Motivations for managing earnings - overstating
- Meet expectations
- Compliance with lending
- Compensation
Understating
- Obtain trade relief in form of quotas/tariffs
- Negotiate favorable terms from creditors/union contractors
Balance sheet - appear more solvent or less solvent to negotiate concessions with creditors or juice performance ratios
Low quality of earnings
- Can select 'acceptable' accounting methods that misrepresent true economics of a transaction. Ex, selecting units of production method when straightline is more representative
- Structuring terms of a lease to keep it operating and not finance
- Lengthening lives or increasing salvage values of depreciable assets (lower depr exp, higher earnings)
- Exploiting the intent of an accounting principle = applying a narrow rule to a broad range of transactions
Fraud triangle
- Incentive/Pressure <> Opportunity <> Attitudes/rationalization
- Note that not all have to be present for fraud to occur
- Incentives/pressure
- Threats to financial stability - competition, declining demand, etc
- Third party pressures - listing requirements, covenants, expectations
- Personal net worth of management/board in danger
- Internal financial goals - sales/profit targets
- Opportunities
- Nature of firm's operations - complex transactions, tax havens, ability to dictate terms/conditions, significant related party transactions (nonaudited e.g.)
- Ineffective management monitoring - mgmt is dominated by a small group, or there is ineffective oversight
- Complex org structure - high turnover, difficulty determining who has control, unusual lines of authority
- Deficient internal controls - acct systems and staff etc.
- Additudes/rationalizations
- Insufficient ethical standards
- Participation by nonfinancial mgmt in selection of accounting standards
- Known history of violations
- Obsession with maintaining/increasing earnings/stock price trend
- Making commitments to third parties to achieve aggressive results
- Failing to correct known reportable conditions in a timely manner
- Inappropriately minimizing taxable income for tax purposes
- Management continually citing materiality to justify inappropriate accounting methods
- Strained relation b/w mgmt and auditors
Common warning signs
- Aggressive revenue recognition
- Bill and hold - recognizing before shipped
- Holding accounting period open past yr end
- Sales type leases
- Recognizing before fulfilling all terms and conditions of sale
- Recognizing revenue from swaps/barters with other third parties
- Different growth rates b/w operating cash flow and earnings
- This should over time be pretty stable - if not, earnings manipulation may be occurring
- Growing earnings without growing cash flow may indicate they are recognizing revenue too soon and/or delaying recognition of expense
- Cash Flow Earnings Index
- CFO / net income
- If consistently less than 1, it is suspect
- Abnormal growth vis a vis industry/peers - increasing AR collection period is a sign of fraud danger
- Abnormal inventory growth vis a vis sales growth
- Could be overstating inventory, decreasing COGS and inflating earnings
- Signalled by a declining inventory turnover ratio
- Boosting revenue with nonoperating income/nonrecurring gains
End
4:00 pm
0.5 hrs
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