Accrual Accounting
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Accrual Accounting and Earnings Management RCJ Chapters 1, 2(48-52), 3(126-132), 7(357-359)
Key Issues
Accrual accounting
Managers’ incentives and reporting abuses
Example: Revenue recognition
How earnings are managed
Paul Zarowin
2
Accrual Accounting
Recognizes the financial benefits and obligations accruing to an enterprise over the reporting period - regardless of cash inflows and outflows.
Objective: Better indication of performance than current cash receipts and payments.
Paul Zarowin
3
Accrual Accounting: Characteristics
subjectivity
assumptions
discretion
incentives
Paul Zarowin
4
Earnings Management
The reporting discretion inherent in accrual accounting can be opportunistically used by managers. information Manag er Reporting incentives:
Investors
• Higher bonus • Cashing out on Stock options • Career and personal ego Paul Zarowin
5
Earnings Management (cont’d)
Why allow reporting discretion?
Rigid rules Flexible rules (e.g. full (e.g. revenue expensing of trade-off recognition) R&D) Reporting biases Enables better reporting of larger number of businesses. No discretion Prone to manipulation Paul Zarowin
6
Earnings Management (cont’d) Important to understand: More often the problem is not the flexibility of the reporting rules, but the fact that the watchdogs are not doing their job!!!
Audit failure
Poor corporate governance
Shareholder involvement
SEC enforcement
Paul Zarowin
7
Common Earnings Management Practices 1.
Shifting income between periods: Revenues
Expenses
Borrowing earnings from the future
1. Premature recognition of revenues Example: Xerox
2. Capitalization of expenses Example: WorldCom
Postponing earnings to the future
3. Deferring recognition of revenues Example: Microsoft
4. Exaggerating current expenses/losses to create cookie jar reserves Example: Microsoft
Note:
Σt Earningst = Σt Cash Flowst Paul Zarowin
8
Common Earnings Management Practices (cont’d): J.E. Actual J.E. 1. Borrowing revenues from the future
DR Cash
2. Deferring expenses to the future
DR Asset Expense
3. Deferring revenue to the future 4. Exaggerating current expenses/losses to create cookie jar
later:
Proper recognition J.E.
CR revenue
DR CR cash def. revenue later: def. revenue revenue
CR cash asset
DR CR cash def. revenue later: def. revenue DR CR revenue loss liability/Asset later: liability cash Paul Zarowin
later:
DR expense
CR cash
DR Cash
CR revenue
DR CR No journal entry loss cash 9
Common Earnings Management Practices (cont’d) 1.
Classification of gains and losses:
2.
Classifying one-time gains as earnings from continuing operations Classifying losses from continuing operations as onetime items
Hiding Debt in unconsolidated subsidiaries
Example: Enron
Legitimate Earnings Management (Within GAAP) of accruals to: Manipulation
Violation of GAAP or SEC rules
I. smooth earnings II. Turn permanent expenses into temporary losses ex. P15-9
10
Example of Scope of Manipulations and Incentives: Xerox Case
Xerox sells/leases copy machines, and related service to be provided for several years after sale. Recorded service revenue at the time of sale. According to the SEC investigation, “accounting tricks” boosted pretax profit by 1.5 billion from 1997 through 2000. In November 1999, CFO told management: "When accounting actions were stripped away, Xerox had essentially no growth through the late 1990s.”
Q: Which of the 4 categories mentioned in slide Paul Zarowin
11
Xerox Case: what were the
incentives? Without the accounting scheme the company would have missed Wall Street's consensus pershare earnings targets in 11 of 12 quarters from 1997 to 1999. Accounting scheme helped keep Xerox's stock price artificially high in the late 1990s so executives could cash in $5 million in performance-based compensation and more than $30 million from stock sales.
Paul Zarowin
12
Example of Reporting Discretion: Seebeyond Case
On March 2002 SeeBeyond sold its software product for $2.2 million to a costumer. Revenue Deployment and payment for recognition: the software in stages that could 2. Earned extend until March 2003. 3. Measurable This customer had bought and successfully deployed software from SeeBeyond before. SeeBeyond is interested in including the $2.2 million in the revenues of the quarter ending on March 31, 2002. Is it possible? 1. No. Revenue not earned. 2. No. Revenue not measurable 3. Yes. Revenue is both earned and measurable. Paul Zarowin
13
SeeBeyond Case (cont’d)
SeeBeyond held a conference call telling investors that revenues would fall short of the previous revenue guidance by approximately $2 million.
The share fell 52% the next day!!! Why?
Paul Zarowin
14
Key Issues
Accrual accounting
Managers’ incentives and reporting abuses
Example: Revenue recognition
How earnings are managed
Paul Zarowin
2
Accrual Accounting
Recognizes the financial benefits and obligations accruing to an enterprise over the reporting period - regardless of cash inflows and outflows.
Objective: Better indication of performance than current cash receipts and payments.
Paul Zarowin
3
Accrual Accounting: Characteristics
subjectivity
assumptions
discretion
incentives
Paul Zarowin
4
Earnings Management
The reporting discretion inherent in accrual accounting can be opportunistically used by managers. information Manag er Reporting incentives:
Investors
• Higher bonus • Cashing out on Stock options • Career and personal ego Paul Zarowin
5
Earnings Management (cont’d)
Why allow reporting discretion?
Rigid rules Flexible rules (e.g. full (e.g. revenue expensing of trade-off recognition) R&D) Reporting biases Enables better reporting of larger number of businesses. No discretion Prone to manipulation Paul Zarowin
6
Earnings Management (cont’d) Important to understand: More often the problem is not the flexibility of the reporting rules, but the fact that the watchdogs are not doing their job!!!
Audit failure
Poor corporate governance
Shareholder involvement
SEC enforcement
Paul Zarowin
7
Common Earnings Management Practices 1.
Shifting income between periods: Revenues
Expenses
Borrowing earnings from the future
1. Premature recognition of revenues Example: Xerox
2. Capitalization of expenses Example: WorldCom
Postponing earnings to the future
3. Deferring recognition of revenues Example: Microsoft
4. Exaggerating current expenses/losses to create cookie jar reserves Example: Microsoft
Note:
Σt Earningst = Σt Cash Flowst Paul Zarowin
8
Common Earnings Management Practices (cont’d): J.E. Actual J.E. 1. Borrowing revenues from the future
DR Cash
2. Deferring expenses to the future
DR Asset Expense
3. Deferring revenue to the future 4. Exaggerating current expenses/losses to create cookie jar
later:
Proper recognition J.E.
CR revenue
DR CR cash def. revenue later: def. revenue revenue
CR cash asset
DR CR cash def. revenue later: def. revenue DR CR revenue loss liability/Asset later: liability cash Paul Zarowin
later:
DR expense
CR cash
DR Cash
CR revenue
DR CR No journal entry loss cash 9
Common Earnings Management Practices (cont’d) 1.
Classification of gains and losses:
2.
Classifying one-time gains as earnings from continuing operations Classifying losses from continuing operations as onetime items
Hiding Debt in unconsolidated subsidiaries
Example: Enron
Legitimate Earnings Management (Within GAAP) of accruals to: Manipulation
Violation of GAAP or SEC rules
I. smooth earnings II. Turn permanent expenses into temporary losses ex. P15-9
10
Example of Scope of Manipulations and Incentives: Xerox Case
Xerox sells/leases copy machines, and related service to be provided for several years after sale. Recorded service revenue at the time of sale. According to the SEC investigation, “accounting tricks” boosted pretax profit by 1.5 billion from 1997 through 2000. In November 1999, CFO told management: "When accounting actions were stripped away, Xerox had essentially no growth through the late 1990s.”
Q: Which of the 4 categories mentioned in slide Paul Zarowin
11
Xerox Case: what were the
incentives? Without the accounting scheme the company would have missed Wall Street's consensus pershare earnings targets in 11 of 12 quarters from 1997 to 1999. Accounting scheme helped keep Xerox's stock price artificially high in the late 1990s so executives could cash in $5 million in performance-based compensation and more than $30 million from stock sales.
Paul Zarowin
12
Example of Reporting Discretion: Seebeyond Case
On March 2002 SeeBeyond sold its software product for $2.2 million to a costumer. Revenue Deployment and payment for recognition: the software in stages that could 2. Earned extend until March 2003. 3. Measurable This customer had bought and successfully deployed software from SeeBeyond before. SeeBeyond is interested in including the $2.2 million in the revenues of the quarter ending on March 31, 2002. Is it possible? 1. No. Revenue not earned. 2. No. Revenue not measurable 3. Yes. Revenue is both earned and measurable. Paul Zarowin
13
SeeBeyond Case (cont’d)
SeeBeyond held a conference call telling investors that revenues would fall short of the previous revenue guidance by approximately $2 million.
The share fell 52% the next day!!! Why?
Paul Zarowin
14
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