Advanced Financial Reporting & Regulation - Assignment Example

Advanced Financial Reporting & Regulation Table of Contents Content Page Introduction to earnings management………………………………………….. 4 Stuffing the channels…………………………………………………………… 8 Cookie Jar Accounting………………………………………………………….. 9 Impairment of Assets……………………………………………………………. 11 PSA Peugeot and Vodafone cases……………………………………………… 14 References……………………………………………………………………… 17 Question 1: A common technique to manage earnings is to ‘stuff the channels’, that is, to ship prematurely to dealers and customers, thereby inflating sales for the period. A case in point is Bristol-Myers Squibb co. (BMS), a multinational pharmaceutical company head-quartered in New York. In August 2004, the Securities Exchange Commission (SEC) announced a USD 150 million’s penalty levied against BMS. This was part of an agreement to settle charges by the SEC that the company had engaged in a fraudulent scheme to inflate sales and earnings in order to meet analysts’ earnings forecasts. According to the SEC, the company also engaged in ‘cookie jar’ accounting. That is, it created phony reserves for disposals of unneeded plants and divisions during high-profit quarters. These would be carried to decrease the operating expenses in results of the quarters where BMS’ income or earnings figures are insufficient to meet the forecasted amounts. Required: a. Using relevant academic papers, discuss the incentives why managers would resort to extreme earnings management technique such as this. b. Critically evaluate the effectiveness of ‘stuffing the channels’ and ‘cookie jar accounting’ as earnings management devices. Consider both from the standpoint of a single year and over a series of years. Answer 1a: Introduction to Earnings Management Earnings refer to the residual net profit left at disposal of a company after deducting all relevant expenses, borrowing costs and taxes from revenue for that period. Earnings management is any legal activity via which the entity administers its profits earned, retained and distributed and thereafter carries out its financial reporting, making decisions regarding the contents, details and disclosures to be provided in the deliverables to give a true and fair view of its operations. According to Lev, earnings play a very important role not only because they shape up success of any business but also because they can have drastic effects if the management’s reporting of earnings get manipulated. Therefore, it is of utmost significance for all key personnel of the entity to excel at earnings management, taking into account that it doesn’t involve any manipulative measures and fraudulent practices (Lev, 1989). According to scenario given in the question, the pharmaceutical company mentioned was similarly involved in maneuvering its books of accounts by using tactics such as ‘stuffing the channels’ and ‘cookie jar’ accounting, resulting into non-compliances, being penalized for the same. The question here arises as to why would managers of this enterprise be engaged in such practices of window-dressing the company’s books of accounts though aware of its adverse consequences of non-compliance? Following are given few incentives which may urge managers to be indulged in wrongful earnings management: Fulfilling Expectations of Capital Markets: The most common reason for majority of the times in such instances is motivation to satisfy capital markets. Managers are mostly under extreme pressures to create value for existing and prospective shareholders and when they find no way to do so in real terms, they end up manipulating reporting of earnings thereby affecting favorably stock’s market price in the short run (Dye, Trueman & Titman, 1988). Apart from aforementioned aspect, there are other factors as well which may push managers to execute earnings management. In a report by DeAngelo, evidences show that during due diligence activities such as acquisitions and buyouts, earnings play an essential role determining the consideration price for acquiring a firm. Managers of the acquiree company may tend to deploy tactics to devalue earnings (DeAngelo, 1988). On the contrary, more recent theory by Teoh, Welch and Wong, suggest that managers tend to apply earnings management to overstate the firm’s earnings prior to acquisition process (Teoh, Welch and Wong, 1998). Satisfying the terms of Contractual Arrangements: Companies are tied through various contracts, with suppliers, customers, vendors and other external stakeholders, through which the companies have to safeguard their interests. As a result, at times, through certain terms in contracts, they are forced to take certain actions which might go against own shareholders (Sweeney, 1994). In order to combat against interests of shareholders, managers are attracted to carry out earnings management which blindfolds the creditors and stakeholders from seeing the real picture while the managers cater their shareholders’ needs. Payments against dividends are often restricted through covenants to protect the liquidity from being consumed which shall be used to pay off interest payments (Watts and Zimmerman, 1986). Performance-based bonuses and compensations: Most of the organizations have in place compensatory entitlements that are linked to performance of the relevant business unit or the company as a whole. Managers are assessed for favorable variances in areas where they have influence and thereafter receive bonuses or likewise for the same. These modes of emoluments, though apparently effective, often have backfiring consequences. Managers tend to defer surpluses to periods of slacks, or when they are entitled to more bonus payments, by using earnings management to show earnings in current period till required margin and transferring the excess part to later periods (Healy, 1985). Complying with regulatory frameworks: There are many tax planning opportunities whereby entities plan carefully its reporting and books of accounts in such manner that they can avoid some portions of taxation. Tax avoidance is however legal and doesn’t necessarily refer to tax evasion. Using laws of taxation to the benefit of company, managers use earnings management to either avoid tax or otherwise defer taxation to later periods according to profitability situations. Furthermore, there are many other regulatory frameworks that govern the companies to comply strictly. The fear of non-compliance, risk of investigation by authorities and fear of violating minimum capital requirements (for banks only) leading ultimately to closure of operations, urges the managers to execute dishonest earnings management thereby creating a picture of ideally complying organization! (Collins, Shackelford and Wahlen, 1995) Answer 1b: ‘Stuffing the channels’ Also known as ‘Channel Loading,’ the company would use this manipulative tool to eliminate excess inventory levels from books of accounts by showing them as sales booked. This would in turn be beneficial for the company in two aspects: to make up for any deficit in periodic sales target and to accelerate or overstate revenue in financial statements of current period depicting favorable inventory turnover periods. Companies involved in this malpractice would usually have trade debtors outstanding in their statement of financial position of proportionately larger amounts as compared to sales booked (Mohanram, 2003). The process involves sending bulks of inventory to customers over and above their demand thereby overloading the selling channels only to reverse them in the latter period when they are returned by the customers. This enables the managers to overstate revenue to influence decisions of investors who are valuing the entity’s worth on the basis of its revenue (Lai, Debo and Nan, 2011). The short-term picture shown at end of period through this mechanism provides a boost in market price of shares and indicates a healthy position of company with no going concern issues. However, for intelligent investors who are aware of such tactics, this isn’t an effective tool since they would study the company’s books in the long term over a period of 3-5 years. As a result the aggregate revenue would be same and a trend can be observed of booking large amounts of receivables at every end of a period and reversing them simultaneously in the first month of next period! ‘Cookie Jar Accounting’ Sometimes, when a company is performing too well, the expectations of stakeholders would automatically enhance for future prospects and therefore it would become more difficult for it to maintain the same level especially in recession times if expected in near future. To cater this, many well-known organizations use a technique namely ‘Cookie Jar Accounting’ to retain certain portion of current income in superficial revenue and capital reserves, saving the funds for rainy days! (Mohanram, 2003) This smoothens the performance of the organization over the years, company neither over-performing nor under-performing in any specific period. This is a very common and easy-to-apply practice nowadays. In a speech by staff of Securities and Exchange Commission (SEC), they state that cookie jar accounting has become an art recently. It is very convenient to form a provision for a future remote expenditure such as restructuring, environmental spendings or dismantling costs, for an amount just below the monitoring margin and booking an expense against the same in the current period. This is very effective as it not only reduces the current year’s earnings thereby lesser tax liability but it also saves funds in a reserve for later use (Schuetze, 1999). In short term, the current performance would appear normal along with future performance not varying either. However, in the long run, the aggregate profits would add up to the same amount as reserves would eventually be utilized to make up for below average profit periods. Question 2: IAS 36 Impairment of Assets was published in 1998and subsequently amended in 2004 and in 2008. Its primary objective is to ensure that an asset is not carried on the statement of financial position (balance sheet) at a value that is greater than its recoverable amount. Required: a. Critically appraise the circumstances where an impairment loss is deemed to have occurred and explain when companies should perform an impairment review of assets. b. Using recent assets impairment decision taken by PSA Peugeot Citroën and Vodafone as examples, discuss the effects of such decision on the firms’ financial position and performance. Answer 2a: Impairment of Assets Impairment is said to have occurred when the carrying amount of an asset exceeds its recoverable amount. This means that the asset’s book value in books of accounts of the company is no longer valid as the maximum amount that can be generated out of the asset either through use or otherwise through disposal is less than the book value. Impairment may or may not necessarily occur in line with industry norms. However, if industry faces a general recession, then it is very probable that company has faced impairment on its assets too and therefore it is very vital to carry out testing at such instances. There are certain circumstances, as prescribed by the International Accounting Standards Board (IASB), when impairment can be deemed to have been occurred possibly, given as follows: The fair value of asset has significantly declined recently; adverse changes in technology, laws or economic conditions thereby making the asset obsolete or otherwise less worthy; asset has been physically damaged or has gone out of date; and asset’s use in the company is no longer needed due to changes in methodologies and processes, diversification or major restructuring. When one or more of circumstances exist as aforementioned, then testing for impairment on specific assets being affected is required immediately. Nevertheless, during normal circumstances, an annual impairment review of assets is recommended by the International Accounting Standards Board (IASB) whereby the recoverable amounts be compared with carrying amounts of all assets and book impairment where evidence exists (Ball, 2006). An annual review is recommended but not mandatory. However, during statutory year-end audits, external auditors ensure to check whether any annual impairment testing has been conducted and check the appropriateness and reasonableness of such testing procedures. Therefore, companies should conduct impairment review of assets, at least once a year, if not more frequent, to comply with internationally followed best practices and to avoid any friction with statutory auditors. The management is responsible for carrying out such testing and in-house internal auditors should ensure that such testing is carried out each year. Since such testing is of a technical nature and the company may not necessarily be equipped with necessary manpower, expertise and resources therefore mostly practically seen, companies bring in an external specialist to provide its services surveying the assets and checking for any impairment indications. Impairment should be carried out by companies instead of avoiding it, perceiving it as disadvantageous for the company’s financial position. Impairment, if carried out periodically, will give clear detailed picture to all its current and prospective investors. If the asset position in financial statements has been overstated, then it shall become basis of a distorted analysis for the investors and on subsequent discovery of actual facts, the public profile of firm shall be notoriously known for window-dressing its financial statements. It also helps investors determine the decision-making capabilities of the management and board of the company. Management that honestly accepts any unfavorable impairment charges depicts more integrity and reality-based firm which doesn’t look into past but instead focuses on getting better in future. On the contrary, a firm that hides its true position and charges impairment in pieces in order to smoothen and stabilize net income, would show poor analytical skills and lack of professional due care (Wayman, 2002). Answer 2b: PSA Peugeot and Vodafone cases The recent decisions taken by well-established firms like PSA Peugeot automotive concern and Vodafone cellular company regarding impairment of assets were huge setbacks on account of global recession. Vodafone, reportedly as per BBC UK, faced a charge of £5.9 billion over its units lying in its two territory business divisions in Italy and Spain respectively. The company claimed that extreme increasing pressures due to price competition and drastic economical conditions have been the main reason for such write-offs occurring as customers in the mentioned territories have been spending less proportions of their disposable incomes over cellular calling charges and tariffs due to recession, reduction in incomes and hyper inflationary circumstances globally (BBC News, 2012). Similarly, Peugeot conducted, on insight of worsening circumstances in European markets, financial analysis to identify any differences between book value of its consolidated equity as reported in its financial statements and economic value-in-use. It resulted into an impairment charge of €3,009 million on its automotive business unit for the year 2012 (PSA-Peugeot-Citroen, 2013). The impact of these decisions is very material on their corporate financial statements including statement of financial position and statement of financial performance. The following few impacts can be suggested to take place: The value of assets on statement of financial position shall deteriorate; the owner’s equity in form of retained earnings shall also reduce by same amounts; impairment charge shall be allocated to assets of divisions or business units being impaired on a pro rata basis; impairment charge shall be expenses out in its statement of financial performance or statement of comprehensive income; impairment charge shall be reversible in future may there arise any indications of increase in recoverable amounts of impaired assets. When reversed, the reversal of impairment shall apply in the same way to assets on pro rata basis in compliance with requirements of IAS 36; Reversal of impairment shall be reversed in the revenue reserve created in comprehensive income, if any, to the extent to which it was booked previously. Any excess amount, however, shall be treated as gain in income statement; Goodwill shall not be impaired or reversed subsequently; The position and public profile of both companies and the net worth in market shall decrease due to impairment. If in near future, for any of the companies mentioned or otherwise in general for any company facing major impairment of assets, the selling price of the company decreases significantly for any due diligence activities (mergers, acquisitions, alliances etc.). When the consideration required to be paid is calculated for consolidation purposes and during acquisition process, impairment of assets is taken into account and therefore amount payable is reduced by the same making worth of company lesser than it was prior to impairment. According to James in his article, impairment of assets is suggested to have following effects on financial metrics of a firm in the current period: Since the value of assets, being the numerator in asset turnover ratio, would decrease, the said ratio would also decline; and the owners’ equity also reduces due to impairment and therefore debt to equity ratio will increase due to denominator being lower than before. Impairment of assets would have following effects on firm’s statistics in the future periods: Due to lower book value of depreciable assets, the depreciation charge in future years would also decrease; as mentioned above, a reduction in depreciation charge will automatically cause net profit after expenses (including depreciation) would rise; and assets as well as the owners’ equity has fallen due to impairment and therefore all ratios where either of them act as a denominator base such as Return on Assets and Return on Owners’ Equity shall boost up (James, 2012). 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