Question

NEW YORK (CNN/Money) - The Securities and Exchange Commission and Microsoft Corp. have settled a long-running inquiry into the software maker's accounting practices. To conclude the matter, Microsoft said it has agreed to comply with SEC provisions that require companies to make accurate filings and maintain records and controls sufficient to prepare financial statements in conformity with generally accepted accounting principles, or GAAP. The agency said its investigation had determined that Microsoft had misstated its income by material amounts between July 1, 1994, and June 30, 1998. The company did so by maintaining seven reserve accounts in a manner that did not comply with GAAP, the SEC said. During 1995 through 1998, the total balance of these accounts ranged from approximately $200 million to $900 million, the SEC said. Microsoft recorded reserves, accruals, allowances, and liability accounts relating to marketing expenses, sales, depreciation, inventory obsolescence, valuation of financial assets, interest income, and impairment of manufacturing facilities that did not have properly substantiated bases, the SEC said. In its filings with the SEC, Microsoft made reference to these accounts but did not fully document them, therefore overstating its income in some quarters and understating it in others, the SEC said. Under the terms of the settlement, which was leaked to the press last week, Microsoft was ordered to discontinue the practice. The company was not fined, nor was it charged with accounting fraud. "This case emphasizes that the commission will act against a public company that issues financial statements with material inaccuracies, even in the absence of fraud charges," Stephen M. Cutler, director of the SEC's enforcement division, stated. Microsoft said the agreement has no impact on its reported financial results and no restatement of any reported financial results is required. Microsoft (MSFT: down $0.87 to $50.04, Research, Estimates) shares were down 1.8 percent in Nasdaq trading early Monday afternoon

Required:

1. In this case, Microsoft was charged of “overstating its income in some quarters and understating it in others”. What are the possible reasons companies are likely to engage in such kind of activities?

2. What are the possible ways a company may engage in earnings management activities? Please provide an example for each type of earnings management activities, and discuss how to figure out such earnings management activities as a financial analyst.

Answer 1

1)

Earnings management is an accounting technique used by the companies in order to make it's financials look beter. This is often done in order to match the actual results with the forecasted or budgeted results for the period. This process is also called Income smoothing.

It involves overstatement of results in some periods and understatement is some other periods. Generally, it is done to even out fluctuations of results between periods. It is widely practiced and not illegal. But if done excessive or abusive manipulation, the Securities Exchange Commission (SEC) will levy penalties on the company practicing such techniques.

The possible reasons for doing such Earnings management are to even out the growth of the entity between different quarters of a year, to manage stake holders expectations, to reduce the fluctuations in return there by reducing the stock Volatility and stabilizing the share price in the market, to meet the forecasts and budgets etc

There is a fine line between earnings management and abusive manipulation of accounts. If the accounts are manipulated to reduce the federal taxes, it is considered as abusive. If the accounts are manipulated over a long term, then also it is taken as excessive manipulation of accounts which will attract severe fines and penalties from SEC. In general income smoothing is done for short period of time between different periods which will offset themselves (overstatement in one period and understatement in other period).

2)

There are many ways in which earnings management is practiced by companies. Some of them include

A. Overstatement/Understatement of provisions :

Many a times companies manipulate their provisions in order overstate or understate the earnings.

To find out, we may ask for the basis on which such provision is based (either previous trends or actuarial calculations)

B. Valuation of assets :

Companies value their assets and take the resultant gain/loss to income statement inorder to have desired results.

We may ask for the actuarial calculations of such valuation or we may get the fair market value from the market and compare with the valued amount

C. Unwanted reserves :

It is the easy way to manipulate accounts as this require no basis as proof for the amount set aside as reserve. In this the company may create unwanted reserves and transfer it's profits to such reserve and stabilizing the profit.

We have to go through the financials to find out all the reserves and ask for the reason of maintaining such reserves. This is the same thing happened in Microsoft case. They maintained excess reserves with no proper basis.

D. Impairment :

Under this the company use the assets and impair them as a result of permanent decline in the value of such fixed assets or intangible assets.

We have to be obtain the actual market value of such assets and also verify the calculation done for value in use (discounted present value calculations) and decide on the overstatement or understatement.

E. Inventory valuation :

This can be used by the company inorder to change its results. It may vary it's valuation technique or closing balance of inventory or obsolescence expense.

We have to get the proper reason for such change in valuation technique, actual invetory balance at the end of year based on physical verification, read for obsolescence.