Question

search and pick at least 1 research paper related to earnings management for: measuring earnings management, detecting earnings management, and preventing earnings management; finally, summarize your findings. ? I need an example of accounting scandal/fraud related to earnings management through the internet

Answer 1

Earnings management is the use of accounting techniques to produce financial reports that present an overly positive view of a company's business activities and financial position. Many accounting rules and principles require company management to make judgments. Earnings management takes advantage of how accounting rules are applied and creates financial statements that inflate earnings, revenue or total assets.

Companies use earnings management to smooth out fluctuations in earnings and present more consistent profits each month or year. Large fluctuations in income and expenses may be a normal part of a company's operations, but the changes may alarm investors who prefer to see stability and growth. A company's stock price often rises or falls after an earnings announcement, depending on whether the earnings meet or fall short of expectations

One method of manipulation is to change an accounting policy that generates higher earnings in the short term. For example, assume a furniture retailer uses the last-in, first-out (LIFO) method to account for the cost of inventory items sold, which means the newest units purchased are sold first. Since inventory costs typically increase over time, the newer units are more expensive, and this creates a higher cost of sales and a lower profit. If the retailer switches to the first-in, first-out (FIFO) method, the company sells the older, less-expensive units first. FIFO creates a lower cost of sales expense and a higher profit so the company can post higher profits in the short term.

Another form of manipulation is to change company policy so more costs are capitalized rather than expensed immediately. Capitalizing costs as assets delays the recognition of expenses and increases profits in the short term. Assume, for example, company policy dictates that every expense under $1,000 is immediately expensed and costs over $1,000 may be capitalized as assets. If the firm changes the policy and starts to capitalize far more assets, expenses decrease in the short term and profits increase.

A change in accounting policy, however, must be explained to financial statement readers, and that disclosure is usually stated in a footnote to the financial reports. The disclosure is required because of the accounting principle of consistency. Financial statements are comparable if the company uses the same accounting policies each year, and any change in policy must be explained to the financial report reader. As a result, this type of earnings manipulation is usually uncovered.

Accounting scandals are political and business scandals which arise with the disclosure of misdeeds by trusted executives of large public corporations. Such misdeeds typically involve complex methods for misusing funds, overstating revenues, understating expenses, overstating the value of corporate assets or underreporting the existence of liabilities, sometimes with the cooperation of officials in other corporations or affiliates.

WorldCom was one of the big success stories of the 1990s. It was a symbol of aggressive capitalism. Founded by Bernie Ebbers, one of the most aggressive acquirers during the US mergers and acquisitions boom of the 1990s, WorldCom’s asset value had soared to $180bn before the US capital market started witnessing a downtrend.

WorldCom admitted in March 2002 that it will have to restate its financial results to account for billions of dollars in improper bookkeeping. An internal audit showed that transfers of about $3.06 billion for 2001 and $797 million for the first quarter of 2002 were not made in accordance with generally accepted accounting principles.

In August 2002, an internal audit revealed an additional $3.3bn (£2.2bn) of improper reported earnings—taking the total to more than $7bn, double the level previously reported. Over $3.3bn money was from the company’s reserves, which was misrepresented as operating income.

As a result of the discovery, WorldCom said that its financial statements for 2000 will have to be reissued. The company said it may now write off $50.6bn in intangible assets. Former chief financial officer Scott Sullivan and ex-controller David Myers were arrested, and face seven counts of securities fraud and filing false statements with the SEC (US Securities and Exchange Commission).

The company filed for Chapter 11 bankruptcy protection on 22 July 2002, a process that protects it from its creditors while it tries to restructure. It became the largest bankruptcy in US history, listing $107bn in total assets and $41bn in debts.

In May 2003, WorldCom agreed to pay a record amount to the US financial watchdog. MCI (formerly WorldCom), while neither admitting nor denying any wrongdoing, came to a settlement over its massive accountancy scandal. It will pay $500m to SEC, the highest fine ever imposed by the regulator. The original figure of $1.5bn was scaled down as MCI declared itself bankrupt and so received favourable treatment.

The settlement sorts out the civil lawsuits that have been filed. But the criminal cases relating primarily to the actions of former employees at the company are still pending.

Summary

Scandal discovered: March 2002

Charges: Overstated cash flow by booking $3.8 billion in operating expenses as capital expenses. Company founder Bernard Ebbers received $400 million in off-the-books loans. The company found another $3.3 billion in improperly booked funds, taking the total misstatement to $7.2 billion, and it may have to take a goodwill charge of $50 billion.

Outcome: Former CFO Scott Sullivan and ex-controller David Myers have been arrested and criminally charged, while rumours of Bernie Ebbers’ impending indictment persist. On 9 March 2005, four foreign banks agreed to pay $428.4 mn for settling the class action law suit by investors accusing them of hiding risks at WorldCom before its collapse.