Solutions Manual - Chapter 1 Questions 1. Earnings management is ...

1 Solutions Manual Detecting Earnings Management

Chapter 1 Questions

• Earnings management is a major issue when evaluating financial accounting. Why?
• What is the difference between earnings management and earnings manipulation.
• Are cookie jar reserves and income smoothing related? Explain.
• What is the relationship of corporate greed and opportunistic behavior?
• Do earnings restatements always indicate earnings manipulation? Explain

• The primary reason is the evaluation of earnings quality: to what extent can the

analyst depend directly on the information in the financial statements? Major earnings management concerns suggest low earnings quality.

• Earnings manipulation is an extreme form of earnings management involving

opportunistic behavior by the company to misstate financial information.

• The use of cookie jar reserves is a type of income smoothing, where funds are “set

aside” in a reserve account until used for earnings management purposes. Companies often have dozens of legitimate reserve accounts (such as bad debt reserves) and any number of cookie jar reserve accounts (that is, not needed for legitimate purposes).

• Corporate greed seems to be a major motivation for opportunistic behavior; for

example, “adjusting” earnings enough to meet analysts’ forecasts to ensure continuing executive bonuses.

• Earnings restatements are considered an extreme step; it’s not supposed to happen

& indicates earnings quality problems. In most cases, the need for need to restate is the result of earlier earnings manipulation.

Cases Case 1. Audit Regulations. Statements on Auditing Standards (SASs) are issued by the Auditing Standards Board (ASB), a committee of the American Institute of Certified Public Accountants (AICPA). Thus, audit standards represent self-regulation by the industry. SAS No. 99 on auditor responsibilities for fraud precludes auditors from reporting evidence of fraud to the SEC or other regulators in most cases. The standard sites ethical considerations associated with confidentiality.

• Give the justification for supporting the ASB position on reporting fraud to regulators.

• Given the potential for lawsuits, why is it in the best interests of auditors to be

mandated to disclose potential fraud to the SEC and other regulators?

• Is it in the best interests of investors for auditors to report suspected fraud to the SEC?

Explain.

(Detecting Earnings Management 1e Gary Giroux) 1 / 4

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• Should all future auditing standards be issued by the Public Company Auditing

Standards Board (PCABO), the new regulatory board established by the Sarbanes-Oxley Act of 2002? Explain.

• According to the CPAs code of ethics, the CPA must maintain confidentiality with

the client.

• When fraud is discovered, lawsuits & other sanction cannot be far off. It is in the

interests of the CPA firm to report suspected fraud and, if the client is not cooperative, notify the SEC and other appropriate regulators; the auditor should also resign the audit.

• Once fraud is discovered, it must be investigated thoroughly and quickly; the SEC

can investigate with reasonable speed & call in the Justice Department & other law enforcement agencies if justified.

• Yes & they are doing exactly that; they are an independent, quasi-public body, which

that AICPA was not, and standards are more likely to get public support.

Case 2. Serial Earnings Restaters. Given below are the eight S&P 500 companies that restated more than one in the last five years.

1997 1998 1999 2000 2001 2002

Avon Expenses Revenue Recog.

Lucent Revenue Recog.

Northrup Grumman Restruct. Revenue Recog.

PNC Fin.Services

• Loan

losses 2.Rev.Recog.Thomas & Betts Restruct. Restruct.Tyco Mergers, Restruct.Reven.Recog.Waste Mgt. Assets

Reven.Recog.

Xerox Related- Party, Expenses Reven.Recog.

• To what extent does the presence of restatements affect the perception of an

environment of earnings manipulation by these firms?

• Do the categories of restatements suggest that these firms are similar in their attitudes

on financial reporting or that each firm should be evaluated separately? Explain 2 / 4

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• Does the fact that these firms restated more than once influence your evaluation

relative to firms that restated only once during this period? Explain

• Restatements imply earnings manipulation & serial restaters suggest corrupt

corporate governance; public confidence seemingly demands a thorough restructuring of corporate governance and replacing of top executives.

• Revenue recognition is the most common category of restatements, but each

company seems to take a unique approach to earnings management; therefore, each company has to be analyzed separately and in detail.

• Once restatements are discovered, manipulation is implicit. Earnings quality is

suspect until actual reform has been demonstrated. 3 / 4

4 Chapter 2

Questions

• Twenty-five companies are listed as “21

st century scandals.” How many of these involve fraud? Explain.

• Dennis Kozlowski, Andres Fastow and Bernie Ebbers are closely associated with the

scandals at Tyco, Enron and WorldCom, respectively. Are the senior executives usually associated with earnings manipulations and fraud? Discuss.

• Compare the similarities and differences of Waste Management and Sunbeam

(scandals of the 1990s) with Enron and WorldCom.

• Review the scandals of the 20

th century. Do they seem less or more disastrous than Enron and the other 21 st century scandals.

• The original Robber Barons were Daniel Drew, Jay Gould, and Jim Fisk. How do

they compare with modern Robber Barons?

• (Appendix). The Sherman Act of 1890 was federal legislation aimed at the perceived

major business of the time, monopolies. Other federal laws included the Federal Trade Commission Act of 1914, the Securities Acts of 1933-4, and the Sarbanes-Oxley Act of

• Review the impact of federal regulations on business practices over the last 100

plus years.

• All are suspected of fraud and most have been charged with fraudulent acts; there

have been several convictions & many cases pending.

• Fraud can occur at virtually any level of a corporation; it’s when top executives are

involved that earnings manipulation is usually found. The big scandals almost always involve manipulation at the top.

• All four cases are different in the sense that the forms of manipulation were unique:

waste management primarily involved manipulating fixed assets, sunbeam with fraudulent revenue recognition, Enron with SPEs and “mark to model” revenue recognition and WorldCom with capitalizing expenses. They’re similar in that fraud was used to manipulate earnings and in all cases Arthur Andersen was the accommodating auditor.

• A major difference of many of the current scandals is the sheer size of the

manipulations and the companies—involving billions of dollars. The major 20 th

century scandals were outright fraud, but involved much smaller companies.

• The early Robber Barons most resemble the current investment banking scoundrels;

they were wheeler-dealers & manipulated both markets and the legal system.

• Almost always, federal regulations followed business scandals and recessions. They

were attempts to fix the most visible abuses & establish new institutions (such as the SEC in the 1930s) to expand for federal regulatory environment

Cases

Case 1. Financial analysis from the 1850s. Attached as Table 2 are the financial statements presented for the Minehill & Schuylkill Haven Railroad from 1850. This was a small Pennsylvania Railroad used to transport coal, mainly to Philadelphia.

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