Financial Accounting:
A Business Process Approach
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11 - 1
Quality of Earnings and Corporate
Governance
Chapter 11
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11 - 2
Learning Objectives
When you are finished studying this chapter,
you will be able to:
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.
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Learning Objectives
4. Describe the corporate accounting failures
of the early 2000s.
5. Explain the requirements of the SarbanesOxley Act of 2002.
6. Evaluate a firm’s corporate governance.
7. Describe the differences between IFRS and
U.S. GAAP
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Ethics Matters
The Sarbanes-Oxley (SOX) Act of 2002 requires
In addition to requiring the availability of an
that firms have a hotline to make it easier for
anonymous hotline for reporting fraud, SOX
In
2002, Sherronto
Watkins
of Enron,
Cynthia
whistle-blowers
anonymously
report
any
also prohibits a company from demoting, firing,
Cooper
of WorldCom,
Coleen
Rowley
ofthe
the
suspicious
actions or and
behavior
going
on in
threatening, or harassing someone for the legal
FBI
were Time
magazine’s
Year.”
company,
particularly
as it“People
pertainsof
tothe
financial
act of disclosing suspected fraud in the
These
womenHowever,
were credited
with
blowing to
the
information.
a study
conducted
company. As you have observed, however,
whistle
onthe
fraud
in their respective
evaluate
effectiveness
of this part of the law
sometimes a person or a company does not
organizations.
found that the number of frauds detected by
abide by the law. Would you blow the whistle
employees blowing the whistle declined from
on fraud? It’s a matter of ethics.
21% before SOX to 16% five years later. Why?
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Learning
Objective 1
Quality of Earnings
Why are earnings so important?
The market focuses on a company’s
earnings.
Analysts study earnings estimates and
announce their own estimated
earnings for a firm.
A firm’s stock price moves up when
earnings exceed analysts’ forecasts
and down when reported earnings do
not meet the forecasts.
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Quality of Earnings
Why are earnings so important?
Among the hundreds of measurements
that investors consider—gross domestic
product (GDP), housing starts, interest
rates, unemployment figures, and
budget deficits, to name a few—there is
one number that Wall Street simply
calls “the number.”
Managers estimate earnings and
disclose those estimates to the public.
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Learning
Objective 2
Quality of Earnings
Quality of earnings describes how well a reported
earnings number communicates the firm’s true
performance.
Three ways to evaluate the quality of earnings:
1. Firms that make more conservative choices of
accounting principles often have a higher quality of
earnings.
2. Firms that face fewer internal and external risks that
threaten their survival and profitability often have a
higher quality of earnings.
3. Firms that recognize revenue early or postpone
recognition of expenses often have a lower quality of
earnings.
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Your Turn 11-1
Describe why earnings is such an
important number.
Earnings are used by investors to
evaluate a firm’s performance. The price
of a firm’s stock often goes up if the
firm meets earnings expectations and
down if the firm doesn’t meet earnings
expectations.
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Learning
Objective 3
Manipulation of Earnings
Managers choose either to be conservative or
aggressive when making accounting estimations.
Conservative choices reduce net income and assets
or increase liabilities.
Aggressive choices increase net income and assets
or decrease liabilities.
Understating income or assets is more conservative
and less risky than overstating income or assets.
If a firm overstates earnings, shareholders may sue
the firm and its auditors, but if a firm understates
earnings, shareholders are less likely to be
disappointed.
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Manipulation of Earnings
Common ways to manipulate earnings:
Cooking the books – falsify accounting records to
make the company’s financial performance look
better than it actually is.
Big bath charges – maximize a current loss to get rid
of expenses that belong on future income
statements.
Cookie jar reserve – use reserve accounts to record
expenses early and make future earnings look good.
Revenue recognition – violate the revenue
recognition principle by recognizing revenue
prematurely or creating fictitious revenue.
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11 - 11
Your Turn 11-2
What makes one firm’s earnings higher
in quality than another’s?
Earnings are a function of the choices
managers make in reporting earnings.
Some choices—such as LIFO for
inventory in a period of rising prices—
lead to a higher quality of earnings
than others.
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Learning
Objective 4
Lessons Learned
1. Some corporate executives will do almost anything to
meet earnings expectations.
2. The ethical climate in a firm is set by top management.
3. Auditors and their clients can get too close.
4. Application of GAAP is subject to significant management
discretion.
5. No matter how good or how effective accounting
principles are, there is no way for accounting standards
to stop fraud.
6. Financial statements are only part of the information
investors need to evaluate company’s past, present, and
future.
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Your Turn 11-3
What do you think auditors learned
from the financial failures of the 2000s?
There are several possible answers to this
question. Two important ones are:
(1)independence, both actual and perceived, is
crucial to doing an effective and credible job,
and
(2)high ethical values and personal integrity
are essential—in auditing and life
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Learning
Objective 5
2002 Sarbanes-Oxley Act
Corporate governance is the process carried out
by the board of directors to provide direction and
oversight on behalf of all the company’s
stakeholders.
Accounting scandals and business failures are not a
modern-day phenomenon. One of the biggest
failures of all time occurred in 1931; Insull Energy
Investment collapsed due to creative accounting.
In 2001, the collapse of one of the world’s largest
energy companies, Enron, and in 2002, the
bankruptcy of WorldCom had an enormous impact
on our economy and the companies’ personnel.
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2002 Sarbanes-Oxley Act
Four major groups
affected by SOX:
1. Management
Areas affected by SOX:
Reporting
Insider Accountability
Penalties
2. Board of Directors
Strengthening the Board
3. External Auditors
Strengthening Auditor
Independence
4. The Public Company
Accounting Oversight
Board (PCAOB)
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Enforcement
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2002 Sarbanes-Oxley Act
Management:
1. Must assess and report on the
effectiveness of the company’s internal
control structure and procedures over
financial reporting. (SOX Section 404).
2. New rules require a code of ethics and a
report on it in the annual 10-K.
3. New penalties exist for management if
the financial statements are inaccurate or
incomplete. Misrepresentation can result
in hefty fines and imprisonment.
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2002 Sarbanes-Oxley Act
Management and Reporting:
The CEO and CFO are responsible for the firm’s
internal controls.
The SOX Act requires a company to include with
its annual report, a separate report on the
effectiveness of the company’s internal controls.
The external auditor must attest to the accuracy
of the internal control report.
Firms must provide a mechanism for anonymous
reporting of fraudulent activities in the company,
including a hotline for the reporting. The
company cannot punish a person for disclosing
suspected fraud.
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2002 Sarbanes-Oxley Act
Board of Directors:
The people elected by stockholders to establish
general corporate policies and make decisions on
major company issues.
Members of the board responsible for overseeing
the financial matters of the firm, its controls over
financial reporting, and overseeing the external
auditors is the audit committee.
SOX set new rules for the composition of the
boards of directors, requiring some directors to
be independent of management, will strengthen
the boards and the audit committees of the
boards.
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2002 Sarbanes-Oxley Act
External Auditors:
SOX set new rules for auditors including
stronger rule regarding auditor independence.
External auditors are accountants specifically
trained to examine the firm’s financial
statements and financial controls and report on
the statements to the shareholders.
External auditors give an opinion on whether or
not the firm’s financial statements fairly
represent the financial position and the results
of operations in accordance with GAAP.
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2002 Sarbanes-Oxley Act
External Auditors:
The SEC requires all publicly traded companies to
have an annual audit of the financial statements
by external auditors and has always had rules
about auditor independence. SOX strengthens
those rules.
SOX requires auditors to remain independent of
their clients to ensure objectivity. Firms can no
longer provide information processing services to
their clients.
SOX requires the independent auditors to report to
the audit committee rather than to the client’s
management team.
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2002 Sarbanes-Oxley Act
Public Company Accounting Oversight
Board (PCAOB):
The SOX Act created the new PCAOB and gave it the
power to regulate auditing firms.
PCAOB Members are appointed by the SEC along
with the Chairman of the Board of Governors of the
Federal Reserve and the Secretary of the Treasury.
All accounting firms that audit public companies
must register with the PCAOB and follow its rules.
The SEC must approve any rules set by the PCAOB.
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2002 Sarbanes-Oxley Act
Potential disadvantages of the new
requirements:
High cost of implementation of Section 404. The
cost of compliance in 2006 was $6 billion, a
decline from $6.1 billion in 2005.
Some people argue that the real problem is the
lack of high moral and ethical values in
corporate America which cannot be solved with
legislation.
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Outlook for the Future
The Federal Bureau of Labor Statistics predicts
the number of new jobs is expected to increase by
18% between 2006 and 2018.
The American Institute of Certified Public
Accountants projects double-digit growth in
hiring by most of its member firms for the next
three years.
The new climate and new laws have resulted in a
surge in employment opportunities for accounting
and auditing firms.
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Outlook for the Future
The financial crisis and resulting recession that
began in 2008 underscore the significance of
accounting.
All business managers must understand
financial information and the way it is gathered
and reported.
Managers must identify risks for their specific
areas and create internal controls to manage
those risks.
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Your Turn 11-4
Explain why internal controls are so important
to firms and their auditors.
Managers must report on the firm’s internal controls
and their effectiveness. Some firms may need new
ways to gather information about the effectiveness
of the firm’s controls. The auditors must attest to
management’s report, which means that the
auditors must gather sufficient evidence to give
their opinion on the truthfulness of management’s
report. These are added responsibilities for the
firm’s managers and the firm’s auditors.
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Learning
Objective 6
Corporate Governance
SOX changed the way corporations govern
themselves in the United States. Most experts
agree that the most important factor in good
corporate governance is an ethical climate,
which top management sets. Many companies
are voluntarily exceeding the new
requirements.
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Learning
Objective 6
Corporate Governance
Other attributes of good governance include:
1. An independent board of directors made up
of high-quality directors with a variety of
backgrounds.
2. A CEO who encourages board involvement in
the review of major management and financial
decisions.
3. Financial information for shareholders that is
transparent—easily understandable, simple,
and straightforward.
4. Strong and independent external auditors.
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Evaluating Corporate Governance
Top five most important elements for strong and effective
corporate governance*:
1. Boards of Directors should be independent from executive
management teams; highly qualified, from diverse
backgrounds.
2. The CEO must encourage board involvement for review of major
management and financial decisions.
3. Financial information for shareholders should be transparent.
4. Incentive-based compensation plans for management should be
based upon performance that creates increased shareholder
value.
5. Auditors should be strong and independent from the firm.
*“Ask the CEO,” Business Week Online, May 6, 2003.
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Corporate Governance
How Can We Evaluate a Firm’s Corporate Governance?
There are two key ways to find out about a firm’s
corporate governance:
1. Web Sites:
Where you can find menus for corporate governance
guidelines, codes of ethics, and various committees of
the board of directors.
2. Annual reports or 10-Ks:
Contains management’s report on the effectiveness of
the company’s system of internal controls and the
external auditor’s attestation and report on
management’s assessment of internal controls.
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Internal Control Report
Another useful input to evaluate a firm’s corporate
governance is management’s report on internal
controls.
External auditors must attest to and report on
management’s assessment of its internal controls.
Corporate governance information provided by a
company is not sufficient to draw definite
conclusions about the integrity and honesty of the
company and its management.
As more information about how a company’s
corporate governance policies are working becomes
readily available, it will be easier to evaluate this
area of the company.
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Your Turn 11-5
Name some characteristics of good corporate
governance.
Here are a few characteristics:
(1)a board of directors (BOD) with a majority of
independent directors,
(2) a BOD with a chairman who is not the firm’s CEO,
(3) a reputable and reliable internal audit function,
(4) independent external auditors,
(5) a strong code of ethics, with top management setting
the tone,
(6) a compensation system that does not place too much
reliance on the stock price but rewards increasing the
firm’s underlying value.
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Learning
Objective 7
Differences between IFRS
and U.S. GAAP
While U.S. GAAP and IFRS have much in common,
there are both minor and major differences between
the two. The overall difference between the two sets
of standards is the approach they take with respect
to detailed guidance for the preparation of financial
statements.
U.S. GAAP are commonly described as rule based,
while IFRS are commonly described as principle
based. This is demonstrated by the fact that U.S.
GAAP have over 160 Financial Accounting Standards,
and IFRS include fewer than 50 International
Reporting Standards.
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Differences between IFRS
and U.S. GAAP
There is significantly less detailed guidance in
IFRS than in U.S. GAAP. This means that a
switch to IFRS will require a new approach to
the preparation of the financial statements. In
particular, auditors will have to be prepared to
exercise more judgment in their task of
providing an opinion on the fair presentation of
the firm’s financial statements.
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Differences between IFRS
and U.S. GAAP
Both sets of standards have similar goals—to
provide useful information for the users of
financial statements. Both are accrual basis, and
both require an income statement, a balance
sheet, and a statement of cash flows. The
composition of these statements is quite
similar, although the format of the statements
can certainly be different.
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publishing as Prentice Hall
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