Memo on Earning Management Abuse
...the basics of financial reporting. The integrity in financial reporting is reflected to the investors. If the investors do not trust the quality of financial reporting this can cause fluctuations in prices and a lack of trust in the capital markets. Earnings management is defined as: “when managers use 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 numbers.The more popular earnings management practices are as follows: 1. Recognizing revenue for out of period sales. 2. Channel stuffing to create the appearance of sale growth. 3. Prematurely recognizing revenue for customer contracts. 4. Cookie jar reserves. 5. Big bath charges. Revenue for out of period sales happens in different ways. Some may reset a computer clock to gain a few days on shipping and receiving which in turn may delay the payment for goods received as well. Falsifying shipping documents is another way in which out of period sales may occur, this will gain revenue for out of period shipments. Channel stuffing is the result of directly manipulating the accounting department to give the appearance of growth within a given period of time. This is done by offering customers incentives in the way of finance and by writing purchase orders before merchandise is purchased. Prematurely recognizing revenue for customer contracts is closely related to channel stuffing. Orders placed before orders are received is another way the bottom line is bolstered to show profits. Even if the customer does not accept the order the inventory is considered to be in the customers possession and not counted against the overhead. Cookie jar reserves is the practice of trading numbers on the balance sheets to smooth over a quarters earnings or losses. In the event that an overage is achieved during a certain period of time, this earning is put in the “cookie jar” until it is needed (like during a declining period) and it is tacked on to the end of the period?. With these different ways of cooking the books, there are measures that can help prevent these types of abuses. In the instances of revenue out period, channel stuffing, premature revenue and cookie jar reserves auditors must keep a close eye on how to prevent these instances. One method would be to disallow the appearance of a system clock on an operating system so the user is unable to change system time, thus thwarting the ability to change shipping dates and times. Channel stuffing and premature revenue can recognized by auditors “performing calculations on reported earnings and related debt positions using CAATs” (Sarva, theiia.org), but care should be taken as in some situations customers/investors take part in manipulation. Cookie jar antics are hard to spot as well, but finding the irregularities is done by “analyzing runoff” and “how the initial estimates changed over time and what the re-estimation detailed” (Sarva, theiia.org). The “big bath” restructuring charges occur when a company restructures and “flushes all the associated costs through the financial statements” (Levitt). Creative acquisition accounting is misl...