Financial Reporting Quality: Earnings Management and Departures from GAAP

Assume that Big Pine Wood Products is experiencing a decline in earnings in the current year due to increased costs of operations and is projecting net income of only USD 30,000 instead of the expected USD 40,000. Big Pine has several bond issues outstanding they decided to retire that resulted in a gain of USD 10,000 that offset the reduced earnings. What do you think of this transaction?

No. The transaction may or may not have been a good business decision, but it is clearly earnings management as the intent of retiring the bonds was to increase earnings in the current period.

Correct. The company clearly intended to increase earnings in the period through the retirement of the bonds, which is an earnings management technique.

Earnings management is not always related to the reported earnings of the company but can be used to influence other measures of performance, such as earnings per share. Assume that Big Pine Wood Products decided that rather than retiring the bonds early, they would repurchase some of their own stock. The company bought 50,000 of the 200,000 shares that were outstanding. Why do you think that Big Pine purchased the shares?

No. Repurchasing stock does not result in a gain.

Incorrect. Even if they sold the stock at a higher price, it would increase equity, not result in a gain.

Correct. By reducing the number of outstanding shares in the calculation of earnings per share, they have effectively maintained the earnings per share that would have been reported at the higher level of earnings. USD 40,000 in net income divided by 200,000 outstanding shares would have been EPS of USD 0.20. The lower net income of USD 30,000 divided by the reduced shares outstanding of 150,000 provides the same EPS of USD 0.20. Companies may include non-GAAP financial information such as pro forma earnings or other presentations using non-GAAP measures, but cannot place emphasis on the non-GAAP information. The non-GAAP measures must be disclosed and reconciled to GAAP for reporting purposes. The reconciliation shows important information as to what was included or excluded from the non-GAAP measurements.

Reports near or at the bottom of the quality spectrum are low-quality reports because they either contain departures from GAAP or, at the very bottom, contain fraudulent or fake transactions. These reports are not useful in evaluating the earnings quality of a company. Billy Bob’s Cattle Company is nearing the end of the year and is projecting less than expected revenues. Billy Bob’s has 50 feeder calves that he will be selling shortly after the end of the fiscal year. He makes an estimate of the sales price and records revenue in the current year. What do you think about the quality of Billy Bob’s financial statements?

Correct. Billy Bob’s is recognizing revenues before it has met the requirements to do so under GAAP and is not in conformance, resulting in low-quality reports. The difference between whether reports are at the very bottom of the quality spectrum or slightly above the bottom is whether or not the information is simply not in conformance with GAAP or whether the information contains transactions that are fake.

Incorrect. Although the transaction has not occurred, it is not fictitious, just not recorded under proper revenue recognition in conformance with GAAP.

Incorrect. The reports are not in conformance with GAAP revenue recognition.

The following year, Billy Bob’s Cattle Company did not have as many calves as expected available for sale. Rather than show lower revenues, Billy Bob's plans to buy 20 calves to resell but doesn’t have them. Billy Bob's created a dummy invoice and recorded the sale of 20 calves on account prior to the end of the year. What do you think of Billy Bob’s strategy of increasing revenues?

No. Recording a non-existent transaction is not a valid or acceptable strategy.

No. Recording sales that did not occur from inventory that does not exist is fraudulent.

Yes! By recording sales that did not occur from inventory that does not exist, Billy Bob's is creating a fictitious transaction that results in financial reports at the bottom of the quality spectrum.

In summary: [[summary]]

__Earnings management__ is intentionally picking accounting options that will create biased reports. Earnings management may be accomplished through the choice of accounting methods or from taking intentional specific actions that will result in "better" earnings outcomes. Whether a decision is simply a biased choice or earnings management depends on whether the intent of the decision was to purposely create a change in earnings outcome.

The transaction is not earnings management, just a good business decision

The transaction is earnings management as intent to increase earnings is clear

To record a gain on the repurchase

To resell at a higher price and record a gain

To increase the earnings per share reported

They are prepared properly as long as he discloses his estimate

They contain fraudulent reporting and are of low quality

They contain departures from GAAP and are of low quality

The strategy is valid since cash wasn’t recorded

The strategy is not in conformance with GAAP but is not fraudulent

The strategy is fraudulent and not in conformance with GAAP

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