CFA Level 1
Red Flags - Managerial Discretion
Under U.S. GAAP, a company's management is given some discretion as to the timing and classification of certain items. Unfortunately, a company's management can use this allotted discretion to manipulate reported earnings.
Types of Earnings Manipulation
1. Classification of good news/bad news – Since analysts and investors tend to focus on income from continuing operations, a reporting company will tend to include good news in this category and keep bad news out (report it below the net-income-from-operations line). If a company sells a subsidiary for a gain, it will most likely be included in the net income from continuing operations. If the company sells the subsidiary for a loss, the company will most likely want to classify it as a discontinued operation (extraordinary or unusual or infrequent event) and report the loss below the line.
2. Income Smoothing – Companies go through cycles of good years and bad years. During the good years some companies will create accounting reserves so when they are no longer doing well, they can increase their net income and effectively smooth out their reported net income over time. Income smoothing can be classified as one of two types:
a. Inter-temporal smoothing takes place when a company alters the timing of expenditures or chooses an accounting method that smoothes out earnings. One example is choosing to capitalize or expense R&D expenditures.
b. Classification smoothing occurs when a company chooses the category of an item based on the reporting implication it will have (i.e. it will be above or below the net-income-from-continuing-operations line). An example is the selling of a subsidiary or asset as if it were a gain or loss from continuing operations or not.
3. Big-Bath Behavior - This often takes place when a company is having what they think their investors will interpret as a really bad year and their previous income reserves are not enough to offset the bad results they are about to report. Management knows that its stock will drop because of this news, and investors will not be happy. As a result, management figures that it is the best time to get rid of all of the inconsistencies that will have a negative impact on the financial statements (impairment of assets etc.). This will create two benefits for a company: first, most of the bad news will be reported below the line, and second, in the future the company will appear to be more profitable than in the past.
4. Accounting Changes – A company can change its accounting methods, such as change its inventory-accounting methodology (LIFO to FIFO), capitalize instead of expense decisions and change its depreciation methodology. Since accounting changes are accounted for below the line (net income from operations), they can be used to manipulate the reported income from continuing operations.