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CHAPTER 11
QUALITY OF EARNINGS, CORPORATE
GOVERNANCE, AND IFRS
CHAPTER OVERVIEW
Students start this final chapter by analyzing why earnings are important. The definition of
quality of earnings, as well as a discussion of measurement techniques, is included. Common
ways to manipulate earnings are given. These include big bath charges, cookie jar reserves, and
revenue recognition issues.
A look back to the business scandals of the early 2000s gives readers an understanding of the
critical importance of quality corporate governance. The key provisions of the Sarbanes-Oxley
Act of 2002 are listed, along with significant implications of this act for the groups of
management, the board of directors, the auditors, and the Public Companies Accounting
Oversight Board. Methods for evaluating corporate governance are given.
LEARNING OBJECTIVES
After completing Chapter 11, your students should be able to answer these questions:
1. Explain Wall Street’s emphasis on earnings and the potential problems that result
from this emphasis.
2. Define quality of earnings and explain how it is measured.
3. Recognize the common ways that firms can manipulate earnings.
4. Describe the corporate accounting failures of the early 2000s.
5. Explain the requirements of the Sarbanes-Oxley Act of 2002.
6. Evaluate a firm’s corporate governance.
7. Describe the differences between IFRS and U.S. GAAP.
CHAPTER OUTLINE
Why Are Earnings Important? (LO 1)
I. Among the hundreds of measurements shareholders consider – gross domestic (GDP),
housing stats, interest rates, unemployment figures, and budget deficits, to name a few,
there is one number Wall Street simply calls “the number” – earnings per share.
II. Earnings per share (EPS) is net income divided by the weighted average number of
outstanding shares of common stock.
III. Earnings alone cannot assess accurately the state of a firm’s financial health.
IV. A firm’s stock price moves up when earnings exceed analysts’ forecasts and down when
earnings do not meet the forecasts.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 11-1
Teaching Tip
Remind students that earnings per share alone cannot accurately assess the state of a firm’s
financial health.
The Quality of Earnings (LO 2)
I. Quality of earnings refers to how well a reported earnings number communicates the
firm’s true performance.
II. It is a subjective concept and few people agree on the definition.
III. There are three ways to evaluate the quality of earnings:
a. Firms that make more conservative choices of accounting principles often have a
higher quality of earnings.
b. Firms that face fewer internal and external risks that threaten their survival and
profitability often have a higher quality of earnings.
c. Firms that recognize revenue early or postpone recognition of expense often have a
lower quality of earnings.
Teaching Tip
Ask students if they perceive that audited statements are guaranteed to be 100% accurate. Point
out that this is not the case and that an audit is designed to tell if statements are presented fairly,
in all material aspects.
Common Ways to Manipulate Earnings (LO 3)
I. Cooking the books is a slang expression that means to manipulate or falsify the firm’s
accounting records to make the firm’s financial performance or position look better than
it actually is.
II. The common ways that firms manipulate earnings include:
a. Big bath charges. When a firm is not going to meet its earnings expectations, the
firm’s managers may decide to go ahead and “clean up” its balance sheet by writing
off anything that looks like it may need to be written off in the next few years.
i. You can identify this by looking at several years of financial statements. Look for
unusual expenses and write-offs that appear out of step with previous years. Read
the notes to the financial statements, management’s decision and analysis, and
popular press articles about the company’s performance in order to help you
identify excessive write-offs.
Teaching Tip
In early 2005, Viacom recorded $18 billion in big bath charges due to the loss in value of a
company it owned, Infinity Broadcasting Corporation. Viacom blamed the enormous write-off on
a weak market.
b. Cookie jar reserves. Some accounting rules related to reserve accounts, for example
the allowance for uncollectible accounts, create opportunities for a firm to “manage”
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 11-2
one of its expenses, and, consequently, manipulate earnings. This is done through
intentionally overstating the bad debt expense for the year that will help future years.
i. You can identify this technique by watching for trends in the reported amounts for
those reserves. You may have to read the notes to learn the detailed numbers.
Ratio analysis may also assist in finding the use of cookie jar reserves.
c. Revenue recognition. A firm should use the basic revenue recognition rules in that
you do not recognize revenue until you have earned it and collection is reasonably
assured. These rules leave room for interpretation and judgment. The firm could
choose to recognize revenue prematurely and/or create totally fictitious revenue.
i. You can identify this by reading the notes to the financial statements to learn a
firm’s revenue recognition policy. If a firm recently changed its revenue
recognition policy, you will want to study the reasons and review the prior years’
revenue patterns.
What We Learned from the Business Scandals of the Early 2000s (LO 4)
I. Congress has rarely interfered with accounting standards.
II. The scandals of the early 2000s, however, prompted Congress to pass the Sarbanes-Oxley
Act of 2002.
III. This act brought the topic of corporate governance into the headlines.
IV. Corporate governance is the way a firm governs itself. It is also described as the set of
relationships among the board of directors, management, shareholders, auditors, and any
others with a stake in the company.
V. What have we learned from the business failures of the past decade?
a. Some corporate executives will do almost anything to meet earnings expectations
and to keep a firm’s stock price rising or stable.
b. The ethical climate is set by top management.
c. Auditors and their clients can get too close.
d. Application of GAAP is subject to significant management discretion. Earnings
should be more transparent.
e. There is no way for accounting standards to stop fraud. Auditors and SOX can
reduce fraud.
f. Overreliance on a single amount – such as EPS – can be a disaster.
The Sarbanes-Oxley Act of 2002 (LO 5)
I. The Sarbanes-Oxley Act of 2002 (SOX) has significant implications for four groups:
a. Management
i. The CEO and CFO are responsible for the firm’s internal controls.
ii. A separate report must be included with the annual report regarding the
effectiveness of a firm’s internal controls.
iii. Management has the ultimate responsibility for the accuracy of the
financial statements.
iv. A firm must have a system for anonymous reporting of fraudulent
activities, including a hotline. Whistle blower protection must be
provided.
b. The board of directors
i. Members of the boards are elected by shareholders to represent their
interests.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 11-3
ii. They are responsible for establishing general corporate policies and
making decisions on major company issues.
iii. Part of the board of directors is the audit committee. Members oversee the
external auditors as well as the firm’s controls.
iv. The audit committee must be made up of independent directors. Managers
cannot be on the committee. The audit committee hires and oversees the
external auditors.
c. External auditors
i. All publicly traded firms must have an annual audit.
ii. Auditors must be independent.
iii. Auditors must report to the audit committee.
d. Public Company Accounting Oversight Board (PCAOB)
i. Board established by SOX
ii. Members appointed by the SEC
iii. Purpose is to regulate auditing profession
iv. All accounting firms that audit publicly traded companies must register
with the PCAOB.
v. The SEC must approve any rules set by the PCAOB.
Teaching Tip
CEOs and CFOs of the largest publicly traded companies are required to vouch for the accuracy
and completeness of the disclosures in the financial statements or state why they cannot do so.
This requirement is in response to several highly publicized accounting scandals and the poorly
performing economy and stock market during that period. It is backed by legislation increasing
penalties, including jail time, for those knowingly making false statements in this filing.
Evaluating Corporate Governance Earnings (LO 6)
I. Measuring and defining good corporate governance
a. The most important factor is an ethical climate set by top management.
b. These are the top five most important elements for strong and effective corporate
governance:
i. Boards of directors should be independent from the executive
management team and comprised of highly qualified directors with
diverse backgrounds.
ii. The CEO must encourage board involvement for major management and
financial decisions.
iii. Financial information should be transparent – easily understandable,
simple, and straightforward.
iv. Incentive-based compensation plans should reward management for
performance that increases shareholder value.
v. Auditors should be strong and independent.
II. How can we evaluate a firm’s corporate governance?
a. Web sites
b. Annual reports or 10-Ks
i. It’s helpful to read management’s report on internal controls.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 11-4
International Financial Reporting Standards (IFRS) (LO 7)
I. The overall difference between IFRS and U.S. GAAP is the approach they take with respect
to detailed guidance for the preparation of financial statements.
II. U.S. GAAP is primarily rules based.
III. IFRS is primarily principle based.
IV. U.S. GAAP has over 160 Financial Accounting Standards.
V. IFRS has fewer than 50 International Reporting Standards.
VI. Both sets of standards have similar goals - to provide useful information for the users of
financial statements.
Teaching Tip
Refer students to Exhibit 11.3 for more specific differences between U.S. GAAP and IFRS.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 11-5
CHAPTER 11 NAME ___________________________________
TEN-MINUTE QUIZ Section _____________ Date____________
_____________________________________________________________________________
_
_____ 1. A term accountants use to describe how well a particular earnings number
communicates the firm’s true performance is:
a. Earnings per share
b. Net income
c. Earnings growth ratio
d. Quality of earnings
_____ 2. Which of the following is not a method used to manipulate earnings?
a. Revenue recognition
b. Big bath charges
c. The matching rule
d. Cookie jar reserves
_____ 3. Higher quality earnings are associated with what kind of accounting choices?
More conservative accounting choices
Accounting choices that have not been changed in the past 3-5 years
Choices where the newest accounting method is selected
None of the above
_____ 4. When a firm is not going to meet its earnings expectations, the managers decide
to go ahead and write off anything that looks like it might have to be written off in the next few
years. This practice is called:
Revenue recognition
Big bath charges
The matching rule
Cookie jar reserves
_____ 5. A firm should use the basic revenue recognition rules in that you do not recognize
revenue until:
It is earned
Collection is reasonably assured
Payment has been received
A and B are both true
_____ 6. Corporate governance is:
The way a firm governs itself
Executed by the shareholders
The responsibility of the accounting staff
All of the above
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 11-6
_____ 7. The PCAOB is:
The Public Company Oversight Board
The Preferred Company Oversight Board
The Prime Corporation Ownership Board
The Public Corporation Ownership Board
_____ 8. The Sarbanes-Oxley Act of 2002 requires:
An audit every month
The majority of directors to be dependent on management
A code of ethics for shareholders
A report on the effectiveness of the company’s internal control structure
_____ 9. All of the following are elements of good corporate governance, except:
Incentive-based compensation plans that offer rewards to management for
performance that raises net income
A CEO who encourages board involvement for review of major management and
financial decisions
The ethical climate in the firm
A strong and independent audit function
_____ 10. Auditors must be:
Overseen by the audit committee of the board of directors
Knowledgeable about all aspects of the company’s operations
Independent
All of the above
ANSWER KEY - CHAPTER 11 – TEN-MINUTE QUIZ
D
C
A
B
D
A
A
D
A
D
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 11-7
