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.