Earning Management- FINANCIAL DISTRESS- FINANCIAL ACCOUNTING AND ANALYSIS

HOW TO MANAGE FINANCIAL DISTRESS

1. Earning Management Dr. Shipra Agrawal Assistant Professor Aryabhatta College

2. Meaning Earnings management (or creative accounting) is using judgment and discretion available in generally accepted accounting principles or making operating decisions in order to produce a pre-determined effect on the financial statements. Ex: deferring advertisement spending to the following quarter (not a crime), showing phony sales (a crime) etc.

3. The term ‘earnings management’ here to refer to managing items in any of the financial statements, and not only the statement of profit and loss. Earnings management is an academic euphemism for financial reporting manipulation. Three types of earnings management: (1) managing accruals; (2) managing real earnings; (3) perpetrating fraud.

4. 1. Accrual-based Earnings Management Accrual accounting requires managers to make critical financial reporting decisions, such as estimating useful lives of property, plant and equipment, determining fair value, selecting depreciation methods, testing for impairment, estimating credit losses debts, and reckoning pension liability.

5. Ideally, their judgment should be neutral and not biased in favour of a particular result. However, decisions involving managerial judgment are the product of conflicting considerations, such as the following: Investors expect companies to show superior performance in every reporting period. Analysts expect companies to meet or beat the earnings forecast or management guidance. Managers don’t want to fall short of their own published guidance or earnings forecast. Creditors may require early repayment or a higher interest rate for violation of debt covenants. The majority shareholder wants to reduce the company’s income tax expense. Managers are keen to get a larger performance-linked bonus.

6. In these circumstances, it is not easy for managers to make judgments about financial reporting in a neutral way, more so because they too are interested parties. So managers engage in accrual-based earnings management (AEM). Earnings management may either (a) increase income, increase assets, decrease liabilities; or (b) decrease income, decrease assets, increase liabilities.

7. Examples of these actions: Increase income, increase assets, decrease liabilities: Companies want to appear successful prior to a public issue of equity or debt. So they report a higher profit. They may raise the useful lives of assets, lower the allowance for credit losses, recognize revenue for goods sent to distributors but not yet sold, switch from WAC to FIFO in a time of inflation and decrease warranty liability. Similar pressures exist when they are below analyst expectations. A likely shortfall in the minimum current ratio stipulated in a loan agreement may induce managers to classify a current liability item as non-current.

8. Decrease income, decrease assets, increase liabilities: Companies want to minimize their income tax expense. So we would expect them to report a lower profit. They may reduce the useful lives of assets, increase the allowance for credit losses, delay recognizing revenue for goods already sold, switch from FIFO to WAC in a time of inflation and increase warranty liability. Similar pressures exist when they have overshot analyst expectations or are facing scrutiny for anti-competitive activities.

9. 2. Real Earnings Management In real earnings management (REM) managers manipulate earnings by modifying operating decisions. Examples of REM: Reducing discretionary expenditures: Expenditure on R & D, technology acquisition and upgrade, advertising, training, and plant maintenance are not related to production or sales. Management has considerable discretion in deciding on the amount and timing of these expenditures. For instance, a consumer goods company may defer an advertisement campaign to the next quarter in order to improve the current quarter earnings.

10. Offering price discounts to boost sales: Prices are reduced towards the end of a reporting period. While this may increase revenue in that period, the risk is that customers may expect similar discounts in future periods. Further, customers may defer purchases until the end of a period in the hope of a repeat act by the company. Selling surplus assets at a gain: Surplus land and buildings may be sold in order to realize the gains.

11. Offering generous credit terms: Customers may be induced into buying more because of easier and cheaper credit. The risk is that customers may get used to diluted standards and resist any tightening later. Also, credit losses may increase because of lax standards. Overproduction: Increasing output reduces fixed overhead per unit and lowers cost of goods sold. It may be difficult to sell the additional inventories in the next period. Also, inventory carrying costs (e.g. interest, storage, insurance) will increase.

12. Delaying plant commissioning: Delaying the commissioning of a new plant defers recognition of depreciation expense. Deferring capital expenditure: Deferring capital expenditure reduces current depreciation expense but would hurt future production capacity. Deferring planned maintenance: Deferring planned maintenance will reduce current maintenance expenditure but will damage the equipment.

13. Managing real activities is perfectly within GAAP, yet it may be harmful to firm value. For instance, reduced R & D spending could affect the introduction of new products and result in a competitive disadvantage. REM may be more difficult to detect than AEM, since management’s operating decisions are not made public.

14. 3. Fraud Fraudulent financial reporting is an extreme form of earnings management. Unlike AEM and REM, fraud involves altering the facts. Fraud is the last resort of beleaguered managers who have exhausted possibilities for AEM and REM. Since it is illegal, it must not be attempted.

15. Different types of earnings management activities