Extreme Earnings Management Techniques - Coursework Example

Earning Management and Cookie Jar Using relevant academic papers, discuss the incentives why managers would resort to extreme earnings management technique: Profit is the primary focus of every business and competition is the main element that stands between organizations and their success. If a company in a particular industry needs to win, it needs to possess some unique quality, it may be in terms of the products and services it offers or the process it employs to produce the output. One cannot be a leader in the industry by merely imitating others and, therefore, the management team needs to find a best option to be innovative and to sustain the organization’s competitive edge. Sometimes the team may make use of any means to get to the top, which would eventually lead to unfair trade practices. There are various business ethics as well as rules and regulations, which are compulsorily to be followed by every business organization. Many of these rules aim to protect the interest of the customers. Any trade practice that is against the ethics, will lead to legal proceedings and penalties. As per the various sections under the Consumer Protection Act, these entities can be punished if they breach any laws and bring harm to the customers. Earnings management can be defined as “a purposeful intervention in the external financial reporting process, with the intent of obtaining some private gain”. (Earnings Management Incentive and Techniques, n.d) Instead of doing business in a proper and sincere way, sometimes the management team may be forced to carry out business illegally due to various reasons. This is due to the fact that human beings are always keen on finding shortcuts for every task and, therefore, they always prefer these types of extreme earning management techniques. The common extra earning techniques followed are “cookie jar reserve technique, big bath techniques, big bet on the future technique, flushing,” (Popular Earning Management Techniques, n.d) stuffing the channel etc. In cookie jar reserve, the accounting rule GAAP is not followed properly. Here the profits made in the current year are used to cover for losses made in some other year, in order to ensure the profitability of the firm by meeting its margin. Big bath is used by companies when stiff competition arises, the company will plan on “restructuring” (Popular Earning Management Techniques, n.d.) the existing system and policies. Then, instead of recording the cost of such changes made in the organization, this loss is “reported as a non-recurring charge against income” (Popular Earning Management Techniques, n.d.). This is done for the purpose of maintaining the market value of the firm, as in case if the investors come to know that the company has made changes to hide its inefficiency in competitiveness, the investors will disinvest in the particular organization and purchase the share of competitors. Big bet on future technique is used by a company when it plans on acquiring another. During acquisition, a part of consideration is “to be written off against current earnings in the acquisition year” (Popular Earning Management Techniques, n.d.) for protecting the earnings in the future years. In stuffing the channel, the company will send more products to the market than required, but the distribution channels will not be able to sell all the products every time. The benefits may be to satisfy personal or organizational interests. It may either be a small team in the firm that has planned to carry out such an activity, and the team members would share the income extra earned among themselves. Otherwise, the entire organization may be a part of the activity and the top executives may have been behind the initiation of such practices in order to reap extra benefits. Such cases will result in an increase in the market value of shares of the firm and the rating of the firm will increase notably. This will entail more profits as well as increment in salaries. These activities reveal the motive of greed and extra monetary benefit that people have. If they get caught, their brand image and fame will disappear within mere seconds. The main incentives for the managers through channel stuffing are “the marginal effect, the boundary effect and the carryover effect” (Manager Incentives for Channel Stuffing with Market-based Compensation, n.d). When the market value of the firm increases, then the incentives for the managers will also increase. The investors or shareholders can verify the final statements and understand the role of the manager and his compensation. So the managers can show excess sales units and can earn in the short run. But it will spoil the goodwill of the company during the long run. Managers can influence the external parties who assess performance of the company such as prospective investors, credit rating agencies, financial institutions etc through this act. Another reason behind such practices is to get into good terms with the suppliers. Some other reasons behind such activity of managers are to reduce the tax burden. This is possible by making delay in recording incomes in the books of accounts, thereby extending the date for tax payment. Achieving the target of marginal income will thus result in bonus to the managers. Critically evaluate the effectiveness of ‘stuffing the channels’ and ‘cookie jar accounting’ as earnings management devices. Consider both from the standpoint of a single year and over a series of years: Stuffing the channels and cookie jar accounting has already been mentioned earlier. In the context of given case of Bristol-Myers Squibb (BMS), a multinational pharmaceutical company, that had to pay a penalty of 150 billion dollars for fraudulent trade. The company had earned “1.5 billion” (Bristol-Myers Squibb Company.2004) “by selling excessive amount of pharmaceutical products to its wholesalers” (Bristol-Myers Squibb Company, 2004). By using cookie jar reserve, the company tried to meet internal sales targets. In the short run, say a year, the benefit of channel stuffing is the rise in market value. In the case of BMS, the main reason behind the fraudulent activity were meeting the sales forecast made by the analysts. When considering a single year, it is effective for the managers to stuff the channels because within such short period it is very difficult to trace them out. As is the usual case, the wholesalers may make complaints to the media or other regulatory bodies because of bulk stock. But in case of BMS, the company itself had paid the carrying cost so there were no complaints from wholesaler’s part. These can be identified by an auditor through a detailed area wise or segment wise disclosure of sales. Over a series of years, stuffing the channels becomes less effective because the unsold goods for the current year will result in reduction in sales next year. From the wholesaler’s part also several problems arise. If at all the company follows the current fraudulent practice during the next year also, there is a chance that the wholesaler may give complaints in the name of the company. This may be because of lack of space in the warehouse or other reasons. The carrying cost also will be very high for BMS. Cookie jar accounting is also hard to detect as is the case of channel stuffing. Here, the firm will follow certain flexible rules while disposing the assets on the disclosure of gains and losses. For any losses, the company can maintain a provision account, therefore the company can charge a high amount as provision because GAAP does not require the disclosure of such reversals. Without full disclosure, one cannot find out the extent of such fraud practices and the same has happened in case of BMS. This calls for investigation to find out various unfair trade practices. A company can use cookie jar as a tool to earn more, but in the long run, it can be identified that the company has undergone some fraudulent activities. Finally, these extra earning management techniques are against the fair business practices and business ethics, which each and every business organizations are compulsorily required to follow. So if at all the business gets caught by any regulated body, the punishment will be very severe and such problems will negatively affect the goodwill of the firm. Critically appraise the circumstances where an impairment loss is deemed to have occurred and explain when companies should perform an impairment review of assets:  The impairment loss recognition has great significance in accounting practice and hence it is important for the quality of the financial statements as it facilitates the estimation of recoverable or actual value of asset. It is very difficult to assess the value of each and every asset during the everyday operations of business, and also quality of the statement would demand the actual value of each asset. So it becomes significantly important to conduct an impairment test at the end of each financial year. The “recoverable amount” (KPMG, 2010) of an asset is calculated to be less than its “carrying amount” (KPMG, 2010), then the carrying amount “should be reduced” (KPMG, 2010) to the recoverable amount. Such reduction is called “impairment loss” (KPMG, 2010). According to International Accounting Standard (IAS), a financial asset is impaired and impairment losses are incurred “when there is any evidence of impairment” (KPMG.2010), which is the result of one or more “event (that have) occurred” (KPMG, 2010) to the financial asset. In the span of a financial year, naturally, each asset is subject to certain changes, which may occur either internally or externally. It may either increase its recoverable value or reduce it. Since it is very difficult to estimate the value of each and every asset, IFRS guidelines provide certain guiding principles to conduct impairment loss assessment. Under its guideline, it points out mainly two stages for impairment loss recognition, which are “reporting date when there is any evidence of impairment” and “annually for certain asset.” Regardless of any indication of impairment, which include intangible asset of indefinite useful life and intangible asset that are not yet available for use as well as asset goodwill which are available by business combination (KPMG, 2010). As mentioned above, certain circumstances directly impact the value of assets, which in turn cause its impairment. Internationally Accepted Accounting Principles clearly mention about the circumstance under which impairment loss occurs. It includes the following: a) “A significant decrease in market price” (Impairment of Value, nd). If market price is decreased significantly, it will also affect the recovery price of assets, so it may lead to impairment of loss. b) “A significant adverse change in how the asset is being used or in its physical condition”. (Impairment of Value, n.d). Another important factor being considered in the impairment is the physical condition and the usage of the particular asset. If the asset is adversely affected by any cause it may also lead to impairment. c) “A significant adverse change in legal factors or in the business climate” (Impairment of Value, nd). Business climate and legal factors have great impact on the impairment. If business climate is adversely affected by any factor, it would indirectly lead to impairment of loss. d) “An accumulation of costs significantly higher than the amount originally expected for the acquisition or construction of an asset” (Impairment of Value, nd). It also makes difference in the account, and in turn leads to impairment. e) “A current-period loss combined with a history of losses or a projection of continuing losses associated with the asset” (Impairment of Value, nd). f) “A realization that the asset will be disposed of significantly before the end of its estimated useful life” (Impairment of Value, nd).  When companies should perform an impairment review of assets? The main purpose of impairment review, conducted at the end of each financial year, is to rectify the changes that might have taken place in impaired assets. At each reporting stage, management assesses whether recognized impaired asset is no longer existing, it may have decreased or not. During the estimation, if it is observed to be decreased, the company “reverses the impairment loss” (Impairment Review Theories and Practice, 2007) on the asset. The impairment review should compare the carrying amount of the intangible asset with its recoverable amount. If there is a decrease in the carrying value, then the management would reverse the impairment of asset. Certain points are listed below, which serve to be the conditions for reversing an impairment loss. The reversal of an impairment loss on intangible assets and goodwill should be recognized in the current period 1. “An external event caused the recognition of the impairment loss in previous year, and subsequent external events clearly and demonstrably reverse the effects of that event in a way that was not foreseen in the original impairment calculations” (HM Revenue& Custom, n.d). 2. “The impairment loss arose on an intangible asset with a readily ascertainable market value and the net realisable value based on that market value has increased to above the intangible assets impaired carrying amount” (HM Revenue& Custom, n.d). The reversal of the impairment loss should be recognized to the extent that it increases the carrying amount of the goodwill or intangible asset up to the amount that it would have been, had the original impairment not occurred.  Circumstances that trigger the need for a review may arise from external as well as internal sources. Internal sources include: 1. “Physical damage or obsolescence of asset 2. A significant reorganization of business operations 3. The loss of key employees 4. Internal reports that indicate worse economic performance than expected” (HM Revenue & Custom, n.d). External sources include: 1. “Fall in the asset’s market value 2. An adverse change in the company’s competitive or regulatory environment 3. A significant increase in market interest rates 4. A key employer in the locality where a company carries on business closes down 5. The balance sheet value of an entity exceeds market capitalization” (HM Revenue & Custom, n.d). Using recent assets impairment decision taken by PSA Peugeot Citroën and Vodafone as examples, discuss the effects of such decision on the firms’ financial position and performance:  The net effects of asset impairment on a business are generally divided into two, namely, loss recognition and asset reduction. “Asset reduction” implies reduction in the value of asset and retained earnings held by the business. Generally, impairment is treated as loss in the income statement (Asset Impairment Procedure, 2013). Depending on the size of the impairment, it may result in notable reduction in profit of the firm, which is termed as “loss recognition” (Asset Impairment Procedure, 2013). In the long term perspective, the aim of asset impairment is to reduce the amount of depreciation recognized, so that profits tend to improve over the periods in which depreciation has been reduced. PSA Peugeot Citroën is a leading multinational automobile and motor cycle company and has encountered significant problems in its automotive division. The “PSA Peugeot citroen’s 2012 report” (PSA Peugeot Citroën, 2013) shows an impairment charge on the assets in the automotive division. By analyzing impairment decision and its effect, it becomes clear that the impairment decision does not affect a firm’s solvency and liquidity position, but it may result in the significant deterioration of its market share. Similarly, by analyzing one of the mobile giants, Vodafone’s latest “impairment decision” in Italy, Spain, Portugal and Greece, due to bad economic circumstances, it becomes evident that this impairment has affected the overall profit adversely, which would fall down by 0.4% in the Europe market (The Independent, 2013). Reference List Asset Impairment Procedure. 2013. Accounting Tools. Available at [Accessed on 28 March2013] Bristol-Myers Squibb Company Agrees to Pay $150 Million to Settle Fraud Charges.2004. U.S.Securities and Exchange Commission. Available at [Accessed on 28 March2013]. Earnings Management Incentives and Techniques in Chinas Listed Companies. n.d. Meng Yanqiong. Available at[Accessed on 28 March2013]. Impairment Review Theories and Practice. 2007. Richard Edwards is Professor of Accounting at Cardiff Business School. Available at [Accessed on 28 March2013]. Intangible Assets: Notes on Accounting Practice: Impairment loss.n.d.HM Revenue & Custom. Available at[Accessed on 28 March2013]. Impairment Testing. 2010. KPMG. Albania. Available at [Accessed on 28 March2013]. Manager Incentives for Channel Stuffing with Market-based Compensation. n.d. Lai.G & Lin Nan Available at [Accessed on 28 March2013]. Popular Earning Management Techniques. n.d. Thomson. Available at [Accessed on 28 March2013]. Property, Plant, and Equipment and Intangible Assets: Utilization and ImpairmentI. n.d. Available at [Accessed on 28 March2013]. PSA Peugeot Citroën: result of impairment tests on Automotive Division assets for Financial Year 2012.2013. PSA Peugeot Citroen. Available at [Accessed on 28 March2013]. Vodafone Write-offs in Southern Europe Wipe out Profits.2012.The Independent. Available at [Accessed on 28 March2013] Read More