EMA: Lay Away Plan

The most common earnings management attempt? The cookie jar, says a new study.

The “cookie jar” reserves approach to earnings management may crumble if new research penned by a triad of accounting professors gets the attention of regulators.

The study, conducted by Mark W. Nelson and John A. Elliott of Cornell’s Johnson Graduate School of Management, and Robin L. Tarpley of George Washington University, provides insight into subtle earnings-manipulation techniques — such as cookie-jar reserves.

The research, which is based on confidential interviews with 253 audit partners and managers from one Big Five firm, also gives the inside dope on pre-audit release decisions that lead to managed earnings.

The auditors and managers estimated that they had encountered roughly 2630 earnings management-attempts (EMAs) by corporate clients — a fairly high number. Of note, auditors said they waived adjustments of 56 percent of the earnings-management attempts in the study sample — 21 percent because the auditors believed the client demonstrated compliance with GAAP, 17 percent because the auditors didn’t have convincing evidence that the client’s position was incorrect, and the remaining 18 percent because of other reasons, usually immateriality.

Of the 515 EMAs analyzed in the study, 25 percent involved reserve transactions, which ranked first among EMA techniques. Revenue recognition (15 percent) and business combinations transactions (14 percent) were next in line.

“Cookie-jar reserves are popular because they provide a method of moving earnings from one year to the next,” says Nelson. In abusive situations, companies take excessive acquisition-related charges when business is good, to create a contingency reserve that can be used to boost earnings when things go sour.

The most recent high-profile cookie-jar case involves Xerox Corp. The document-management giant reached a settlement agreement in April with the Securities and Exchange Commission to restate earnings going back to 1997 in connection with improper revenue-allocation allegations. The restatement could include more than $300 million worth of adjustments based on the establishment and release of certain reserves.

What pushes management teams to manipulate earnings? Analyst expectations and stock price, executive bonuses and incentives, debt covenant compliance, and concern about the parent company’s reaction — in that order, says the study.

The Cornell/Washington University research results tend to jibe with CFO.com’s own surveys. In one online poll, nearly 40 percent of CFO.com readers who voted said they had engaged in “aggressive bookkeeping practices” to help improve their companies’ reported financial results. To see that survey (“Funny Numbers”), and others on aggressive accounting practices, click here.

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Editor’s Note: To read about how one large company uses cookie jar accounts to full advantage, read “Deconstructing Tyco” .

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