The easy money days of the 2010s are over. Bonuses and threats of job loss push managers to match expectations. Earnings management techniques are not always “cooking the books” to reach short term targets. Rather, they can involve making valid operational decisions that benefit shareholders.
By Mark D. Harris
Earnings Management Techniques
Managers are under intense pressure to make quarterly and annual earnings conform to expectations of analysts in the greater market. In a given quarter, if the prevailing expectation is that Company A will have earnings of $10/share (EPS), management at Company A wants to report EPS of $10, or perhaps $10.03. They don’t want to report EPS of $11.50 because that might raise eyebrows, encourage a much higher expectation of EPS in the future, and suggest a volatile earnings pattern. Investors and lenders like smooth growth in EPS, sustainable and predictable, over the long haul.
Even worse than exceeding expectations by too much is falling short. If Company A falls short of earnings targets, reporting perhaps EPS of $9.80, Company A’s stock price is likely to drop, their cost of capital from lenders will increase, and others interested in Company A might liquidate holdings out of fear for the company’s future. Finally, managers’ bonuses, salaries, and even job security are often tied to meeting earnings targets. Woe to the manager who misses his mark.
To avoid such unpleasant circumstances, managers have an array of accounting techniques that they can use to smooth earnings, and to make them appear sustainable and predictable in the near and long term.
Improper Revenue Recognition
Accounting standards require a company to complete five steps before it can recognize revenue (Revsine et al., 2021). First, there must be a valid contract with a customer. All parties must have approved the contract, have their rights identified, and incurred the legal obligations therein (Revsine et al., 2021). The contract must have commercial substance, somehow changing the future cash flows of each participant, and collection of payment must be probable (Revsine et al., 2021).
Second, the contract must specify performance obligations. This involves determining if performance obligations are separate for each good and service or if they are bundled as related goods and services. A contract for a farmer to sell half a cow and four bushels of wheat to a restaurant has distinct, readily identifiable obligations. A contract to build and maintain a website, adding content, and troubleshooting problems, does not have such distinct components.
Third, the transaction price must have been mutually agreed upon. The price may be modified as needed if a party exceeds or fails to meet contract terms. For example, if Company Z signs a contract with the city of Venice to build a bridge by January 1 for one million dollars, Z will exceed the contract if the bridge is built for $790,000 by December 1, and may be entitled to additional financial consideration. If Company Z builds the bridge for $1,200,000 and is not finished until March 1, it may suffer penalties.
The fourth step in revenue recognition is to allocate the transaction price to the performance obligations in the contract (Revsine et al., 2021). Under the adjusted market approach, if a contract stipulates that Company M will sell a cement mixer and a backhoe to Company N, since both items can be sold as stand-alone items, the contract should include the stand-alone prices for each item, minus any previously agreed upon discounts. If the contract also includes the cost of warranties and service provided, if these are not stand-alone items, their cost might be determined by the cost plus or residual approaches.
The fifth step to accomplish before recognizing revenue on financial reports is to ensure that the performance obligation has been met (Revsine et al., 2021). Has the customer taken physical possession of the goods? Has the customer indicated acceptance? Has the customer legal title? Has the customer incurred a legal obligation to pay? Has the customer acquired the risks and rewards of ownership?
Channel stuffing, an example of improper revenue recognition, involves a company inflating its sales figures by forcing more product through its distribution channel than that channel thinks it can sell (Edspira, 2021). For example, if Company A is having a bad Quarter 2, it might pressure retailers (Companies B and C) to buy larger than usual shipments of product in Quarter 2 and agree to buy unsold units back in Quarter 3. This inflates reportable sales for Company A in Quarter 2. In Quarter 3, Company A hopes that business will improve, and they will be able to report good earnings, as well as buy back the unsold products from Companies B and C. In some cases, Companies B and C wouldn’t even be asked to buy the merchandise but just hold it and ship unsold units back in Quarter 3.
Changing the Timing of Events
Firms may have assets, such as land, machinery, buildings, debt, or other property, plant, and equipment (PPE) that they wish to sell at an undecided time in the future. If a quarter is looking rough and the managers are fearful of missing their earnings targets, they could sell the asset to raise their revenue (Edspira, 2021). For example, suppose that Company A bought a plot of land in year 1 for $10,000, and the land was worth $16,000 in year 10. Company A has a $6,000 unrealized gain on the land, but since balance sheets often use cost (book value), not current (market) value, the gain has not been reported. In a bad quarter (or year), Company A could decide to sell the land, realizing the $6,000 gain and improving its cash flow at the needed time.
Decisions like this are gray areas. Selling the land is an operational, not an accounting decision, and therefore doesn’t strictly fall under the category of “cooking the books.” If Company A was going to sell the land this year anyway, or if the whole purpose of buying the land was to park excess cash until it was needed, the firm did not commit wrongdoing. Still, it looks bad, and while perception is not reality, it is important.
Items that will be used within a year should be reported as expenses on income statements, while those that will remain in use for more than a year should be reported as an asset on balance sheets (Edspira, 2021). Expenses count against the company immediately, but assets are depreciated and so only affect income over time. For example, office supplies count as expenses while office computers and printers count as assets.
Imagine that a manager wishes to decrease expenses in a quarter. Ten company cars need new tires, and given the average mileage driven, each tire has a useful life of less than one year. The manager should classify the purchase of the forty tires for $10,000 as an expense. However, she could place these tires under the classification of capital assets, depreciating them over two years, and only counting $5,000 as a current expense. This would improve her quarterly earnings, but would misrepresent the actual costs.
WorldCom was notorious for such legerdemain. They categorized rental payments for the use of major fiber optic channels (“line costs”), as capital assets, which could then be depreciated, instead of reporting them as expenses. Thus, WorldCom underestimated its expenses and overestimated its revenue on public financial reports for several years. When WorldCom could not keep up with its payments and the subterfuge was discovered, it collapsed.
Managers estimate many things in the life of a business, such as future earnings, sales, and costs. Another is the useful life of an asset. Managers can impact their company’s cash flow by depreciating a capital item too slowly (Edspira, 2021). A machine costing $100,000 with a useful life of five years should be depreciated over five years, thereby counting against expenses at $20,000 per year (for straight line depreciation). If management claims its useful life is ten years, it can depreciate it at $10,000 per year, improving income reports. Extending estimates of useful life can also improve residual value of assets. The slower depreciation takes less money out of current earnings, thereby improving reporting.
Altering Business Decisions
Managers may delay expenses during a bad quarter or incur them early during a good quarter to smooth earnings. Deferring research and development, staff training, or equipment maintenance or purchase will save money now but may cause trouble in the long run (Edspira, 2021). Delaying expenses is not necessarily a bad thing if doing so is in the best interest of the company and its shareholders. Companies that do so should report it in the notes section of their financial statements.
Inventory can be accounted for on a first-in-first-out (FIFO) basis or a last-in-first-out (LIFO) basis (Edspira, 2021). Suppose that a bicycle shop had eleven of a certain type of bicycle in inventory, four of which arrived in January for $100 each, three in February for $105 each, and four in March for $110 each. If the shop sold four of those bicycles in April for a price of $130 each and received cash, the total revenue would be $520, regardless of the accounting system. The cost of goods sold (COGS) would be $400 under the FIFO method but $440 under LIFO. Profit would be $120 under FIFO and $80 under LIFO. If the company was having a good year, they may wish to use LIFO to reduce their earnings, avoid unsettling peaks and valleys, and reduce taxable income. If it was struggling, it may wish to use FIFO to help meet earnings targets.
In normal operations, companies would almost always use the earliest arriving inventory first. Older inventory is usually less valuable than newer inventory, may degrade during storage, and can even become obsolete. LIFO and FIFO are purely accounting techniques. Revealingly, LIFO accounting is illegal under International Financial Reporting Standards (IFRS). Under LIFO and FIFO, as well as in many other ways, firms can modify their financial statements with accounting choices that they make.
Related Parties, Mergers, and Acquisitions
When one person or group (such as a family) owns multiple businesses, transactions between those businesses can be fraught. Family-owned cable provider Adelphia was found to have defrauded investors by improper cash flows between companies that they owned, fraudulently hiding expenses in related accounts, in the early 2000s (US SEC, 2019). Accounting during mergers and acquisitions is phenomenally complex, especially with large and complicated companies.
A “cookie jar” is a reserve of cash not disclosed on financial statements. It is a place where businesses stash assets such as cash, or funds to cover a liability that does not actually exist. In a famous example, Dell Computers had a secret agreement with Intel to only use Intel central processing units (CPUs) in its computers. Intel paid Dell for this consideration, but Dell did not report any of the revenue on its financial statements. Instead, Dell put Intel’s payments into a secret account and used the money to compensate for poor earnings for several years (US SEC, 2010). Microsoft, Fannie Mae, and Bristol Myers Squibb have also been investigated for cookie jar practices.
Executives can make “cookie jars” based wholly on expectations. If the leaders of a company tell investors that they plan to restructure the company at a cost of $1,000,000, and the company fails to meet financial goals, the managers can “cancel” the restructuring and cancel the liability of $1,000,000. Even if the money does not exist, investors may see it as a canceled liability, costs not incurred, and therefore as unused cash. Management use that “money” to report a higher EPS for investors.
Corporate America, and the world, is more complicated than ever before. Such complication invites obscurity and ill-doing. But it also invites honest confusion and hard decisions. Some managers deliberately mislead others and should be punished. Others make mistakes and should be educated. Still others make decisions that look bad but do so for sound operational reasons. Christians must be wise as serpents and innocent as doves in every area, including this one.
Mankind is always ready to condemn, at least everyone except ourselves. But remember, he who does not forgive will not be forgiven (Matthew 6:15). Thankfully, God takes our sin upon Himself. The Lord will punish the wrongdoer in perfect proportion to his or her wrong. Simultaneously, He always invites others to find themselves in Him.
AICPA. (2014, December 15). AICPA Code of Professional Conduct. AICPA. https://us.aicpa.org/research/standards/codeofconduct
Brealey, R. A., Myers, S. C., & Marcus, A. J. (2020). Fundamentals of Corporate Finance (10th ed.). McGraw-Hill.
Edspira. (2021). Earnings Management Techniques. In YouTube. https://www.youtube.com/watch?v=327iV7LL3Wk
Revsine, L., H Fred Mittelstaedt, & Soffer, L. C. (2021). Financial Reporting & Analysis. Mcgraw-Hill Education.
US SEC. (2002, November 5). Complaint: SEC v. WorldCom, Inc. http://Www.sec.gov. https://www.sec.gov/litigation/complaints/comp17829.htm
US SEC. (2010). SEC Charges Dell and Senior Executives with Disclosure and Accounting Fraud (Press Release No. 2010-131; July 22, 2010. http://Www.sec.gov. https://www.sec.gov/news/press/2010/2010-131.htm
US SEC. (2019). SEC Charges Adelphia and Rigas Family With Massive Financial Fraud. Sec.gov. https://www.sec.gov/news/press/2002-110.htm