Revenue Recognition & Earnings Management - Research Paper Example

 Table of Contents Table of Contents 2 Introduction 3 Revenue Recognition and Earnings Management 3 Instances of Revenue Recognition and Earnings Management in the organizations 11 Conclusion 16 Reference 17 Bibliography 19 Introduction Recent accounting scandals have stimulated a wave of hysteria within the accounting community. This had led to a number of debates regarding the quality of earnings and the earnings management. For the regulators and standard setters, the research has confirmed their worries that revenue recognition and earnings management is an issue which is in need of considerable attention. This report aims to provide an insight into the ethical considerations of revenue recognition and earnings management of the companies. The issue has gained momentum in the wake of recent recession. A number of companies have gone bankrupt due to faulty revenue recognition and fraudulent earning activities of the management. It is high time for the concerned authority to look into the matter and introduce appropriate, transparent and quality revenue recognition and earning management activities. Revenue Recognition and Earnings Management A good example that shows the disparity between guidance in rule based and principles based standards is the manner in which both recognizes the revenue of a company when there are more than one deliverables. Revenue can be recognized when it is either realized or realizable and earned. Revenue can also be recognized when the delivery is made and the payment is assured. However, the revenue recognition can be termed as ‘conservative’ and ‘aggressive’. In ‘aggressive revenue recognition’ techniques companies recognize the revenues immediately. Trade loading and channel surfing are two techniques of aggressive revenue recognition. Receivables, which are not yet received at the end of a financial year, can be recognized as revenue for the company and is termed as aggressive revenue recognition. Xerox has recognized the cash from the leased contracts and reported that as its revenue amount. The company had admitted that it has overstated its revenue and profit amount starting from the year 1997 till 2001. This had been due to the over aggressive revenue recognition policies. As per Wall Street Journal, the overstatement had affected $ 6 billion revenues of Xerox (InformationAge, Xerox admits to overstating revenues by $1.9bn). The restatement had been achieved from the early recognition of revenue from on-going service, equipment, rental and finance contracts. A number of definitions have been assigned to the earnings management practices. Back in 1999, Healy and Wahlen argued that earnings management takes place when corporate managers use their judgment in the financial reporting or in structuring transactions to amend financial reports and deceive the stakeholders (Lehman, Re-Inventing Realities). In 1995, one more precise definition was offered by Fischer and Rosenzweig. According to them, earnings management is defined as the behavior of the managers by which they increase or decrease present reported earnings of a firm without consequent increase or decrease in the long term economic profitability of the firm. Levitt has defined the terminology in much simpler words. As per the researcher, it is an ‘accounting hocus-pocus’ which helps the management to hide the financial reality of the organizations. The ethics of earnings management is still under consideration but without any clear declaration from the authority. Both Dechow and Skinner have noticed that earnings management may not be always legal; still it can pose a moral challenge to the accounting profession. However, as per a former SEC Chairman, any earnings management activity is unacceptable regardless of its materiality as it demands hiding significant information from the shareholders which they ought to know. There is a thin distinguishing line between earnings management and frauds, which is not much appealing for most of the managers. A number of empirical evidences support this fact. A research has shown that a decline in the perceived reliability of the financial statements of a firm has resulted in a downward movement of all the perceived earnings quality. Parfet has introduced two types of earnings management. The first type deals with the contravention of GAAP by reporting superseded inventory and improper revenue recognition. The second one happens when the management of the organization establishes stable financial performance by acceptable and deliberate business decisions. These decisions may include selling surplus assets at the end of a period to increase income and working overtime at the year end to raise the production (Lehman, Re-Inventing Realities). Some argue that the later type is acceptable. The argument was also favoured by Deschow and Skinner. According to them, eliminating all flexibilities would mean eliminating the efficacy of earnings as an assessment of performance. Undoubtedly, earnings management can be used to increase the shareholders’ value. A continual increase in earnings can result in enhanced price to earnings ratio. However, discovery of the earnings manipulation within an organization can result in a decline in the stock prices. Apart from enhancing the shareholders’ value, there are certain other influential factors which make earnings management a treacherous area for the managers. Executives’ and even the employees’ incentive scheme and contracts may lead them to manage the earnings. Bausch & Lomb, Cendant and Sears are examples of organizations whose managers have manipulated the earnings. The driving force had been the incentive scheme and other such goals which would bring personal benefits to the managers. However, the question challenging its ethical nature is still valid. The accountants and managers may comply with the technicalities; however, the financial picture can be deceiving for the investors. A number of researches have shown that organizations, which are involved in earnings management, are more prone to boards of no independence (Jennings, Business Ethics: Case Studies and Selected Reading). Earnings management can be done by defalcation of assets involving the theft of an entity’s assets with a misrepresentation of the financial statement. Misappropriation of assets can be achieved in a number of ways including stealing assets, embezzling receipts and forcing an entity to pay for goods and services which are not yet received. The misappropriation process can demand the involvement of one or more parties including management, employees and third parties. Sometimes corporates may use earnings management to smoothen the earnings over two or more interim and annual accounting periods; or sometimes it can be done to attain a certain level of security valuation forecasts. Earnings management may also consider intentionally calculating and realizing transactions in the wrong accounting period or recording some fictitious transactions which have no existence. Both of these are considered to be fraudulent activities. For an instance, if an entity in response to increased costs, announces a hike in its price to meet the current period sales target or some other financial standards. The entity has a plan to increase the price at the starting of the next quarter. So, the event will make some consumers to buy unusually high quantities before the end of present quarter. If this sale meets all kinds of revenue recognition, the entity would like to recognize the revenue when it is shipped to the customers. This has every possibility to be recognized as an effective and legitimate management of earnings. However, if the sale has a right to return privilege attached to it, the sales would be termed as a conditional sale; in such a case, recognizing the revenue at the time of shipment would violate GAAP and misrepresent the financial statement. If, at the time of auditing, the part ‘right to return’ condition is concealed from the auditor, the act can even come under fraudulent financial reporting. This actually proves that there can be a wide range of earnings management activities which cannot be categorized and hence they can have a wide implication on the financial reporting starting from complete legitimacy in one to fraudulence in other. GAAP offers certain flexibilities in carrying out financial transactions as all the companies cannot have identical economical situation. Financial statement preparation takes into account those GAAP alternatives and uses its own estimation and judgment while aligning with the respective principles. Undoubtedly, companies have made the most out of it by amending the financial results of the organization. As mentioned earlier, most of the managers administer the earnings to structure the transactions, to alter the financial report, to either deceive the stakeholders regarding their real financial state or to manipulate the contractual outcomes depending upon the reported financial figures on accounting books. Earnings management is said to be an active manipulation to meet some pre-specified target. The target may be something set by the managers, more sustainable income stream or some forecasts made by the analysts (Ortega, William, Grant and Gerry, 2003). This may sound clichéd, but still it is quite true that accounting figures do not have any significance as long as they are not compared to some benchmark figures. That is why, the organizations have enough reasons to manage the earnings to meet such requirements and standards, and make expected changes in the income figures between parallel periods. A number of evidences have suggested that strong incentives are there to avoid accounting the losses. Income smoothing by earnings management strategy has been able to survive the test of time. The techniques had been in existence since decades. Two reasons have been there to influence the managers to amend the financial figures to smoothen the income. At first, smoothing presents a questionable efficient vehicle for the managers to reveal the private information. Secondly, smoothing represents ‘garbling’; smoothing is an activity carried out by the managers in an attempt to deceive the analysts and others and sometimes even to enhance managerial compensation. Managers carry out income smoothing either with the intention of information garbling or for benefits in order to transform and report the insider information about future prospective earnings. For many years, studies based on income smoothing have revealed that one of its purposes is to enhance the level of market return. A large number of rationales have been offered that income smoothing is done to enhance the firm’s stock. There can be two different ways to smoothen the income streams; the smoothing can be naturally done or it can be intentionally done by the management. A natural income smoothing can result from an income generating process. Managers use this to structure the revenue generating event to produce a smooth income stream. Manipulating profits can be a way to smoothen the income stream. The manipulation even can be done by adjusting the firm’s percentage change in earnings per share to the average percentage value of the industry, smoothing the earnings per share towards a standard value and smoothing the firm’s rate of return on common shareholders’ equity (Copeland & Licastro, A Note on Income Smoothing). Income shifting is one of the techniques of managing the earnings by shifting income from one period to another one. This is achieved by accelerating or delaying the revenues or expenses (Wild & Hasley, Financial Statement Analysis). This type of revenue recognition and earnings management usually demands a reversal of the effects in the later periods. For this, shifting the income in different periods is quite useful for smoothing the income. Some technique instances have been detailed below. One example has given above where a company can make the dealers and the consumers to buy more products in a specific period. This is known as ‘Channel Loading’. This kind of revenue recognition and earnings management technique can be seen mostly in automobile, cigarettes and manufacturing industry. Some companies even make delay in recognizing the expenses by capitalizing those and amortizing the expenses over the coming periods. Examples involve interest capitalization and even capitalizing the software development costs. Shifting expenses to the coming periods can be done by adopting few accounting methods. For an instance, adopting a ‘First in First out (FIFO)’ for valuing the stock level rather than using the ‘Last in First out (LIFO)’ can exercise delay in revenue recognition. Some companies use straight line depreciation against accelerated ones to make delay in recognizing the expenses. Writing off large one time charges for asset impairments and restructuring is one of the ways to manage the earnings. This allows the organization to accelerate the recognition of the expenses and make the earnings look enhanced in subsequent periods. A number of financial managers manage the earnings by categorizing the selective earnings and expenses. One of the most common forms is to mention the expenses as unusual and nonrecurring items, which are not of much significance for the analysts. Managers try to classify the expenses under the non recurring section of the income statement. Some examples can be able to offer more insights into the matter. When an organization discontinues a segment of its business, the income needs to be reported separately as either income or loss from the discontinued operations. This is not given any significance as the business segment is no longer in a position to affect the whole business. However, a number of companies take the benefits of these by shifting larger common costs as corporate overheads to the discontinued business segment by enhancing the income of the rest of business. Companies have been increasingly mentioning charges like asset impairment and restructuring charges. Many analysts ignore this segment which had been the motivation behind such activities of the management because of its unusual and nonrecurring nature. By considering these special charges which also include operating expenses, organizations make the analysts to ignore some amount of the operating expenses. Instances of Revenue Recognition and Earnings Management in the organizations Some examples of the companies have been given to have a better understanding of revenue recognition and earnings management within various organizations. Financial fraud in Fine Host Corporation can be an example to demonstrate the ways and techniques of amending the financial figures. The organization is a provider of food and beverage concession, catering and other services in the United States (Ryerson, Improper Capitalization and the Management of Earnings). While the organization was a private company, it was the organization’s accounting practice to put certain costs, related to pursuit of contracts, in the ‘acquisition cost’ account. After the contract was signed, the cost was shifted to ‘contracts right’ account and treated as capitalized costs to be amortized over the life of the contract. As per GAAP, this can only be done if the costs are directly related to acquisition of assets, acquired to gain future benefits. However, the organization put some of its general and administrative costs in that account, rather than properly recognizing them as period expenses. The amount of improper capitalization was huge amounting approximately 75 % of pretax income. The primary fraud mechanism in this case was inappropriate capitalization of company expenses as its assets. Another example has been Aerosonic, the airplane instrument manufacturer. The company had violated GAAP standards through some accounting schemes to record fictitious revenue. The whole story began in the year 1999 and continued for some three years. Adding to it, the company had also initiated inventory schemes to understate the expenses and overstate its inventory level. Among all these accounting manipulations, labour and overhead costs were inappropriately capitalized and recognized as inventory cost. The fraud involved understating a considerable amount of expenses amounting to around $ 6.7 million. Del Global Technologies corporation, Inc is another organization which was charged with materially overstating revenues and making a number of material misrepresentations of figures in various places. The company has inappropriately accounted its obsolete inventory level at its full value. Adding to it, the company had overstated its work in progress values and had recognized certain ordinary expenses as capital expenditures. The actions had violated GAAP regulations and resulted in exaggeration of reported pretax income at least by $ 3.7 million. Back in 1983, Bernie Ebbers started its long distance telecom company; later on he changed its name to ‘Worldcom’ in 1995. The company had undergone various mergers with other companies. Managers at WorldCom took advantage of the company’s culture of conflict of interest and proper lack of control to manage the reported earnings aggressively. WorldCom had a solid asset amount of $ 104 billion and debt to equity ratio of 79.3 %. However, half of the assets consisted of goodwill and some other intangibles. In the year 2002, at the time of auditing it was found that the company had capitalized its operating expenses. In the month of June in the same year, the company announced $ 3.8 billion in the accounting errors. The company was capitalizing its ‘line costs’ which were the fees paid to a number of telecom companies to get access to the network; these were supposed to be the operating expenses. Actual capitalization figures amounted to over $ 11 billion. In 2002, the company filed its bankruptcy which stood out as the largest one in US history. Companies like Cedant, Lucent Technologies and MicroStrategy showed accounting standards which can be termed as ‘abusive earnings management schemes’. All these three companies have been engaged in earnings management mainly to ‘smooth’ earnings to meet all the earnings forecasts and analysts’ expectations. Tyco started off its business as a research lab. The company has emerged as a conglomerate through a binge of acquisitions. The company has acquired some 750 companies and used their earnings in combination accounting. The company made huge loss after selling CIT. The CEO of the organization indicated that it was for evading taxes and ‘raiding Tyco’. However, the company did not go bankrupt as it was not clear whether the company was actually involved in criminal activities. Staring as a gas company, Enron expanded its business to other industries. However, the business segments were not doing well. Adding to it, the company had huge debt on the balance sheet. This dramatically raised its financial risk. Enron was unwilling to report its real losses incurred from its business segments. In the mid 2001, the company share prices dropped. Even the company’s bonds were downgraded to ‘junk bond’ category. To remove the debt amount from the organization balance sheet, the company had established a special purpose entity to shift all its debt to that entity. In the absence of credibility, the organization declared its bankruptcy at the end of the year, 2001. The bankruptcy was termed as the biggest after WorldCom. SmarTalk was charged with reporting materially false and deceiving financial figures to the SEC. This had been happening from the year 1997 till the second quarter of 1998. It was found that the company has fraudulently reported a net profit amount of $ 478, 000 in the third quarter of 1997. However, the company incurred losses for that specific time period. The organization had been doing inappropriate capitalization of general operating expenses. These items included travel and entertainment costs for the executives, consulting and legal fees, relocation expenses for the employees, and telephone expenses. In the third quarter of the year 1997, the total cost amounted to be around $ 1.1 million. These costs were supposed to be reported as expenses. However, instead of that, the company reported them as prepaid expense which is an asset on the balance sheet. In this way the company created some fictitious assets. Although the company had incurred a loss amount of $ 622,000, this had allowed the organization to improperly report the $ 478,000 in third quarter net income. In April of 2003, a report had revealed the inappropriate accounting done by Chancellor Corporation. The company had managed its earnings while acquiring a subsidiary. The organization had inappropriately recorded $3.3 million in consulting fees payable to Vestex Capital Corporation (Vestex). The fees had been reported as an acquisition cost of the subsidiary rather than being reported as an expense to the company. If the organization had reported the fees as expenses, it would have resulted in a net loss of $2.45 million for the year 1998. The company had capitalized the fee amount and as a consequence, the company had been able to report a net gain of $ 850,000. The recognition of the cost was inappropriate as Vestex was owned by the CEO of Chancellor. As per GAAP, the charges payable to the employees or to the entities owned or controlled by the organization employees are considered and should be reported as internal costs and must be mentioned while reporting the financial figures. Adding to it, charges were found to been paid for the services yet to be rendered. An unjustifiable payment was inappropriately capitalized instead of reporting it as an expense. The next example includes The Warnaco Group, Inc and its materially deceptive annual report for the fiscal year 1998. The restatement of a material of $145 million of the earlier three years’ financial results had been included in the Form 10-K. This had, in turn, decreased the net income by a total of $ 104.8 million. As per the commission, the annual report was found to be misleading as the organization had lied about the motivation of restatement. The company mentioned that the restatement was due to huge write-off. The amount was formerly deferred and “start-up related” costs incurred as the company had adopted a new accounting pronouncement. Actually, the restatement was due to a material stock exaggeration which had been the consequence of a faulty cost accounting. The faulty cost accounting system had been operated at one largest division of the firm. In that division, certain cost data had been omitted by the erroneous cost accounting system and at the same time the costs, incurred, had been inappropriately capitalized. The company used to utilize a standard costing system which had been poor in service and even was not able to approximate the production costs of the division. However, the variance among the actual and reported figures was huge. These figures, in compliance with GAAP, were allocated between the proper inventory accounts and the account for cost of goods sold. This had been done in an endeavor to estimate actual product costs. However, the method to estimate these costs has a number of deficiencies. As a consequence, huge variance had raised and was capitalized in organization inventory. This had led to the overstatement of the inventory level by around $ 145 million. One of the reasons had been inappropriate reporting of start-up related costs by the organization. In short, the company was forced to restate its financial figures as it failed to match the expenses with its revenues. The company had failed to make a balance between cost of goods sold and the sales amount. As per the concerned authority, the costs were inappropriately assigned and were even overstated by a considerable amount due to the erroneous capitalization of certain costs as product costs rather than accounting them as period costs. Conclusion Since earnings management by improper recognition of revenues and expenses distorts the financial statements, identifying and making adjustments can be a significant task in the analysis part. Despite of a rapid increase in the earnings management scandals, the awareness among the investors is less spread than presumed. It has been noticed that companies like Enron, WorldCom and Tyco had certain similarities in them. The companies had carried out deception at a huge scale; the manipulation of the highest order had been executed. All these companies attained growth by acquiring and combining the related business accounting. Organizations operating in this competitive business environment are under tremendous pressure to meet the quarterly earnings targets. Adding to it, the senior managers of the firms expect a parallel enrichment in their job profiles and remuneration schemes. This had made more companies to recognize revenue in a faulty manner and amend the earnings in such a way so as to mislead the shareholders. The organizations must not forget the ethical side of the business while operating and competing with each other. Reference Copeland, R. & Licastro, R. 1968. 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