Question

(a) Parfet argued in "Subjectivity and Earnings Management: A Preparer Perspective" (2000) that the "primary goals of earnings management" were "reporting stable, positive earnings growth to meet market expectations in terms of EPS". Parfet identified two methods of earnings management: i) Operational earnings management. (ii) Improper earnings management through fraudulent or artificial means. Show how these two methods differ by giving examples of how each method may be applied (b) (b) The IFRS plans to bring back the prudence principle which they define as "the exercise of caution when making judgements under conditions of uncertainty" and "means that assets and income are not overstated and liabilities and expenses are not understated". Discuss whether it is ever possible to produce "neutral" financial statements that give a "true and fair view" and whether giving management authority to introduce “a bias towards conservatism" in this way is in owners' interests (c) (c) The US LIFO Coalition claims that the "repeal of LIFO would significantly and permanently harm broad sectors of America's economy, endangering the viability of thousands of businesses and the livelihood of their employees and their families... Recapturing up to 70 years of (deferred) income simply in search of additional revenue to fund other tax priorities is unfair, and is unjustified." Argue the case for the prohibition of the use of LIFO by US oil companies made by the opponents of the US LIFO Coalition, countering the arguments put forward by those who favour its retention (d) (d) In the event of a firm being put into liquidation many creditors often receive only a small fraction of what they are owed (if anything at all). Explain why this is so often the case

Answer 1

(A) Earnings Management, its methods and their application:

Earnings Management may be defined as ''reasonable and legal management decision making and reporting intended to achieve stable and predictable financial results''. Earnings Management is not to be confused with illegal activities to manipulate financial statements and report results that do not reflect economic reality. These types of activities, popularly known as ''cooking the books'', involve misrepresenting financial results.

Earnings management is primarily achieved by management actions that make it easier to achieve desired earnings levels through:

• Accounting choices from among GAAP.
• Operating decisions (sometimes called economic earnings management)

Earnings management activities may occur (a) because managers have flexibility in making accounting or operating choices or (b) because managers are trying to convey private information to financials statement users. It is important for readers of financial statements to determine which type is being practiced and to understand its significance. Some examples:

(1) Flexible Accounting or Operating Choices: Managers may adopt a depreciable life for a new computer chip plant that is at the high end of industry norms in order to lower depreciation expense and thus maximise reported earnings for future periods. The aim here is to manage earnings (and thus share price) in a direction desired by current shareholders.

(2) Private Information: Managers may adopt a depreciable life for a new computer chip plant that is substantially less than industry norms because anticipated technological changes make it likely that the plant will be obsolete sooner than has been the norm for the industry. The motive here is to give stakeholders information not otherwise available so they can adjust their expectations appropriately.

Careful release of such information may lower earnings and the share price for the company, but if the information conveys significantly new news to analysts and other users of financial statements, they may also adjust earnings estimates (and share prices) downward for other companies in the industry, so that the company revealing the information may actually feel some positive impact on its share prices because it is perceived as having a higher ''quality of earnings''.

(B) Prudence Principle and IFRS Conceptual Framework for Financial Reporting:

It may seem obvious that prudence is a desirable thing when preparing financial information. However, establishing the characteristics of useful financial reporting has long proved difficult and controversial. Until 2010, prudence was included in the International Accounting Standards Board’s (IASB) Conceptual Framework. In the 2010 revision IASB removed the reference to prudence, but is now proposing to put prudence back. The IASB has just published an Exposure Draft of a revised Conceptual Framework for Financial Reporting. In it, the IASB proposes to reintroduce prudence as one aspect of the characteristics that make financial statements useful to investors.

The Conceptual Framework for Financial Reporting describes the objective of and concepts for general purpose financial reporting; it deals with issues such as the definitions and measurement of assets and liabilities and when and how income and expenses should be recognised and presented. The Conceptual Framework also includes a discussion of the necessary (and in some cases desirable) characteristics of useful financial information. To be useful, financial statements must provide information that is relevant and faithfully represents the economic activity it depicts. Prudence is one possible component of these characteristics and has attracted much attention.

Prudence in Practice: The various dictionary definitions of prudence are all very similar, with references to synonyms such as ‘careful’, ‘cautious’, ‘wise’, ‘well judged’ and ‘circumspect’. Applying these dictionary definitions to financial reporting, however, is not so easy. Few would disagree that management should be careful and considered when arriving at the figures presented. Good judgement is particularly important in financial reporting, because many amounts require estimation.

But it is important to understand the context within which these judgements are made. Management teams making accounting estimates are subject to many incentives that could lead them to favour either an overstatement or an understatement of financial position and financial performance (in other words, to introduce a bias into financial reporting). For example, an overstatement of financial performance may avoid the negative consequences for management of reporting poor performance, whereas an understatement of financial performance in a good year may provide management with reserves that can be used to smooth reported profits and thereby avoid reporting poor performance in the future. For investors using financial statements to make decisions on their investment, any deliberate over- or under-statement is likely to lead to suboptimal decisions and a misallocation of capital.

It therefore seems that prudent and well-considered estimates should be neither overstated nor understated. It is sure that few would support an accounting framework that allowed bias and manipulation of financial results by management. The IASB has always recognised the desirability of avoiding a bias in the preparation of financial statements, which is why ‘neutrality’ is, and always has been, included in the IASB’s Conceptual Framework as a feature of useful information. We regard neutrality as a necessary component of providing a faithful representation of the underlying economics. For example, when measuring the depreciation of a fixed asset, management must estimate the useful economic life of that asset. Investors should be able to expect that such estimates are realistic, well-judged and without bias. The word prudent seems to be entirely consistent with such an estimate and also entirely consistent with the desire for neutrality. There should be prudent but unbiased estimates of the useful lives of fixed assets.

Conservative Accounting: It seems that many of the investors who argue for a conservative bias in the recognition and/or measurement principles applied in financial reporting are often thinking beyond making estimates for the purpose of preparing financial statements that give the most relevant information to investors and the most realistic representation of the reporting entity’s activities. They believe that financial reporting needs to also take into account other consequences of those reported amounts. These consequences include using financial statement information to help determine dividend payments to shareholders, bonus payments to management and the amount of capital a company is required to maintain. In each of these cases, the consequences of overestimating assets and profit may be more severe than the consequences of underestimates. They argue this asymmetry of consequences should drive an asymmetry of accounting.

For example, paying a dividend is much easier than raising additional equity capital in a future period. If, therefore, a dividend is paid but it turns out with hindsight that the business is undercapitalised, it may be difficult to raise the additional capital needed. The adverse consequence of an undercapitalised business (business disruption and possible insolvency) may be more damaging that that of an overcapitalised business (an inefficient use of capital and a lower rate of return to investors). For this reason, a conservative dividend policy and conservative approach to business capitalisation may well be desirable.

Neutral Accounting: After much debate about prudence, the IASB proposes in the current Exposure Draft to reinstate the concept of prudence and define it in a manner that is consistent with neutrality (see figure 3). It seems that this definition will be clearer than that in the pre‑2010 Conceptual Framework. A ‘basis for conclusions’, explaining the thinking behind the IASB’s proposals, will help clarify further both what the IASB intends and what it does not intend.

It is very important that management do not prepare financial statements with an optimistic bias. Choosing estimates that are constantly at the optimistic end of the range of plausible values is unlikely to result in financial statements that faithfully represent that business. Many investors have argued that an explicit reference to prudence can help to counteract the natural optimism of management. Prudence can therefore be seen as reinforcing a true adherence to the principle of neutrality in financial reporting. It is a reminder that there needs to be a solid basis for accounting estimates and it gives auditors a basis to challenge numbers and ‘kick the tyres’ on behalf of investors.

However, taking a pessimistic view when making estimates of assets and profit can be just as damaging for investors. Not only does it give investors poor information in the current period, but it can be used by management to mask a deterioration in the business in future periods. The solution is to apply IFRSs in a prudent but neutral and unbiased manner.