Creative Accounting: Definition, Causes, Consequences, and Detection, Diapositivas de Análisis de estados financieros

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Financial Statement Analysis

Course: 2020 / 2021 2 nd Semester Baptiste Colas

Session 2 : Earnings

management

Introduction

Economic environment Accountanting framework (accountants):

• disclousre of accounting policies
• statement of financial position
• statement of profits/losses
• accrual basis of accounting
• statement of cash flows
• etc. Judgment Financial information Users Communication Decision Making

Introduction

Earnings management (or creative accounting) is a process whereby accountants use their knowledge of accounting rules to manipulate the figures reported in the accounts of a business Economic environment Accountanting framework (accountants):

• disclosure of accounting policies
• statement of financial position
• statement of profits/losses
• accrual basis of accounting
• statement of cash flows
• etc. Judgment Financial information Users

Is earnings management fraud?

Manipulation Real Accounting Out of the norm Crime Crime Within the norm Out of the accounting framework (called « real earnings management ») Earnings management (Creative accounting)

Type of creative accounting

Optimistic :

• Improve the financial statements numbers
• Aggresive accounting: increase earnings to artificially look better Pessimistic :
• Worsen the financial statements numbers
• Conservative accounting: decrease earnings (we will see why later) Income smoothing : smooth earnings over the years
• Reduce the volatility of the earnings = less risk

Ways to manage earnings

The potential for creative accounting (earnings management) is found in six principal areas:

• Regulatory flexibility ,
• a dearth of regulation: some areas are not fully regulated ,
• a scope for managerial judgment in respect of assumptions about the future,
• the timing of some transactions,
• the use of artificial transactions , and
• the reclassification and presentation of financial numbers

Categories of incentives

Three categories of incentives for creative accounting:

• Market incentives: influence market participants
• Contractual incentives: influence execution of contracts
• Regulatory incentives: compliance with regulation

Contractual incentives

Optimistic (↗) :

• Increase liquidity or solvency (balance sheet items) :
  • Comply with debt covenants
  • Obtain financing (through debt)
  • Decrease interest rate
• Increase earnings (income statements items):
  • Greater rewards through contracts that are based on earnings (e.g. compensation)

Contractual incentives ( 2 )

Pessimistic (↘) :

• Negotiations with unions
• Save earnings for future periods to maximize compensation (e.g. contract between employer and employee where bonus are given based on meeting a certain level of earnings)
• Big bath accounting when a new management is appointed
  • Impair assets to record an important loss in the year of the appointment (= ↘ Earningst)
  • Attribute this poor performance to the previous management team
  • Benefit from the cookie jar created in future periods (i.e. ↘Amortizationt+ 1 , t+ 2 , etc. = ↗Earningst+ 1 , t+ 2 , etc.)

Methods

Focus on creative accounting in the area of financial accounting (i.e. for external users) External users Shareholders Creditors Unions/Public bodies Profitability Risk Liquidity Solvency Profitability

Methods

17 Profitability Risk Liquidity Solvency Income statement Balance sheet Classification shifting Earnings management Classification shifting Change in balance sheet items

Methods ( 1 ): Timing

From the income statement point of view: ∆Earnings = ∆Revenues - ∆Expenses To ↗ Earnings (∆Earnings> 0 ) you can either have

• ∆Revenues> 0
  • E.g.: adjust timing of the sales contract to your incentives
• ∆Expenses< 0
  • E.g.: overestimate asset life = ↘Amortization

Methods ( 1 ): Timing

Managers can change the timing of certain transactions to manage earnings:

• Change in amortization rate
• Delay recognization of sales
  • Ex.: CEO of Colas Corp. has a bonus of 100 k€ every year if total sales> 100 M
  • At 30 / 12 /N sales are 120 M
  • Huge sales contract is about to be concluded
  • What would the CEO do? => Delay the conclusion (and recognition) of this contract to the following year to maximise its chance of obtaining the bonus in N+ 1