Do Earnings Lie? – A Case Demonstrating Legally-Permissible Manipulation
of Corporate Net Income
James Bannister, PhD
University of Hartford
Susan Machuga, Ph.D, CPA – contact author
University of Hartford
This case demonstrates the flexibility management has in determining Net Income under Generally
Accepted Accounting Principles (GAAP). Most courses dealing with Financial Accounting present the
student with technical material, and focus on applying GAAP as though management exercises no
subjective input in the process. The present case forces students to re-think this assumption and to learn
how much leeway management really has in applying GAAP rules. After completing this case, students
see that there is a substantial range of potential reported Net Income amounts, depending upon the
estimates and assumptions they select.
INTRODUCTION
Do earnings lie? An unequivocal “YES” may seem too strong an answer, but there are many grey
areas surrounding management’s choice of the timing and amount of items reported on their company’s
Income Statement and Balance Sheet. These choices can lead to very different outcomes, even though
such accounting is perfectly legal and is in accordance with Generally Accepted Accounting Principles
(GAAP). Many investors assume that financial accounting has rules that are set in stone, and that it is an
exact discipline with only one correct answer. In reality, this statement cannot be further from the truth.
GAAP allows management to choose between methods of accounting for certain assets (e.g.,
LIFO vs. FIFO inventory method, alternative depreciation methods for fixed assets, and lease-
accounting). Furthermore, there are many areas where management must make estimates (e.g., the
allowance for bad debts for products sold on credit, estimation of useful lives of long-term physical assets
for depreciation, and impairment of intangible assets with indeterminable useful lives). Collectively, the
estimates, assumptions and accounting choices made by managers can lead to markedly different reported
Net Income numbers, and different carrying values for assets, liabilities and equity, all of which can
misrepresent/mislead financial statement users as to a company’s financial situation or how well it is
performing (Easton, et.al., 2011, p.1-19).
It is fairly well established that corporate management is under pressure to deliver the kind of
results that impress different company stakeholders. Share prices react strongly to the sign of the change
in earnings, managers are under pressure to ensure earnings increase and/or meet beat analysts’ forecasts
for their own personal wealth gain (Nichols and Wahlen, 2004). Shareholders, for instance, want a good
(realized) return on equity number that surpasses their marginal required return on equity. Wall Street
Analysts, who provide buy/sell/hold recommendations for the stock, in part base their analyses on
corporate financial statements and what they imply for share-pricing. The impressions of each of these
groups influence share prices and thereby affect managers’ performance evaluations and wealth as well as
the firm’s cost of capital. Credit rating agencies monitor a number of company financial indicators
obtained from the financial statements to develop their ratings of outstanding corporate debt. These
ratings have direct consequences for determining the future cost of borrowing for the company and,
ultimately, its future capital investment spending and growth.
This case presents a teaching approach that is more comprehensive than what commonly appears
in accounting textbooks. The aim is to have students experience how a situation that appears to involve
clearly- and unambiguously-stipulated GAAP, can result in more than one method of application with
more than one correct answer leading to very different end results and conclusions about a company’s
financial performance. To understand the demonstrations given in this case, students are expected to
possess a basic understanding of concepts learned in Intermediate Accounting I and II, which accounting
majors typically take in their junior year. The case demonstrates that even in a relatively simple context,
there is no one correct “answer” but rather a multitude of potential correct income values. This wide
dispersion of answers leads to equally diverse implications for the perceived financial performance of a
company. An additional benefit of the case is that students can treat it as a simulation tool in which they
vary assumptions and estimates, and witness firsthand how all variables, individually and collectively,
affect the reported bottom-line Net Income number. The points illustrated in this case are very often
overlooked or mentioned in passing in textbooks that seem more interested in teaching GAAP rules in a
static environment rather in a dynamic and interactive one.
DEVELOPMENT OF THE CASE
In this case, students acting in two contrasting roles, make decisions regarding the selection of
accounting methods and estimates. The first role is that of an aggressive manager who wishes to increase
income, the second a conservative manager who wishes to avoid overstating income. The case at hand
requires students to make decisions about: (a) estimates of uncollectible accounts, (b) useful lives of
physical assets, (c) selection of inventory valuation methods (LIFO versus FIFO), and (d) selection of
depreciation methods (straight-line versus declining balance),. The case is conducted in a dynamic and an
interactive way that imparts realism to the exercise. We believe that this case offers students very useful
and interesting insights, and proves to be a valuable learning tool not only for undergraduate accounting
majors, but also for students pursuing a Master’s in Accounting or an MBA with an Accounting
concentration.
Below is a hypothetical Unadjusted Balance Sheet and Income Statement for the year ended
December 31, 2012. Additional information is provided allowing students to prepare both an Adjusted
Balance sheet and Income Statement making decisions under different sets of assumptions based on their
assigned role:
BALANCE SHEET
AT DECEMBER 31, 2012 (UNADJUSTED)
ASSETS:
LIABILITIES:
Current assets:
Current liabilities:
Cash
$19,740
Accounts payable
$50,468
Accounts receivable (less allowance)
24,039
Unearned revenue
10,000
Inventory
1,569,500
Total current liabilities
60,468
Prepaid Insurance
24,000
Long-term liabilities:
Total current assets
1,637,279
Notes Payable
250,000
Total Liabilities
310,468
Long-term assets:
Property and equipment
500,000
STOCKHOLDERS’ EQUITY:
Less: accumulate depreciation
-0-
Common stock, no par
251,676
Total long-term assets
500,000
Retained Earnings
1,575,135
Total Stockholders’ equity
1,826,811
TOTAL ASSETS
$2,137,279
TOTAL LIAB. AND
EQUITY
$2,137,279
INCOME STATEMENT
FOR THE YEAR-ENDED DECEMBER 31, 2012 (UNADJUSTED)
Sales
$2,233,109
Less: selling and admin expenses
655,974
Rent expense
NET INCOME
$1,575,135
