Surveys completed by 169 CFO’s showed , “…CFOs believe that in any given period about 20% of firms manage earnings…only about 60% of earnings management is income increasing, while 40% relates to income-decreasing activities…CFOs believe that it is difficult for outside observers to unravel earnings management…” (Earnings Quality: Evidence from the Field, September 2012).
There are policies and practices within GAAP, that allow for a certain amount of flexibility, i.e. where reasonable individuals may disagree , such as revenue recognition timing; depreciation and amortization policies; allowance for doubtful accounts projections; pension expense estimates; and inventory valuation.
These discretionary practices are also causing issues within the Auditing community. Based on a recent report issued by the Public Company Accounting Oversight Board – REPORT ON 2007-2010 INSPECTIONS OF DOMESTIC FIRMS THAT AUDIT 100 OR FEWER PUBLIC COMPANIES (PCAOB Release No. 2013-001 February 25, 2013), audit deficiencies identified include – auditing revenue recognition; auditing fair value measurements; auditing accounting estimates; and, auditing procedures to respond to the risk of material misstatement due to fraud.
Issues arise when these policies allow for abuse. Private companies may wish to increase expenses and lower earnings, to minimize taxes; while public companies may wish to decrease expenses and increase earnings, to achieve a higher stock valuation. These strategies primarily move earnings from period to period. To sustain the desired approach, successive quarters will need to be manipulated. Regardless of your initial reason to manage the earnings, the end result will be a strategy where you mislead investors and lenders, i.e. commit fraud.
Additionally, there are also policies within GAAP that make targeted manipulation possible. Common manipulation techniques include – over-accruing “cookie-jar reserves”; and establishing a reserve for restructuring charges “big-bath reserves.”
To avoid this situation – institute a strong control environment; and, retain a CFO with sound ethical convictions. While it may be difficult to identify earnings management for an outsider looking in, an insider with the proper training in Accounting, Finance, that understands the business model, should easily identify the issue and implement corrective measures going forward.© Copyright 2013 Regis Quirin, All rights Reserved. Written For: CFO Tips - What you need to know, to be a CFO TODAY!