Measurement Errors Caused Intentionally

Management Manipulation

A major error in the financial statements is the error introduced through intentional managerial manipulation. Given the many estimates that the accounting rules require, it is an inevitable fact that some managers will use this discretion in order to achieve their own short-term objectives. The most common goal being-managers manipulating the financial statements to inflate reported earnings in a particular period, by any of the financial shenanigans described above.

Earnings management, as it is referred to, takes the shape of abusive earnings management when there is a deliberate effort by the management to circumvent the GAAP rules and thereby influence reported earnings. Though GAAP has been designed to provide guidelines for measuring revenues, the relative flexibility in the rules has been used as an instrument for manipulation and smoothening of earnings.

Revenue Manipulation

Revenue manipulation is the most common type of earnings management. The sales transaction is the pillar for recognition of revenue in the business and it is this figure that is manipulated to inflate earnings. This is resorted to by any of the following practices:

1. Vendor Financing: It occurs when a company loans money to a customer to purchase goods from the company. The result is an increase in sales revenue on the income statement and an increase in notes receivable on the balance sheet.

2. Trade Loading or Channel Stuffing: In this form of manipulation, sales are recorded even before they are earned by shipping inventory to customers before the customer really needs it. This is taken up usually at the end of the reporting period by borrowing sales of next accounting period into this period's sales and thereby inflating current sales.

3. Overstatement of Value of Accounts Receivables: Yet, another form of manipulation is overstating the amount of accounts receivables or understating the allowance for uncollectible accounts. To overstate accounts receivables, the business increases the volume of credit sales by granting more generous credit terms or by selling to customers with lower credit quality. But such sales push up the cost of uncollectible accounts and if they are not recognized, it results in revenues and earnings being overstated.

4. Not Recognizing Rebates or Discounts: Not reducing the sales for the promised rebates is another technique to increase revenues. Sometimes, a business may boost current period sales transactions by promising to provide enhanced future service or additional future products at discounted prices. If the cost of these future obligations is not recorded as a liability, then current period equity and earnings will be overstated.

  Expense Manipulation

1. Capitalizing Revenue Costs: Whenever an asset is used up in a firm's operating activities, an expense must be recognized unless a new asset is created. In other words, there must be a future benefit that satisfies the criteria for recognition as an asset. Therefore, earnings can be manipulated by capitalizing costs that should in realty be expensed.

2. Accounting for Inventories: Inventory valuation is also an area for expense manipulation. Inventory valuation techniques like FIFO, LIFO etc, are used in the business for determining the amount of inventory that has been used up and therefore recognized as cost of goods sold. The management can use these techniques in timing inventory purchases and changing cash flow assumptions in order to manipulate earnings. Earnings can also be manipulated in the allocation of joint costs.

3. Non-current Assets Depreciation: In case of non-current assets, GAAP rules point out that these assets need to be depreciated, amortized or impaired over time. However, there are several laxities in determining the amount of depreciation. For example, if a company depreciates its fixed assets over a longer period of time than its competitors, then the company would look more profitable than its competitors.

4. Understating Liabilities: Expense manipulation may also be resorted to by understating liabilities. For example, let us consider the case of warranty liabilities. When a firm sells a product with a warranty, the expected future costs of the warranty should be recognized as an obligation of the company at the same time that the sales transaction is recognized. This will result in an increase in liabilities and a decrease in equity and earnings. By understating or ignoring the warranty liability, the  management can overstate earnings.

5. Employee Pension and Other Retirement Benefit Schemes: In accordance with GAAP, the employee pension and other amounts related to retirement benefits need to be estimated, recognized as a liability and charged off as an expense in the same period that the employees provide the services that earn the benefits. However, there is a huge subjectivity involved in determining the amount of benefits, rate of return on benefits, etc. A change in these assumptions causes a wide variation in the reporting income.

6. Cookie Jar Accounting: It involves making provisions when profits are higher than expected, and releasing them during difficult times. The basic tactic is to create a provision by making a charge against profits, and carrying forward a credit in the balance sheet.  In other words, the management manages to avoid recording certain expenses on the income statement, using an off balance sheet account to absorb the impact on earnings.

For example, a cookie jar can be created with bad debt expense account. Suppose the business follows the practice of charging 2% on credit sales for bad debts provision. Managed earnings will occur (a) when, during periods of less revenue, the percentage is reduced to jump earnings upward, resulting in lower bad debt expense, or (b) when, during periods that management needs to reduce earnings, the percentage is increased. The cookie jar (provision account) thus floats up and down to accommodate the desired expense accrual. The user fails to understand the manipulation as the statements reveal only the net accounts receivables.

Cookie jar accounting in practice does not involve managing a single expense account but is simultaneously employed to a number of relatively small balance sheet accounts which are manipulated in the same direction for manipulating the overall figure of reported earnings.

1. Big Bath Accounting: This is most frequently applied when a group takes over a new subsidiary but may also occur when there is a change of a chief executive. The idea is that the acquiring group, or the new chief executive, identifies over valued assets (and under valued liabilities) and makes a
   once-and-for-all provision for these. This involves a major charge against profits but is explained as an exceptional year where a major clean up exercise (big bath) has been done. However, the advantage of this is future depreciation charges will be lower, or that excess provisions are available to boost future profits, but at the same time the current share price is often not affected.

2. Postponment of Discretionary Costs: Discretionary costs are the costs which the group can stop incurring without having any immediate effect on profitability such as research and development costs, staff training, advertisement, etc. Most companies try to postpone or abandon the recognition of these costs in the books of account, if the forecast for a period shows less profit. By not disclosing these expenses, the short-term profits increase and there is little or nothing visible on the outside to warn the analyst. Where a company shows research and development costs, they may show a decrease. But even here, the classification as to what is development expenditure and what is ordinary running costs is not that clear, and a little creative redefinition could hold the figure up even when real expenditure has dropped.   

3. Off-Balance Sheet Entities: Off balance sheet entities are the separate legal entities that a firm may create which is not required to be consolidated in the firm's financial statements. The firm, however, exerts influence over this new entity and uses the entity to manipulate the financial statements. This influence is exercised either by appointing related parties to the management of the entity or by being a key financier, supplier, customer or guarantor of the entity. Once such entity is created, several transactions may fictitiously emerge between the parent company and the off-balance sheet entity. Unearthing existence the off-balance sheet entities is a difficult task but there are three potential disclosures that give information - the note on related parties, the note relating to equity investments and other unconsolidated investments and finally the note on contingent liabilities which discloses if the firm has guaranteed any debt of unconsolidated entity.

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