Earnings Management

Bryan Eubank began his accounting career as an auditor for a Big 4 CPA firm. He focused on clients in the high-technology sector, becoming an expert on topics such as inventory write-downs, stock options, and business acquisitions. Impressed with his technical skills and experience, General Electronics, a large consumer electronics chain, hired Bryan as the company controller responsible for all of the accounting functions within the corporation. Bryan was excited about his new positionfor about a week, until he took the first careful look at General Electronics' financial statements.

The cause of Bryan's change in attitude is the set of financial statements he's been staring at for the past few hours. For some time prior to his recruitment, he had been aware that his new employer had experienced a long trend of moderate profitability. The reports on his desk confirm the slight but steady improvements in net income in recent years. The disturbing trend Bryan is now noticing, though, is a decline in cash flows from operations. Bryan has sketched out the following comparison ($ in millions):

2018 2017 2016 2015

Operating income$1,400 $1,320 $1,275 $1,270

Net income 385 350 345 295

Cash flows from 16 110 120 155

operations

Profits? Yes. Increasing profits? Yes. So what is the cause of his distress? The trend in cash flows from operations, which is going in the opposite direction of net income. Upon closer review, Bryan noticed a couple events that, unfortunately, seem related:

a.The company's credit policy has been loosened, credit terms relaxed, and payment periods lengthened. This has resulted in a large increase in accounts receivable.

b.Several of the company's salary arrangements, including that of the CEO and CFO, are based on reported net income.

Required:

1.What is likely causing the increase in accounts receivable? How does an increase in accounts receivable affect net income differently than operating cash flows?

2.Explain why salary arrangements for officers, such as the CEO and CFO, might increase the risk of earnings management.

3.Why is the trend in cash flows from operations, combined with the additional events, such a concern for Bryan?

4.What course of action, if any, should Bryan take?