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.

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. 

Understanding the Consequences

Although managers sometimes perceive manipulating reported earnings as being in the best short-term interest of the organization, the process can lead to serious long-term problems, including:

• REDUCED COMPANY VALUE. Many operating decisions that are made for the primary purpose of influencing short-term earnings can hurt the organization's long-term economic health. For example, efforts to accelerate revenues might result in an organization selling a product on Dec. 30 on significantly less favorable terms than it would have received if it had sold the same product to the same customer on Jan. 2. 

Delaying discretionary expenses can also hurt the long-term performance of the organization. Deferring maintenance, research and development, and employee training may result in equipment failure, loss of market share, and reduced productivity.

• ERODED ETHICAL STANDARDS. Even if earnings management does not explicitly violate accounting rules, it is an ethically questionable practice. An organization that manages its earnings sends a message to its employees that bending the truth is an acceptable practice. Executives who partake of this practice risk creating an ethical climate in which other questionable activities may occur. A manager who asks the sales staff to help accelerate sales one day forfeits the moral authority to criticize questionable sales tactics another day. Earnings management can also become a very slippery slope, with relatively minor accounting gimmicks becoming more and more aggressive until they create material misstatements in the financial statements.     
• CONCEALED PROBLEMS AT OPERATING UNITS. Earnings management is not practiced only at the corporate level. Operating units have also been known to manage their reported results. Unit managers manipulate financial information to earn bonuses, win promotions, or avoid criticism for poor performance. One significant danger of earnings management at lower levels is that operating problems might be concealed from top management. Errors might go uncorrected, and problems remain unsolved for long periods of time.     
• SANCTIONS AND RESTATEMENTS. In recent years, the U.S. Securities and Exchange Commission (SEC) has imposed harsh sanctions on companies that were caught managing their earnings. For example, in the early 1990s, W.R. Grace & Co. was fined $1 million by the SEC and ordered to restate its earnings. Between 1990 and 1992, the company deflated its reported earnings by recording $55 million of improper reserves. Between 1993 and 1995, the reserves were released back into earnings as needed to meet quarterly earnings targets.  

Even if the SEC does not impose a fine or other punitive sanction, just being required to restate earnings can be very costly. Over the last five years, companies that have restated earnings have lost an average of almost 10 percent of their market value during the three days surrounding the announcement of the restatement.

Taking a Proactive approach

Preventing earnings management is always preferable to having to detect and correct it. If an organization's employees are made aware of the potential dangers of the practice, they will be less likely to give in to its temptations. Internal auditors can educate employees through formal internal control training sessions or informal discussions. Internal auditors should ensure that their organization's code of conduct addresses earnings management and promotes truthful financial reporting.

Because it's not always possible to prevent earnings management, internal auditors also must work to detect and eliminate the practice. Auditors should perform the following procedures.

• ANALYZE TRENDS. Trend and ratio analyses are valuable tools for detecting earnings management. Look for unexpected patterns in revenues and profit margins between periods. For example, unusually high sales in the last month of a fiscal year followed by unusually low sales in the first month of the subsequent year suggest the company may have accelerated recognition of revenue. When possible, review weekly or daily sales data. Some of the most egregious cases of earnings management have involved companies recording huge amounts of sales during the last day or two of a reporting period (see "Patterns That Suggest Earnings Management").     
• REVIEW SIGNIFICANT YEAR-END TRANSACTIONS. Review significant transactions near the beginning and end of each reporting period for evidence of earnings management. Examine the terms of sales transactions to determine if there were any unusual price discounts or credit terms. Also, review customer correspondence and inquire about the existence of any side agreements. Review returns and allowances recorded near the beginning of each reporting period to ascertain if there is any evidence that revenue was inflated in the preceding period.     
• REVIEW SIGNIFICANT ESTIMATES AND ASSUMPTIONS. Review significant financial statement estimates, such as asset reserve accounts and accrued liabilities, to determine whether or not the recorded amounts comply with the organization's stated procedures. For example, bad debt expense should be computed based on the organization's historical collection rate and the current amount of its past due receivables. It should not be "estimated" based on how much the company can record and still meet its earnings target. If the organization doesn't have formalized procedures for estimating important account balances, report this deficiency. 

Review all significant financial statement estimates with professional skepticism. Examine the methodology and calculations to ensure that the estimated amounts were not influenced by deliberate manipulation or unconscious bias. Also, review significant assumptions such as the rate of return on pension plan investments, the useful lives of fixed assets, and the rate of increase in health-care costs. When the organization changes an important assumption, review the rationale and determine whether the change is justified. Additionally, be alert for changes in the economy or the organization's operations that indicate that underlying assumptions should change.

• REVIEW RESTRUCTURING ACCRUALS AND REVERSALS. Accruals for corporate reorganization costs are often highly material and are susceptible to abuse. The temptation is to record excessive reserves in one period and reverse the reserves in subsequent periods to create an impression of improved profitability. Review restructuring charges to make sure no accruals are made for future operating costs, and review all reversals to make sure only restructuring costs are charged against the reserve. 

Reporting Findings

Internal auditors should report evidence of earnings management to the audit committee. The audit committee is responsible to the shareholders for ensuring the reliability of the financial information reported to them. In addition, Rule 301 of the U.S. Sarbanes-Oxley Act of 2002 requires audit committees to establish procedures for receiving and investigating complaints about questionable accounting or auditing matters.

It is essential that internal auditors carefully document evidence of earnings management. Because it rarely involves the obvious violation of explicit accounting rules, the practice is difficult to prove. In the case of suspicious year-end transactions, internal auditors should document how the terms of the transactions differ from other transactions so the audit committee can decide whether the altered terms accomplish a legitimate business purpose or simply affect the timing of earnings.

When accrual estimates appear either overly aggressive or too conservative, internal auditors should document the assumptions and methodology used to calculate the accruals so the audit committee can decide whether the recorded amounts are reasonable. Whenever earnings management is suspected, the internal auditors should be able to explain to the audit committee the effects of the suspicious transactions or estimates on reported earnings.

Creating an ethical Climate

During the boom market of the 1990s, it appeared that companies were rewarded for cleverly manipulating their reported earnings. The current environment is very different. Regulators have recognized the harmful effects of earnings management on financial reporting and are aggressively investigating companies suspected of the practice. Investors have become more skeptical of financial statements and are fleeing companies that use suspicious accounting practices. Business leaders have seen huge companies destroyed by the unethical actions of a few employees and are determined to avoid their fate.

Internal auditors can improve their organizations' financial reporting process by reviewing accounting and operating decisions for evidence of earnings management and by educating managers and directors about the dangers of the practice. By reducing earnings management practices, internal auditors can prevent their organizations from making value-reducing operating decisions, improve the quality of information executives receive from operating units, and reduce the likelihood of government sanctions. On a wider scale, internal auditors can help restore investor confidence in the financial reporting process.

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NOTES:

This article was reprinted from the August 2003 issue of  "Internal Auditor" magazine, with permission from The IIA.  All rights are reserved by The IIA and by the Internal Auditor magazine.   

This article appears here, available to the public, until shortly after Dr. Clikeman's Student-Educator Night talk to the Central Virginia Chapter and its guests in Mid-February 2004.   After that time, please refer to the magazine itself or to the following link at The IIA's main site (which may be restricted to "members only"):  http://www.theiia.org/iia/index.cfm?doc_id=4338   

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PAUL M. CLIKEMAN, Ph.D., CIA, is an associate professor in the Robins School of Business at the University of Richmond, in Richmond, Va.

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