Going Concern & Earnings Management

Initial GCO issued to subsequently viable client-85% of all GCOs

Bankrupt client received unmodified (clean) opinion during the preceding year

50% of all bankruptcies

Receivables – allowance for bad debts

Inventories – obsolete inventory

PP&E, natural resources, intangibles – useful lives, residual values

Accruals – loan loss reserves, deferred compensation

Revenues – subscription income

Contracts – revenue earned, costs incurred, % completed

Litigation – probability and amount of loss

Rates – annual effective tax rates for interim reporting

The purposeful intervention in the external financial reporting process, with the intent of obtaining some private gain

EM is w/in GAAP, uses loopholes

Fraud is intentionally deceptive, not GAAP

Earnings management via “accounting manipulation”
E.g., opportunistic accounting estimates

Earnings management via “real activities”
The use of actual business transactions to manipulate earnings.

Classification shifting
The opportunistic classification of items within the income statement, statement of cash flows, and balance sheet.

A company uses an optimistic estimate of useful life in depreciating its equipment.

A company records an addition to its warranty liability that it knows is too small.

A company overaccrues a restructuring charge to be able to reverse part of the accrual in the future, if needed.

AUDITORS SHOULD BE VERY CONCERNED WITH THESE

Advertising expenditures are accelerated in the 4th quarter so as not to exceed the earnings target in the current year and increase 1st quarter earnings in next year.

Credit standards are relaxed near the end of the year to boost sales and earnings.

Shipments close to year-end are delayed to provide an increase in sales in 1st quarter of next year.

The purchase or maintenance of fixed assets is postponed to shift the expense to a future accounting period.

AUDITORS NOT AS CONCERNED WITH THESE

Income Statement Examples of Opportunistic Classification Shifting:
-Classification of items as extraordinary or from a discontinued component
-Levitating items to revenue
-Moving expenses out of COGS into SG&A
-Moving items into or out of operating income
-Obscuring items by netting
-Cash Flow Statement Example of Opportunistic ------

Classification Shifting:
-Moving cash inflows (outflows) into (out of) Cash Flows from Operating Activities during the bad times.
-Reverse is true during the good times.

“Big bath” restructuring charges
Creative acquisition accounting
“Cookie jar” reserves
“Immaterial” misapplications of accounting principles
Premature recognition of revenue

GAAP based net income that is adjusted to produce a non-GAAP measure of earnings.

If company uses this then they must also show most directly comparable GAAP measure to reconcile the non and GAAP measures

Must also state why they think non-GAAP measure is better.

1-Better Disclosure of impact of changes in accounting estimates

2- Clarified accounting rules for purchased in process R&D, large acquisition write-offs and restructuring charges

3- Guidance on qualitative materiality factors

4-guidance on revenue recognition

5-Prompt definition of FASB's definition of liabilities

6- Target reviews of public companies announcing restructuring liability reserves, major write offs or other earnings management practices

7-ENHANCED OUTSIDE AUDITING

8- STRENGTHENING THE AUDIT COMMITTEE PROCESS

9-PURSUING CULTURAL CHANGE