Earnings Management Checklist
Accounts receivable
Has allowance for uncollectible accounts changed significantly?
If a decrease, current profit might be overstated since the allowance account is not sufficiently replenished
If an increase, current profit might be understated if the company is "padding" the allowance account
Inventories
FIFO earnings include both economic profit (selling price - replacement cost) plus holding gains on inventories.
This problem is greater to the extent inventory turns are slow and/or inflation rates are high in the industry
LIFO liquidations
If inventories have decreased significantly the firm's earnings might be overstated since old costs are matched against current selling prices
Increasing production levels capitalize operating costs into inventories, thereby increasing current profits
Investments
Companies can manage earnings via sale of held-to-maturity bonds, available-for-sale equities or stock investments accounted for under equity method
Equity method earnings are not cash until received as dividends
Deferred taxes
Increases in deferred tax liabilities mean that the company is reporting more profit to shareholders than it is to the IRS. Significant increases are usually due to purchases of fixed assets depreciated on an accelerated basis for tax, but may also be due to new revenues not recognized for tax purposes that inflate current earnings.
Watch for "allowances" writing down deferred tax assets. These allowances reduce current period profit and can be reversed in the future for added earnings.
Contingent liabilities
Failure to recognize contingent liabilities increases current income.
Examples include environmental liabilities, warranties, and litigation.
Pensions
Pension costs are a function of the discount rate and expected return assumptions. Interest costs and expected returns are computed based on beginning-of-year balances.
Inflated pension assets will reduce pension costs in subsequent year, regardless of investment performance in that year.
Increasing the expected return increases profit via reduction of pension expense.
Decreasing the discount rate generally reduces pension expense despite offsetting effects.
Gains (losses) on sales of assets, and bond redemptions
Since assets (other than "trading" securities) as well as long-term liabilities are carried on the books at historical cost, market prices may diverge from book values. Gains (losses) on asset sales and /or bond redemptions may be used to achieve profit targets and should be viewed skeptically and should not be included in long-range earnings estimates.
Watch for hidden gains buried in SG&A expense
Foreign exchange rate fluctuations
Under current rate method, I/S is translated at current rates revenues/expenses/profit can change with no change in unit volumes
Subsidiary weight in consolidated statement can change with relative weighting of currencies
Use of temporal method delays currency effects in I/S
Revenue recognition
Revenue should be recognized only when "earned" and realized or realizable.
Watch out for sales with buybacks, rights of returns, markdown moneys available to assure margins or, in general, any program in which the seller is helping to sell the goods for their distributors. As the number of conditions on the sale increase, the probability that revenue cannot be recognized also increases.
Watch out for trade loading (channel stuffing) that accelerates the recognition of revenues.
Recognition of deferred revenues will depress future revenues.
Expense recognition
Expenses should be recognized when incurred (regardless of when paid)
Asset writedowns shift profit into the future by removing costs from the balance sheet that are no longer available as future expenses.
Much of this activity occurs in the form of restructuring expenses.
Increasing depreciation / amortization periods spreads out costs over a longer period of time and increases current income
Capitalizing costs increases current income as costs are placed on the balance sheet rather than run through the income statement
Equity method investments can distort revenue and expense recognition as only equity in net income is reported.
Derivatives
All derivative costs end up in reported expenses (cash flow hedges are warehoused in OCI until transaction completes)
Watch out for speculative hedges
Statement of cash flows
Companies can reclassify cash flows between operating, investing and financing
Watch for techniques to improve operating cash flow
Extending payables
Reducing R&D and other necessary operating expenses
Securitizing receivables
Treating operating costs as CAPEX
Tax benefits from ESO exercise
Financing customer purchases
Related parties
Related party transactions (leases, transfer prices on intercompany sales) can shift profit from one company to another.
Related party transactions for publicly traded companies are unusual and should be critically examined
Stock options
If strike price = market price at date of grant, no compensation expense is recognized and profit is increased.
Look in the notes for disclosure of the proforma earnings that would have been reported had the company valued the options (using Black-Scholes) and recognized compensation expense ratably over the service lives of the employees covered.
Split-offs / Subsidiary IPOs / Put Options and convertibles
Split-offs result in transitory gains if stock repurchase is not prorata
Companies can account for gains on subsidiary stock sales either as income or as a credit to APIC
Sales of put options on the company’s stock are accounted for as liabilities. When exercised, the “loss” is not recognized
Convertible featured of debt and preferred stock are not valued separately. When converted, no gain (loss) is recognized.
Operating activities
Watch for reduced R&D, deferred maintenance, etc. that increases current earnings through the reduction of expenses.
Watch out for proforma statements – these are outside of GAAP … companies want to redefine the way in which they will be evaluated and will define it favorably to themselves
Consolidations
Watch for full-year revenues with pre-acquisition expense (check footnotes for computation of full year revenues)
Watch for spring-loading due to unusual expenses prior to consolidation date
Watch for asset allocations that push acquisition costs into goodwill or expense as IPRND
Misc.
Watch for qualifications in the auditor's opinion or changes in auditors
Robert F. Halsey, 2002. All rights reserved
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