Earnings Management Hw

1. What is earnings management?

The companies use earnings management as a strategy by which they can easily control and manipulate their earnings to reach their pre-determined earning target.

2. Why do companies employ earnings management techniques?

Accountants cannot predict every business structure, every new and innovative transaction. Therefore, they build up principles that allow for flexibility so that they can adapt to changing circumstances. However, people make use of that flexibility. They employ earnings management techniques to shade financial unpredictability. Thus, the real results of the decisions of the management are veiled.

3. Describe 5 popular techniques used by companies that Levitt believes are illusions. Do you know of companies that have used these techniques?

5 popular techniques used by companies are: "big bath" restructuring charges, creative acquisition accounting, "cookie jar reserves," "immaterial" misapplications of accounting principles, and the premature recognition of revenue.

пÑ"? “Big bath” technique: In that technique, companies attempt to overload one period with expenses therefore, the next accounting period shows an upgrading in earnings. Moreover, companies can set up an earnings reserve that can be used to be added to future periods when they need the extra income to meet their earnings estimates. This method violates the matching principle. Cisco and Tyco are using that method to meet their earnings estimates.

пÑ"? Creative Acquisition Accounting technique: In that technique, the accounting measures are manipulated. An acquiring company uses its stock as a currency to buy other companies in an attempt to buy another source of sales and profits and if the acquiring company buys another company for more than its net worth, the price paid for the company which is acquired can be written off over a period of years. The over payment which is written over periods will create expense which lowers the earnings.Enron case is an example of that technique. “Enron used special purpose entities and investment partnerships (over 3000) and created series of joint ventures (many involving related parties at Enron) and excluded the results from its consolidated accounts. The method of accounting allowed Enron to materially inflate its profits and to hide debts from shareholders”.

пÑ"? “Cookie Jar Reserves” technique: In that technique, liabilities are estimated for such items as sales returns, loan losses or warranty costs. Therefore, the company stores accruals in cookie jars during its good times and used them at its bad times.W.R. Grace, a premier global specialty chemicals and materials company used that technique and caught by SEC in December 1998. SEC says that the company was stashing the profits to declare them in future years.

пÑ"? "Immaterial" Misapplications of Accounting Principles technique: In that technique, errors within a defined percentage ceiling are recorded saying that is not material.

пÑ"? Premature Recognition of Revenue technique: In that technique, revenue is being documented prior to the completion of the sale, prior to delivery of the product to the customer, and when customers still keep the options to terminate, cancel, or postpone the sale therefore that results in an increase in sales and the observation of higher net income. Leslie Fay Companies, a women's apparel firm used that method and caught by SEC in 1993. The company was pre-billing its sales.

4. What recommendations does Levitt propose to address the problems created by earnings management?

Levitt proposed some recommendations to address the problems created by earnings management. Firstly, Levitt informed SEC staff to get well-detailed information about the impact of changes in accounting assumptions of the companies which includes supplement