FINC Stmt Analysis Unit 5

Creative Accounting

What is the process of earnings management (or creative accounting)?

where accountants use their knowledge of accounting rules to manipulate the figures reported in the accounts of a business

What is the objective of creative accounting?

To change the decisions made by financial information users

Definition of creative accounting

an assembly of techniques, options, and freedom room left by accounting regulation, without moving away from laws or accounting requirements, allowing the managers to change the financial result or alter the financial statements’ face

What are the three areas that make creative accounting legal?

Regulatory flexibility, some areas not fully regulated, managerial judgement scope in respect of assumptions about the future

Why does creative accounting exist?

Because managers possess the skills do it due to the limits of accounting norms

A conflict is created by the ___ that exists in complex corporate structures between a privileged ____ and a remote body of ____

information asymmetry, management, shareholders

What are the three main incentives categories for creative accounting?

market, contractual, and regulatory

Market incentives influence

market participants

Contractual incentives influence

execution of contracts

Regulatory incentives are there due to

compliance with regulation

What are the three types of creative accounting?

optimistic: improve the financial statement numbers

• aggressive accounting: increase earnings to artificially look better

pessimistic: worsen the financial statement numbers

• conservative: decrease earnings

Income smoothing: smooth earnings over the years

• reduce the volatility of the earnings = less risk

Optimistic market incentives

An increase in financial statement numbers leads to higher stock prices

• increase compensation (more profit with stock options)

  • increase negotiation power (for financing activities, M&A, IPOs)

Pessimistic market incentives

lower stock price or higher risk

• decrease the cost of a management buyout

Optimistic Contractual incentives

• credit financing: comply with debt covenants to decrease interest rates and obtain financing

  • compensation: greater rewards through contracts that are based on earnings

Pessimistic contractual incentives

• Negotiations with unions: want to appear poorer

• Save earnings for future periods to maximize compensation (contract between employer and employee when bonus is given based on certain earnings level)

• big bath accounting when new management is appointed

What is the process of big bath accounting?

• impair assets to record an important loss in year of appointment

• attribute poor performance to previous management team

  • benefit from cookie jar created in future periods

Optimistic regulatory incentives

• avoid litigation from investors and comply with capital adequacy ratios (banks with their reserve requirements)

Pessimistic regulatory incentives

obtain financial grants from public bodies to look poorer

avoid appearing in monopolistic situation

What are the four main methods of creative accounting

• timing of expenses and revenues

• increase (decrease) expenses, revenues, assets or liabilities

• classification shifting

• manipulation through consolidated earnings

Describe the timing method

Delay recognition of sales (or expenses)

Describe examples of artificial increases (decreases) of revenues, expenses, assets, or liabilities

inflate assets; change valuation criteria of assets, overestimate provisions, big bath accounting, change value of inventories to increase or decrease COGS

Describe examples of accruals manipulation

anticipate revenues by changing the estimation of completion of long term contracts which increases revenues account and accounts receivable

• is reversed in following years

Example of classification shifting

Some managers can shift some expenses to inflate earnings - different external users rely on profits other than NI

managers can shift operating expenses to extraordinary items, which inflates operating income, but net income stays the same

Example of manipulation through consolidated earnings

Managers can use subsidiaries

• artificial revenues or expenses with non-consolidated subsidiaries

• avoid the consolidation of an entity alleging strategic differences

What is the Beneish M-Score

Empircal model used to identify earnings management that takes into account firm’s incentives and indicators of potential manipulation

What is the methodology of the Beneish M-Score?

model is based on eight ratios, compares two consecutive years, and compares companies that committed fraud with others that did not and calculate a manipulation index (M-score) that allows detection of potential manipulators

What is the cut off value (anything above this is potential manipulator)

-1.78