Accounting Bias and Earnings Manipulation | CFA Level I FSA

In our previous lesson, we learned that biased reporting is undesirable as it makes financial reports less decision-useful. Biased reporting can be conservative or aggressive, but ideally, financial statements should be neutral. Both conservative and aggressive accounting can be used to smooth earnings over time, affecting the company’s share price.

Methods to Introduce Accounting Bias and Earnings Management

Management can use various methods to manipulate earnings, including:

• Delaying or bringing forward revenue recognition
• Expensing or capitalising current period costs
• Using accelerated vs. straight-line depreciation method
• Lowering or raising the residual value of a depreciable asset
• Shortening or lengthening the useful life of a depreciable asset
• Bringing forward or delaying recognition of amortisation expense or impairment
• Using LIFO vs. FIFO as the inventory cost flow method
• Raising or reducing bad debt reserves
• Raising or reducing valuation allowance

Revenue Recognition: Opportunities for Earnings Manipulation

Management can manipulate revenue recognition by:

• Choosing the free-on-board point
• Accelerating or delaying the shipment of goods
• Using bill-and-hold transactions

Warning Signs of Revenue Recognition Abuse:

• Changes in revenue recognition methods
• Use of barter transactions
• Use of rebate programs
• Lack of transparency in customer order recording
• Revenue growth out of line with peer companies
• Declining receivables turnover
• Decreases in total asset turnover
• Inclusion of non-operating items or significant one-time sales in revenue

Manipulating Current Period Costs

Management can manipulate earnings by capitalising or expensing current period costs. Analysts should watch for instances where a firm capitalises costs that are not typically capitalised in the industry.

Manipulating PP&E Valuation

Management can manipulate earnings through depreciation parameters:

• Choosing the depreciation method
• Changing the residual value
• Changing the estimated useful life of a depreciable asset

Warning Signs for Depreciation, Amortisation, or Impairment Abuse:

• Depreciation methods, residual values, or useful lives out of line with industry peers
• Carrying value of assets out of line with fair market value

Inventory Costing Methods and Their Impact

Choosing between FIFO, LIFO, and weighted average cost methods can significantly affect reported earnings and inventory values. For example, under rising prices:

• FIFO results in lower cost of goods sold and higher earnings.
• LIFO results in higher cost of goods sold and lower earnings.
• Weighted average cost method yields results between FIFO and LIFO.

Analysts should monitor inventory turnover ratios and check for LIFO liquidations as potential indicators of earnings manipulation.

Bad Debt Reserves and Valuation Allowances

Management can use bad debt reserves and valuation allowances to smooth earnings:

• Decreasing bad debt reserves or valuation allowances increases net income.
• Increasing bad debt reserves or valuation allowances decreases net income.

Comparing bad debt reserves and valuation allowances as a percentage of relevant accounts with peer companies can help analysts spot potential earnings manipulation.

Manipulating Cash Flows

Companies may attempt to increase reported cash flow from operations (CFO) through various means:

• Stretching payables by delaying payments to suppliers.
• Classifying interest and dividends under IFRS to manage reported CFO.
• Capitalizing interest expense to decrease CFI and increase CFO.

Warning Signs of Earnings Manipulation

Analysts should be vigilant for these red flags that could indicate earnings manipulation:

• Inconsistent fourth-quarter earnings patterns.
• Significant transactions with related parties.
• Recurring “nonrecurring” expenses.
• Higher gross or operating profit margins than peer companies.
• Minimal financial reporting information and disclosure.
• Emphasis on non-GAAP earnings measures.
• Aggressive growth through acquisitions.
• A CFO-to-net-income ratio persistently below one or declining over time.

By understanding how accounting choices can affect reported earnings, financial position, and cash flow classification, you’ll be better equipped to identify potential biases and manipulations in financial reports.