Solutions manual intermediate accounting 18e by stice and stice ch06

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

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CHAPTER 6 QUESTIONS

1 The four factors that might motivate a

man-ager 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

impor-tant tool in motivating managers to

in-crease 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

earn-ings upward if they are close enough to

reach the bonus threshold and are more

likely to manage earnings downward,

sav-ing the earnsav-ings for a rainy day, if reported

earnings substantially exceed the

maxi-mum 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

addi-tion, there is a lump on the distribution just

above zero, indicating that the number of

companies with earnings just above zero is

significantly greater than expected This

suggests that companies that compute a

preliminary earnings number that is slightly

less than zero make more favorable ac-crual assumptions to get earnings to be positive

6 If analysts‘ earnings forecasts are merely a mathematical forecast of a mechanically generated number, the forecasts should be less than actual earnings half the time and more than actual earnings half the time The fact that many companies meet or ex-ceed analysts‘ forecasts for many quarters

in a row strongly suggests that the process

is being managed in some way The figure

in Exhibit 6-2 demonstrates that managers

do indeed manage reported earnings There is also evidence that managers pro-vide ―guidance‖ to analysts to try to ensure that the analysts‘ forecasts are not too high

to reach So, companies can consistently meet or beat analysts‘ forecasts because they manage earnings and they also man-age the forecasts

7 Income smoothing is the practice of

care-fully timing the recognition of revenues and expenses to even out the amount of re-ported earnings from one year to the next

8 As described in the text of the chapter,

General Electric‘s business structure is par-ticularly well suited to income smoothing because of the company‘s large number of diverse operating units (e.g., financial ser-vices, heavy manufacturing, home ap-pliances) A large one-time loss reported by one business unit can frequently be matched with an offsetting gain reported by another unit By carefully timing the recog-nition of these gains and losses, GE can avoid reporting earnings that bounce up and down from year to year Perhaps more important, GE has had very successful un-derlying operations over the past 20 years Because of this, any income smoothing un-dertaken by GE has been merely the care-ful timing of the recognition of income, not a desperate attempt to create earnings out of thin air

9 Many studies have demonstrated the

ten-dency of managers in U.S companies to

boost their reported earnings using

ac-counting 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

Interna-tional Trade Commission (ITC) when

peti-tioning for import barriers is financial

state-ments 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

in-formation value by using estimates and

as-sumptions to convert the raw cash flow

data into accrual data Net income is a

bet-ter measure of a company‘s economic

per-formance 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

manage-ment continuum, and the general types of

actions associated with each, are as

fol-lows:

Label Types of Actions

1 Savvy

Transac-tion Timing

Strategic matching

2 Aggressive

Ac-counting

Change in methods or estimates with full dis-closure

3 Deceptive

Accounting

Change in methods or estimates but with little

or no disclosure

4 Fraudulent

Reporting

Non-GAAP accounting

5 Fraud Fictitious transactions

13 Changing accounting estimates to reflect

the most current information available is

an essential part of accrual accounting

However, to ensure that financial state-ment users can meaningfully compare the results for this year (prepared using the new estimate) with the results for last year (prepared using the old estimate), the im-pact of such changes in estimate must be fully disclosed

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 Exhibit 6-4) mirror the pro-gression in earnings management strategies followed by individual companies It is un-likely that a company would jump straight to creating fictitious transactions in order to manage earnings Instead, the company would probably start with small and legiti-mate attempts to improve reported perfor-mance, such as the careful timing of trans-actions The company would then progress through accounting changes, both disclosed and undisclosed, and then to non-GAAP ac-counting The creation of fictitious transac-tions 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 fol-lows:

(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 substantially

li-mited the flexibility a company has to recog-nize a big-bath restructuring charge by adopting stricter rules on the accounting for impairment losses (FASB ASC Section 360-10-35) and on the timing of the recognition

of restructuring obligations (FASB ASC Topic 420)

19 When a company establishes a cookie jar

reserve, it overreports expenses or

underre-ports revenues during the current year in the

anticipation that these deferred earnings can

then 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 has concern about future years

20 The traditional concept of materiality is

based on straightforward numerical

thre-sholds 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

operat-ing income but the nonrecognition of this

expense would result in a company having

earnings high enough to meet analysts‘

ex-pectations, the item is material

21 In order to limit the abuse of revenue

recog-nition to manage earnings, the SEC has

re-leased SAB 101, identifying more carefully

the circumstances in which it is appropriate

for a company to recognize revenue Also,

the FASB and IASB are in the midst of a

joint project involving a comprehensive

revi-siting of the rules regarding when revenue

should be reported

22 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

23 A trustworthy manager can reveal even

bet-ter information about the underlying

eco-nomics 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

24 The SEC formalized the recommendation

made by the Financial Executives Interna-tional (FEI) and the NaInterna-tional Investor Rela-tions 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

25 The financial statements are one of a large

number of vehicles used by the managers of

a company to communicate information about the company to the public In this sense, financial reporting is part of a com-pany‘s general public relations effort

26 (a) Point E represents the highest earnings

of the five points included in Exhibit 6-7; point C represents the second highest earnings However, point E is different from point C in that point E violates GAAP whereas point C is in conformity with GAAP

(b) Points A and C are both in conformity

with GAAP They differ in that point A represents consistently conservative choices within GAAP resulting in the lowest GAAP earnings possible Point C represents the highest GAAP earnings possible

27 Whether a manager violates GAAP in an

effort to manage earnings is a function of the costs of getting caught, of the compa-ny‘s general ethical culture, of the manag-er‘s personal ethics, and of the managmanag-er‘s awareness of the ease with which one can unwittingly pass from the inside to the out-side of the GAAP oval if one is not careful

28 One way to distinguish between earnings

management that is ethically right and earn-ings management that is ethically wrong is management intent If earnings manage-ment is undertaken within GAAP to better communicate the economic performance of the business to financial statement users, it

is ethically right If the intent of earnings management is to deceive financial state-ment users, it is ethically wrong

29 The seven elements of an earnings

man-agement 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

(g) Massive loss of reputation

30 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

market-ing

31 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

ac-counting scandal, losing valuable reputation,

and perhaps losing a large lawsuit

32 Some financial analysts work for brokerage

houses that also do investment banking

work for clients If a financial analyst

releas-es a report on a company that is very

unfa-vorable, that company may be less likely to

use that analyst‘s brokerage house for

in-vestment banking work

33 After finding evidence of misleading financial

reporting, the most common punishment by

the SEC is a cease and desist order that

in-structs 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

fi-nancial reporting

34 An earnings management meltdown does

not become public knowledge until stage 6,

the regulatory investigation Before that, the

business downturn and resulting earnings

management cover-up are just a secret

earnings management meltdown waiting to happen

35 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) ne-cessary to induce investors to provide equity capital

36 A company produces financial statements to

better inform lenders and investors about the performance of the company Conse-quently, good financial statements reduce the uncertainty of lenders and investors With lower uncertainty, the information risk surrounding the company is lower, and the company‘s cost of capital is lower

37 By increasing the quality of financial

report-ing, good accounting standards are able to reduce information risk Thus, the overall cost of capital is lower when accounting standards are of higher quality

38 According to the AICPA Code of

Profes-sional Conduct, the guiding precept in ba-lancing conflicting pressures among clients‘ interests and the public‘s interest is that act-ing ethically and in the public interest is also

in the best long-run interest of the client

39 The best long-run business practice is

ethi-cal behavior

CASES

Discussion Case 6–1

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

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

man-age earnings Even employees at a low level in the organization may misstate the reported results to report higher earnings Thus, an earnings-based bonus plan puts pressure on the credibility of the fi-nancial reporting system This also increases the audit risk and may require 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 short-term drop in

profits

Discussion Case 6–2

Chris can revise many accounting estimates that will lower expenses and increase net income For ex-ample, he can reevaluate the allowance for bad debts to look at the possibility of lowering the allowance

He can examine the depreciation life estimates to see how they relate to industry norms If some depreci-ation 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 for warranty expenses, environmental cleanup expenses, and so forth In short, many estimated expenses 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 will send to users

of the financial statements Dallas Company may develop a reputation as having low-quality financial statements This reputation can be costly as Dallas tries to obtain loans and raise investment capital in the future Personally, Chris should be concerned about his own reputation 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 his personal 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 or too high, the odds of forecasting too low 27 quarters in a row are 1 in 134 million Stella may be a poor forecaster, but the evidence provided doesn‘t provide support one way or the other on that issue What is almost cer-tainly happening is that Olsen Company has been managing its earnings 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 financial executives of Olsen, Stella may have been careful not to forecast earnings so high that Olsen couldn‘t reach the forecasted amount An important part of the job of

an analyst is maintaining information contacts Stella has had to balance her desire to maintain good rela-tions with Olsen with her desire to maintain her forecasting credibility It appears that so far she has de-cided that maintaining her relationship with Olsen has been more important than preparing unbiased earnings 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 sustainable future earnings for Clark Company than for Durfee Company The earnings series makes Durfee appear to be a more vola-tile and risky investment Thus, in the absence of any conflicting evidence, an investor would probably be willing to pay more for a share of Clark Company than for a share of Durfee Company

The chapter information discussed the possibility that a company could time its transactions and use ad-justments in accounting estimates to smooth the reported amount of earnings from one year to the next

An analyst would want to look at the reported operating cash flow numbers for these two companies to determine whether the underlying cash-flow-generating ability of Clark Company is as stable as its ap-parent earnings-generating ability An analyst would also want to look carefully at the notes to Clark‘s fi-nancial statements for the past three years to find whether any accounting changes have been made that might have contributed to the smooth earnings stream An analyst also would like to see the quarterly earnings amounts; one would be suspicious of Clark‘s reported annual amounts if the quarterly earnings

in the first three quarters were widely variable but the fourth quarter results consistently led to steady overall income growth 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 per-sonal integrity, 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 of establishing the credibil-ity of the company with investors This reputation for credibilcredibil-ity will be particularly 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 overly positive, financial statements With stronger financial statements, the IPO price likely will be higher 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 that are raised through the IPO, the better Mr Zhang looks to his superiors Thus, Mr Zhang‘s future career 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 Chinese state-owned enterprises are subject to some earnings management efforts in advance of an IPO

Discussion Case 6–6

Of course, Cruella‘s opinion is personally repugnant and reflects a very cynical view of the world In addi-tion, her opinion may very well reflect poor business judgment Once financial statement users are aware

of her opinion, they will be very skeptical about any financial statements she prepares Users will have to

do more independent verification to ensure that her financial statements are not intentionally misleading Basically, Cruella‘s approach will increase her company‘s cost of capital

Discussion Case 6–7

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

Depreciation Heidelberg can use longer depreciation lives and increase salvage value estimates

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 of sales

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 cost associated with the un-paid pension obligation to the employees and the expected long-run rate of return to be earned

on the pension fund Lowering the former percentage and raising 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, local governments, and so forth) The first three groups are usually sophisticated financial statement users and are the least likely to

be influenced by blatant earnings management The final group, the other stakeholders, is the least so-phisticated of financial statement users They are most likely to be influenced, in a public relations sense,

by the four quarters of reported profits in the centennial year They also are the least likely to carefully scrutinize the financial statements to see whether any deceptive earnings management has taken place This scenario matches the general fact situation in a well-known Harvard Business School case, Har-nischfeger Corporation, written by Professor Krishna Palepu

Discussion Case 6–8

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 Arthur Andersen audit of Waste Management:

Waste Management's financial statements were not presented fairly, in all material respects, in con-formity 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 not presented fairly, in all material respects, in con-formity with GAAP but nonetheless approved the issuance of an unqualified audit report on the fi-nancial statements each year

The key phrase in the SEC statement is that Andersen was ―reckless in not knowing‖ about the lack of con-formity to GAAP in Waste Management‘s financial statements It is not sufficient justification to say that a prob-lem was overlooked because of an innocent mistake The audit should be designed to detect such errors if they are of a material magnitude; so if the audit didn‘t reveal the misstatements, the audit firm recklessly de-signed it The SEC formally sanctioned Arthur Andersen in this case

Discussion Case 6–9

It may be possible for you to assemble enough evidence to get an indictment against John and Mary It is reported that Sol Wachtler, the former Chief Judge of the New York State Court of Appeals, observed,

"Even a modestly competent district attorney can get a grand jury to indict a ham sandwich." Getting a conviction won‘t be so easy What Earnings Management, Inc., is doing certainly appears to be sleazy and unethical However, on closer inspection, it isn‘t clear what laws John and Mary have broken They have merely taken unsavory little facts and packaged them for sale However, a venture capitalist or a banker might like to get a list of John and Mary‘s clients to know what companies to avoid when investing

or lending money

Discussion Case 6–10

The first year of a new management offers a unique opportunity for making asset impairment write-downs because the negative impact on earnings will be blamed on the previous management Managements are typically replaced because of dissatisfaction with their performance Accordingly, reevaluations of the as-sets are expected In calculating these charges, the new management has no incentive to understate their magnitude When faced with a difficult decision of whether or not to write off an asset, new man-agement would always have an incentive to write it off in the first year when old manman-agement will be blamed rather than waiting until subsequent years when the new management will be held responsible for poor earnings

Discussion Case 6–11

Scenario 1 Earnings this year are high, but earnings in future years are in doubt If Lily Company‘s board wants to establish a cookie jar reserve that can be used to bolster earnings in future years, a 4% bad debt expense should be used this year This will allow for the reporting of lower bad debt expense in future years if earnings are low

Scenario 2 Earnings this year are low, but those in future years are expected to be strong If Lily Compa-ny‘s board wants to show consistent, steady income growth, a 1% bad debt expense should be used this year This low expense will increase reported income this year In future years, experience may necessi-tate a higher bad debt percentage estimate, but that can be balanced against the expected future profit improvements

By using the bad debt percentage estimate to create a cookie jar reserve to smooth earnings, Lily Com-pany runs the risk of reducing the credibility of its financial reports Financial statement users will be able

to detect the fluctuating bad debt estimates If changes in business conditions do not justify these changes, Lily will be suspected of being an earnings manager This will cause financial statement users

to be more skeptical of future financial reports and perhaps other claims by Lily‘s board or managers

Discussion Case 6–12

Revenue cannot be recognized until the company has substantially completed its performance Although the membership fees are nonrefundable, the membership is for the person‘s lifetime Thus, the revenue should be spread over the estimated time that a member will use the facilities In attempting to secure a new loan, Kristen and her partners wish to portray the performance of their health club in the best light possible If a potential lender is nervous about the club‘s economic viability, the loan may be offered on very unfavorable terms Thus, Kristen and her partners would like to recognize as much revenue as poss-ible Timing is very important since the loan is being sought now; revenue recognized next year or the year after won‘t improve the financial statements given to a potential lender now On the other hand, Kris-ten and her partners do have an economic incentive for maintaining, or increasing, their credibility with their lender If the revenue recognition rules are stretched and extra revenue is reported, the lender could very well ignore the financial statement numbers and focus instead on the negative connotation that this earnings management has with respect to the character of Kristen and her partners Through straightfor-ward financial reporting and revenue recognition, Kristen and her partners might increase their credibility and lower their cost of borrowing

Discussion Case 6–13

The Worthington Company pro forma disclosure is an example of how pro forma reporting can help finan-cial statement users better understand a company‘s earnings By removing the effects of the one-time item and the expensing of an unquestionably valuable R&D effort, the Worthington pro forma number gives the financial statement user a better measure of the sustainable or permanent component of the company‘s earnings In contrast, the Millward Company pro forma earnings number is an illustration of the abuse of the flexibility of pro forma reporting One can make an argument that the costs of the stra-tegic initiative and the employee training are economically equivalent to long-term capital investments However, it is equally likely that these costs are required for the company merely to maintain its current operating performance and do not add productive capacity It appears that Millward‘s pro forma earnings disclosure is merely an attempt to report higher earnings

Discussion Case 6–14

Benefits

Under Jacob Marley, Dickens Company‘s financial reporting system is extremely reliable Finan-cial statement users can be assured that no attempt has been made to fluff the numbers to meet earnings forecasts or other targets

Marley‘s approach removes the financial statements from the set of strategic actions that Dick-ens‘ management can use to improve reported performance Marley‘s approach forces manage-ment to fix the underlying business rather than rely on accounting solutions to paper over any problems

Costs

Marley is wrong in thinking that the financial statements speak for themselves and need no clarifi-cation or amplificlarifi-cation A business is a very complicated entity, and its economic performance over any period of time cannot possibly be completely captured in a set of financial statements Some financial statement numbers are best understood in the context of ongoing developments

in a company It can be useful to a company to have the financial statement numbers placed in context by someone inside the company who has a fuller perspective than do external users By refusing to do this, Marley is depriving financial statement users of important background informa-tion

As in every aspect of business, personal relationships are critical By refusing to build relation-ships with the investment community, Marley is contributing to an isolation of Dickens Company

In a crisis, a company would be well served by having sympathetic allies in the business commu-nity Marley is driving away these potential allies

Discussion Case 6–15

Your best defense is a reputation within the company for consistent ethical behavior with respect to finan-cial reporting If you have developed a reputation for cutting corners and being willing to change account-ing estimates to meet earnaccount-ings targets, you are probably in trouble Assumaccount-ing that you have a solid repu-tation, you might make some of the following points:

Reliable financial reporting is crucial to the well-being of the company

Part of reliable financial reporting is the use of consistent and defensible estimates in the preparation

of the financial statements

Discussion Case 6–15 (Concluded)

These estimates must be not only defensible but also reasonable in light of what other, similar com-panies are using

Given a certain set of estimates, only one earnings number is possible for a given set of facts

However, there is no sure way to identify the single best set of estimates for a given company in a given year

Thus, the purpose of the presentation is to show the shareholders what earnings would be if other sets of acceptable estimates had been used

This is not to say that this range of possible earnings numbers was examined and the most favorable number chosen to be reported Instead, a set of estimates, consistent with the estimates that have been made in prior years, was applied to the facts, resulting in the reported earnings number

Discussion Case 6–16

Kara thinks that the time she spends explaining quarterly earnings to the business community could be much more productively spent in developing long-run initiatives to improve her business, initiatives that might not bear fruit within the current reporting period but which are in the best long-run interest of the company

As described in Chapter 19, the Business Roundtable (an organization of 200 CEOs of top U.S corpora-tions) has claimed that quarterly earnings reports are very costly in terms of preparation and are counter-productive because they cause management to focus on short-term earnings rather than long-term growth This concern about the counterproductivity of quarterly reporting was echoed by Peter A Mago-wan, then-CEO of Safeway, the large supermarket chain based in Oakland, California In November 1986, Safeway was taken private in a $5.3 billion leveraged buyout (LBO) In looking back on the success of the restructuring that followed the LBO, Magowan reported that one of the key advantages enjoyed by Safe-way was that as a private company, it was no longer locked into the cycle of fixation on reported quarterly earnings According to Magowan, this freedom from pressure to report ever-increasing quarterly profits made it possible for Safeway to institute aggressive pricing, store expansion, and increased spending for training and technology—all actions that would hurt reported profits in the short run but were for the com-pany‘s long-term good

Discussion Case 6–17

The criticism about overly optimistic forecasts is directed at sell-side analysts Sell-side analysts work for brokerage houses and are thus susceptible to some pressure to help secure clients Thus, a sell-side analyst must balance his or her incentives to produce accurate earnings forecasts with the desire to keep clients and potential clients happy A buy-side analyst is employed to help an investment fund identify good investments Thus, a buy-side analyst has no incentive to curry favor with the companies whose earnings he or she is forecasting Instead, the buy-side analyst has an incentive to identify good invest-ments on behalf of the investors in the fund This identification of good investinvest-ments is best done by mak-ing unbiased earnmak-ings forecasts