Back To CourseAccounting 101: Financial Accounting
14 chapters | 137 lessons | 13 flashcard sets
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Rebekiah has taught college accounting and has a master's in both management and business.
A company's number one goal is to make money. Not only do the company owners want to have a profit at the end of every accounting period, but they also want the company financial statements to look as good as they can. After all, the financial statements are what potential investors and creditors look at when they make the decision whether or not to lend the company money or to become an investor.
This is where the concept of earnings management comes into play. Earnings management, in a nutshell, is the creative use of different accounting techniques to make financial statements look better. Now that doesn't exactly sound like a legal thing to do, does it? But, believe it or not, it actually is.
This was a very hard concept for me to grasp when I was learning it. How could something that seems so illegal actually be legal? And, why would there be the need to dabble on that fine line between legal and illegal? The best way to answer this question is to use the acronym WISE. WISE stands for: Window dressing, Internal targets, income Smoothing, External Expectations.
Window dressing refers to the company's decision to dress up the financial statements for potential investors and creditors. The goal of this is to attract new supporters by having financial statements that look like the company's doing great. The company needs to appear to have a history of being profitable, even if it means lowering profits in one accounting period to increase profits in another. Even though this seems fraudulent, it isn't. Overall, the company is still reporting the same amount of profits, but is spreading the amount evenly over a specific time period.
Internal targets are another reason that a company may choose to use earnings management techniques. Often times, the company has set its own internal goals, such as departmental budgeting, and wants to be sure to meet those goals. No department wants to be the one to blow the proposed budget, so earnings management techniques are used to balance this out.
Income smoothing comes into play here because of the fact that potential investors generally like to invest in companies that have a continuous growth pattern. Smoothing out income generated, when there may be spikes at certain times and drops at others, allows it to appear like the company has that smooth growth pattern.
External expectations comes into play when the company has already made projections as to what their profits will be and investors now expect that exact amount of profits or more. Management may feel the need to shift revenue from one accounting period to another in order to meet the projected goal. Earnings management, quite simply, takes advantage of the different ways that accounting policies and procedures can be applied to financial reporting.
Now that you're familiar with some of the reasons why earnings management occurs, let's look at some of the legal techniques that are used. Though there are a number of these techniques, for this lesson, we're only going to look at the top five.
1. The big bath- This technique is often called a 1-time event. What happens with the big bath technique is that an out of the ordinary, or non-recurring, event occurs in a company, and expenses associated with that event are actually inflated. So, how can they inflate expenses and still be within GAAP guidelines? Easily! The company reports all of its expenses, but instead of attributing them to the correct accounts, they're all attributed to the 1-time event. Let me give you an example, and this will help you understand.
Billy owns multiple pizza restaurants. After months of struggling, one of the restaurants just has to be closed. This is a 1-time event and not one that is considered common. Since Billy knows that this loss will already cause a decrease in his reported net earnings, he decides to go ahead and charge a majority of the companies expenses to this business unit shut down.
He also knows that he doesn't want investors and creditors to think that the company is faltering, so he decides to count part of the loss in one accounting period and part in another. When the annual financial statements are printed and made available to the public, the bottom line net profit for the company will be correct.
2. Cookie jar reserves - This technique is also an income smoothing technique. It occurs when expenses are based on estimates. If the company over estimated expenses, then it may choose to use a portion of the expenses in one accounting period and save the other for future accounting periods.
Let's go back and look at Billy again. There was an electrical fire at one of Billy's pizza parlors. Billy hires a contractor to totally rewire the building and make sure that everything is up to code in the restaurant. Since all this happened at the end of the accounting period, Billy took the estimate that the contractor gave him and counted that as an expense for the current period.
When the actual payment was made to the contractor, it was for much less than the estimate, and it was paid in another accounting period. This caused there to be an overage of expenses claimed in the prior accounting period. When it came time to close the books for this accounting period, Billy sees that he made a bit more money that he actually wants to report. He decides to pull some of those expenses out of the cookie jar and apply them to the current period.
3. Operating activities - This earnings management technique occurs when managers plan certain events to occur in certain periods. This means that managers may decide to purchase new equipment in a period where income has been reasonably high. They want to ensure that the income is leveled out with prior periods so that there won't be a spike in some months and dramatic decline in others. Even though they're rearranging the timing of the purchase to best benefit the financial reports, they're still accurately reporting the expense. Once again, let's go back to Billy.
Billy has had two really good months in the pizza business. He knows that his revenue generated is well above what he reported in the last accounting period. He decides that now is the time to purchase the new brick ovens that he wants in the pizza parlors. He purchases $25,000 in new equipment for the restaurants, which increases his expenses for the accounting period and decreases his revenue.
4. Materiality - This may be the most common form of earnings management for big business. The term 'materiality' refers to the degree that a financial transaction will impact the overall financial statements. Materiality is often times considered a gray area, since what is material for one business may not be material for another.
Billy filed an insurance claim on the electrical fire that occurred at the pizza parlor. The insurance company agreed to pay him $26,500 for repairs in the restaurant. The actual cost of the repairs was $28,678. Billy ended up with a loss of $2,178. He can't decide if he should report the extra ordinary loss on his financial statements. The net income that Billy has for this period is $89,136. The percentage of the loss is only 2.4%. Because the loss is such a small percentage of net income, reporting the loss would not have any effect on the financial statements, so it's not material in nature.
5. Revenue recognition - In this earnings management technique, the timing of when revenue is recognized is manipulated. Since the decision of when revenue was earned and expenses incurred can vary based on individual opinion, this earnings management technique, like the others, is legal. However, this is also one that can quickly turn fraudulent if numbers in the next accounting period are drastically affected by the choice to not realize revenue or expenses in the prior period. Management sometimes finds itself trying to constantly cover up the mistake and may cross the line from legal to illegal quickly.
Billy knows that sales during the summer are much higher than in the winter. He wants to make sure that he doesn't show a dramatic drop in income from the July, August and September quarter to the October, November and December quarter. He decides to push sales at the end of September by offering employees bonuses for increased sales. He knows that the revenue won't be recognized until the next accounting quarter and can cushion the decrease in sales that have historically occurred.
Earnings management is the creative use of different accounting techniques to make financial statements look better. This can be a very hard concept to grasp simply because there is a fine line between legal earnings management and fraud. Now, why would someone want to take the chance to even participate in earnings management? That question can be answered in one acronym: WISE. WISE stands for Window dressing, Internal targets, income Smoothing, and External expectations.
Window dressing refers to a company dressing up the financial statements to make them look better for financial statement users. Internal targets are drivers of earnings management when a company has set its own internal goals and wants to be sure to meet them. Income smoothing occurs when companies choose to smooth out spikes and dips in income. External expectations occur when management predicts a certain degree of profits for investors and investors now expect it.
There are five common techniques that are used to manage earnings. The big bath technique occurs when a company has a 1-time, non-recurring event happen and expenses associated with that event are inflated. Cookie jar reserves occur when expenses are based on estimates. Operating activities refers to managers planning certain events to occur during certain periods. Materiality refers to the degree that a financial transaction will impact the overall financial statements. Revenue recognition refers to the manipulation of when revenue is recognized.
No matter what earnings management technique is used, the bottom line is this: accounting professionals must always follow the guidelines set forth in the law and be careful that any stretches do not break the limits of the law.
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Back To CourseAccounting 101: Financial Accounting
14 chapters | 137 lessons | 13 flashcard sets