Lecture 7- Accounting manipulation Flashcards
(19 cards)
why do companies manipulate financial statements
They manipulate accounting so that performance looks better than it really is
What are the 3 main reasons for manipulation
Market related expectations
Contracting reasons
Other incentives
How do companies actually implement these strategies
They implement these strategies:
- via income smoothing - to make investors feel safer. They do this by perhaps shifting earnings between years.
- Small loss avoidance - trying to avoid the smallest lost so profits can look higher
- Via Window Dressing - before major events like an IPO, Companies make their earnings look as strong as possible. But this is often short term after the event, real performance might fall
- Via cookie Jar accounting - in good years companies overestimate expenses (like future repairs). These extra expenses are recorded like a cookie jar. In bad years they reverse these estimates to boost profits
What is discretionary accruals and how can they be used for accounting manipulation
Discretionary accruals are those subject to managerial judgment and not strictly dictated by accounting rules
Managers may intentionally adjust discretionary accruals to:
Overstate earnings (e.g. reduce expense provisions, overstate revenue).
Smooth income across periods (by shifting revenue or expenses).
Meet earnings targets, such as:
Analyst forecasts
Debt covenants
Executive bonus thresholds
SO its hidden accruals
What are current accruals
Short term accruals based on the balance sheet.
what is non discretionary current accruals
part of the current accruals arising from normal operating activities unrelated to earnings management. A regression is used to statistically estimate non discretionary current accruals from current accruals.
CAaa= Alpha + beta(change in sales) + Et
NDCA = Alpha + Beta(change in sales)
Therefore discretionary accruals = Current Accruals - Non discretionary current accruals
what are contracting reasons to maniupulate accounts
Firms may manipulate accounts so that they are able to get a favourable credit rating and try to avoid violations of debt covenants (rules lenders impose to reduce risk)
and They may manipulate to avoid low performance so that they can meet targets
What are some debt covenants example ratio
Fixed Charge coverage
debt charge coverage
interest coverage ratio
cash interest coverage ratio
debt to cash flow ratio
what is the formula for fixed charge coverage
EBITDA/ Interest charge + long term lease payments
What is the formula for debt service ratio
EBITDA/ interest expense + quantity of principle repayments
what is the formula for interest coverage
EBITDA/ interest expense
what is the formula for cash interest coverage
Operating cash flow/ Cash interest expense
What is the formula for debt to cash flow
Outstanding debt/ Net income + depreciation + non cash charges
What are some balance sheet and earnings covenants that firms may apply to reduce risk
Current ratio
debt to tangible net worth
net worth
Leverage ratio
what is the formula for net worth and Debt to tangible net worth
Net worth= total assets- total liabilities
debt to tangible net worth = Total Debt/ Total assets- tangible assets
What is the formula for leverage ratio
total assets/ total equity
What are some examples of big bath strategies implemented by firms
Asset write downs, restructuring provision
what are some other incentives to manipulate accounts
- Competitive pressures- to avoid attracting competitors
- Tax minimisation
What are some ways to manipulate
Choice of accounting method- eg depreciation (straight line or reducing balance)
- accounting estimates- over or underestimating some useful life’s of assets
- via real activities - e.g sales of assets with a gain on disposal, unusual end of year discounts
