Solution manual intermediate accounting 15e by stice ch06

The four factors that might motivate a manager to attempt to manage earnings are as follows: a Meet internal targets b Meet external expectations c Provide income smoothing d Provide win

CHAPTER 6 QUESTIONS

1 The four factors that might motivate a

manager to attempt to manage

earnings are as follows:

(a) Meet internal targets

(b) Meet external expectations

(c) Provide income smoothing

(d) Provide window dressing for an

IPO or a loan

2 (a) Internal earnings targets are an

important tool in motivating

managers to increase sales efforts,

control costs, and use resources

more efficiently

(b) The risk with internal earnings

targets is that the person being

evaluated will forget the underlying

purpose of the measurement and

instead focus on the measured

number itself

3 Academic research has demonstrated

that managers subject to an

earnings-based bonus plan are more likely to

manage earnings upward if they are

close enough to reach the bonus

threshold and are more likely to

manage earnings downward, saving

the earnings for a rainy day, if reported

earnings substantially exceed the

maximum bonus level

4 Because the existence of an

earnings-based bonus plan increases the

incentive of managers to manipulate

the reported numbers, auditors

consider such plans to be a risk factor

as they plan the nature and extent of

their audit work As a result, it is

possible that the existence of such a

plan might increase the amount of audit

work performed

5 The figure in Exhibit 62 displays a

trough just below zero, indicating that

the number of companies with earnings

just below zero is significantly lower

than expected In addition, there is a

lump on the distribution just above

zero, indicating that the number of

companies with earnings just above

zero is significantly greater thanexpected This suggests thatcompanies that compute a preliminaryearnings number that is slightly lessthan zero make more favorable accrualassumptions to get earnings to bepositive

6 If analysts’ earnings forecasts are

merely a mathematical forecast of amechanically generated number, theforecasts should be less than actualearnings half the time and more thanactual earnings half the time The factthat many companies meet or exceedanalysts’ forecasts for many quarters in

a row strongly suggests that theprocess is being managed in someway The figure in Exhibit 62demonstrates that managers do indeedmanage reported earnings There isalso evidence that managers provide

“guidance” to analysts to try to ensurethat the analysts’ forecasts are not toohigh to reach So, companies canconsistently meet or beat analysts’forecasts because they manageearnings and they also manage theforecasts

7 Income smoothing is the practice of

carefully timing the recognition ofrevenues and expenses to even out theamount of reported earnings from oneyear to the next

8 As described in the text of the chapter,

General Electric’s business structure isparticularly well suited to incomesmoothing because of the company’slarge number of diverse operating units(e.g., financial services, heavymanufacturing, home appliances) Alarge one-time loss reported by onebusiness unit can frequently bematched with an offsetting gainreported by another unit By carefullytiming the recognition of these gainsand losses, GE can avoid reportingearnings that bounce up and downfrom year to year Perhaps more

237

years Because of this, any income

smoothing undertaken by GE has been

merely the carefully timing of the

recognition of income, not a desperate

attempt to create earnings out of thin

air

9 Many studies have demonstrated the

tendency of managers in U.S

companies to boost their reported

earnings using accounting assumptions

in the period before an initial public

offering (IPO) Research has also

shown that socialist managers in

Chinese state-owned enterprises

(SOEs) do exactly the same thing in

advance of selling shares of the SOE to

the public

10 An important piece of evidence that

U.S companies can submit to the U.S

International Trade Commission (ITC)

when petitioning for import barriers is

financial statements showing a

reduction in profitability corresponding

to an increase in the import of

competing foreign products Research

suggests that, at least in the past, U.S

companies may have managed

earnings downward in advance of filing

a petition with the ITC

11 Accountants, using the concepts of

accrual accounting and the accounting

standards that have been patiently

developed over the course of the past

500 years, add information value by

using estimates and assumptions to

convert the raw cash flow data into

accrual data Net income is a better

measure of a company’s economic

performance for a period than is

operating cash flow Thus, even though

the flexibility of accrual accounting

opens the door to some abuse, the

basic system provides useful

information for financial statement

users

12 The five labels in the earnings

management continuum, and the

general types of actions associated

with each, are as follows:

Transaction Timing

2 Aggressive Accounting

Change in methods

or estimates with full disclosure

3 Deceptive Accounting Change in methods or estimates with little

or no disclosure

4 Fraudulent Reporting

Non-GAAP accounting

5 Fraud Fictitious

transactions

13 Changing accounting estimates to

reflect the most current informationavailable is an essential part of accrualaccounting However, to ensure thatfinancial statement users canmeaningfully compare the results for thisyear (prepared using the new estimate)with the results for last year (preparedusing the old estimate), the impact ofsuch changes in estimate must be fullydisclosed

14 Non-GAAP accounting can be the result

of intentional, fraudulent misstatement

or an inadvertent error

15 The five items in the earnings

management continuum (see Exhibit64) mirror the progression in earningsmanagement strategies followed byindividual companies It is unlikely that acompany would jump straight to creatingfictitious transactions in order to manageearnings Instead, the company wouldprobably start with small and legitimateattempts to improve reportedperformance, such as the careful timing

of transactions The company wouldthen progress through accountingchanges, both disclosed andundisclosed, and then to non-GAAPaccounting The creation of fictitioustransactions is typically a last-ditch effort

to manage reported results after other,less drastic, measures have fallen short

16 The five techniques of accounting

hocus-pocus identified by Arthur Levitt

are as follows:

(a) Big bath charges

(b) Creative acquisition accounting

(c) Cookie jar reserves

(d) Materiality

(e) Revenue recognition

17 If a company expects to have a series of

losses or large expenses in future years,

the notion of a big bath is that it is better

to try to recognize all of the bad news in

one year, leaving future years unspoiled

by continuing losses According to this

notion, after a year or two financial

statement users will have forgotten

about the horrible bath year and instead

will be impressed that no additional

pieces of bad news have hit the financial

statements

18 Since 1998, the FASB has limited the

flexibility companies have to recognize

big bath restructuring charges by

adopting SFAS No 144 on impairment

losses and SFAS No 146 on the timing

of the recognition of restructuring

obligations

19 A company can “take a bath” when

recording the acquisition of another

company by allocating a large amount of

the purchase price to “purchased

in-process R&D.” Purchased in-in-process

R&D is expensed immediately in

accordance with the mandated U.S

GAAP treatment of all R&D

expenditures The net result is similar to

a big bath in that a large R&D expense

is recorded in the acquisition year, and

expenses in subsequent years are lower

than they would have been had the

purchase price been allocated to a

depreciable asset

20 When a company establishes a cookie

jar reserve, it overreports expenses or

underreports revenues during the

current year in the anticipation that

these deferred earnings can than be

recognized as needed in a future year

Thus, the most likely candidate for a

company to be tempted to establish a

cookie jar reserve is one that has

better-than-expected performance in the

current year but with concern aboutfuture years

239

21 The traditional concept of materiality is

based on straightforward numerical

thresholds such as 1% of sales, 5% of

operating income, or 10% of

stockholders’ equity The concept of

materiality in SAB 99 requires that one

look at the context to decide whether an

amount is material For example, if a

$100,000 expense is just 2% of

operating income but the nonrecognition

of this expense would result in a

company having earnings high enough

to meet analysts’ expectations, the item

is material

22 In order to limit the abuse of revenue

recognition to manage earnings, the

SEC has released SAB 101, identifying

more carefully the circumstances in

which it is appropriate for a company to

recognize revenue

23 A pro forma earnings number is the

regular GAAP earnings number with

some revenues, expenses, gains, or

losses excluded In a general sense,

“pro forma” results are those that would

have happened or will happen under

certain defined circumstances Thus, pro

forma numbers offer a “what-if”

scenario The controversy about pro

forma earnings numbers is that the

exclusions from GAAP earnings are

sometimes made merely to make the

earnings number look better, not

necessarily to provide a better picture of

the company

24 A trustworthy manager can reveal even

better information about the underlying

economics of the business through

appropriate adjustments to GAAP

income in computing pro forma

earnings The danger with pro forma

earnings is that a desperate manager

seeking to hide operating problems

might try to use the flexibility of pro

forma reporting to report deceptively

positive pro forma results

25 The SEC endorsed the recommendation

made by the Financial Executives

International (FEI) and the National

Investor Relations Institute that firms

give a reconciliation to GAAP net

income whenever reporting pro forma

numbers This reconciliation highlights

the adjustments made by management

in reporting pro forma earnings

26 The financial statements are one of a

large number of vehicles used by themanagers of a company tocommunicate information about thecompany to the public In this sense,financial reporting is part of a company’sgeneral public relations effort

27 (a) Point E represents the highest

earnings of the five points included

in Exhibit 67; Point C representsthe second highest earnings.However, Point E is different fromPoint C in that Point E violatesGAAP whereas Point C is inconformity with GAAP

(b) Points A and C are both in

conformity with GAAP They differ inthat Point A represents consistentlyconservative choices within GAAPresulting in the lowest GAAPearnings possible Point Crepresents the highest GAAPearnings possible

28 Whether a manager violates GAAP in an

effort to manage earnings is a function

of the costs of getting caught, of thecompany’s general ethical culture, of themanager’s personal ethics, and of themanager’s awareness of the ease withwhich one can unwittingly pass from theinside to the outside of the GAAP oval ifone is not careful

29 One way to distinguish between

earnings management that is ethicallyright and earnings management that isethically wrong is management intent Ifearnings management is undertakenwithin GAAP to better communicate theeconomic performance of the business

to financial statement users, it isethically right If the intent of earningsmanagement is to deceive financialstatement users, it is ethically wrong

30 The seven elements of an earnings

management meltdown are as follows:

(a) Downturn in business (b) Pressure to meet expectations (c) Attempted accounting solution (d) Auditor’s calculated risk (e) Insufficient user skepticism (f) Regulatory investigation

Chapter 6 241

(g) Massive loss of reputation

31 Another way to respond to the pressure

caused by poor operating performance

is to seek to fix the underlying business

problems through better operations and

better marketing

32 When signing an audit opinion, the

auditor is balancing the multiyear future

revenues from continuing as a

company’s auditor with the potential

costs of being swept up in an accounting

scandal, losing valuable reputation, and

perhaps losing a large lawsuit

33 Some financial analysts work for

brokerage houses that also do

investment banking work for clients If a

financial analyst releases a report on a

company that is very unfavorable, that

company may be less likely to use that

analyst’s brokerage house for

investment banking work

34 After finding evidence of misleading

financial reporting, the most common

punishment by the SEC is a cease and

desist order that instructs a company to

stop its misleading practices and not to

repeat them The SEC also charges

fines such as the $10 million fine levied

against Xerox for misleading financial

reporting

35 An earnings management meltdown

does not become public knowledge until

stage 6, the regulatory investigation

Before that, the business downturn and

resulting earnings management coverup

are just a secret earnings management

meltdown waiting to happen

36 The cost of capital is the cost of

obtaining the external financing

necessary to fund a company’s

operations and expansion The cost of

debt capital is the after-tax interest cost

associated with borrowing the money

The cost of equity financing is the

expected return (both as dividends and

as an increase in the market value of the

investment) necessary to induce

investors to provide equity capital

37 A company produces financial

statements to better inform lenders and

investors about the performance of the

company Consequently, good financial

statements reduce the uncertainty oflenders and investors With loweruncertainty, the information risksurrounding the company is lower, andthe company’s cost of capital is lower

38 By increasing the quality of financial

reporting, good accounting standardsare able to reduce information risk.Thus, the overall cost of capital is lowerwhen accounting standards are ofhigher quality

39 According to the AICPA Code of

Professional Conduct, the guidingprecept in

balancing conflicting pressures among

clients’ interests and the public’s interest

is that acting ethically and in the public

interest is also in the best long-run

interest of the client

40 The best long-run business practice is

ethical behavior

243 Chapter 6

DISCUSSION CASESDiscussion Case 61

The advantage of an earnings-based bonus plan is clear: Employees are unified and directlyinterested in the overall performance of the company However, there are a number ofdisadvantages:

1 The existence of an earnings-based bonus plan greatly increases the incentive of employees

to manage earnings Even employees at a low level in the organization may misstate thereported results to report higher earnings Thus, an earnings-based bonus plan puts pressure

on the credibility of the financial reporting system This also increases the audit risk and mayrequire the auditor to conduct more tests

2 Encouraging employees to focus on periodic income may cause them to adopt a short-term

focus Thus, employees may oppose long-term strategic initiatives that may result in a term drop in profits

short-Discussion Case 62

Chris can revise many accounting estimates that will lower expenses and increase net income.For example, he can reevaluate the allowance for bad debts to look at the possibility of loweringthe allowance He can examine the depreciation life estimates to see how they relate to industrynorms If some depreciation life estimates are on the low end of the range of industry norms,Chris might consider increasing those estimates He can also look again at the estimates forwarranty expenses, environmental cleanup expenses, and so forth In short, many estimatedexpenses might be lowered a little on closer scrutiny

Chris should be concerned about the precedent that will be set if he uses accounting adjustments

to change a loss into a profit Externally, Chris should consider what type of message this willsend to users of the financial statements Dallas Company may develop a reputation as havinglow-quality financial statements This reputation can be costly as Dallas tries to obtain loans andraise investment capital in the future Personally, Chris should be concerned about his ownreputation If he develops a reputation as a flexible accountant who is willing to change estimates

to satisfy the board’s earnings targets, he may find it more difficult in the future to maintain hispersonal integrity in the face of more aggressive requests to manage earnings

Discussion Case 63

This is almost surely not a coincidence If there is an equal chance of a forecast being too low ortoo high, the odds of forecasting too low 27 quarters in a row are 1 in 134 million Stella may be apoor forecaster, but the evidence provided doesn’t provide support one way or the other on thatissue What is almost certainly happening is that Olsen Company has been managing itsearnings and the “guidance” it gives to analysts to ensure the ability to meet or beat the analysts’forecasts on a consistent basis In addition, to maintain a good relationship with the financialexecutives of Olsen, Stella may have been careful not to forecast earnings so high that Olsencouldn’t reach the forecasted amount An important part of the job of an analyst is maintaininginformation contacts Stella has had to balance her desire to maintain good relations with Olsenwith her desire to maintain her forecasting credibility It appears that so far she has decided thatmaintaining her relationship with Olsen has been more important than preparing unbiasedearnings forecasts

Discussion Case 64

Over the past three years, Clark Company has had a more stable, predictable earnings series As

a result, an analyst would typically feel more comfortable making a forecast about sustainablefuture earnings for Clark Company than for Durfee Company The earnings series makes Durfeeappear to be a more volatile and risky investment Thus, in the absence of any conflictingevidence, an investor would probably be willing to pay more for a share of Clark Company thanfor a share of Durfee Company

The chapter information discussed the possibility that a company could time its transactions anduse adjustments in accounting estimates to smooth the reported amount of earnings from oneyear to the next An analyst would want to look at the reported operating cash flow numbers forthese two companies to determine whether the underlying cash-flow-generating ability of ClarkCompany is as stable as its apparent earnings-generating ability An analyst would also want tolook carefully at the notes to Clark’s financial statements for the past three years to find whetherany accounting changes have been made that might have contributed to the smooth earningsstream An analyst also would like to see the quarterly earnings amounts; one would besuspicious of Clark’s reported annual amounts if the quarterly earnings in the first three quarterswere widely variable but the fourth quarter results consistently led to steady overall incomegrowth for the year Finally, an analyst would like to get a sense for the character of the managers

of both companies For example, if the managers of Clark Company are people of high personalintegrity, the analyst can place much more reliance on the smooth reported earnings series

Discussion Case 65

Mr Zhang has several motives for releasing very honest, straightforward financial statements.First, he has his own personal integrity to consider Second, he is aware of the benefits ofestablishing the credibility of the company with investors This reputation for credibility will beparticularly valuable if a decision to sell more shares of Dalian to the public is made in the future

Mr Zhang also has some incentives to push for the issuance of very positive, perhaps overlypositive, financial statements With stronger financial statements, the IPO price likely will behigher and more funds will flow into the budget of the ministry of which Mr Zhang is an employee.This additional cash inflow will be good for the people of China In addition, the more funds thatare raised through the IPO, the better Mr Zhang looks to his superiors Thus, Mr Zhang’s futurecareer may be impacted by the type of financial statements released in connection with this IPO

As mentioned in the chapter, there is some evidence that the financial statements of Chinesestate-owned enterprises are subject to some earnings management efforts in advance of an IPO

Discussion Case 66

The primary issue that should be weighing upon your mind is the public relations disaster that willresult if Flame Control reports record earnings because of the fires that have destroyed thestate’s forests The financial statements could very well be used as evidence in the statelegislature as laws are considered that would punish profiteering from natural calamities such asforest fires Even in the absence of direct punishment from such legislation, Flame Control willhave lost a large amount of public goodwill by seeming to profit from the misfortunes of the rest ofthe state As a result, you as Flame Control’s CFO will feel a strong incentive to make pessimistic,income-decreasing assumptions as you supervise the preparation of the financial statements.You may consider decreasing depreciation life assumptions, increasing bad debt estimates, and

so forth

Chapter 6 245

Discussion Case 66 (Concluded)

Rather than rely on accounting assumptions to lower your reported earnings and conceal the factthat, from a business standpoint, you had a record year at the expense of the rest of the state,you might convince the board of directors to address the issue head on Yes, Flame Controlmakes more money when there are more fires That also means, however, that Flame Controlsuffers financially in years that are relatively fire free Perhaps in recent years Flame Control hashad to lay off workers because of slowdowns at its factories associated with a low incidence offorest fires Flame Control might also be advised to use some of its windfall profits to rebuild thecommunities harmed by the fires In summary, the reported earnings of Flame Control are going

to provide politically sensitive information this year Rather than trying to cover over its financialsuccess with accounting assumptions, Flame Control might consider more direct ways to placatepublic anger

Note: Various industries in the United States have faced this exact issue in the past In the

mid-1970s, soaring oil prices generated windfall profits for the big oil companies Congress evenpassed a “Windfall Profits Tax” to try to extract some of the oil profits that appeared to have beengenerated through the suffering of the American people In the mid-1990s, public scrutiny focused

on the profits generated by pharmaceutical companies

Discussion Case 6 7

The frustration of your finance professor is understandable However, we should be careful not toallow this frustration to throw out the practice of accrual accounting that has been carefullydeveloped over the past 500 years Some points that you might make in response to the financeprofessor are as follows:

 Research has demonstrated that net income is a better measure of a company’seconomic performance for a period than is operating cash flow This indicates that, onaverage, the accrual assumptions made by accountants add value to the data

 Research has also demonstrated that current net income is a better forecaster of futureoperating cash flow than is current operating cash flow

 Operating cash flow is also subject to manipulation through the timing of cash paymentsnear the end of a quarter

Rather than throwing out earnings, it makes more sense to punish those companies andmanagers who issue deceptive financial reports and reward those companies that engage intransparent financial reporting Much of this punishment and reward can take place as financialstatement users become more discriminating in their analysis of financial statements and theassumptions that underlie them

Discussion Case 68

Of course, Cruella’s opinion is personally repugnant and reflects a very cynical view of the world

In addition, her opinion may very well reflect poor business judgment Once financial statementusers are aware of her opinion, they will be very skeptical about any financial statements sheprepares Users will have to do more independent verification to ensure that her financialstatements are not intentionally misleading Basically, Cruella’s approach will increase hercompany’s cost of capital

Discussion Case 69

Accounting assumptions can be used to improve Heidelberg’s reported earnings as follows:

 Depreciation Heidelberg can use longer depreciation lives Also, if the company is using

an accelerated method for any of its long-term assets, it can switch to straight line

 Bad debts Heidelberg can reduce its bad debt allowance as a percentage of outstanding

accounts receivable This is equivalent to reducing bad debt expense as a percentage ofsales

 Pensions As explained in Chapter 17, two key assumptions related to accounting for a

defined benefit pension plan are the assumption about the implicit interest costassociated with the unpaid pension obligation to the employees and the expected long-run rate of return to be earned on the pension fund Lowering the former percentage andraising the latter reduces the reported amount of pension expense

Four major categories of financial statement users are investors (including financial analysts),banks, the board of directors, and other stakeholders (such as suppliers, employees, localgovernments, and so forth) The first three groups are usually sophisticated financial statementusers and are the least likely to be influenced by blatant earnings management The final group,the other stakeholders, are the least sophisticated of financial statement users They are mostlikely to be influenced, in a public relations sense, by the four quarters of reported profits in thecentennial year They also are the least likely to carefully scrutinize the financial statements tosee whether any deceptive earnings management has taken place

This scenario matches the general fact situation in a well-known Harvard Business School case,Harnischfeger Corporation, written by Professor Krishna Palepu

Discussion Case 610

First, whether a company is a good investment or not depends primarily on what the current

market price of the stock is Every stock is a good investment at some price Setting that aside,

your analysis of Denethor’s financial statements suggests that the company may have engaged

in earnings management in the most recent year by changing its depreciation life estimates Theexplanation given in the financial statement notes looks to be merely a boilerplate justification; noexplanation is given for what changed this year to cause the depreciation estimate to be changed.The evidence suggests that the key factor motivating the change was a desire to report positiverather than negative earnings Once you put all of this together, the one definitive statement isthat you now are questioning the credibility of Denethor’s management It would probably beappropriate to pass along these doubts to your client

Discussion Case 611

In Accounting and Auditing Enforcement Release No 1405, Administrative Proceeding File No.3-10513 dated June 19, 2001, the SEC had the following to say with respect to the ArthurAndersen audit of Waste Management:

Waste Management's financial statements were not presented fairly, in all materialrespects, in conformity with GAAP for 1993 through 1996 For each year 1993 through

1996, Andersen, as a result of the conduct of certain of its partners as described herein,knew or was reckless in not knowing that the Company's financial statements were notpresented fairly, in all material respects, in conformity with GAAP but nonetheless approvedthe issuance of an unqualified audit report on the financial statements each year

The key phrase in the SEC statement is that Andersen was “reckless in not knowing” about thelack of conformity to GAAP in Waste Management’s financial statements It is not sufficientjustification to say that a problem was overlooked because of an innocent mistake The auditshould be designed to detect such errors if they are of a material magnitude; so if the audit didn’t

Discussion Case 6 13

The first year of a new management offers a unique opportunity for making asset impairmentwrite-downs because the negative impact on earnings will be blamed on the previousmanagement Managements are typically replaced because of dissatisfaction with theirperformance Accordingly, reevaluations of the assets are expected In calculating these charges,the new management has no incentive to understate their magnitude When faced with a difficultdecision of whether or not to write off an asset, new management would always have an incentive

to write it off in the first year when old management will be blamed rather than waiting untilsubsequent years when the new management will be held responsible for poor earnings

Discussion Case 614

To accomplish the CEO’s directive to show big earnings growth in the next few years, you want toallocate as much of the purchase price as possible to in-process R&D, which is expensedimmediately Costs that are expensed immediately are then not included in the computation ofdepreciation expense in future years This suggests that you choose Allocation 2 To give RosieCompany the maximum flexibility to show consistently increasing earnings in future years, youwant to pick depreciation lives at the low end of the acceptable range This then gives youflexibility to increase the depreciation lives, within the acceptable range, in future years, resulting

in increasingly lower depreciation expense You should thus choose a 15-year life for the buildingand a 3-year life for the machinery

This request from the CEO should trigger a host of concerns From a practical standpoint, youmust be concerned whether this accounting for the acquisition will pass the scrutiny of yourauditor and the SEC staff (if you are publicly traded) In addition, this request confirms the CEO’sreputation of being without scruples You should be concerned about the wisdom of continuing towork for such a person In addition, if you go along with this request, what will happen to yourpersonal reputation?