Why is earnings management considered a trick of the trade

For example, assume a furniture retailer uses the last-in, first-out LIFO method to account for the cost of inventory items sold.

Under LIFO, the newest units purchased are considered to be sold first. Since inventory costs typically increase over time, the newer units are more expensive, and this creates a higher cost of sales and a lower profit. If the retailer switches to the first-in, first-out FIFO method of recognizing inventory costs, the company considers the older, less-expensive units to be sold first.

FIFO creates a lower cost of goods sold expense and, therefore, higher profit so the company can post higher net income in the current period.

Another form of earnings management is to change company policy so more costs are capitalized rather than expensed immediately. Capitalizing costs as assets delays the recognition of expenses and increases profits in the short term. A change in accounting policy, however, must be explained to financial statement readers, and that disclosure is usually stated in a footnote to the financial statements. The disclosure is required because of the accounting principle of consistency.

Financial statements are consistent if the company uses the same accounting policies each year because it allows the financial statement user to easily identify variations when looking at the company's historical trend. Therefore, any change in policy must be explained to the financial report reader. As a result, this type of earnings manipulation is usually revealed.

Tools for Fundamental Analysis. Financial Statements. Investing Essentials. Your Privacy Rights. The authors also showed that companies that had previously reported similar write-offs were more likely to do so.

Managers often have the ability to modify the timing of events such that the accounting system will record those activities in the period that is most advantageous to management. The activity does not alter the long-term economic value of the transaction, just the timing and thus, comparability of financial statements. For example, a company could accelerate its sales and delivery process such that it records sales in December that normally would have been reported in January.

Thus, the company reports higher fourth quarter sales, revenue and profits. In the long-term, the company would ultimately report the same sales and profits; however, it has inflated its growth in the near term, and reduced profits in the future period. One type of significant event that may be used to mask other charge-off is mergers and acquisitions. In most cases, there is some form of restructuring involved creating the need for a large one-time charge along with other merger-related expenses.

The event provides the acquirer with the opportunity to establish accruals for restructuring the transaction, possibly attribute more expense than necessary for the transaction. The company may also identify certain expenses that are revalued on the seller's balance sheet, increasing goodwill.

If the conservative valuations prove to be excessive, the company is able to reduce its operating expenses in the near term by reducing its estimate for the liability. The additional goodwill created would be amortized over a long period of time and not have a significant impact on near term results.

There are two methods of accounting for mergers and acquisitions. Pooling of interests "pooling" accounting and purchase accounting. Pooling recognizes the transaction as a merger of equals, thus the transaction is recorded as company A plus company B. Purchase accounting treats the transaction as a purchase. The fair value of the purchased company is assessed and compared to the purchase price. Any excess or premium paid above the fair value of the assets is recognized as goodwill.

Goodwill is amortized over a period of time not to exceed forty years. Abraham Brilloff, professor emeritus at Baruch College, in an article in the October 23, issue of Barron's entitled "Pooling and Fooling" brought attention to the use of pooling accounting by Cisco Systems to inflate its operating earnings. In addition, five of the acquisitions were deemed "too immaterial" to restate prior period financial statements. If a company pays a premium to acquire another firm, the premium, or goodwill, is amortized and reduces earnings going forward.

Thus, companies seek transactions that will allow them to use pooling of interests. It has been contended that additional premiums have been paid in instances where pooling of interests will be allowed.

Criticism of pooling accounting has been significant and the FASB has reacted by announcing the elimination of the method. However, the effective date has been delayed as the FASB has received strong opposition from industry. Under the purchase method of accounting for acquisitions if the price paid by the acquiring firm exceeds the fair value of the company acquired, the difference is recorded as an intangible asset, goodwill. Goodwill is amortized over future periods, thus, the creation of goodwill causes future expenses, therefore reducing reported earnings.

If the acquirer conservatively values assets such as private placement or illiquid securities and real estate or liabilities reserves, accrued liabilities , the company may be able to recognize additional earnings in the near future as it estimates become less conservative. Professor Brilloff has also been a critic of the accounting practices of Conseco, a financial services company. Accounting Shenanigans or Tricks of the Trade. For example, at Enron, the Mark to Market accounting for revenue allowed Enron to recognize the revenue for the complete amount of a contract even if the contract was over multiple years.

Revenue recognition was also the manipulation issue discussed with the Krispy Kreme scenario at the beginning of the chapter.

One-Time Charges are allowed when a financial event occurs one time only. Since this event is not expected to occur again, it is treated as a one-time charge. Refer to Exhibit 2. What is a Ponzi scheme? Describe the key elements of the Bernie Madoff fraud. Is this fraud primarily a case of asset misappropriation or fraudulent financial reporting? Create an Account and Get the Solution. Log into your existing Transtutors account. Have an account already? Click here to Login.