Defining Earnings Quality: The Largest Corporate Frauds In The World via CSInvesting

Patricia M. Dechow

University of Michigan Business School

Catherine M. Schrand

Wharton School of the University of Pennsylvania

Defining Earnings Quality: The Largest Corporate Frauds In The World – Introduction

The United States has been home to some of the largest corporate frauds in the world. Enron Corporation’s use of special-purpose entities enabled it to keep billions of dollars’ worth of debt off its balance sheet, with investment bankers, lawyers, and accountants showing the company how. WorldCom used a simple scheme to capitalize more than $11 billion of expenditures as assets rather than expenses. Tyco International has been charged with failure to disclose millions of dollars of low-interest and interest-free loans to its executives. Qwest Communications International was forced to restate its revenues by $2.4 billion after the U.S. Securities and Exchange Commission discovered that its impressive revenue growth was mainly the result of swapping network capacity. Xerox Corporation boosted results by prematurely booking revenue from long-term leases of copiers and printers that it should have reported years later and by setting up “cookie jar” reserves during acquisitions that were later used to make up for shortfalls in operating results. Its restatement of earnings was more than $1.4 billion. Waste Management capitalized all sorts of expenditures that should have been expensed. And the list of financial accounting abuses goes on and on.

Why have accounting abuses become so prevalent in the United States in recent years? The volume of financial information provided by companies in the United States is among the highest in the world. The rules governing the production of the financial information are reputedly among the strictest in the world. Analysts in the United States are among the most accurate in the world at forecasting earnings, and the audit profession takes pride in the training and experience required of its professional staff. In addition, investor
rights are among the strongest in the world. Certainly, the United States should be a safe place for an investor to purchase equity.

Perhaps part of the answer lies in the nature of accrual accounting and its interaction with economic cycles. Under accrual accounting, current experience is used to make accounting estimates for future periods and these estimates feed back into current-period earnings. Thus, the positive effect of real performance on earnings during booming economies is leveraged by the effects of optimistic forecasts concerning continued growth and investment opportunities. As the economy slows down, however, managers find it increasingly difficult to meet the high earnings hurdles set during the boom times. Downturns mean fewer sales, more bad debts, and more obsolete inventory.

The real decline in sales and earnings is exacerbated by the reversals of optimistic prior-period accruals. Some managers at this point use aggressive accounting—or, in the extreme, fraud—to avoid reporting a decline in earnings. The increased frequency of accounting abuses following the 1990s, which represent one of the longest periods of economic expansion in recent U.S. history, is not surprising.

The fundamental question is: Why do managers feel so much pressure to report continued growth in earnings? Managers may actually create part of the problem themselves by “guiding” analysts about future results and thus creating unrealistic expectations. When a manager’s reputation is on the line, earnings management (viewed as “temporary”) may seem like a low-cost way to avoid admitting a mistake. Corporate culture and management compensation packages also influence accounting choices. Divisional managers often feel intense pressure to meet targets set by top management. Stock option compensation can create incentives for top managers to set unrealistic targets for divisions to
show “growth” so stock prices will continue to rise. Whether intentionally or unintentionally, managers have many incentives to “massage” earnings.

Our goal in this monograph is to provide structure for understanding “earnings quality.” Earnings quality is contextual; it means different things to different financial statement users. The financial press refers to fraudulent reporting as an “earnings quality” problem. All financial statement users would probably agree with this definition. But the financial press also suggests that a company has an earnings-quality problem if earnings contain unusual items or lack transparency, even if reported earnings and the related disclosures are in accordance with generally accepted accounting principles. Standard setters, regulators, and auditors may disagree with the press on this point.

Regulators generally view earnings to be of high quality when they conform to the spirit and the rules identified in GAAP. In contrast, creditors are likely to view earnings to be of high quality when they are easily convertible into cash flows. Compensation committees are likely to view earnings to be of high quality when they reflect managers’ real performance and are little influenced by factors beyond management control. These examples illustrate that the decision maker’s objective and the role of earnings in the decision model drive the definition of earnings quality.

Earnings Quality

Earnings Quality

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