Management of Earnings
Management of Earnings
- Who is Arthur Levitt Jr.? What was his role in government when this article was written?
Arthur Levitt was the chair of the Securities Exchange Commission (SEC) in 1998. His primary role was to ensure the institution enforced federal laws on financial integrity, issues new rules and amends the existing ones, and it coordinates the United States securities regulation with foreign authorities, federal, and states governments. Additionally, he had a mandate to oversee that SEC inspects security firms, investment advisers, brokers, and rating agencies. Finally, he had a duty of supervising private regulatory organization in the securities, accounting, and auditing fields (United States Securities and Exchange Commission [SEC], 2017).
- According to Mr. Levitt, what “pliancy” in the accounting profession do companies “exploit” to engage in earnings management?
Mr. Levitt asserts that companies use the flexible accounting regulations to manipulate their books of accounts. Most rules in accounting and audit are adjustable to allow them to keep pace with business innovations. Unfortunately, this relaxed guidelines creates a window that is used by organizations to exaggerate their incomes, revenues, total assets, and hide some expenses.
- What were the five more common earnings management techniques that Mr. Levitt identified in the article?
The common earning management techniques identified by Mr. Levitt were as follows:
- “Big bath” restructuring charges.
- Creative acquisition accounting.
- “Cookie jar reserves.”
- “Immaterial” misapplication principles.
- Premature recognition of revenue.
- What three main actions did Levitt call for to solve this earnings management problem?
Mr. Levitt advocated for the following actions to solve earning management problem:
- Making changes to the technical rules set by regulators.
- Increasing oversight of the financial reporting process.
- Changing the culture of the financial community and corporate management.
Earning management occurs when an organizations use accounting techniques to develop financial reports that show a misleading and overly favorable view of the company. Mostly, the falsification of these documents aim at misleading various stakeholders on the underlying performance of the firm. They are also used to influence contracts that depend on these reports. Typically, the regulators of accountants and auditors allow for adjustments in financial statements to enable proper valuation of a firms’ assets, liabilities, and capital (Nelson, Elliot, & Tarpley, 2003). Unfortunately, these guidelines also lead to the formation of gray areas that are used to falsify financial papers.
One way of managing earnings is through manipulation of the expenses account. In this case, accountants and auditors reconstruct reserves by recognizing too much or too little inventory, loan loss, bad debts, valuation allowance, insurance claim-loss, deferred tax, and accrued compensation in the current year. Accountants also capitalize and defer too much or too little expenses. They at times create fixed assets, recognize too much or too little asset impairment, or modify depreciation and amortization life of items (Nelson, Elliot, & Tarpley, 2003). These methods allow them to decrease current income to make the business appear to be earning huge profits in the future.
Besides the falsification of expenses, accounts also exaggerate or decrease revenues and other gains. Typically, accountants use “cut off” manipulation or defer too much or too little revenue over the life of a contract. Additionally, they recognize revenue before sale using strategies such as the bill and hold technique. Finally, they also use sale-leaseback transactions, related-party transactions, confusing revenue and non-revenue accounts, and misstating the value of received consideration (Nelson, Elliot, & Tarpley, 2003). In rare occasions, they change the revenue recognition method, which allows them to “smoothen” their accounts and avoid sharp increases or decreases in profits or the value of the business.
The use of business combination is often used because it is difficult to identify the manipulated accounts. Usually, accountants over or understate assets and liabilities, which they later offset with goodwill. They use the in purchase-method business combinations because it creates a chance for them to have a “cookie jar” liability reserve, which can be used in future periods to increase income. Moreover, they over or understate expense incurred during acquisition. Finally, they involve inappropriate changes to goodwill and reserve in the year after purchase to affect income in post-acquisition year (Nelson, Elliot, & Tarpley, 2003). Other innovative tactics used to manage earnings include the wrong classification of revenues and expenses income statements, labeling some amounts as non-recurring, inappropriate disclosures, and avoiding consolidations (Nelson, Elliot, & Tarpley, 2003). Consequently, these techniques allow businesses to falsify their financial reports and prevent sharp increases in declines in profits or assets.
Nelson, M., Elliot, J., & Tarpley, R. (2003). How are earnings managed? Examples from auditors. Accounting Horizon, 17(suppl), 17-35.
U.S. Securities and Exchange Commission [SEC]. (2017). About the SEC. What we Do. Retrieved from https://www.sec.gov/Article/whatwedo.html.