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Strategic methods or methods or
matching estimates with estimates but
full disclosure with little or no
disclosure
9
Earnings Management Techniques
The
The Earnings
Earnings Management
Management Continuum
Continuum
Fraudulent
reporting Fraud
Non-GAAP Fictitious
accounting transactions
Enron ZZZZ
Best
10
1. Shifting income between periods:
Revenues Expenses
Borrowing 1. Premature 2. Capitalization of
earnings from recognition of expenses
the future revenues Example: WorldCom
Example: Xerox
Postponing 3. Deferring 4. Exaggerating
earnings to the recognition of current
future revenues expenses/losses to
Example: Microsoft create cookie jar
reserves
Example: Microsoft
11
2. Classification of gains and losses:
Classifying one-time gains as earnings from
continuing operations
Classifying losses from continuing operations as one-
time items
3. Hiding Debt in unconsolidated subsidiaries
Example: Enron
12
The 2008 balance sheet comprised
faked and inflated figures of revenue,
profit, interest and debt. The list
includes Rs 5,040 crore of non-existent
cash and bank balances, non-existent
accrued interest, understated liability
of Rs 1,230 crore on account of funds
raised by Mr Raju and overstated
debtors position of Rs 490 crore (as
against Rs 2,651 crore).
13
Worldcom (expense capitalization)
Satyam Computers (bogus revenue)
Tyco (executive loans, merger magic)
Adelphia (borrowing from company)
Waste Management (materiality)
SunBeam (channel stuffing, cookie jar
reserves)
Healthsouth (false earnings)
Why does management manage earnings?
External pressures
Analysts forecasts
Access to debt markets
Competition
Contractual agreements & debt covenants
Roaring stock market
Emerging financial instruments
Market disregard for big charges
Pressures within the company
Merger attractiveness
Management compensation
Short term focus
Unrealistic budgets and plans
Excessive profits followed by decline
Personal factors bonus, promotions, job
retention
Signals that should be checked in company reports
Read the audit report
Reduction in managed costs such as advertising in relation to
sales
Changes in accounting policies towards more liberal
applications
Unexpected increase in accounts receivable
Extension of trade payables longer than normal credit
Unusual increase in intangible assets
One time sources of income
Decline in gross margins
Reduction in reserves
Reliance on income sources other than core business
Not reserving for future probable losses
Unusual increase in borrowings
Increase in deferred taxes
Increase in unfunded pension liability
Low cash and marketable securities at year end
Peak short borrowings at year end
Slowdown of inventory turnover ratio
When should you pay more attention to the company?
Audit failure
Shareholder involvement
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