978-0136115274 Chapter 11 Lecture Notes

Unlock access to all the studying documents.

View Full Document

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.

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”

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.

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.

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.

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

_____ 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