Chapter 7 - Earnings Management and the Quality of Financial Reporting

     Arthur Levitt says the following: "Increasingly, I have become concerned that the motivation to meet Wall Street earnings expectations may be overriding common sense business practices...."
     Earnings management is when companies change their revenues, expenses, or earnings per share by 1) using aggressive accounting techniques such as capitalizing costs what should be expensed, or 2) by changing accounting methodology such as lengthening of useful lives of equipment.
    Rosensweig and Fischer followed a Bruns and Merchant survey with one of their own that asked accountants about the causes of earnings management.  Accounting manipulating factors include recording expenses in the wrong periods or changing the inventory value.  Operating factors include deferring expenditures to subsequent year or offering unusually attractive terms to customers at year end.
     In a later survey Akers, et al. in 2006 asked accountants and students about their views of of earnings management.  The results showed that operating manipulation is more acceptable than accounting manipulation.
     Chapter 7 also defines materiality. One problem with the use of materiality in audits is that using it as a measure may not capture items that are right below the radar.
     SOX  plays a huge part in the creation/maintenance of internal controls.  Under Section 302 of SOX, companies must 1) review disclosure controls and procedures on a quarterly basis, 2) identify key control exceptions and determine control deficiencies, 3) assess impact of deficiency, and 4) identify and report control deficiencies to the audit committee and to the external auditor.
     SAS No. 107 gives guidance on materiality during an audit. It points out that the materiality consideration is a matter of professional judgement and that the auditor does not consider the effect of misstatements on individuals and are made in light of surrounding circumstances and necessarily involve both quantitative and qualitative considerations.
      A restatement may not only be due to discovered fraud but could also be due to an error in accounting such as improperly classifying on an income statement or balance sheet. 
     In 2007, the SEC sought to improve the quality of financial reporting.  They came up with the Advisory Committee on Improvements to Financial Reporting.  The result is that the committee believes that companies should be required to disclose not only the amount of restatement and periods impacted, but also how the restatement was discovered, why the restatement occurred, including internal control weaknesses that contributed to the restatement, and corrective actions, if any, taken to prevent the error from re-occurring.
      The chapter uses Schilit's framework to discuss earnings management which include: 1) recording revenue too soon,  2) recording bogus revenue, 3) boosting income with one-time gains, 4) shifting current expenses to another period, 5) failure to record liabilities, 6) shifting revenues to a later period, 7) shifting future expenses to the current period or special charge.
     The remainder of the chapter goes into example cases such as Xerox, Lucent Technologies, and Enron to show accountants and students the most likely end when one practices earnings management.

Chapter 6 Legal and Regulatory Obligations in an Ethical Framework

     Chapter 6 starts with an Ethical Reflection of the case of Cenco, Inc. v. Seidman which deals with common-law legal standards for auditors who fail to detect fraud. In this case, managers were inflating inventory. Cenco, in turn, sued Seidman, the audit firm for not detecting the fraud.  The court ruled in favor of Seidman because Cenco's management was just as complicit as Seidman and would not receive damages from their own audit firm.
    Later, in an answer to the onslaught of audit liability cases, the AICPA pushed Congress to pass the PSLRA in 1995.  The act establishes proportionate liability meaning audit forms can only be liable for the proportion of damages connected with the portion of what was actual audited.  There is argument that this may have helped auditors veer away from the due care standard. One wonders if this was a pre-curser to later cases such as Enron and MCI.
     The chapter outlines the duties of officers and directors and the loyalty, liability and the Business Judgement Rule.  The Business Judgement Rule limits the liability of officers and directors to losses as a result of fraud...and not simply a poor business decision such as marketing or M&A.
    The Chancery Court as outlined in Chapter 6, is a forum used to resolve commercial business litigation matters.
     Common-Law liability has to do with the performance of due care by the auditor.  The second paragraph of the audit statement is meant to emphasis and hold the auditor accountable for due care in performing the audit using GAAS.
     Privity relationships exist between the auditor and client due to auditor's contractual obligation to the client.  Therefore, a client sue an accountant for failing to live up the terms of the contract.  The 1933 Ultramares decision set the precedent that third parties without privity could sue if the negligence was so great that it could be called constructive fraud.  By 1985, the decisions started coming back in favor of the auditors.  A 1985 case established tests that must be passed before holding an auditor liable for negligence to third parties.  1) knowledge by the accountant that the financial statements are to be used for a particular purpose, 2) the intention of the third party to rely on those statements, and 3) some action by the accountant linking them to the third party that provides evidence of the accountant's understanding of intended reliance.  So, there is liability to clients, liability to third parties, and also foreseen third parties.  Section 552 of the Law of Torts, limits loss to those whom the auditor knew would rely on the financial statements for a specific transaction.
     In common-law liability for fraud is available to third parties as long as they can prove 1) a false representation by the accountant, 2) knowledge or belief by the accountant that the representation was false, 3) the accountant intended to get the third party to rely on false statements, 4) the third party relied on the false representation, and the third party suffered damages.
      Statutory laws are those laws, which if violated, can result in a prison sentence.  The Securities Act of 1933, and later the Securities Exchange Act of 1934 established regulations for publicly traded companies to follow.  Violations of these acts can result in steep fines and even prison sentences.  Ask Martha Stewart.
     The Foreign Corrupt Practices Act establishes standards for payments made by U.S. entities to foreign governments.  The act makes it a crime to offer or provide payments to officials or foreign governments, political candidates , or political parties for the purpose of obtaining or retaining business.  Recently Johnson and Johnson was brought up on these very charges. 
     Finally, the RICO act, in the case of Reves v. Ernst & Young, established that the plaintiff prove the accounting firm participated in the operation of management of the client's business.

   
    

    

    
     

Chapter 5 - Audit Responsibilities and Accounting Fraud

Chapter 5 starts out outlining the audit statements and goes into the premise behind each one. 
     The introductory paragraph identifies what has been examined, management's responsibilities in respect to the conformance of the financials to GAAP, and the auditor's responsibility.
     The scope paragraph goes into specifics as to the auditor's responsibility as to following GAAS, "reasonable assurance"/"material misstatements", how the auditor assessed the financial statements, and that the audit provided a reasonable basis for the opinion.
      The meat and potatoes is the actual audit opinion which can be either: qualified, unqualified, or adverse.  The audit firm can also issue a disclaimer or no opinion, or withdraw altogether.
      Next, the chapter provides an overview of GAAS.  Apparently the AICPA lacked the fortitude to hold those auditors accountable when they do not practice GAAS.  The SEC took over and formed the PCAOB, whose audit standards are required and not just generally accepted.
     One would think that with the formation of PCAOB, that fraud would decrease, but in fact, it has increased, or rather the reporting of it has.  Looking at the SEC website, I noticed that in 1998, there were 98 bulletins published, by 2010, the number was 258.  So far, there have been 89 in 2011, among the latest is a case against Johnson and Johnson for bribery of European officials.  The fine levied as $70million.
     Where did that money go?  

Ethics and Game Theory

I've really been thinking about my professor's question on last Monday.  Are we, as a society, capable of making ethical decisions? 
I've been trying to find a really good reason for why people continue to make unethical decisions when they know the manner and magnitude will land them in positions of censure, bankruptcy, or even prision.
I've gotten interested in game theory.  When I have more time, I will study this in depth. 
Game Theory analyzes the function of morality.   One of the most famous examples is "the prisoner's dilemna"
The example below is from Stanford's Enclyclopedia of Philosophy.
     Tanya and Cinque have been arrested for robbing the Hibernia SavingsBank and placed in separate isolation cells. Both care much more about their personal freedom than about the welfare of their accomplice. A clever prosecutor makes the following offer to each. “You may choose to confess or remain silent. If you confess and your accomplice remains silent I will drop all charges against you and use your testimony to ensure that your accomplice does serious time. Likewise,if your accomplice confesses while you remain silent, they will go free while you do the time. If you both confess I get two convictions,but I'll see to it that you both get early parole. If you both remain silent, I'll have to settle for token sentences on firearms possessioncharges.  If you wish to confess, you must leave a note with the jailer before my return tomorrow morning."
So the question is:  are they both better off confessing or being silent? 
      According to the Stanford writing, each participant will  be better off confessing but if both confess, the punishment is greater than if both remained silent. 
     As I get more into game theory I will be better able to apply it to various cases and may be able to use it to better answer my professor's question.