Auditors and Earnings Management

By Scott B. Jackson and Marshall K. Pitman

In Brief

Inside the Motivations and the Methods

Former SEC Chairman Arthur Levitt spoke loudly and often about the widespread negative effect on the investing public when it learns that management has manipulated earnings to report good performance when in reality performance has been poor. The SEC has focused on this problem and, through several staff accounting bulletins, provided guidance to prevent it. Within the business community, auditors are the best-equipped professionals to detect and curtail inappropriate earnings management.

Auditors can be most effective when they understand the motivations and methods behind abusive earnings management. There are a number of incentives for managers to manipulate reported earnings, such as meeting contractual requirements or augmenting performance-based compensation. Whatever the motivation, there are as many avenues to earnings management as there are accounting judgments, estimates, and accruals. As additional abuses become known, involved parties’ reputations will suffer and the results they report may look meaningless to the investing public—and invite additional regulatory scrutiny and possible penalties.

There is growing concern in the investment community that certain practices of earnings management are eroding public confidence in external financial reporting and impeding the efficient flow of capital in financial markets. Critics contend that managers abuse the discretion afforded them by generally accepted accounting principles (GAAP) and intentionally distort information contained in financial statements. In his September 1998 “Numbers Game” speech, SEC Chairman Arthur Levitt, Jr., expressed concern about the practice of earnings management and the negative effects that this practice can have on earnings quality and financial reporting.

Independent auditors should lead the crusade to prevent deceptive accounting practices, because they not only possess in-depth knowledge of accounting and reporting matters, but they also have access to the audit committee and the board of directors responsible for scrutinizing a company’s decision makers. Furthermore, over the past decade the SEC has devoted considerable effort to empowering audit committees so that their members can more effectively discharge their oversight responsibilities. Consequently, auditors are in a prime position to curtail abusive earnings management and help maintain and enhance public confidence in financial reporting.

Earnings Management and Professional Literature

“Earnings management” has been defined in various ways. One definition is “purposeful intervention in the external financial reporting process with the intent of obtaining some private gain.” Another definition is the “use of judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company, or to influence contractual outcomes that depend on reported accounting judgments.” Yet a third definition is “an intentional structuring of reporting or production/investment decisions around the bottom line impact.”

Most frequently, accounting accruals (estimates)—adjustments to operating cash flows in calculating net income—are the means for achieving a desired earnings figure. By their nature, accruals involve estimation, require subjective judgments, and are difficult for auditors to objectively verify before their realization. Although auditors are likely to scrutinize financial statement accounts involving managers’ subjective judgment, it is nonetheless unlikely that they could fully counteract deliberate, pervasive efforts to shade accruals in one direction or another. Auditors develop a range of reasonable values for an account but rarely insist upon an exact estimate within that range. Nonetheless, auditors, financial executives, and regulators must understand the motivations for earnings management in order to counteract it effectively.

Auditing standards directly relevant to the issue of earnings management include SAS 57, Auditing Accounting Estimates; SAS 82, Consideration of Fraud in Financial Statement Audits; SAS 89, Audit Adjustments; and SAS 90, Audit Committee Communications. SAS 57 warns of the potential for bias in determining accounting estimates. Auditors should be sensitive to the increased likelihood of account misstatement that accompanies the increased judgment inherent in the determination of its balance. Intentional, as well as unintentional, bias in the process of formulating significant accounting estimates is a common form of earnings management. Managers’ accounting biases stem from a variety of circumstances and incentives. An adequate understanding of those circumstances and incentives is necessary to comply with the spirit of SAS 57.

The SEC has addressed the problem, providing specific, limited advice in relevant SEC administrative proceedings, such as its Accounting and Auditing Enforcement Releases (AAER), which can be found at www.sec.gov/ litigation/admin.shtml. Broader guidance can be found in the three Staff Accounting Bulletins (SAB) released by the SEC in 1999: SABs 99, 100, and 101.

SAB 99, Materiality, indicates that qualitative factors are important considerations in evaluating the materiality of financial statement misstatements. The exclusive reliance on quantitative benchmarks is unacceptable. For example, an amount, though quantitatively small, may be considered material if it affects financial statement trends, allows a company to meet analysts’ earnings expectations, or affects compliance with loan covenants. Moreover, misstatements introduced into the accounting records with the intent of managing earnings are unacceptable regardless of materiality. The difficulties in determining intent notwithstanding, business circumstances, including the incentives discussed below, provide some vital insights. SAB 99 applies only to SEC registrants, although it covers issues relevant to all audit engagements.

SAB 100, Restructuring and Impairment Charges, addresses potential accounting abuses related to restructuring charges, purchase accounting, and impairment write-offs that have attracted increased scrutiny over the last ten years. In SAB 100, the SEC staff narrowly interpreted existing accounting principles and required additional disclosures to enhance financial statement transparency. In a practical sense, SAB 100 places an increased burden on auditors to carefully evaluate and scrutinize client accounting for restructuring activities, business combinations, and asset impairments because managers appear to abuse their discretion in such instances.

SAB 101, Revenue Recognition in Financial Statements, provides the staff’s views on applying GAAP to selected revenue recognition issues. Generally, for revenue to be recognized, it must be realized or realizable and earned. These criteria are generally satisfied when—

• there is persuasive evidence of an agreement,
• delivery has occurred or services have been rendered,
• the exchange price is fixed or determinable, and
• collectibility is reasonably assured.

SAB 101 also stipulates the revenue recognition disclosures that registrants should provide in their financial statements and in management’s discussion and analysis. It is sometimes difficult to determine when to recognize revenue, and managers may make questionable judgments despite their best efforts. Ambiguity about when to recognize revenue indicates that these transactions engender substantial risks for auditors.

Incentives to Engage in Earnings Management

Incentives lie at the heart of earnings management. Absent certain incentives, managers would make accounting judgments and decisions solely with the intention of fairly reporting operating performance. In a variety of situations, however, there are compelling economic incentives for managers to engage in earnings management, because the value of the firm and the wealth of its managers or owners are inextricably linked to reported earnings. See the Sidebar for research related to contractual, market, and regulatory incentives.

Contractual incentives. Contractual incentives to manage earnings arise when contracts between a company and other parties rely upon accounting numbers to determine exchanges between them. By managing the results of operations, managers can alter the amount and timing of those exchanges. Four major contractual situations could stimulate earnings management: debt covenants, management compensation agreements, job security, and union negotiations.

Debt covenants frequently involve accounting numbers or derivatives of those numbers (i.e., working capital, number of times interest earned). Managers of firms close to violating those covenants can avoid default by making income-increasing accounting choices. Even firms that have violated debt covenants are candidates for managing earnings because such actions may improve the firm’s bargaining position in case of renegotiations. These incentives are likely to be compelling because violations of debt covenants usually lead to higher cost of borrowing or new restrictive covenants.

Management compensation agreements typically provide for bonuses that are determined, in part, by firm earnings. By managing accounting numbers, managers can influence their current and future compensation. To illustrate, consider a bonus arrangement in which the CEO earns no bonus if earnings are below a predetermined amount, no incremental bonus if earnings are above another predetermined amount, and a predetermined percentage of earnings if earnings are between these two amounts. When earnings are below the lower amount or above the upper amount, there are incentives to manage earnings downward to improve future results. When earnings are between the two amounts, there are incentives to manage earnings upward to maximize current-period compensation.

Managers may also attempt to smooth earnings out of concern for job security. When current earnings are poor and future earnings are expected to be good, managers may shift earnings from the future to the present. Conversely, when current earnings are good and future earnings are expected to be poor, managers may shift earnings from the present to the future. Managers believe that a smooth earnings profile is valued highly by financial analysts and therefore may enter a variety of transactions and alter operating decisions to maintain a smooth earnings profile.

During negotiations with unions, managers have incentives to dampen earnings to support a claim that the company cannot grant wage increases or needs labor concessions to survive. Because union representatives are likely to focus on company earnings, the financial incentives to manage earnings downward could be quite compelling.

Market incentives. Market incentives to manage earnings arise when firm managers perceive a connection between reported earnings and the company’s market value. Casual observation and the financial press reinforce this connection. Managers can use their accounting discretion to bolster earnings in the periods surrounding initial public offerings and seasoned equity offerings (i.e., stock offerings by companies that have previously sold stock to the public) in an apparent effort to alter investors’ perceptions. Not surprisingly, high accruals in the periods before stock offerings presage an earnings decline following offerings, which is consistent with the claim that managers shift earnings to the present at the expense of the future. Interestingly, earnings declines often lead to shareholder lawsuits, suggesting that earnings management may result in costly litigation.

Management buyout offers (MBOs) of public stockholders may also encourage earnings management. Managers typically engage independent investment bankers to evaluate the adequacy of buyout offers. In turn, investment bankers typically use earnings-based valuation methods, creating a link between earnings and the amount that must be paid to consummate an MBO. Because managers have a financial incentive to minimize the buyout price, it is not surprising that some managers choose to manipulate earnings downward before MBOs.

The capital markets are sensitive to companies that miss analysts’ earnings expectations or management’s earnings forecasts. Companies in danger of falling below these earnings targets may use their discretion to manage earnings upwards. In addition, research indicates that managers may manipulate earnings in an effort to report positive earnings and earnings growth.

Companies reporting a long string of annual earnings increases enjoy a higher earnings multiple than other companies; breaking this pattern often results in a lower multiple. The desire to avoid an earnings decline in this situation could lead to earnings management.

Finally, investors may look beyond a onetime loss and only focus on future earnings. Companies having a bad year may include an unusually large amount of expenses in current-year earnings (i.e., a “big bath”) to ensure an earnings turnaround in future years. Big bath charges are quite common, particularly when there has been a change in top management, in order to clean up the balance sheet and provide a fresh start.

Regulatory incentives. Regulatory incentives to manage earnings arise when reported earnings are thought to influence the actions of regulators or government officials. By managing the results of operations, managers may influence the actions of regulators or government officials, thereby minimizing political scrutiny and the effects of regulation.

For example, the debate over healthcare reform during the first two years of the Clinton administration centered on prescription drug prices. In support of their calls for government regulation, political leaders called attention to the “obscene” profits of pharmaceutical companies. In response to this scrutiny, managers of pharmaceutical companies apparently used their accounting discretion to dampen earnings during the healthcare debate. Similarly, there is evidence that managers of oil companies managed earnings downward during the 1990 Persian Gulf crisis to deflect political scrutiny.

The Department of Justice and the Federal Trade Commission use accounting earnings as evidence in prosecuting antitrust cases. The costs of an unfavorable antitrust ruling can be extremely high, creating a compelling stimulus for earnings management. Not surprisingly, some companies under antitrust investigation report downward earnings trends as evidence to undermine the case against them.

Similarly, the U.S. International Trade Commission uses accounting earnings as evidence in evaluating requests for import relief (e.g., tariff increases, quota restrictions). Companies that obtain import relief capture financial benefits. Companies seeking import relief frequently exhibit reduced earnings during import relief investigations to exaggerate the harm caused by foreign competition and increase the likelihood of a favorable ruling.

Banking regulators use accounting numbers to determine compliance with capital adequacy ratios. Banks close to regulatory minimums have an incentive to avoid noncompliance and the costs of increased regulation. Some banks close to minimum capital adequacy ratios have undertaken a variety of accounting actions designed to avoid regulatory noncompliance.

Methods of Earnings Management

The GAAP accrual accounting system requires managers to make numerous accounting judgments that have a profound impact on reported earnings. Examples of accounting discretionary judgments that could subtly shade earnings in one direction or another include:

• Long-term construction contracts require estimates of progress toward completion and costs to complete. Managers could use optimistic estimates of progress toward completion to inflate earnings.
• Depreciation computations require estimates of useful lives and salvage values. Managers could use optimistic estimates of the life and salvage value of depreciable assets, reducing depreciation expense.
• Accounts receivable must be stated at net realizable value. Managers could use optimistic estimates of collectibility to overstate earnings.
• Costs must be classified as product costs or period costs. By classifying some borderline costs as product rather than period costs, managers can reduce expenses during times of inventory growth.
• Gains on asset dispositions may be fully recognized in the period of sale. Managers could time the sale of appreciated assets such as marketable securities and fixed assets to bolster earnings.
• Software development companies must estimate the point at which technological feasibility is reached for software products and capitalize software development costs after that point. Managers could accelerate this date to avoid immediately expensing some software development costs.
• Anticipated costs of satisfying warranty obligations must be accrued and matched to revenues. By making optimistic estimates of product warranty costs, managers could reduce current expenses.
• Ordinary repairs are expensed as incurred, while major repairs are capitalized. By treating ordinary repairs as major repairs, managers could bolster current earnings.
• Managers could offer incentives (i.e., price concessions) to their customers to accelerate sales and bolster earnings.
• Inventories must be stated at the lower of cost or market. Managers could use optimistic market values, resulting in reduced inventory write-downs.

Audit Procedures

GAAP requires management to make the discretionary judgments highlighted above. Auditors should be alert to the situations that could motivate management to abuse their accounting discretion. There are some positive steps that auditors can undertake to curtail earnings management:

• During the risk assessment phase, effort should be devoted to identifying contractual, market, and regulatory incentives to manage earnings. Audit programs and procedures should reflect this knowledge. The audit staff should be aware of company-specific incentives so that tests, conclusions, and reviews reflect an appropriate degree of professional skepticism.
• A schedule should be prepared to accumulate differences between significant management estimates used to prepare the financial statements and the best estimates indicated by the audit evidence, even if these differences are individually immaterial. If the individual differences consistently reinforce a directional effect on earnings and the aggregate difference is material, the auditor should evaluate the reasonableness of management estimates taken as a whole.
• Auditors should perform analytical procedures on total accruals and significant individual accrual accounts. These procedures might include comparing total accruals in the current year to total accruals in prior years and total accruals elsewhere in the industry. Caution should be exercised in drawing firm conclusions from such analyses because there may be a legitimate basis for unusually large or small total accruals.
• Conservatism should not by itself be a justification for unusually large, income-decreasing accounting estimates or accruals. Overstating expense in one year means that there will be upward pressure on earnings in subsequent years, effectively creating an earnings turnaround.
• Auditors should explain to management the unintended consequences of earnings management. These consequences include loss of reputation, lower-quality earnings, and meaningless numbers. Furthermore, managing earnings in the current period may only exacerbate problems in the future. For example, understating the allowance for uncollectible accounts in one year puts upward pressure on bad debt expense in subsequent years.