Where auditors fear to tread: internal auditors should be proactive in educating companies on the perils of earnings management and in searching for signs of its use

Internal Auditor, August, 2003 by Paul M. Clikeman

WITH ALL OF THE CONCERN SURROUNDING fraudulent financial reporting, fraud's "innocent" little brother--earnings management--is often overlooked. Earnings management is the practice of choosing accrual estimates or timing operating decisions to move short-term earnings in a desired direction. Examples of earnings management include offering customers extended payment terms at the end of a period to accelerate sales or recording generous reserves in a particularly good quarter to make it easier to meet earnings goals in a subsequent quarter.

Earnings management is more subtle than fraud; it is usually accomplished within the flexibility allowed by U.S. Generally Accepted Accounting Principles (GAAP) rather than through blatant violation of accounting principles. Earnings management is also more accepted than fraud; it is often ignored or even encouraged. What fraud and earnings management have in common is the goal of misrepresenting the organization's financial performance. Fraud is an outright lie while earnings management is a mere shading of the truth, but both are used to obtain some advantage by influencing the judgments of financial statement readers.

By understanding the motives behind earnings management and recognizing the signs of its use, internal auditors can take a leading role in keeping this deceptive process in check.

MOTIVES FOR MANAGING EARNINGS

A wide variety of situations and pressures motivate managers to manipulate their companies' reported earnings, including:

* MARKET EXPECTATIONS. Corporate managers whose companies' earnings are in danger of falling below analysts' forecasts often feel tremendous pressure to inflate short-term earnings. During the 1990s, many organizations suffered large stock-price declines following earnings announcements that narrowly missed forecasted amounts.

* INCOME SMOOTHING. Organizations facing small losses or earnings declines are occasionally tempted to inflate current period earnings. Companies experiencing unusually strong earnings sometimes hide a portion of the earnings in "cookie jar" reserves, meaning they record overly conservative accruals for future costs such as warranties or corporate restructuring so subsequent earnings will not look poor in comparison. By reporting steadily increasing quarterly and annual earnings, managers can maximized their companies' stock prices.

* CONTRACTUAL MOTIVES. Many contracts, such as bonus plans and debt agreements, are based on accounting information. Managers sometimes are motivated to manipulate reported earnings to maximize their compensation or avoid violating debt covenants.

* REGULATORY MOTIVES. Managers sometimes manage reported earnings in an effort to influence the actions of government regulators. Companies under investigation for potential antitrust violations occasionally deflate current earnings to avoid sanctions. Similarly, in some instances, companies seeking tariff increases or quota restrictions against foreign competitors deflate current earnings to win support for import relief.

Executive stock options have been blamed for amplifying top managers' incentives to manipulate their companies' reported earnings. Lower-level employees may feel pressure from their superiors to help the organization meet its earnings targets.

PRACTICING CREATIVE ACCOUNTING

One way an organization can manage earnings is through its accounting decisions. Managers can accelerate or delay reported earnings through their accrual estimates and choices of accounting methods. For example:

* Managers can influence reported earnings through their estimates of asset valuation accounts such as the allowance for uncollectible accounts and the inventory obsolescence reserve.

* Organizations can influence reported expenses by accruing larger or smaller liabilities for items such as warranties, environmental cleanup costs, and corporate restructuring costs.

* Managers can influence reported expenses through assumptions and estimates such as the assumed rate of return on pension plan assets and the estimated useful lives of fixed assets.

* Reported income can be affected dramatically by the company's choice of depreciation method, inventory cost flow assumption, and method of accounting for employee stock options.

Organizations also can practice earnings management in their operating decisions. Management can influence reported earnings by controlling the timing of purchases, deliveries, discretionary expenditures, and sales of assets. For example:

* Sales can be "pulled" from a future period into the current period by offering price concessions or more favorable credit terms on deliveries accepted before period end. Conversely, revenue may be deferred by delaying delivery of goods from the last few days of one accounting period until the first few days of the next period.

* Managers can influence reported earnings by accelerating or postponing discretionary expenses such as maintenance, advertising, research and development, and employee training.

* Companies that value their inventory on a last-in, first-out basis can influence reported earnings by building up or drawing down their inventory balances. Organizations can also influence their reported earnings by strategically timing the sale of assets such as securities, unused equipment, and even subsidiaries.