Module 7 Flashcards
(34 cards)
Income Smoothing
- Investors willing to pay premium for stocks with steady and perceived predictable earnings.
- Such practices may lead to erosion in quality of reported earnings.
- Accelerate recognition of revenue
- Delay recognition of expenses
- “Cookie jar reserves” for use in future periods as unrecognized revenue or expense.
- Banks can do by adjusting outlook for loan-loss reserves.
- Techniques can also be used to defer tax liability to future years.
Cookie jar reserves are used to set aside reserves in good years and then seed to prop up earnings in lean years. Or in the case of Crazy Eddies to avoid taxes initially and they inflate earnings when wanting to go public.
Defining Reported Earnings Management
Inflate or deflate reported revenues, earnings or EPS by:
- Using aggressive accounting techniques such as capitalizing costs that should have been expensed.
- Establishing/altering the elements of an estimate to achieve a desired goal.
- Accelerating/delaying recording of revenue or expenses, including using “cookie jar” reserves for smoothing.
Accountants must have ethical intent to make morally-sound decisions. The techniques above generally are not ethically or morally sound as they represent “cooking the books” to alter financial statements that are used by others to make financial decisions. Underlying motivation could be to help the company survive or for individual self-interest, such as inflating a bonus.
Management Intention
In evaluating earnings management, the key attributes are what was management’s intention besides fair reporting and the method(s) used to achieve management’s intention.
Using an Ethics Framework
Virtue ethics examines reasons for the actions taken by the decision maker AND the action actually taken.
One should use an ethics framework to judge acceptability of earnings management techniques used.
McKee’s Explanation of Earnings Management
McKee believes management merely rationalizes reported earnings management if the adjustments are not outright fictitious.
However, this rationale:
- Doesn’t hold true to the virtues of honesty and dependability.
- Ignores the rights of shareholders and other stakeholders to receive fair and accurate information.
- Masks true financial performance.
Just like any type of fraud, perpetrators frequently rationalize that under the circumstances, the fraudulent actions were OK.
Utilitarian Perspective of Earnings Management
A decision made by weighing benefits of earnings management to smooth reported net income vs. costs of providing false information to shareholders is acceptable if benefits out-weigh the risks.
Financial statements should never be manipulated for personal gain/benefit of management.
From an ethical standpoint, this perspective disregards the rights of financial statement users and other stakeholders. For example, the premature recognition of revenue to increase reported net income for the current period will require even larger manipulations in the next quarter to make up the amounts moved back.
Ethical Questions
Were the rights & needs of ALL stakeholders considered?
Do the actions or methods merely alter amounts from operational decisions, such as expediting sales by offering discounts at yearend or delaying entry into a new market?
Are the methods violations of GAAP or other reporting framework (IFRS)?
The reason for the last question is that the financial statements are prepared on a certain basis that is usually identified if not in accordance with GAAP. External auditors will ask the CEO and CFO to confirm the criteria used to prepare the financial statements and the auditor states so in the audit report.
For companies who issue stocks or bonds in the U.S., the CEO and CFO must also certify that the financial statements were prepared in accordance with GAAP because of SOX.
FASB Definition
FASB defines “material” from an accounting perspective as:
“The magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement.”
Misstatements can relate to amounts or disclosures in in financial statements as either can mislead financial statement users.
Qualitative and Quantitative Factors
- Both qualitative & quantitative factors must be considered when assessing materiality.
- Judged by relativity of the amount and nature of item in the F.S.
- Qualitative factors that cause small misstatements to become material reclassifications or disclosures (e.g., loan or agreement noncompliances).
For the nature of the item that is misstated, some items in the financial statements are more important to financial statement users. Sometimes a financial statement users can view very small misstatements if the misstatement makes a difference in the perspective of how successful a company has been. A misstatement keeps a client in compliance with a loan covenant or regulatory capital requirements is usually material. Or, the difference between reporting a net profit or a net loss.
Current Auditing Standards and Presumptions
- Materiality is matter of professional judgment.
- Materiality threshold(s) are based on the auditor’s perception of needs and views of a prudent, reasonable users of financial statements as a group; not as individuals.
Auditors generally use benchmarks as guides to evaluate materiality, such as percentages of assets, net worth, total revenue or gross profit. The benchmarks may be different for different components of a financial statement.
Assumptions About F.S. Users
According to the auditing standards, auditors can assume that financial statement users:
- Have appropriate knowledge of business and economic activities .
- Understand statements are prepared and audited to levels of materiality.
- Recognize uncertainties in amounts based on estimates, judgment, and future events.
- Make appropriate economic decisions based on information in F.S.
So, the auditor does not have to evaluate materiality based on the perspective of an uninformed financial statement user.
Vorhies’ Four Considerations in Satisfying SOX Requirements:
Vorhies’ four considerations in satisfying SOX requirements:
- The actual financial statement misstatement/error.
- An internal control deficiency was caused by the failure in design or operation of an internal control.
- A large variance in an accounting estimate compared with the actual determined amount.
- Financial fraud by management or other employees to enhance in company’s reported financial position and operating results.
Under SOX internal control over financial reporting, the client and the auditor must consider size of any un-prevented or undetected misstatement and the frequencies when a deficiency might result in a misstatement.
Ineffective Internal Controls over Financial Reporting
Design failure
- Occurs when management fails to establish appropriate and sufficient internal controls to address the risks of unreliable financial reporting.
Operating failure
- Occurs when adequately designed controls are not performed or are not performed effectively.
Accounting estimates
- As long as the process is reasonable and unbiased, variance with subsequently determined actuals is irrelevant, unless historically variances have been large in only one direction.
Having uncorrected material weaknesses as of balance sheet date means an audit opinion of “ineffective internal controls over financial reporting” for the auditor and a negative report for the client and financial statement users.
Materiality & Evaluating Internal Control
Materiality of potential impact of internal control deficiencies is used to determine if such deficiencies reach the level of “significant” or “material”.
A significant deficiency is a deficiency, or a combination of deficiencies, in internal control that is less severe than a material weakness, yet important enough to merit attention by those charged with governance.
A material weakness is a deficiency, or combination of deficiencies, in internal control, such that there is a reasonable possibility that a material misstatement of the entity’s financial statements will not be prevented, or detected and corrected in a timely manner.
Per PCAOB and SOX, a single material weakness means internal controls over financial reporting are ineffective. A reasonable possibility generally means anything higher than a 20% probability of occurrence.
F.S. Restatement Trends
- Represent revising (voluntarily or advised/recommended) previously issued F.S.
- Restatements increased during 2000-2006
- Since 2006, number has gone down.
- Restatements are due to errors or fraud in previous year’s accounting or financial reporting.
Many believe that the increase during 2000-2006 was due to the financial shenanigan’s during the early part of this period and then the implementation of SOX in the middle.
Since 2006, number has gone down, possibly due to SOX and its internal control reporting and certification requirements and more scrutiny by CPA firms due to inspections of CPA firms by the PCAOB. Many of the advised or recommended restatements may have come from problems discovered in subsequent audits which showed same issues in prior years.
As indicated in the textbook, 1,295 restatements were in 2005 alone, which represents about 1 restatement for every 12 public companies. Restatements usually show lowered financial position or results of operations.
Investor Needs
Materiality judgments should shift from professional judgment and the “reasonable person” standard to emphasizing whether a restatement may be desirable to meet user (investor) needs.
So, the SEC committee apparently believes that the FASB, AICPA and PCAOB criteria for materiality may not always consider what really matches what is important to investors. However, financial statements are used by other stakeholders, like bank and supplies.
Assessing Materiality
Too many restatements did not result in much market reaction and this may indicate that materiality is being assessed too conservatively in deciding to restate F.S.
What the SEC committee may not have fully considered is that auditors and companies may believe that it is legally better to restate financial statements as they are unsure of the materiality definition that the SEC, PCABO or the Department of Justice might use if they do not restate and the misstatements are later discovered.
Qualitative Aspect
Unethical reporting should also be a factor in deciding to restate as informative to investors as to future reporting risks from management who has been dishonest or lack of integrity.
The SEC committee did acknowledge that there is a “qualitative” aspect to materiality as the reason for the original misstatement might have a bearing on how investors interpret the information for their decision making purposes.
So, past fraudulent financial reporting information has a greater impact on investor decisions than account errors or mistakes – ethics of those during the reporting does matter
What caused the need for restatement?
All companies with restatement should be required to disclose:
- How the restatement was discovered.
- Why the restatement occurred.
- Corrective actions to prevent future misstatements.
The committee recommended that the SEC require details what caused the need for a restatement and how such causes will be dealt with through corrective actions – probably internal control enhancements.
Schilit’s 7 Common F.S. Shenanigans
- Recording Revenue too soon or of questionable quality
- Recording bogus revenue
- Boosting income with one-time gains
- Shifting current expenses to a later or earlier period
- Failing to record or improperly reducing liabilities
- Shifting current revenue to a later period
- Shifting future expenses to the current period as a special charge
These are probably the most common examples of unethical earnings management techniques. Enron used at least numbers 1, 2, 3 and 5. Worldcom primarily used number 4. Some companies do number 7, when they believe the investing community expect negative results, so they increase expenses using special charges, like several banks were believed to have wrote down some mortgage-based assets more than necessary after the 2008 financial crisis. This is an example of what the textbook labeled as “cooking jar reserves”. Number 6 might be used by a privately held company to reduce their tax liability
FASB Changed the Rules Afterward
FASB Interpretation No. 45(R)
Consolidation of Variable Interest Entities:
- Requires unconsolidated variable interest entities to be consolidated if they do not effectively disperse risk among parties involved. At Enron, virtually all of the risk remained with Enron.
- The percentage of ownership test is no longer used, which Enron manipulated with the CFO and other accounting executives controlling the ownership for Enron’s SPEs.
As a result of manipulations of SPEs that Enron did, the FASB did tighten up the rules on consolidating liabilities from SPEs.
Enron’s Role in SOX
Provisions that were motivated by the Enron fraud:
- Prohibiting the providing of internal audit services external audit firm.
- Off-balance sheet financing activities must be disclosed in notes to financial statements.
- Related-party transactions involving SPEs must be fully disclosed in notes to financial statements just like other related party balances and transactions.
Enron has indirectly made financial reporting for public companies better.
Enron: Lessons Learned
- Weak internal controls can lead to possible fraud.
- An ethical tone at the top is very important.
- Be cautious of the ethical slippery slope.
- Watch out for greed as it can create that slippery slope, especially when bad ethics are not punished.
Executive bonuses were frequently based on reported revenue and earnings which the same executives has a significant role in determining what was report and when it was reported. Besides the financial reporting fraud, Enron also developed a number of unethical practices that were effectively rewarded by top management. Enron manipulated a number of utility markets to alter prices to their advantage. This type of environment can breed expanding unethical conduct.
Should we have any?
- Of Course. Why Not?
- Discovery of unknown information which was available at audit report date
- Learning of omitted but necessary audit procedures
From the AICPA Code of Professional Conduct we covered in module 4, CPAs have responsibilities to the public. When we learn that our previous audit opinion is no longer appropriate we should do something.
