|
...approach: expense recognition, revenue recognition, issues unique to business combinations, and other issues. Then, within each of those broad categories, we subclassify attempts by the particular approach used in the attempt. For each specific approach, we report the accounts involved, the frequency with which the approach increased or decreased current-period income (and the frequency of adjustments required by the auditor), and provide descriptions by auditors of income-increasing and income-decreasing examples of the more frequent approaches. We also link our findings to recent SEC Accounting and Auditing Enforcement Releases (AAERs) that illustrate extreme versions of the specific approaches identified by our partici pants. This experienced-based, example-rich framework and frequency data should assist investors, auditors, audit committees, and other participants in the financial reporting process who need to be vigilant for earnings-management approaches.
INTRODUCTION
Earnings management occurs "when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers" (Healy and Wahlen 1999, 368). We interpret this broad definition as including earnings management that is consistent with GAAP (e.g., structuring leases to allow lessors to use capital lease treatment and recognize gross margin at lease inception), earnings management that is difficult to distinguish from GAAP (e.g., over- or underestimating bad debt reserves), and earnings management that is clearly not GAAP (e.g., intentionally misapplying revenue recognition rules).
Aggressive earnings management has been of concern to regulators for several years (e.g., Levitt 1998), and concern has only intensified following evidence of improper accounting by Enron, WorldCom, and some other major corporations. Responses include the SEC's recent guidance about appropriate revenue recognition (SAB No. 101), expense recognition (SAB Nos. 100 and 102), and materiality definition (SAB No. 99), the AICPA's recent requirement that auditors report to clients' audit committees about waived audit adjustments and clients' quality of earnings (SAS Nos. 89 and 90), the SEC's recent requirement that CEOs and CFQs certify the accuracy and completeness of their annual reports, and the various reforms included in the Sarbanes-Qxley Act. Yet, there exists relatively little systematic research concerning the specific methods by which earnings management is attempted (Healy and Wablen 1999; Dechow and Skinner 2000; McNichols 2000). A better understanding of how earnings management occurs could help (1) re gulators and standard setters identity the areas most in need of regulatory change; (2) auditors evaluate and report on their clients' quality of earnings, and train novice auditors about earnings management; (3) CEOs, CEOs, audit committees, and investors focus attention on those areas of the financial statements where they should be most skeptical; (4) managers and audit committees anticipate the transactions that investors will view most skeptically; (5) educators teach students about earnings management; and (6) researchers focus their analyses on areas of high-earnings-management activity.
This article provides evidence about specific approaches that are used by managers when they attempt to manage earnings. Results are based on a data set (also analyzed in Nelson et al. 2002) that includes 515 earnings-management attempts identified and characterized by 253 auditors from one Big 5 firm.
Prior research in psychology and accounting suggests that people can best learn about important types of earnings management by first developing a knowledge framework of common approaches used to attempt earnings management and then populating that framework with individual examples. Understanding the approaches used to attempt earnings management, and the frequency with which these approaches occur, could facilitate future identification of attempts.
We develop a two-tiered framework that categorizes earnings-management approaches, and we provide examples and frequency data about the more common approaches within that framework. The first level of the framework categorizes attempts by whether they involve expense recognition, revenue recognition, issues unique to business combinations, or other issues. The second level of the framework categorizes attempts according to specific approach (e.g., "recognizing too much or too little asset impairment"), accounting area (e.g., "fixed assets," "investments," "intangibles"), and current-period income effect (current income increasing, decreasing, or no effect apparent or determinable). For each approach we report the frequency with which attempts occurred and the percentage for which auditors required adjustment of attempts. For each approach we also provide auditor descriptions of illustrative income-increasing and income-decreasing attempts, and references to recent SEC Accounting and Auditing Enforcement Relea ses (AAERs) that illustrate extreme examples of that particular approach.
The most important contribution of this paper is the listing of earnings-management approaches, frequencies, and examples that we provide. However, the paper also provides evidence that complements and converges with that provided by prior research. For example, similar to studies of SEC AAERs, our sample includes numerous attempts that involve revenue recognition, but we also document numerous attempts that involve reserve manipulation and other forms of expense recognition that appear less frequently in AAERs.
BACKGROUND
Prior studies examine extreme instances of earnings management identified in SEC AAERs (see, e.g., Feroz et al. 1991; Dechow et al. 1996; Beneish 1997; Bonner et al. 1998; Panel on Audit Effectiveness 2000; Beasley et al. 2000), or list potential earnings-management approaches based on personal experience and/or published press accounts (e.g., National Association of Certified Fraud Examiners [NACFE] 1992; Schilit 1993; Mulford and Comiskey 1996). These studies naturally focus on instances of earnings management that severely biased the audited financial statements and attracted enforcement by the SEC or public attention. Yet, much earnings management may be relatively more subtle, and therefore not attract public scrutiny, and much earnings management may be attempted by managers but prevented by auditors. Therefore, we complement prior studies by organizing and reporting data from auditors' descriptions of managers' earnings-management attempts.
We draw on prior research to determine a useful way in which this data can be organized and communicated. Psychology and accounting studies provides evidence that people tend to organize their knowledge using "schemas" or "scripts" that relate information in a logical, causal manner (see, e.g., Alba and Hasher 1983). Such schematic structures affect how auditors organize and process information about internal controls (Frederick 1991; Tubbs 1992), going-concern risks (Ricchiute 1992), and financial statement errors (Frederick et al. 1994). The types of knowledge structures most relevant to our study are categories, which serve to identify and organize concepts and classify the particular instances that are experienced (see, e.g., Smith and Medin 1981; Smith and Minda 1998).
Prior research provides evidence that experienced auditors develop category structures with respect to financial statement errors that focus on useful causal relationships, such as "audit objective violated" (Tubbs 1992; Frederick et al. 1994). Such category structures can be taught effectively (Bonner et al. 1997), particularly by conveying a conceptual framework that includes key features and representative examples (Bonner 1999; Bonner and Walker 1994). The accuracy of future identification and classification is enhanced by having a well-defined, example-rich category structure (Bonner 1999).
Prior research also indicates the importance of knowing the relative frequency with which various types of attempts occur. For example, auditors face higher risk of litigation when they fail to identify frequently occurring frauds (Bonner et al. 1998), and numerous studies in auditing suggest that frequency information helps auditors generate hypotheses (Libby 1985), evaluate hypotheses (Smith and Kida 1991), and plan audit effort (Heiman 1990; Libby and Frederick 1990). Frequency knowledge could be accumulated by individuals from experience (Butt 1988; Nelson 1993), but it is difficult for a given individual to experience enough attempts to develop accurate frequency knowledge. An alternative approach is to accumulate frequency information and convey it in the form of simple facts that are used in subsequent decisions (Nelson 1994). Prior research has assessed the frequencies with which audit adjustments are proposed (for a review, see Kinney and Martin [1994]) and the frequency with which extreme forms of e arnings management are identified (see the aforementioned AAER studies), but none have focused specifically on earnings-management attempts.
In light of prior research, we provide a causally organized, example-rich categorization framework and related frequency information with respect to the various approaches used to attempt earnings management. We provide for each approach one or more representative descriptions to highlight the distinctive features that are associated with each approach (as recommended by Bonner [1999, 23]). We also provide one or more references to recent SEC AAERs that describe extreme versions of each approach, both to allow readers to identify more examples of approaches and to provide evidence that the attempts in our data are of general importance. To highlight the more frequent approaches used to attempt earnings management, we report the number of times each approach was used in an attempt (and the percentage adjusted by the auditor) in each accounting area (e.g., investments, fixed assets, intangibles) in our sample, in total and by current-year income effect.
METHOD
Data Collection
We collected data in Autumn 1998. Survey packets were mailed to 532 audit partners selected randomly from U.S. offices of one Big 5 firm. The packets included a survey for the partner and surveys for two senior managers to be selected by the partner. We received 253 responses from auditors (43 percent partners, 57 percent managers) who had an average of 14.1 years of experience.
Although the number of auditors participating in our study is high, the final response rate is only 16 percent (20 percent for partners and 14 percent for managers). This response rate is higher than response rates of mailed surveys...
NOTE: All illustrations and photos
have been removed from this article.
More articles from Accounting Horizons
Investors' perceptions of earnings quality, auditor independence, and ..., January 01, 2003
Earnings quality and short sellers., January 01, 2003
Measuring stockholder materiality., January 01, 2003
The quality of financial statements: perspectives from the recent stoc..., January 01, 2003
Earnings quality., January 01, 2003
Looking for additional articles?
Search our database of over 3 million articles.
Looking for more in-depth information on this industry?
Search our complete database of Industry & Market reports by text, subject, publication
name or publication date.
About Goliath
Whether you're looking for sales prospects, competitive information, company
analysis or best practices in managing your organization,
Goliath can help you meet your business needs.
Our extensive business information databases empower business
professionals with both the breadth and depth of credible,
authoritative information they need to support their business
goals. Whether it be strategic planning, sales prospecting,
company research or defining management best practices -
Goliath is your leading source for accurate information.
|
