Question I

Give definition of earning management. Discuss in what instances is earnings management

acceptable and in what instances is it not acceptable.

Before defining what earnings management is, it is important to understand the meaning
of earnings first. Earnings are the profits of a company. Investors and analysts look to earnings
to determine the attractiveness of a particular share. Companies with poor earnings prospects
will typically have lower share prices than those with good prospects. Remember that a
company’s ability to generate profit in the future plays a very important role in determining a
share’s price.

Earnings management may be defined as reasonable and legal management decision

making and reporting intended to achieve stable and predictable financial results. Referred to
Financial Accounting Theory book, third edition wrote by William R. Scott, earnings
management is the choice by a manager of accounting policies so as to achieve some specific
objective. So, it is not surprise that company management has an interest in how they are
reported. The manager of the company needs to understand the effects of the accounting
reporting that they reported so they can make the best decision on behalf of the company.

In addition, earnings management is a strategy used by the management of a company

to deliberately manipulate the company’s earnings so that the figures match a pre-determined
target. This practice is carried out for the purpose of income smoothing. Thus, rather than
having years of exceptionally good or bad earnings, companies will try to keep the figures
relatively stable by adding and removing cash from reserve accounts. So, the financial
statements of the company will be seen smoothly over the years with the smooth earnings or
net profits.

The reasons for many companies using earnings management within the company are
whether to maintain steady earnings growth or to avoid reporting in losses. So, people use
earnings management in different ways and with different degrees of appreciation to cover their
variety of activities, whether the activities are acceptable or not acceptable. The earnings
management is not be called as not acceptable activities if the activities not manipulate financial
statements and report results that do not reflect economic reality. In other word, the earnings
management will be not acceptable if it misrepresenting financial results.
 Some earnings management can be classified as acceptable and some can be
classified as not acceptable. The instance of acceptable earnings management is advertising
expenditures, which generally should be expensed when incurred, may be accelerated in the
fourth quarter if the company is exceeding its earning target or deferred if it is failing to meet that
target. Other than that, it particularly involves accounting estimates and judgments, in
conformity with generally accepted accounting principle (GAAP). For example, the
implementation of a decision to enhance the company’s collection activities may be acceptable
in supporting the reducing of estimate bad debt expenses. These are acceptable management
decisions that affect reported earnings whose consequences are accounted for in conformity
with GAAP.

For not acceptable earnings management, the instances are the management inflated
figures for cash and bank balances to increase the revenue of the company. Other than that, the
managers whose financial statements reflect any of the activities that may be committing fraud
even if they do not think of their actions as earning management not acceptable activities. It
includes recording unavailable sales, backdating sales invoices, failing to properly record
expenses and overvaluing assets. In other word, the not acceptable earnings management is
the activities that committed fraud.
Question II (a)
Discuss the earning management techniques employed by the management of Enron.

Enron and other energy suppliers earned profits by providing services such as wholesale
trading and risk management in addition to building and maintaining electric power plants,
natural gas pipelines, storage, and processing facilities. When taking on the risk of buying and
selling products, merchants are allowed to report the selling price as revenues and the products'
costs as cost of goods sold. In contrast, an "agent" provides a service to the customer, but does
not take on the same risks as merchants for buying and selling. Service providers, when
classified as agents, are able to report trading and brokerage fees as revenue, although not for
the full value of the transaction.

Although trading firms such as Goldman Sachs and Merrill Lynch used the conventional
"agent model" for reporting revenue (where only the trading or brokerage fee would be reported
as revenue), Enron instead elected to report the entire value of each of its trades as revenue.
This "merchant model" approach was considered much more aggressive in the accounting
interpretation than the agent model. Enron's method of reporting inflated trading revenue was
later adopted by other companies in the energy trading industry in an attempt to stay
competitive with the company's large increase in revenue.

Between year 1996 to 2000, Enron's revenues increased by more than 750%, rising
from $13.3 billion in 1996 to $100.8 billion in 2000. This extensive expansion of 65% per year
was unprecedented in any industry, including the energy industry which typically considered
growth of 2-3% per year to be respectable. For just the first nine months of 2001, Enron
reported $138.7 billion in revenues.

In Enron's natural gas business, the accounting had been fairly straightforward: in each
time period, the company listed actual costs of supplying the gas and actual revenues received
from selling it. However, when Skilling joined the company, he demanded that the trading
business adopts mark-to-market accounting, citing that it would reflect "... true economic value.”
Enron became the first non-financial company to use the method to account for its complex
long-term contracts. Mark-to-market accounting requires that once a long-term contract was
signed, income was estimated as the present value of net future cash flows. Often, the viability
of these contracts and their related costs were difficult to judge.
 Due to the large discrepancies of attempting to match profits and cash, investors were
typically given false or misleading reports. While using the method, income from projects could
be recorded, this increased financial earnings. However, in future years, the profits could not be
included, so new and additional income had to be included from more projects to develop
additional growth to appease investors. As one Enron competitor pointed out, "If you accelerate
your income, then you have to keep doing more and more deals to show the same or rising
income.” Despite potential pitfalls, the U.S. Securities and Exchange Commission (SEC)
approved the accounting method for Enron in its trading of natural gas futures contracts on
January 30, 1992. However, Enron later expanded its use to other areas in the company to help
it meet Wall Street projections.

For one contract, in July 2000, Enron and Blockbuster Video signed a 20-year
agreement to introduce on-demand entertainment to various U.S. cities by year-end. After
several pilot projects, Enron recognized estimated profits of more than $110 million from the
deal, even though analysts questioned the technical viability and market demand of the service.
When the network failed to work, Blockbuster pulled out of the contract. Enron continued to
recognize future profits, even though the deal resulted in a loss.

The first major sham operation was Enron executives' apparent use of SPEs to deceive
shareholders and to enrich themselves. Enron used about 500 such SPEs and thousands of
other questionable partnerships in order to structure transactions to achieve off-balance sheet
treatment of assets and liabilities. During the 1990s, Enron needed additional capital to continue
its growth despite its substantial debt load. Funding new investments by either issuing additional
debt or raising capital was unattractive because such financing would dilute earnings per share.
Therefore, it used SPEs to borrow funds directly from outside lenders, often supplying its own
credit and stock guarantees. The use of these SPEs included many aspects of Enron's
business: synthetic lease transactions; sales to SPEs of "financial assets" (i.e., debt or equity
interests that Enron owned); sales of Enron stock and contracts to "hedging" SPEs in return for
Enron stock; and transfers of other assets to entities that had limited outside equity.

A second questionable accounting transaction was the improper recording of a note

receivable from Enron's equity partners in various limited partnerships. These notes were the
apparent promises to pay for the equity claims in the limited partnerships, which Enron recorded
as assets even though GAAP requires subscribed equity to be reported as a contra-
stockholders' equity account, rather than as a note receivable. Once it was accused of GAAP
violations, Enron announced it would restate the previous 4 1/2 years of financial statements by
recording a $1.2 billion reduction in stockholders' equity, adjusting its income statements and
balance sheets for the unconsolidated SPEs, and making prior-period proposed audit
adjustments and reclassifications that had originally been considered as immaterial.

Question II (b)
In your opinion, why do the managers of Enron want to manage their earnings and
subsequently be engaged in fraudulent activities?

There are many causes of the Enron collapse. Among them are the conflict of interest
between the two roles played by Arthur Andersen, as auditor but also as consultant to Enron;
the lack of attention shown by members of the Enron board of directors to the off-books financial
entities with which Enron did business; and the lack of truthfulness by management about the
health of the company and its business operations. In some ways, the culture of Enron was the
primary cause of the collapse. The senior executives believed Enron had to be the best at
everything it did and that they had to protect their reputations and their compensation as the
most successful executives in the U.S. When some of their business and trading ventures
began to perform poorly, they tried to cover up their own failures.

At Enron, for example, corporate greed and arrogance were apparent in the entity's
aggressive use of a trademark-to-market accounting for its energy trading contracts. Under this
generally accepted accounting principle, the entities are required to adjust the reported amounts
of such contracts and record a gain (or loss) for any adjustment upward (or downward). By
optimistically valuing its energy contracts, Enron was able to report significant unrealized gains
in its profit numbers. In the year 2000, for example, more than half of Enron's $1.4 billion of
pretax profit was made up of these unrealized gains.
Question II (c)
What were the consequences that befell the company upon the discovery of the fraudulent
activities?

Charges of fraud at Enron have been asserted and are being addressed in the courts.
But a couple of things are clear: It's the responsibility of an entity's management to publish
financial statements that reflect economic reality, and the management of Enron failed in that
responsibility. Also, it's the external auditor's job, Arthur Andersen in this case, to provide
assurance that management's financial statements do in fact present actual results, but
Andersen failed in its responsibility.

Upon the discovery of the fraudulent activities there has uncovered several instances of
financial fraud committed by high-ranking executives at Enron. Many of the executives have
been charged with wire fraud, money laundering, securities fraud, mail fraud, and conspiracy.
The following is players who are suspected of fraud related to the Enron scandal. There is
Andrew Fastow – former CFO of Enron. Fastow was indicted on 78 counts of securities fraud,
money laundering, wire and mail fraud, as well as conspiracy to inflate Enron’s profit. Michael
Kopper – former director in the global finance, pleaded guilty to financial wrongdoing in August
2002. J. Clifford Baxter – former Vice Chairman of Enron. Accused of securities fraud, Baxter
died in an apparent suicide in January 2002. Timothy Belden – former head of trading at
Enron’s Portland, OR office. Belden pleaded guilty to one count of conspiracy to commit wire
fraud related to Enron’s activities during the California power crisis. Gary Steven Emigre,
Gilles Robert Hugh Darby, David John Birmingham – three former employees of NatWest
(National Westminster Bank). These men have been charged with wire fraud that defrauded
their employer but benefited themselves and executives at Enron. Arthur Anderson – the
accounting firm that was responsible for auditing Enron. Arthur Anderson was found guilty on
June 15, 2002 of obstruction of justice for shredding documents related to the Enron scandal.

The firm consented to the revocation of its license to practice public accounting on Sept.
3, 2002. Similar to the downfall of Enron and WorldCom, critics said that Andersen's failures
were rooted in its culture and failed in its responsibility
Question III
In your opinion, what are the strategies that the accounting profession can take to curb the
abuses in earning management that subsequently result in fraudulent activities.

In my opinion, there are a few strategies that the accounting profession can take to curb
the abuse in earnings management. First is improving the accounting framework. To improve
the accounting framework, the accounting profession needs to clarify the procedures that an
auditor should use in audit process regarding restructuring, large acquisition write-offs and
revenue recognition practices. In addition, they must provide additional guidance in determining
what are material and their factors. The evaluating materiality requires consideration of all
relevant factors that could impact an investor’s decision. With improving the accounting
framework, it will lead to the successful of audit process since it will follow all the procedures
and guidance.

Second is the strengthening the audit committee process. The existing audit committee
must be committed, independent, and tough-minded, since they can be most reliable guardians
of the public interest. However, in the today situation, the audit committees are composed of
members who lack expertise in the basic principles of financial reporting. Additionally, the audit
committee meets rarely to receive the independent auditor’s report in many of the cases. As the
best way is, the audit committee should have capability to ask the tough questions of
management and the outside auditors. So, the members of audit committee should have the
financial background and not have any relation with the chairman or the company. It will make
the audit committee become stronger and have a good knowledge to prevent fraud.

Third is the improved outside auditing in the financial reporting process. Certainly the
failure of audits has leaded some people with question in their mind the thoroughness of audits.
The auditors serve as the public’s watchdog in the financial reporting process. The investors
rely on auditors to provide an independent and objective evaluation of the company’s financial
reporting practices. To provide a good reporting in their audit process, they should perform the
high quality of auditing. The high quality of auditing requires well-trained, well-focused and well-
supervised auditors. So, the external auditors should improve themselves to give their best in
process of auditing financial report.