Ethical Obligations

Business

Quiz 7 :

Earnings Management

Quiz 7 :

Earnings Management

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Are the use of non-GAAP financial measures ethical?
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GAAP:
Generally accepted accounting principles (GAAP) are the accounting standards that are commonly used by companies and must be followed when the companies accumulate their financial statements.
Non-GAAP:
Non- GAAP financial measure are the statistical measure of the future or past performance of the company, which includes that amount that are not the part of or excludes the most directly comparable GAAP measure.
There is pressure to show the company's position favorable which compels the companies to report such incomes that exclude unusual events that show any depress earnings. Financial performance measures were used by the companies for a long time, rather than using GAAP. These measures show the favorable part of the company and mislead consumers.
Sarbanes- Oxley Act had an objective to eliminate any misleading or manipulative use of non-GAAP financial measures. This use can be allowed only to that extent till it is not misleading.
Thus, it can be said that the use of non-GAAP measures is not ethical but it cannot be said that the use of such measures is 100% unethical.

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In Arthur Levitt's speech, referred to in the opening quote, he also said, "I fear that we are witnessing an erosion in the quality of earnings, and therefore, the quality of financial reporting. Managing may be giving way to manipulation; integrity may be losing out to illusion." Explain what you think Levitt meant by this statement. What role do financial analysts' earnings expectations play in the quality of earnings?
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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.

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Nortel Networks Questions 1. Discuss Nortel's accounting for the following transactions and why they were not in conformity with GAAP: • Revenue recognition • Reserve accounting • Accounting for contingent liabilities 2. The following two statements are made in the case: • Accounting experts said the case is sure to be closely watched by others in the business community for the message it sends about where the line lies between fraud and the acceptable use of discretion in accounting. • Darren Henderson opined that "The message... is that it is okay to use accounting judgments to achieve desired outcomes, [such as] a certain earnings target." Evaluate these statements from the perspectives of representational faithfulness and fair presentation of the financial results reported by Nortel. 3. During the trial, lawyers for the accused said that the men believed that the accounting decisions they made were appropriate at the time, and that the accounting treatment was approved by Nortel's auditors from Deloitte Touche. Judge Marrocco accepted these arguments. Marrocco added he was "not satisfied beyond a reasonable doubt" that the trio [i.e., Dunn, Beatty, and Gollogly] had "deliberately misrepresented" financial results. Given the facts of the case do you believe Judge Marrocco's decision was justified? Explain. 4. Does it appear from the facts of the case that the Deloitte auditors met their ethical and professional responsibilities in the audit of Nortel's financial statements?
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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.

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Comment on the statement that what a company's income statement reveals is interesting, but what it conceals is vital.
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In 2010, LinkedIn reported trade payable obligations totaling $10.8 million in other accrued expenses within accrued liabilities instead of accounts payable. In 2011, note 2 in the 10-Kfinancial statements described the use of accrued liabilities instead of accounts payable as a classification. Do you believe LinkedIn's accounting qualifies as a financial shenanigan?
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Beazer Homes Questions 1. What role did organizational ethics play in the Beazer Homes fraud? Is this something the auditors of Deloitte should have been more conscious of? Explain. 2. Evaluate Beazer's accounting for cost-to-complete reserves from a GAAP perspective. Was the initial accounting for the reserve in conformity with GAAP? What was the company trying to achieve with its accounting? 3. Categorize the accounting devices used by Beazer into one the financial shenanigan groupings. Include a discussion of how earnings were managed in each case. 4. Assume you were hired to analyze the information in this case and write a two- to three-page report on your findings. Discuss each element of the fraud and why Beazer, Rand, and/or Deloitte violated ethical and professional standards.
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GE: "Imagination at Work" Questions 1. Review the SEC's complaint against GE (see Note 1) and explain the specifics of the company's hedging transactions and why they violated GAAP. 2. Did GE violate the rules for revenue recognition (pre-2016-change) on the "sale" of its locomotives? Explain. 3. Did GE engage in earnings management? How would you make that determination given the facts of the case?
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The North Face, Inc. Questions 1. Use the fraud triangle to analyze the red flags that existed in the case and the role and responsibilities of the auditors at Deloitte Touche in The North Face accounting fraud. 2. Identify the general principles that dictate when revenue should be recorded. How did North Face violate those rules? 3. Evaluate the actions of Deloitte Touche first proposing an audit adjustment on the $1.64 million balance of the December 29, 1997, transaction with the barter company and then passing on the adjustment based on it not having a material effect on the financial statements. In this regard, should auditors conceal materiality levels from audit clients?
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Relevance and faithful representation are the qualitative characteristics of useful information under SFAC No. 8. 93 How does ethical reasoning enter into making determinations about the relevance and faithful representation of financial information?
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Evaluate earnings management from a utilitarian perspective. Can earnings management be an ethical practice? Discuss why or why not.
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TierOne Bank Questions 1. Was TierOne's accounting for the loan loss reserve indicative of "managed earnings?" How would you make that determination? 2. What role does professional judgment have in auditing the adequacy of a loan loss reserve? Do you believe KPMG exercised a degree of care and professional skepticism that is consistent with the level of ethical and professional judgment expected by the accounting profession? What about the public? 3. Given the facts of the case with respect to audit work performed by Aesoph and. Bennett, do you believe the sanctions imposed by the SEC were appropriate? Explain.
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Comment on the statement that materiality is in the eye of the beholder. How does this statement relate to the discussion in this chapter of how to gauge materiality in assessing financial statement restatements? Is materiality inconsistent with the notion of representational faithfulness?
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Needles talks about the use of a continuum ranging from questionable or highly conservative to fraud to assess the amount to be recorded for an estimated expense. Do you believe that the choice of an overly conservative or overly aggressive amount would reflect earnings management? Explain.
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Dell Computer Background Questions 1. How would you characterize Dell's accounting techniques described in the case? Was it a case of aggressive accounting? Was it earnings management? Link your discussion to the specific accounting methodology and GAAP rules. 2. Identify the red flags that should have alerted PwC that Dell may have been engaging in fraud. Given that Dell issued clean opinions during the fraud years, do you think it is possible that the firm conducted its audit in accordance with GAAS? What indicators would you look for to make that determination? 3. The court decision relied on the concept of scienter for not holding PwC legally liable for issuing clean opinions when the financial statements did not fairly present financial position. Would you reach the same conclusion from an ethical perspective? Explain.
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Sino-Forest: Accounting for Trees Questions 1. Should operational and cultural considerations play a role in determining whether Sino-Forest committed a fraud? Explain. 2. Did Sino-Forest manage earnings? Refer to the discussion in this chapter about different perspectives on earnings management in responding. 3. Critically evaluate the audit work of Ernst Young from the perspective of generally accepted auditing standards and professional ethics. Was this a failed audit?
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Harrison Industries (a GVV case) img img Questions 1. What are the real and anticipated arguments that could be made by those at Harrison Industries who may try to convince Donna to go along with the accounting for future severance payments? Include in your discussion the possible motivation for the accounting treatment. 2. What is at stake for the key parties? What are Donna's ethical obligations to them? 3. What is Donna's most powerful and persuasive response to the reasons and rationalizations she needs to address? To whom should the argument be made? 4. What is Donna's most effective approach to giving voice to her values? Explain.
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Sunbeam Corporation Questions 1. How did pressures for financial performance contribute to Sunbeam's culture, where quarterly sales were manipulated to influence investors? To what extent do you believe the Andersen auditors should have considered the resulting culture in planning and executing its audit? 2. Why is it important for auditors to use analytical comparisons such as the ratios in the Sunbeam case to evaluate possible red flags that may indicate additional auditing is required? How does making such calculations enable auditors to meet their ethical obligations? 3. Assume you were the technical advisory partner for Andersen on the Sunbeam engagement and reported directly to Harlow. You have just reviewed all the workpapers on the audit including materiality judgments. You are concerned about what you have just seen. Further assume that you consider yourself to be a pragmatist, one who is concerned with your own material welfare, but also with moral ideals. Develop a plan of action for voicing your values to ensure you are heard by Harlow and others in the firm. Consider the following in developing the plan to do the right thing: • What do you need to say to Harlow? • What are the likely objections or pushback? • What would you say next? To whom, and in what sequence?
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Solutions Network, Inc. (a GVV case) Questions 1. What are the main arguments Sarah is trying to counter? That is, what are the reasons and rationalizations she needs to address in deciding how to handle the meeting with Paul? 2. What is at stake for the key parties in this case? What are Sarah's ethical obligations to them? 3. Should Sarah follow Shannon's advice? What if she does and Paul does not back off? What additional levers can she use to influence Paul and make her values understood? 4. What is the most powerful and persuasive response to the reasons and rationalizations Sarah needs to address? To whom should the argument be made? When and in what context?
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Evaluate the following statements from an ethical perspective: "Earnings management in a narrow sense is the behavior of management to play with the discretionary accrual component to determine high or low earnings." "Earnings are potentially managed, because financial accounting standards still provide alternative methods."
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Maines and Wahlen 94 state in their research paper on the reliability of accounting information:" Accrual estimates require judgment and discretion, which some firms under certain incentive conditions will exploit to report non-neutral accruals estimates within GAAP. Accounting standard scan enhance the information in accrual estimates by linking them to the underlying economic constructs they portray." Explain what the authors meant by this statement with respect to the possible existence of earnings management.
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