Earnings Management and Earnings Quality

1. Earnings Management and Earnings Quality

2. Prospect Theory Test 1: • An 80% chance to win $4,000, 20% win nothing • A certain gain of $3,000 Test 2: • An 80% chance to lose $4,000, 20% to lose nothing • A certain loss of $3,000 Experimental economists found most of people choose B over A; and C over D. Therefore the value function can be demonstrated as follows.

3. Value Loss Gain

4. Implications for the Prospect Theory: • People seem to respond to perceived gains or losses rather than to their hypothetical final wealth positions, the latter of which is assumed by expected utility theory. • There is a diminishing marginal sensitivity to changes, regardless of the sign of the changes; and • Loss looms larger than gains.

5. What is Earnings Management? • Arthur Levitt: “practices by which earnings reports reflect the desires of management rather than the underlying financial performance of the company.”  • Earnings management (or income smoothing) is often defined as the planned timing of revenues, expenses, gains and losses to smooth out bumps in earnings. In most cases, earnings management is used to increase income in the current year at the expense of income in future years. Earnings management can also be used to decrease current earnings in order to increase income in the future.

6. The Public Perception of Earnings Management • Earnings management has a negative effect on the quality of earnings if it distorts the information in a way that it less useful for predicting future cash flows. The term quality of earnings refers to the credibility of the earnings number reported. Earnings management reduces the reliability of income. • The investing public does not necessarily view minor earnings management as unethical, but in fact as a common and necessary practice in the everyday business world.  It is only when the impact of earnings management is great enough to affect the investors’ portfolio that they feel fraud has been committed.

7. How company smoothes earnings Check list • Does level discretionary cost conform to past • Is there a drop in trend of discretionary costs as percentage of sales • Does cost cutting program involve significant cut in discretionary costs • Does cost cutting program eliminate fat? • Do discretionary costs show fluctuations relative to sales • Is there a sizable jump in discretionary costs?

8. The Impact of Earnings Management • The practice of earnings management damages the perceived quality of reported earnings over the entire market, resulting in the belief that reported earnings do not reflect economic reality. This will eventually lead to unnecessary stock price fluctuation.  This uncertainty ultimately has the potential to undermine the efficient flow of capital thereby damaging the markets as a whole.

9. Incentives to Manage Earning A. EXTERNAL FORCES • Analyst Forecasts – • Debt markets and contractual obligations – • Competition - B. INTERNAL FACTORS • Potential mergers - • Management Compensation - • Planning and budgets - • Unlawful transactions - C. PERSONAL FACTORS • Personal bonuses - • Promotions and job retention –

10. SEC Response to Earnings Management • SAB 99 regarding Materiality in August of 1999:  A favorite practice of corrupt management is to justify earnings management by claiming it is immaterial. • SAB 100 was released in November of 1999 in an attempt to eradicate the common earnings management practice of taking a “big bath” through the use of restructuring and impairment charges.  • SAB 101A concerning Revenue Recognition was released at March of 2000, and later SAB 101B.  • The issuance of SAB 102 concerning Loan Loss Allowances, which is another preferred tool of earnings management, July of 2001.

11. Types of Earnings Management and Manipulation (by Scott McGregor) a. "Cookie-jar" Reserves b. Capitalization practices-Intangible assets, software capitalization, research and development. c. "Big bath" one-time charges d. Operating activities e. Merger and acquisition activities 1. Pooling on interests 2. Purchase accounting and goodwill f. Revenue Recognition g. Immaterial misapplication h. Reserve one-time charges

12. Examples of Fraudulent Earnings Management (I) • Aug.22, 2005: The SEC filed civil fraud charges against former officers of BMS • “Fraudulent Earnings Management Scheme” • Deceiving investors about the true performance, profitability and growth trends of the company • Sold excessive amounts of its products to wholesalers ahead of demand and improperly recognized revenue of $1.5 billion • Used “cookie jar” reserves to further inflate its earnings

13. Examples of Fraudulent Earnings Management (II) • Nov.30, 2004: The SEC announced filing and settling charges against AIG • “Offer and sale of an Earnings Management product” • Special Purpose Entities to enable the buyer to remove troubled or other potentially volatile assets from its balance sheet • Enabling the buyer to avoid charges to its reported earnings from declines in the value of theses assets

14. Examples of cases of earnings manipulation a. Cendant b. Manhattan Bagel c. Sunbeam d. Tyco e. Sensormatic f. 3Com g. W.R. Grace h. MicroStrategy i. Lucent

15. Cendant • Cendant was created in 1997 by merge of equals between CUC and HFS. • HFS later found CUC recorded 500M phony profit before merger. • This is driven by management’s determination to meet Wall Street analysts’ expectations. • CUC management maintained an annual schedule setting forth opportunities that were available to inflate operating income. • Top down approach. Top management allocate the amount that each subsidiary needs to come up with the earnings. Then the management make additional adjustment to ensure the earnings and expenses ratios are similar to that of previous year.

16. Cendant • 1996 CUC established merger reserve that is double its cost, simply view as opportunity the viability of future earnings at CUC. • 1997 CUC used merger with HFS as another chance to cover up its shortfall of earnings. • In April 1998, Cendant suited 7 former CUC executives for accounting fraud. SEC brought similar charges in June 1998. • The day after fraudulent financial reporting was announced in April 1998, Cendant’s stock price drop 46.5%, eliminating $14 billion in market capitalization. • 1998 December, Ernst and Young, CUC’s auditors agreed to pay $335M to Cendant stockholders.

17. MicroStrategy • MicroStrategy's reporting failures were primarily the result of premature recognition of revenue. • Management did not sign contracts received near the end of quarters until after it determined how much revenue was required to achieve desired quarterly results. • MicroStrategy engage in complex transactions involving the sale of software as well as extensive software application development and consulting services. The nature of the multiple element deals at MicroStrategy gave rise to accounting practices that were not in accordance with GAAP.

18. MicroStrategy • SEC documents detail a transaction in which MicroStrategy negotiated a $4.5 million transaction to provide software licenses and extensive consulting and development services. The majority of the software licenses were to be used in conjunction with to-be developed applications, indicating that the product and service elements were interdependent. • However, MicroStrategy recognized the entire $4.5 million received in the transaction as software product license revenue, allocating no revenue to the extensive service obligations.

19. MicroStrategy • MicroStrategy also entered into an agreement in which it agreed to provide software licenses, maintenance and services to a large retailer. In a side letter to the agreement, MicroStrategy's sales staff promised the retailer future product at no cost, although the product had not yet been developed. • Under GAAP, the revenue should have been deferred because the value of the future product could not be determined.

20. MicroStrategy • MicroStrategy announced that it would restate earnings for three years to comply with GAAP. After the announcement, MicroStrategy stock fell 62 percent in one day. Its stock price dropped from a high of $333 per share to $33 per share. • In April 2001, the company settled a class action suit alleging fraud arising from its accounting practices. Three of its executive officers at the time of the restatement agreed to fraud injunctions and paid penalties of $350,000 each. • The company agreed to undertake corporate governance changes and implement a system of internal controls.

21. Lucent • Lucent Technologies, an AT&T spin-off, started trading publicly in 1996 with an initial public offering that was, at the time, the largest in domestic history. • In December 1999, Lucent's stock was selling at $77.78 and was the nation's fourth most widely held stock. However, by July 2001, Lucent's stock was trading at $6.43, the SEC was investigating its accounting practices and several former, high-level managers. • The decline in Lucent's stock value has been attributed to a Nov. 21, 2000 announcement in which Lucent said it had voluntarily reported accounting irregularities to the SEC. As a result of its own internal investigation, Lucent restated its Sept. 30, 2000 financial statements, reducing revenue by $679 million.

22. Lucent • According to a January 2000 Wall Street Journal article, Lucent had used "a whole myriad of aggressive accounting moves to boost its growth." One analyst estimated that Lucent added about 27 cents a share to its earnings through "deft accounting moves," including creative acquisition accounting. • In October 1998, Business Week reported that Lucent avoided some goodwill amortization by writing off $2.3 billion of in-process research and development as companies were acquired. Lucent's earnings also benefited from a $2.8 billion reserve for "big bath" restructuring charges that were recorded as part of Lucent's spin-off from AT&T. Some analysts believe Lucent put aside far more than was needed to cover restructuring expenses and used the excess reserves to smooth earnings .

23. Lucent • Although revenue and accounts receivable increased in fiscal 1999, Lucent lowered its bad-debt reserves. In addition, some observers believe that Lucent improperly lowered its reserves for obsolete inventory in 1999. • Lucent's December 2000 restatement in which revenues were reduced by $679 million, created doubt. Two-thirds of the $679 million reduction in revenue, or $452 million, was attributed to "channel stuffing" sales, in which transfers of products to distributors are recorded as sales although the products are not yet sold to end-users. • The restatement also reduced revenues by $199 million because customers were promised discounts, credits and rights of return. • Lucent also nullified $28 million in revenue recognized on a partial shipment of equipment.

24. The Cendant, MicroStrategy and Lucent cases share several common characteristics 1. The earnings management activities took place over extended periods of time, escalating from questionable and improper revenue recognition practices to other forms of earnings management; 2. The earnings management practices were initiated "at the top," but eventually involved high-level managers and their subordinates; and 3. The earnings management practices were not uncovered by external auditors or audit committees. These characteristics and the SEC's announced policy of enforcing action against companies engaging in abusive earnings management suggest that accountants and auditors should be vigilant in their attempts to identify earnings management activity in its early stages.

25. A survey of fraudulent accounting management --When earnings management becomes fraud? Done by Internal Auditing, Sept./Oct. 2002 • In most cases, top management is involved with perpetrating the fraud. • Those industries in Computer Software, Medical Service, and Telecommunications are most likely to conduct fraudulent accounting management. • Improper revenue recognition is the most often seen violation of GAAP.

26. Corporate Mechanisms to avoid fraudulent Earnings Management (by Raymund Breu) • Board oversight • External Audit • Internal Audit reporting to Audit Committee of Board • Accounting manuals • Training • Whistleblower procedures • Code of Conduct • Code of Ethics of Financial Officer

27. Special Purpose Entity (SPE) • SPEs typically are defined as entities created for a limited purpose, with a limited life and limited activities, and designed to benefit a single company.  They may take form of a partnership, corporation, trust, or joint venture.  • The financial risk of the sponsor is limited to its investment or explicit recourse obligation in the SPE or SPV.  In many instances, creditors of a bankrupt SPE or SPV cannot seek additional assets from the sponsor beyond what was invested or contracted for by that sponsor.  • The net assets of the SPE or SPV may be protected from creditors of its sponsors such that the SPE or SPV is not the deep pockets in the event that any sponsor goes bankrupt. 

28. Cash Flow Structure  (Sponsors Receive Cash for Asset Sales to the SPE) • Each sponsor factors (sells) ownership of actual assets (e.g., receivables "factoring") to the structure.  Assets are deleted from the sponsor's balance sheet.  • The sponsors record the transfer of the assets as a sales under FAS 140 or other GAAP rules.  Gains and losses are based upon estimated fair value at the time of the transfer.  • The transferred assets are protected from lawsuits against the sponsor, although the sponsors may have to add more "assets" based upon contractual trigger events. • Enron corporation estimate fair values well above realistic fair values and, thereby, beef up their own earnings per share with questionable levels of recorded sales to SPEs. 

29. Cash Flow Structure  • The transferred assets may serve as security (securitization) for borrowing by the SPE, and the cash flows from the assets and borrowings may be used to purchase additional assets from the sponsors. • Some SPEs may purchase equity shares of the sponsor for cash, or equity shares may be directly transferred to cover trigger event declines in an SPE's net asset value. • It is alleged that the collapse of Enron would not have arisen in late 2001 had Enron share prices not fallen below $80.  Plunging share prices hit SPE trigger points that allowed the SPEs' creditors to demand early collections on an SPEs' debt. 

30. Derivatives Financial Instrument Structure in Lieu of an Asset Transfer • Enron enters forward energy contracts with a new power plant built by Enron.   Suppose the plant is originally financed with floating rate, short-term debt until the plant begins to generate electricity. • Once the plant is operational, the sponsor's forward contracts can be transferred to an SPE that in turn uses these forward contracts as collateral to borrow on fixed rate notes at lower rates than the sponsor could otherwise obtain on its own. • After using the sale proceeds to pay off construction loan, the sponsor (e.g., Enron) no longer has floating rate interest risk and retains title to the plant, although the plant itself may have to serve as additional collateral to obtain the fixed rate debt. • When the forward sales contracts mature over time, those energy sales at forward prices are used to service the SPE fixed rate debt.  

31. Diamond Structure • A diamond structure arises when three or more sponsors form an SPE where no one sponsor has control over the SPE.  Diamond structures may be separate corporations that not even meet the definition of a SPE and yet function exactly like an SPE. • Suppose three major oil companies (sponsors) want to build a pipeline.  A pipeline corporation is formed with each sponsor owning  a third of the voting shares.  The sponsors invest little if any cash in the pipeline company.  • The pipeline company can borrow millions or even billions based upon long-term throughput contracts signed by the partners to purchase millions of gallons of fuel carried each year in the completed pipeline. • The throughput contracts are essentially forward contracts to purchase throughput, revenues from which go to service the pipeline's debt and to operate the pipeline. 

32. Defeasance (In Substance Defeasance) • Defeasance OBSF was invented over 20 years ago by Exxon in order to report a $132 million gain on removing $515 million in bond debt from its balance sheet.   • An SPE was formed in a bank's trust department.  The bond debt was transferred to the SPE and the trustee purchased risk-free government bonds that, at the future maturity date of the bonds, would exactly pay off the balance due on the bonds as well as the periodic interest. • At the time of the bond transfer, Exxon captured the $132 million gain that arose because the bond interest rate on the debt was lower than the current market interest rates. • FASB Statement No. 125 requires de-recognition of a liability if and only if either (a) the debtor pays the creditor and is relieved of its obligation for the liability or (b) the debtor is legally released from being the primary obligor under the liability. 

33. Synthetic Lease Structure (sales and lease back) • The sponsor sell the asset to the SPE and then lease it back from the SPE.  • A synthetic lease is structured under FAS 140 rules such that a sale/leaseback transaction takes place where the fair value of the assets "sold" can be reported by the sponsor as "revenue" for financial reporting.  • In a synthetic lease, this "revenue" does not have to be reported up-front for tax purposes even though it is reported up-front for financial reporting purposes.  • Proceeds from the sale to an SPE in this instance are generally long-term receivables rather than cash. • The synthetic leaseback terms are generally such that the sponsor does not have to book the leased asset or the lease liability under FAS 13 as a capital lease.

34. Enron’s History • In 1985 after federal deregulation of natural gas pipelines, Enron was born from the merger of Houston Natural Gas and InterNorth, a Nebraska pipeline company. • Needed new and innovative business strategy Kenneth Lay, CEO, hired McKinsey & Company to assist in developing business strategy. They assigned a young consultant named Jeffrey Skilling. His background was in banking and asset and liability management. • His recommendation that Enron create a “Gas Bank” to buy and sell gas. Lay created a new division in 1990 called Enron Finance Corp. and hired Skilling to run it. • Enron soon had more contracts than any of its competitors and, with market dominance, could predict future prices with great accuracy, thereby guaranteeing superior profits.

35. Enron’s Strategy • Skilling began hiring the “best and brightest” traders and rewarded them handsomely—they were allowed to “eat what they killed”. • Started Enron Online Trading in late 90s • Created Performance Review Committee (PRC) that became known as the harshest employee ranking system in the country—based on earnings generated, creating fierce internal competition. • Enron’s core business (transportation) was losing money—shifted its focus from bricks-and-mortar energy business to trading of derivatives.

36. Enron’s Strategy • Most derivatives profits were more imagined than real with many employees lying and misstating systematically their profits and losses in order to make their trading businesses appear less volatile than they were. • Enron’s top management gave its managers a blank order to “just do it” • Deals in unrelated areas such as weather derivatives, water services, metals trading, broadband supply and power plant were all justified.

37. Enron’s Strategy • Enron delivered smoothly growing earnings (but not cash flows). In its last 5 years, Enron reported 20 straight quarters of increasing income. • Wall Street took Enron on its word, but didn’t understand its financial statements. Enron was a trading company and Wall Street normally doesn’t reward volatile earnings of trading companies. (Goldman Sachs is a trading company. Its stock price was 20 times earnings while Enron’s was 70 times earnings.) • Enron, that had once made its money from hard assets like pipelines, generated more than 80% of its earnings from its vaguer business known as “wholesale energy operations and services.”

38. Aggressive Nature of Enron • Because Enron believed it was leading a revolution, it pushed the rules. Employees attempted to crush not just outsiders but each other. • “Enron was built to maximize value by maximizing the individual parts. “Enron traders were afraid to go to the bathroom because the guy sitting next to them might use information off their screen to trade against them.”

39. Enron’s Arrogance • “Those whom the Gods would destroy they first make proud.” • Enron’s banner in lobby: Changed from “The World’s Leading Energy Company” to “THE WORLD’S LEADING COMPANY” • “Older, stodgier companies will topple over from their own weight” (Jeff Skilling) • Conference of Utility Executives in 2000: “We’re going to eat your lunch” (Jeff Skilling)

40. Special-purpose Entities (SPEs). • The parent can bankroll up to 97% of the initial investment in an SPE without having to consolidate it into its own accounts. Normally, once a company owns >50% of another, it must consolidate it under the 1959 rules. The controversial exception: outsiders need invest only 3% of an SPE's capital. (it is changed to 10% by FASB on January, 2003)

41. Chewco • In 1993, Enron and the California Public Employees' Retirement System ("CALPERS") entered into a joint venture investment partnership called Joint Energy Development Investments LP ("JEDI"). Enron was the general partner of JEDI and contributed $250 million in Enron stock; CALPERS was the limited partner and contributed $250 million in cash. • In approximately the summer of 1997, Enron began to seek a buyer for CALPERS’ share of the JEDI partnership so that CALPERS would agree to invest additional funds in an even larger partnership to be called JEDI II. CALPERS imposed a deadline of November 6, 1997 for the buyout to occur at the negotiated price of $383 million.

42. Chewco • Fastow proposed the formation of Chewco to buy out CALPERS' JEDI interest. • Before the November 6, 1997 deadline, Fastow and others arranged to fund the buyout temporarily through "bridge" loans from Barclays Bank PLC ("Barclays") and Chase Manhattan Bank ("Chase"). Each bank loaned $191.5 million to Chewco, with repayment guaranteed by Enron, and Chewco used those loan proceeds to buy CALPERS' interest in JEDI.

43. Chewco • Fastow and others knew that Chewco failed to comply with SPE non-consolidation rules because Chewco had no genuine outside equity investment, and because Enron guaranteed Barclays and Chase against risk of loss. • As a result, Enron's year-end financial statements for the years 1997, 1998, 1999, and 2000 were materially false and misleading. In November 2001, Enron announced that it would consolidate Chewco and JEDI retroactive to 1997. This resulted in a massive reduction in Enron's reported net income and a massive increase in its reported debt. The consolidation revealed the following effect, according to Enron: reduction of net income in the amounts of $45 million (1997), $107 million (1998), $153 million (1999), and $91 million (2000), and debt increased in the amounts of $711 million (1997), $561 million (1998), $685 million (1999), and $628 million (2000).

44. Chewco SPE • The CEO of Andersen testified -the firm had performed unspecified "audit procedures" on the transaction in 1997, was aware at the time that $11.4 million had come from "a large international financial institution" (presumably Barclays), and concluded that it met the test for 3% residual equity. • Kopper received $2 million in "management" and other fees relating to Chewco. The participation of an Enron employee as a principal of Chewco appears to have been accomplished without any presentation to, or approval by, Enron's Board of Directors.

45. JEDI Enron stock gains • From 1993 through the first quarter of 2000, Enron picked up its share of income from JEDI using the equity method of accounting. • Changes in fair value of the assets were recorded in JEDI's income statement. JEDI held 12 million shares of Enron stock, at fair value. Enron and Andersen apparently developed a formula in 1996 • The first quarter of 2000 - Enron recorded $126 million in Enron stock appreciation • The third quarter of 2000 decision that income from Enron stock held by JEDI could no longer be recorded on Enron's income

46. JEDI Enron stock gains • In the first quarter of 2001, Enron stock held by JEDI declined in value by approximately $94 million. Enron share $90 million. • Enron's internal accountants decided not to record this loss based on discussions with Andersen. • According to the Enron accountants, they were told by Andersen that Enron was not recording increases in value of Enron stock held by JEDI and therefore should not record decreases.

47. LJM • In 1999, two partnerships in which Fastow was the manager and an investor. LJM 1 and LJM 2. The purposes of the LJMs • (1) manipulate Enron's financial results by fraudulently moving poorly performing assets off-balance-sheet; • (2) manufacture earnings for Enron through sham transactions with the LJM entities when Enron was having trouble otherwise meeting its goals for a quarter; and • (3) improperly inflate the value of Enron's investments by backdating transaction documents to dates advantageous to Enron.

48. LJM • Near the end of the third and fourth quarters of 1999, Enron sold interests in seven assets to LJM1 and LJM2. The legitimacy of the sales… • (1) Enron bought back five of the seven assets after the close of the financial reporting period • (2) the LJM partnerships made a profit on every transaction • (3) according to a presentation Fastow made to the Board's Finance Committee, those transactions generated, "earnings" to Enron of $229 million in the second half of 1999

49. LJM • Fastow and the LJM entities engaged in these transactions because: • (1) as CFO,Fastow readily could rid Enron of poorly performing assets and thereby improve Enron's reported financial results, which in turn would enable Fastow to earn continued prestige, salary, bonuses, and other benefits from Enron; • (2) the LJM entities would make money on their dealings with Enron, since Enron illegally and secretly guaranteed that the LJM entities would not lose money and, if they did, would be made whole in future transactions; and • (3) Fastow and others at the LJM entities personally reaped huge sums of money from such transactions, both in the form of management fees and skimmed deal profits.

50. Raptor I/AVICI • Enron invested in other companies, including start-up ventures that later did initial public offerings ("IPO") of their shares. At the time of an IPO, Enron often owned millions of shares of the newly public company. Following the IPO, Enron was at risk for market price fluctuations in the shares. • Raptor I was created in April 2000 through an off-balance-sheet SPE called Talon LLC ("Talon"). Talon was designed to generate accounting gains which would offset Enron's significant mark to market losses on certain investments. Talon would enter into transactions with an Enron subsidiary that would lock in the value of Enron's stock portfolio. If the price of Enron's stock portfolio increased, Talon would be entitled to the upside gain, and if the stock portfolio declined, Talon would be obligated to pay the Enron subsidiary the amount of the loss.