HOW DO YOU MANAGE?
Earnings management is alive and well, say CFOs.
By Tom Leander

Ask a CFO if he or she manages earnings, and the most likely response is to demur. It’s no wonder, because the practice is associated with the outright lies and manipulation of accounting that brought down Worldcom, for one. But according to a study by Michael Peters, Rich Houston, and Jamie Pratt, finance professors at US business schools at Villanova University, University of Alabama, and Indiana University, respectively, about one-third of CFOs worldwide say they engage in some kind of earnings management. This group used ‘allowable discretion’ to influence their reported numbers.

This seems strange. Why should any manipulation of reported numbers be allowed? One reason is that earnings themselves are based on so many assumptions that they can never present a totally accurate view of a company’s financial condition. Baruch Lev, a professor of accounting and finance at New York University’s Stern School of Business, notes that, with some exceptions, practically every item on a balance sheet and income statement is based on an estimate that can be changed or adjusted by management. Asset values rely on estimates, as do statements of depreciation and bad debt reserves. Fair value of financial instruments is based on prices of similar instruments, another use of estimates. No wonder, then, that most manipulation of earnings involves the “massaging” of estimates, according to Lev. The other common method involves how transactions, such as sales and spending decisions, are timed.

This jibes with the results of the CFO survey, which garnered 743 responses from readers of the three regional CFO editions – in Asia (238), Europe (182), and the US (323). Across the regions, the approximately 23% that said they would increase earnings were more likely to do this via sales-related actions. These included accelerating efforts to induce customers to buy before year-end, and speeding up order processing. They also cited other methods, such as altering expenditures on operating items, R&D, and projects.

When it came to decreasing earnings, Asian and European CFOs preferred doing so by massaging accounting estimates, while the US CFOs shunned the practice, preferring to dabble with operating expenditures.

Says Peters: “That may be because of a less stringent regulatory environment in some parts of the world outside the US.” The use of principles-based accounting under International Accounting Standards, rather than prescriptive GAAP, may also encourage the practice.