Question

A common tactic to manage earnings is to “stuff the channels”, that is, to ship product prematurely to dealers and customers, thereby inflating sales for the period. A case in point is Bristol-Myers Squibb Co. (BMS), a multinational pharmaceutical company headquartered in New York. In August 2004, the SEC announced a $150 million penalty levied against BMS. This was part of an agreement to settle charges by the SEC that the company had engaged in a fraudulent scheme to inflate sales and earnings in order to meet analysts’ earnings forecasts.

The scheme involved recognition of revenue on pharmaceutical products shipped to its wholesalers in excess of the amounts demanded by them. These shipments amounted to $1.5 billion U.S. during 2001-2002. To persuade its wholesalers to accept this excess inventory, BMS agreed to cover their carrying costs, amounting to millions of dollars per quarter. In addition, BMS understated its accruals for rebates and discounts allowed to its large customers.

According to the SEC, the company also engaged in “cookie jar” accounting. That is, it created phony reserves for disposals of unneeded plants and divisions during high-profit quarters. These would be transferred to reduce operating expenses in low-profit quarters when BMS’s earnings still fell short of amounts needed to meet forecasts.

Required:

1. Give reasons why managers would resort to extreme earnings management tactics such as these.

[4 marks]

2. Evaluate the effectiveness of stuffing the channels as an earnings management device. Consider both from the standpoint of a single year and over a series of years.

[5 marks]

1. Evaluate the effectiveness of cookie jar accounting as an earnings management device.

Answer 1

1. Reasons why managers would resort to extreme earnings management:

(i) Meet investors earnings expectations to receive higher pricing for the shares and portay that the firm has performed very well.

(ii) To earn higher bonuses especially when the earnings of the managers are linked to profit and financial performance

(iii) To meet analyst forecasts in order to avoid the reputation damage and a strong negative price reaction.

(iv) To increase proceeds from a planned IPO in a hope of receiving higher price for their shares.

2. From the standpoint of a single year stuffiing channels are most likely to be effective since it is difficult to detect irregularities in a very short span of time. In the short run one a user can detect through careful analysis of sales patterns. Also the company may never voluntary disclose unless insisted by an external auditor. Wholesalers on the other hand may reject the company's offer if too much inventory is forced on them. Since BMS is an external party to the company it will difficult for them to complain to the regulators or media of the company's tactics and the business is paying carrying costs which may act as a deterrent. However in the long the such behavior can be possibly detected through following means:

(i). Reversal of accruals: The sales are likely to reduce next year due to products already stuffed into channels. There has to be long term strategy to keep it going for years.

(ii). Space limitations: The wholesalers may run out of space to stock the products.

(iii). Cost: The payment of carrying costs over years may increase the overall expenditure for BMS.

3. BMS is using cookie jar accounting to smoothen earnings. It is an effective way of managing earnings and is hard to detect. The company is overproviding for losses and putting future earnings in to the bank. Also, GAAP does not specify any accounting rule to disclose the effect on operating income when accruals reverse. BMS has taken advantage of the lack of this provision. However if such unusual items appear frequently on the financial statements, it can possibly signal cookie jar accounting. The market may not ideally find out the actual accounting being done, a suscipion by the SEC can lead to a full fledged investigation. Also, if BMS as excess reserves and provision it will lead to restatement of financials and subsequent charges by the regulators and lawsuits. The effectiveness of cookie jar is only useful if it is judiciously by the management. The recent accounting standards do not favor the cookie jar accounting and this tactic is now very dangerous.