied against BMS. This was part of an agreement to settle charges by the SEC that the company had engaged in a fraudulent scheme to inflate sales and earnings in order to meet analysts earnings forecasts.

The scheme involved recognition of revenue on pharmaceutical products shipped to its wholesalers in excess of the amounts demanded by them. These shipments amounted to $1.5 billion U.S. during 2001-2002. To persuade its wholesalers to accept this excess inventory, BMS agreed to cover their carrying costs, amounting to millions of dollars per quarter. In addition, BMS understated its accruals for rebates and discounts allowed to its large customers.

According to the SEC, the company also engaged in cookie jar accounting. That is, it created phony reserves for disposals of unneeded plants and divisions during high-profit quarters. These would be transferred to reduce operating expenses in low-profit quarters when BMSs earnings still fell short of amounts needed to meet forecasts.

Required:

1. Give reasons why managers would resort to extreme earnings management tactics such as these.

[4 marks]

2. Evaluate the effectiveness of stuffing the channels as an earnings management device. Consider both from the standpoint of a single year and over a series of years.

[5 marks]

1. Evaluate the effectiveness of cookie jar accounting as an earnings management device.