Quiz 7: Earnings Management
Facts: The case is that of accounting and financial fraud committed by Canada's N Telecom, one of the world's premier Telecommunications companies. The Company during 1990's engaged in a series of accounting fraud such as recording revenue which is not yet received by the company and the company maintained secret cash reserves which are not revealed in the books. The company's efforts are to improve the stock price of the company in the stock exchanges, investments made by the company backfired and as a result the company filed for bankruptcy in U.S, Canada and Europe. Investigating agencies launched a full scale investigation into the financial fraud committed by the company. Revenue Recognition: GAAP offered specific guidelines based on which revenue recognition can be done, for example, GAAP mentions that revenue resulting from financial transactions can be recorded only when a particular transaction takes place and the revenue is measurable. Reserve accounting: It is an accounting practice in which profits are reserved for a particular purpose such as purchase of fixed assets, purchase of machinery etc. This categorized use of profits for a special use is referred as reserve accounting. Contingent liability accounting: Contingent liabilities are recorded as liabilities which are most likely to happen and the expenses are recorded only when the exact amount of expenses to meet the liability are known. 1. Discussion: The Company engaged in accounting and financial fraud by resorting to fraudulent revenue recognition, reserve accounting and contingency liability accounting procedures. They are done in the following manner: Revenue recognition: The company had huge surplus of inventory left with them and is unable to sell them in the market because of lack of orders. In order to convert this into revenue, the company opted for a technique called as "bill and hold", in which customers can order certain equipment, bill for it and wait to take the delivery at a later period of time. Reserve Accounting: The company resorted to creation of unrecorded reserves of funds and engaged in activities such as releasing the reserves into income to boost the income whenever needed. Contingency planning: The company kept hidden reserves which are off the records so that they can be used at a later period whenever it is necessary. They are not in confirmation with the GAAP regulations because of improper recording of information and failure to use proper accounts management principles. 2. The accounting practices followed by N Telecommunications Company in the case and the discretion they have adapted in keeping the information are in total disagreement with the statement offered by accounting experts. Accounting experts say that a certain amount of discretion is required by the firms when disclosing key financial information. However, basic factual information cannot be neglected and left out from the records, similarly key information such as profits and reserves cannot be left out of records. Thus, the accounting practices are in total disagreement with the opinion of the experts. 3. Judge M's statements regarding the justification of the accounting practices advocated by the defendants are not justified. This is because the actions of the defendants are in practice for a long time, during the later period of 1990's and at a time when the company is facing a slowdown in the market. Thus judge M's comments are not justified. 4. The auditors of N Telecommunications failed to display professional responsibility while performing the audit of the N T's case. This is because they have failed to suggest correction measures to correct the accounting irregularities in the financial statements. Also, the auditors failed to suggest proper internal controls for controlling and preventing accounting irregularities. Thus, the auditors failed to perform their professional responsibilities.
In the given statement, A thinks that sales are recognized prematurely or sales may have booked prior to prices have been fixed or finalization of contracts or booking of sales revenue even when a customer is in a condition to void or terminate or delay the sale. He describes the practices of improperly booking of revenues. Financial reporting is the base for investor, creditor and other stake holders to judge the performance of the company. They all feel that company that has quality built in financial reporting is much safer to invest and such company will be able to raise fund from market easily. The financial analyst plays an important role in earning expectation and reporting quality of earning. The auditors meet their ethical obligation properly and hence show true picture of company and protect interest of public and help in detecting fraud. In view of financial analyst, quality of earning is also an important consideration. When earnings are reported properly without any error then financial analyst can clearly derive its conclusion and clearly report it as what it meant to report.
Every business is set up with a motive (sometimes profit is the motive while sometimes service is the motive) and to fulfill the motive many people are involved in the business (employees as well as other stakeholders). All the people involved also can have their own personal as well as professional motives to fulfill and move ahead. Companies sometimes want to grow bigger and faster and so get involved in some unethical practices. Such things done by some companies makes it difficult for the public to believe and find out which company is working honestly and which is not. So to keep a check and give authentic, certified information to the public and other stakeholders about the company there are many regulatory bodies as per the industry/ sector any particular company is working in. Similarly, accounting norms are also different industries and companies in different industries. One thing that is common for all industries is the Audit requirements that is, every company registered under a specific act has to maintain some books of accounts (financial records) to show them to various stakeholders (like shareholders, employees, investors, bankers etc.) about the financial position of the company. Now, Auditors have a role to play that is, Auditors certify that the records maintained and shown by the specific company are reflecting true and fair position of the company. Auditors do face many challenges and pressures from the company's management to show various things or sometimes to compromise on the documentation part or may be sometimes proper documents/ proofs are not available with the company and they start pressurizing the auditors to compromise on it. Sometimes auditors face pressures from their own companies to finish the audit work faster or within deadlines and so they compromise on checking the documents etc. So many of them face many such challenges and pressures but their job is to handle these pressures and still do not compromise and be answerable to the public (their first stakeholders). 1. Doing the audit and representing the useful information of the financial statements faithfully is a basic requirement and expectation from all auditors by the all stakeholders whether it is general public or shareholders or Banks etc. the basic reason behind this is everybody wants to have a clear picture of the performance as well as position of the company at the year-end because everybody has some stake or the other involved in the company. Auditors have this responsibility of providing true and fair position of the company to all the stakeholders so that they can take their decisions based on company's performance last year as well as plan of action suggested for upcoming years. In this case, Ms. S is trying to counter arguments on: 1. The ideal situation of company disclosing the actual facts and figures even if they were not able to meet the projected sales targets so that corrective measures can be thought of for the next year. 2. as given in the case, if the company discloses the transaction as a sale transaction than it is not the right recording of the transaction because that is only first half part of the agreement executed and next half of the agreement is supposed to be executed after 30 days so, it is not right to record an incomplete transaction. 3. Ms. S will have to answer their client about "if the company is not recording this transaction than the company's sales as well as net income target is not met so how to justify that in front of the stakeholders. 4. Also, justification should be given to other stakeholders like: shareholders, Banks etc. if the company does not the transaction because as per the auditors, transactions should be reported on the economic substance of the transactions rather than on the legal form of the transactions. That is, if this transaction is reported as a sale and later on, the company fulfills (or not) its agreement than what will be the effect of the same on the company's financial status. The rationalizations that Ms. S needs to address when in meeting with Mr. P are: 1. it's the duty of auditors to show a True and Fair position of the company for all the stakeholders. 2. What can be the after effects of recording an incomplete transaction and what if they are caught later? 3. Ms. S will have to provide a genuine justification for the stakeholders for why the company was not able to meet the sales as well as income targets and what are future plans regarding the same. 4. By recording incomplete/ wrong transactions company's financial status as well as financial position of the company can have serious impact on the company as well as the stakeholders. 2. The key parties involved in this are: the company (SN Inc.), CFO (Mr. P), Audit committee and other stakeholders. The company has a stake because its yearly performance is showcased after this audit and so if this transaction (as referred in the question) is not included than the sales are not meeting the targeted sales and so the company can face problems in terms of decrease in goodwill, decrease in net income and sales and further other financial parameters will be suffering. CFO has a stake because he is representing the company and will be answerable to the Board of Directors as well as shareholders and other stakeholders for company's performance. Also, he is under pressure to show results so he is expecting Ms. To include the revenue from an incomplete transaction to be included in the yearly revenue of the company. Audit committee and Ms. S (specifically in the Audit Committee) has a stake because she is conducting the audit (internally) and is responsible for recording of transactions and if any such transaction is caught by the external Auditors (expected on January 15, 2016) she will be the one answering them. She has some ethical obligations to give a True and Fair position of the company for other stakeholders to take right decisions as per their respective requirements. Also, Ms. S is responsible for the company's performance. If Ms. S gives wrong figures about the company's sales etc. than it can mislead the various stakeholders and their many things can be at stake for this so Ms. S has ethical obligations towards the various stakeholders also Other stakeholders like: shareholders, Bankers, debtors, creditors etc. have all the rights to know about the exact financial position of the company for them to take appropriate decisions based on the current financial position of the company. 3. Yes, Ms. S should follow her friend's advice and try to explain the ethical obligations because of which she is not convinced to record the partial sale transaction in the books of accounts. She is into ethical dilemma because the transaction is not complete as per the agreement and so should not be recorded before the transaction is completed (by both parties) as per agreement. Recording the partial completion as a complete sale transaction can be misleading for the stakeholders because if something goes wrong and the transaction is cancelled than it will have huge impact on the net income and revenues. As given in the question the deal in question is of $ 20 million and the net income increase (because of this revenue) is $ 1 million. This transaction although helps management to justify the sales as per the budget but in case it is not completed than it will affect the net income in turns the stakeholders. If still Mr. P does not back off than she can give examples of companies like Enron etc. who's frauds were highlighted later and the whole management, finance department was involved in giving misleading figures in the books of accounts. Also, she can talk about the various surveys conducted and finally the cookie-jar effect to be used as a rescue for them at later time if income goes down and create a reserve right now rather than showing higher income by manipulating the transaction records. 4. Ms. S needs to address rationalizations given by Mr. P about the budgeted sales figures required to be achieved by the year end and the company will be very close to the target sales with this single transaction (because the transaction is a material transaction) if recorded in the books of accounts while as per Ms. S this transaction should not be recorded as of now because it is an incomplete transaction till the year end (as per agreement). Although it is a material transaction and will be give a positive impact on the Net Income and sales of the company for all the stakeholders to look at the financial position but at the same time it is their duty to keep the stakeholders informed about the true and fair position of the company rather than giving any misleading figures just to upkeep the company's image. All the stakeholders have their own interests and reasons to know about the exact financial position of the company and so it is their (company and CPAs) duty to keep them informed about the true and fair position of the company.