Motivations for managing earnings

Overstate net income to:

-meet earnings expectations

-remain in compliance with lending covenants

-recieve higher incetive compensation

Understate net income to:

-obtain trade relief in the form of quotas or protective tariffs

-nogotiate favorable terms from creditors

-nogiate favorable labor union contracts

Activities that will result in low-quality earnings

1. selecting GAAPs that misrepresent the economics of a transaction (EX: using DDB when straight line is more accurate)

2. structuring transactions to achieve a desired outcome (Ex: structuring terms of a lease to avoid capitalization)

3. using aggressive or unrealistic estimates and assumptions (Ex: high useful lives and salvage values)

4. exploiting the intent of an accounting principle

Fraud Triangle

Fraudulent activities most often occur when there is:

1. Incentive/pressure

2. Attitudes/rationalization

3. Opportunity

1. Threats to financial stability or performance (declinging margins)

2. excessive third-party pressures on management (debt covenants, stock listing requirements)

3. Personal net worth of management or the board of directors is threatened (financial interest in the firm, contingent compensation based on performance)

4. Excessive pressure on management or operating personnel to meet internal financial goals (sales goals)

1. nature of the firms industry or operations (EX: large volume of international business where ethical values are different)

2. Ineffective management monitoring (EX:management team is too small)

3. Complex or unstable organizational structure (EX: difficultly determining who is in control)

4. Deficient internal controls (EX: due to high employee turnover in accounting or ISYS)

1. Inappropriate ethical standards

2. Excessive participation by nonfinancial management in the selection of accounting standards

3. known history of violations of laws and regulations by management or board members

4. A management obsession with maintaining or increasing the firms' stock price or earnings trend

5. making commitments to third parties to achieve aggressive results

6. failing to correct known reportable conditions

7. inappropriately minimizing earnings for tax purposes

8. use of materiality as a basis to justify inappropriate or questionable accounting methods

9. strained relationship between management and the current or previous auditor

Accounting warning signs of low-quality earnings

-aggressive revenue recognition

-different growth rates of CFO and earnings

-abnormal sales growth compared to the economy or peers

-abnormal inventory growth compared to sales growth

-boosting revenue with non operating income "moving up"

-delaying expense recognition

-abnormal use of operating leases

-hiding expenses by classifying them as extraordinary or nonrecurring

-LIFO liquidations

-abnormal gross margin and operating margin as compared to industry peers

-extending useful life of long-term assets

-aggressive pension assumptions

-year-end surprises

-equity method investments and off-balance-sheet special purpose entities

-off-balance sheet financing

-insufficient operating cash flow

-pressure to support stock price and debt ratings

-revenues reported using mark to market accounting

-excessive revenues reported in teh last half of the year

-inflated sales to SPEs

-use of mark to market accounting for equity method investments

-use of barter transactions

-significant use of related-party transactions

-senior management compensation and turnover

-created "cookie jar" reserves

-receivables increased faster than sales

-generated negative CFO

-engaged in bill-and-hold sale arrangements

"bill-and-hold"--recognizing revenue before goods are shipped

-inappropriately reduced bad debt expense

-increaesd fourth quarter revenues

Forecasting sales: obtain estimates of GDP growth. historical relationships can be used to determine industry growth related to GDP growth. If we assume that market share will be the same, sales growth will be the same as industry growth

Forecasting earnings: use historical ratios--net margin, gross margin, or operating margin based on our sales forecast

Forecasting cash flows: consider potential increases in working capital, capital expenditures, issuance or repayments of debt, and issuance or repurchase of stock

*one typical assumption is that noncash working capital as a percentage of sales remains constant

*interest expense in each period must be adjusted for expected increases in debt

Three Cs of credit analysis

-Character

-Collateral

-Capacity (to repay)