Issues in Accounting Education Vol. 17, No. 4 November 2002
Grey Paints: Using Earnings Quality Concepts to Clarify the Earnings Measurement Process Jerry G. Kreuze and Jack M. Ruhl ABSTRACT: This case uses the concepts of earnings quality and earnings management to illustrate the inherent ambiguity in the earnings measurement process. Accounting students are often uncomfortable with ambiguity. Students want faculty to provide them with a single correct answer, such as the precise earnings for a given time period. Accounting textbooks rarely address this perception; we have yet to find a textbook that illustrates a range of acceptable amounts. This case demonstrates that earnings can be, and often are, ambiguous in the real world.
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GREY PAINTS: A FAMILY-RUN OPERATION
effrey Grey, the new CEO of Grey Paints, spoke with his corporate controller one wintry morning in January 2004. “We agree that the purpose of financial reporting is to provide our stakeholders with relevant and reliable information about Grey’s performance. The best financial reports allow readers to distinguish firms that are performing well from firms that are performing poorly. “For at least the past 20 years, our financial reports have not helped our stakeholders in this way. We have had very high-quality earnings, but that message has never gotten through to the stakeholders. “You and I know our industry and our firm very well. Now that I am CEO, we can use our combined knowledge to improve Grey Paints’ financial reporting. Specifically, we can select reporting methods, estimates, and disclosures to show that Grey is financially very strong. How soon can we get to work?” A Family-Run Operation Grey Paints has been in business for many years. Winston Grey founded the company 40 years ago. His son, Henry Grey, has been the majority (51 percent) shareholder for the past decade. Henry’s cousins, who are not actively involved in the company, own the remaining 49 percent. As a result of being organized as an S-corporation for tax purposes, Grey Paints does not pay corporate income taxes. Instead, Henry and his cousins report their proportionate shares of Grey Paints’ income on their personal tax returns.
Jerry G. Kreuze and Jack M. Ruhl are Professors at the Western Michigan University.
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As a result of hard work and considerable managerial skill, Henry expanded the company from a job shop specializing exclusively in a powder coating paint operation (the application of a paint powder to a product that is then heated in an oven to create a hard, durable, consistent painted surface) to a manufacturer and distributor of specialty wall hangings (decorative picture frames, candle holders, brass spoon holders, and so forth). These specialty wall hangings are the brainchild of Winston’s wife, Adele; they are decorative and made from a variety of materials. Grey continues to operate a powder coating process, but that operation now accounts for only 20 percent of total revenue. Grey’s financial statements for the calendar years 2002 and 2003 are presented in Exhibit 1. EXHIBIT 1 Grey Paints Income Statements for the Years Ending December 31, 2002 and 2003 2002
Gross Sales
Powder Coating
Wall Hangings
Total
Powder Coating
Wall Hangings
Total
$250,000
$1,000,000
$1,250,000
$260,000
$1,040,000
$1,300,000
—
—
—
—
—
—
250,000
1,000,000
1,250,000
260,000
1,040,000
1,300,000
90,000
395,000
485,000
95,000
423,000
518,000
Less: Returns Net Sales Cost of Goods Sold (Approximating 50% fixed, 50% variable) Gross Profit
2003
$160,000 $
605,000 $ 765,000
$165,000 $ 617,000 $ 782,000
$250,000
$250,000
200,000
200,000
Depreciation Expense—Office Equipment
30,000
28,000
Office Expense
60,000
63,000
Advertising Expense
53,000
57,000
3,000
4,000
Interest Expense
16,000
15,000
Travel Expense
25,000
30,000
637,000
647,000
$128,000
$135,000
Operating Expenses Executive Salaries Office Salaries
Bad Debt Expense
Total Operating Expense Net Income
(Continued on next page)
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433 EXHIBIT 1 (Continued) Grey Paints Balance Sheets December 31, 2002 and 2003
Assets Current Assets Cash Securities Available for Sale (approx. market) Accounts Receivable Inventory Prepaid Expenses
2002
2003
$ 370,000 90,000 92,000 30,000 29,000
$ 350,000 90,000 95,000 32,000 52,000
611,000
619,000
600,000 2,000,000 1,900,000
600,000 2,000,000 1,900,000
Total Less: Accumulated Depreciation
4,500,000 2,200,000
4,500,000 2,450,000
Property, Plant, and Equipment, net
2,300,000
2,050,000
$2,911,000
$2,669,000
2002
2003
Total Current Assets Property, Plant, and Equipment Land Buildings Equipment
Total Assets Liabilities and Stockholders’ Equity Current Liabilities Accounts Payable Payroll Taxes Payable Salaries Payable Current Portion of Long-Term Debt Total Current Liabilities Long-Term Liabilities Notes Payable—Bank (less current portion) Total Liabilities Stockholders’ Equity Common Stock, $1 par, 400,000 shares authorized, 200,000 shares issued and outstanding Paid-In Capital—Common Stock Retained Earnings Total Stockholders’ Equity Total Liabilities and Stockholders’ Equity
$
50,000 9,000 16,000 6,000
$
35,000 7,000 13,000 6,000
81,000
61,000
244,000
219,000
325,000
280,000
200,000
200,000
500,000 1,886,000
500,000 1,689,000
2,586,000
2,389,000
$2,911,000
$2,669,000
(Continued on next page)
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Issues in Accounting Education EXHIBIT 1 (Continued) Grey Paints Statement of Stockholders’ Equity for the Years Ending December 31, 2002 and 2003
Retained Earnings, 1/1 Net Income Cash Dividends Paid Retained Earnings, 12/31
2002
2003
$2,038,000
$1,886,000
128,000
135,000
(280,000)
(332,000)
$1,886,000
$1,689,000
Grey Paints Statements of Cash Flows for the Years Ending December 31, 2002 and 2003 Cash Flow from Operating Activities Net Income Adjustments to Net Income Depreciation Expense Decrease (Increase) in Accounts Receivable Decrease (Increase) in Prepaid Expense Decrease (Increase) in Inventory Increase (Decrease) in Accounts Payable Increase (Decrease) in Taxes Payable Increase (Decrease) in Salaries Payable Cash Provided by Operating Activities Cash Flow from Investing Activities Cash Flow from Financing Activities Cash Dividend Paid Payment on Long-Term Note Payable Increase in Cash Beginning Cash Ending Cash
2002
2003
$128,000
$135,000
257,000 8,000 (5,000) (3,000) 6,000 (2,000) (1,000)
250,000 (3,000) (23,000) (2,000) (15,000) (2,000) (3,000)
388,000
337,000
—
—
(280,000) (10,000)
(332,000) (25,000)
98,000 272,000
(20,000) 370,000
$370,000
$350,000
Grey manufactures and controls distribution of top-quality wall hangings, which are sold in upscale shops across the country. Grey has established a distribution channel of retailers in exclusive resort communities including places such as Palm Island, South Carolina, Martha’s Vineyard in Massachusetts, and the Hamptons in New York. The wall hangings are a high-end product for most of the retailers, whose customers are typically in the top income brackets. These retailers are geographically disbursed so as to minimize seasonal impacts on sales. As a result, sales are fairly constant throughout the year. Sales are also constant on a year-to-year basis, regardless of the state of the economy, since the consumers purchasing the hangings are wealthy and not affected by economic downturns.
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Historically Conservative Management As CEO, Henry has always been fiscally conservative in managing the company. He sold only to established retailers after critically evaluating their creditworthiness. As a result, bad debts were insignificant on sales of specialty wall hangings. No bad debts were experienced with the powder coating operation. Because of the immateriality of this bad debt expense, Grey has elected to use the direct write-off method in accounting for bad debts. Jeffrey, the only child of Henry and his wife Katherine, has worked in the firm since his teen years. For several years, Jeffrey advocated the manufacture of a much lower-quality line of wall hangings, which Grey would sell to large retailers such as Wal-Mart and Target. Henry had resisted implementing Jeffrey’s suggestion, pointing out that a small company like Grey could expect to have difficulties dealing with these big customers, who might take full advantage of liberal return policies, make late payments, and return shopworn merchandise. Although these large companies might use disputes over quality and salability to justify late payments, they would probably pay all undisputed amounts at some point. To estimate sales returns, Henry investigated industry return percentages, had conversations with industry and trade specialists, and communicated with other suppliers of these large retailers. As a result of these efforts, Henry determined that sales returns (typically shopworn merchandise that Grey would have to discard) from these large retailers could reasonably be estimated at 5 percent of the additional sales. Henry could not dissuade Jeffrey, who consistently argued that the additional profits from sales to these other retailers would outweigh any problems resulting from the potential sales returns and late payments. Henry, as CEO, had to this point decided not to pursue these additional sales opportunities. Passing the Gavel Henry was getting on in years and had decided it was time to retire. Henry and Katherine decided to allow Jeffrey to purchase Henry’s 51 percent stock interest in Grey at its book value on December 31, 2003. Jeffrey was able to cash out a large part of this purchase with his inheritance from his grandfather and his own personal savings. Henry had no intention of continuing with the company as an employee or consultant after the sale; rather, he and Katherine planned to permanently move to their condominium in Palm Springs, California. The business had been good to Henry; for the past two years, he had drawn an annual salary of $250,000. Henry felt a great sense of accomplishment as a result of his management of Grey Paints. Now that he is about to retire, he has become concerned that Grey Paints might not survive with anyone but himself as CEO. Henry believes that his son is an inexperienced manager who could possibly deplete the business by pursuing strategies such as selling the low-end hangings to large retailers. He has expressed these thoughts to his son as diplomatically as possible. Upon hearing his father’s concerns, Jeffrey responded that Henry’s “ultraconservative” management practices had resulted in Grey Paints achieving only a fraction of its potential. Further, Jeffrey told his father that Grey Paints would only survive in the new millennium if he, Jeffrey, were CEO. Henry told Jeffrey to back up his “big talk” with his wallet. After a lengthy discussion, father and son agreed to a wager. If Grey performed better in 2004
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under Jeffrey’s leadership than it did in 2003 under Henry’s leadership, Henry would pay for a large and beautiful plaque with the following engraved in large letters: “To Jeffrey Grey: the best CEO in the history of Grey Paints.” He would also write a check to his son in the amount of $100,000. However, if company performance did not improve, then Jeffrey would write his father a check for that amount. He would also purchase a plaque similar to the one described, except that Henry would be named best CEO. Henry agreed to sell his 51 percent interest in Grey Paints to Jeffrey, which meant his son could implement whatever measures he deemed appropriate. Henry, however, has retained the right to question the selection and application of accounting principles and the associated assumptions and estimates used in formulating the year-end 2004 financial statements. Jeffrey Takes Over Jeffrey knew the importance of setting ambitious goals. These goals included expanding the product line to include low-end wall hangings. He estimated that sales of the low-end wall hangings would increase revenues by 50 percent over 2003 levels, and operating income would increase by $60,000 over 2003. In the long run Grey would need additional raw material storage and greater manufacturing space to consistently maintain the expected level of sales. Jeffrey did not waste any time before implementing his plans. He immediately contacted numerous large retailers and got commitments from several of them that would allow for the 50 percent sales increase. As Henry had suspected, to obtain these commitments Jeffrey had to agree to a very liberal return policy allowing these retailers to return shopworn merchandise. Conversations with the personnel in the accounts payable departments of these retailers revealed that suppliers were typically paid in 100 days following the receipt of merchandise. These credit terms were significantly different from the standard 30 days provided to Grey Paints’ existing retailers. Jeffrey, nevertheless, agreed to these terms and production began. The present manufacturing facility had enough capacity, with the exception of a required welder/punch press, to support the anticipated increased sales level in the short run. Jeffrey paid $600,000 for the new machine, which had an estimated useful life of ten years and a $30,000 salvage value. Although all previously acquired assets were consistently depreciated using the double declining balance depreciation method, Jeffrey elected to use the straight-line depreciation method for this new asset. Although Grey Paints had sufficient cash to pay for the welder/punch press, Jeffrey paid $400,000 cash and financed the balance with a note payable to the bank. He borrowed from the bank for several reasons. First, interest rates were currently very low. Second, he wanted to conserve cash that he expected to need to maintain higher inventory levels. Finally, if Henry proved to be correct about large retailers being late with payments, Jeffrey would need the cash to cover operating expenses. Jeffrey paid himself a $250,000 salary in 2004, the same compensation level Henry had received (classified as executive salaries). Office salaries remained the same in 2002–2004, because Jeffrey hired a highly qualified assistant at his previous salary level.
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2004: The Year in Review Remaining confident that additional retailers could be enticed to sell Grey’s specialty wall hangings, Jeffrey set and maintained production levels at 175 percent of last year’s sales. By the end of 2004, actual sales (as presented in Exhibit 2) increased by 50 percent over 2003’s sales levels. The entire sales increase was attributable to sales of low-end wall hangings to new customers. Sales of highend hangings to existing customers and powder coating revenues remained constant. Ending inventory of wall hangings (mostly attributable to low-end wall hangings) at the end of 2004 rose by 338 percent over 2003 levels ($140,000 compared to $32,000) and now accounts for 56 days sales in inventory. Due to a lack of storage space, Jeffrey rented a warehouse to store the additional inventory at an annual rental rate of $50,000. Just as Henry had anticipated, cash collections from these new retailers were slow. EXHIBIT 2 Grey Paints Income Statement for the Year Ending December 31, 2004
Gross Sales Less: Returns Net Sales Cost of Goods Sold (Approximating 40% fixed, 60% variable) Gross Profit
Powder Coating
Wall Hangings
Total
$260,000
$1,690,000
$1,950,000
—
—
—
$260,000
1,690,000
$1,950,000
100,000
840,000
940,000
850,000
$1,010,000
$160,000
$
Operating Expenses Executive Salaries Office Salaries Depreciation Expense—Office Equipment
$ 250,000 200,000 26,000
Office Expense
108,000
Rent Expense
50,000
Advertising Expense
49,000
Bad Debt Expense Interest Expense Travel Expense Total Operating Expenses
4,000 35,000 138,000 860,000
Income from Continuing Operations
150,000
Other Revenue: Gain on Sale of Land
50,000
Net Income
$ 200,000 (Continued on next page)
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Issues in Accounting Education EXHIBIT 2 (Continued) Grey Paints Balance Sheet December 31, 2004
Assets Current Assets Cash Securities Available for Sale (approx. market) Accounts Receivable Inventory Prepaid Expenses
$ 160,000 100,000 185,000 140,000 78,000
Total Current Assets
663,000
Property, Plant, and Equipment Land Buildings Equipment
550,000 2,000,000 2,500,000
Total Less: Accumulated Depreciation
5,050,000 2,750,000
Property, Plant, and Equipment (net)
2,300,000
Total Assets
$2,963,000
Liabilities and Stockholders’ Equity Current Liabilities Accounts Payable Payroll Taxes Payable Salaries Payable Current Position of Long-Term Debt Total Current Liabilities Long-Term Liabilities Notes Payable—Bank (less current portion) Total Liabilities Stockholders’ Equity Common Stock, $1 par, 400,000 shares authorized, 200,000 shares issued and outstanding Paid-in Capital—Common Stock Retained Earnings Total Stockholders’ Equity Total Liabilities and Stockholders’ Equity
$
38,000 8,000 19,000 10,000 75,000 415,000 490,000
200,000 500,000 1,773,000 2,473,000 $2,963,000 (Continued on next page)
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439 EXHIBIT 2 (Continued) Grey Paints Statement of Stockholders’ Equity for the Year Ending December 31, 2004 2004
Retained Earnings, 1/1
$1,689,000
Net Income
200,000
Cash Dividends Paid
(116,000)
Retained Earnings, 12/31
$1,773,000 Grey Paints Statement of Cash Flows for the Year Ending December 31, 2004
Cash Flows from Operating Activities Net Income Adjustments to Net Income Gain on Sale of Land
$200,000 (50,000)
Depreciation Expense
300,000
Increase in Accounts Receivable
(90,000)
Increase in Prepaid Expenses Increase in Inventory
(26,000) (108,000)
Increase in Accounts Payable
3,000
Increase in Taxes Payable
1,000
Increase in Salary Payable Cash Provided by Operating Activities Cash Flows from Investing Activities Sale of Land Purchase of Securities Available for Sale Purchase of Equipment Cash Used by Investing Activities Cash Flows from Financing Activities Note Payable – Long-Term Cash Dividends Paid Cash Provided by financing activities
6,000 236,000 100,000 (10,000) (600,000) (510,000) 200,000 (116,000) 84,000
Decrease in Cash
(190,000)
Beginning Cash
350,000
Ending Cash
$160,000
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Jeffrey found it mandatory to cut back in several areas. He instructed Mabel Thom, the maintenance supervisor, to trim 50 percent off her maintenance budget for 2004. The maintenance budget included amounts to maintain equipment and prevent breakdowns. To date, breakdowns had rarely occurred. Mabel, believing a 50 percent reduction would severely affect future long-term production capacity, only trimmed 20 percent from her budget. Jeffrey expressed his displeasure with her in the strongest terms. In addition, Jeffrey cut back on advertising expenditures. However, office and travel expenses increased from 2003 levels. These increases were associated with the additional sales efforts: office costs to handle the increased number of customer accounts and travel expenses for direct selling activities. These expense amounts should remain constant at these new levels for the next few years. Depreciation related to the new welder/punch press, considered a product cost, was included in cost of goods sold, ($48,450) and ending inventory ($8,550). Overall, Jeffrey was pleased with Grey’s performance for the calendar year 2004. Grey reported a net income of $200,000, which represented a 48 percent increase over the $135,000 net income for 2003. Henry Returns from Palm Springs In January 2005, Henry received a conference call from his cousins expressing their serious concern over the sharp reduction in dividends. Dividends had been $280,000 in 2002, and $332,000 in 2003, but plummeted to only $116,000 in 2004. Henry told his cousins that he had expected a decline in net income in 2004, and this decline would explain the dividend reduction. He promised to investigate the matter when he met with his son later in the month. On January 29, Henry met with Jeffrey at the corporate headquarters. Given his expectation of a drop in net income as well as the decline in dividends, he was shocked by Jeffrey’s assertion that Grey Paints’ performance in 2004 exceeded that of 2003. Jeffrey argued that shareholder value was being enhanced by limiting dividends and retaining cash in the business through investments in assets, namely inventory and equipment. Henry was skeptical. Not being an accountant, he could not be certain whether Jeffrey followed generally accepted accounting principles and made logical, consistent assumptions in the preparation of the 2004 financial statements. However, based upon his understanding of the business and a reading of the financial statements, Henry had some concerns. He noticed that Jeffrey used straight-line depreciation for the punch press/ welder acquired during 2004. This depreciation method was inconsistent with the method used for all previous asset acquisitions. He wondered why Jeffrey would adopt a different depreciation method and what impact that change had on the 2004 reported net income. Bad debts and sales returns on the 2004 income statement represented only actual bad debts and returns experienced prior to December 31, 2004. Jeffrey had made no provision for possible bad debts or sales returns. He did this because Grey had traditionally used the direct write-off method to account for bad debts, and sales returns had not been an issue in the past. Henry wondered whether possible sales returns should be estimated prior to actual occurrence, especially
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since sales returns from the new customers were expected to be 5 percent of sales. Henry noticed that the balance sheet for December 31, 2004 showed a decrease in the land account in the amount of $50,000. The cash flow statement revealed that this land was sold for $100,000; a gain of $50,000. Jeffrey revealed that he sold some excess land located in another state. This land had been held in the family business for many years and had sentimental value attached to it. Henry was upset that his son sold this land, but Jeffrey reminded Henry that no one from the family had even stepped on the land in years. Henry remained upset and wondered whether this gain should be included when determining whether Grey performed as well in 2004 as in 2003. At this point, Henry heard maintenance supervisor Mabel Thom calling him from a nearby office. Out of Jeffrey’s earshot, Mabel told Henry that her maintenance budget was decreased by 20 percent (from $40,000 to $32,000 per year) and about a sale Jeffrey booked in 2004 and shipped FOB shipping point on December 31, 2004, which arrived at the customer’s warehouse on January 5, 2005. If not for this transaction, the December 31, 2004 ending inventory would have been $20,000 higher and sales $38,000 lower in 2004. Mabel indicated that the goods were finished and boxed by December 26, 2004, but were not shipped on that day due to confusion as to the exact delivery location. The confusion was not cleared up until December 30th. At that point, the customer decided she would rather have it delivered after January 1, 2005, because she had arranged for a large party to be held in the inventory receiving area on December 31, 2004. For reasons unknown to Mabel, Jeffrey had hired an independent shipping company to make the delivery and had insured the cargo during transit (Grey’s fleet insurance routinely covered these deliveries). It was a half-day trip to the customer’s warehouse, but Jeffrey loaded the delivery truck with the merchandise on December 31, 2004, and the driver drove the merchandise approximately half-way to the customer’s warehouse. Mabel told Henry that Jeffrey paid the driver to stay in a four-star hotel for two nights until January 2, 2005, when the delivery was made in the early morning. The driver had quickly volunteered for the trip, since he was paid time and a half and given a generous meal allowance. After all, it was not every day that he got to stay in a fancy hotel and baby-sit a truckload of wall hangings. Henry deeply regretted agreeing to a contract that did not clearly specify how performance was to be determined. He acknowledged that the net income amounts Jeffrey had calculated for 2004 were greater than the 2003 income. However, Henry suspected that his son had selected only the income-maximizing accounting treatments. He pointed out that cash flows from operations for 2004 were below that of 2003. Could this mean that Grey, in fact, did not perform as well in 2004? Henry was beginning to question exactly what it means to “perform as well” and how that can be best measured. Henry did breathe a sigh of relief knowing that the bank required an audit of Grey’s 2004 financial statements. Bank policy required all businesses with outstanding loan balances to provide annual audited financial statements within four months after year-end. Jeffrey employed the same audit firm that Henry had used for the past several years.
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REQUIREMENTS
There are numerous people involved in the preparation and use of financial statements, including company management, auditors, and external users. Each of these user groups may have different concerns relating to the financial statements. Requirements 1, 2, and 3 ask you to consider Grey Paints’ financial statements from these different perspectives. Requirement 4 asks you to consider the question of earnings quality more generally. In Question 1, you are the auditors hired by Grey Paints, at the demand of the bank, to audit the year-end 2004 financial statements. Take Jeffrey’s perspective (company management) in Question 2 and respond to any auditor-proposed adjustments to the year-end 2004 financial statements. In Question 3, take Henry’s position (external users) in determining whether Grey did, in fact, perform better in 2004 than in 2003. Finally, Question 4 addresses the importance of earnings quality in evaluating performance, how to assess the quality of earnings, and the relative importance of cash vs. earnings. Questions 1. The External Auditors. You are the manager in charge of the 2004 Grey audit. You are to review the financial statements prepared by Jeffrey and consider the information presented in the case. Are any adjustments to the financial statements needed? If you propose any adjustments, prepare the necessary journal entries (assuming Grey’s books have not been closed for 2004). In addition, prepare a letter to Jeffrey outlining your proposed audit adjustments (if applicable), what impact each adjustment would have on 2004 net income, and indicate why those adjustments are necessary for the financial statements to fully comply with generally accepted accounting principles. 2. Jeffrey. From Jeffrey’s perspective, after reviewing any proposed adjusting journal entries, any impact of those adjustments on reported net income, and a possible letter from the auditors outlining the necessity of adjustments, defend the financial statements as previously presented and prepare written arguments to the auditors for any adjustments they proposed. 3. Henry. From Henry’s perspective, you desire a fair, unbiased assessment of whether Grey performed better in 2004 than in 2003. Review the financial statements prepared by Jeffrey and any proposed audit adjustments (if applicable), and consider the information presented in the case. Based on that review, prepare a written response to Jeffrey, either congratulating him on a job well done and promising him a check for $100,000 and an engraved plaque (i.e., Grey did perform better in 2004 than in 2003), or argue that Jeffrey must write a $100,000 check and engrave a plaque (i.e., Grey did not perform better in 2004 than in 2003). Provide specific reasons supporting your position. Consider the reduced cash flow from operations and apparently increased net income. How do these issues affect earnings quality? The question is particularly relevant because Jeffrey, in the introduction to the case, says “Grey has had very high quality earnings, but that message has never gotten through.” What measures (selection and application of accounting principles and timing of transactions) did Jeffrey take that would constitute earnings management? Do these measures enhance earnings quality? Why or why not? Has Jeffrey improved the quality of financial reporting? Does Henry or Jeffrey deserve a check for $100,000?
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4. Sheryl Skolnick, an analyst at the investment-banking firm BancBoston Robertson Stephens, made the following statement. “Earnings are irrelevant. If I don’t see cash, then I really don’t care. Revenues have become something of increased importance. If there’s no cash, there’s no real revenue. Earnings reporting doesn’t reflect the cost of business anymore” (Skolnick 1999, 1). Comment on this quote in light of the Grey case.
REFERENCE
Skolnick, S. 1999. Analysts begin to question earnings management. Investor Relations Business (November 15): 1, 18.
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CASE LEARNING OBJECTIVES AND IMPLEMENTATION GUIDANCE
Introduction This case introduces students to the concepts of earnings quality and earnings management and links these concepts with concepts they learned in prior accounting coursework. We have used the case in an undergraduate intermediate financial accounting course with great success, and it is appropriate for either the first or second intermediate accounting course. Alternatively, the case could effectively be used in an accounting theory course or a capstone accounting course. Students are engaged by the potential arguments of the case and the fact that there is room for professional judgment in the solution. On the flip side, however, some students become impatient with the lack of a single definitive solution. Bernstein and Wild’s (2000) three-dimensional earnings quality model is used to show how factors both within and outside of the firm affect earnings quality. This model provides a structure for class discussion, and students are able to link specific case details with each of the dimensions. The case also provides other views of earnings quality, such as Parfet’s (2000) idea of “good” and “bad” earnings management. A benefit for instructors is the option of having students answer questions from various perspectives, which increases their appreciation of the interpretations and estimates that managers must make when preparing financial statements. Depending on the perspective adopted, students will tend to see the same economic event in different ways. For example, students taking the perspective of a new CEO will argue for a higher income figure, while students assuming the viewpoint of the external auditor will want a conservative income amount. Considering the issues from different perspectives naturally leads the students to the following questions: Is the new CEO managing earnings? If so, is managing earnings always a bad thing? Is the new CEO guilty of fraud, or is he simply playing within the rules of the (GAAP) game and doing what any other CEO might do? Like the amount of earnings, there are no easy answers to these questions. Learning Objectives We use this case to achieve the following educational objectives. 1. First, students learn that earnings measurement is fraught with ambiguity. Managers interpret business transactions and make estimates as part of the process of determining accrual-based income. These interpretations and estimates provide important information to financial statement users; information that is not available from cash flow statements or cash basis measures of income. 2. Students gain a better understanding of the concepts of earnings quality and earnings management. These terms are used regularly by the media, business people, and academics who rarely define exactly what they mean (e.g., Loomis 1999). Many media commentators seem to equate earnings management with financial fraud, while business people (e.g., Parfet 2000) and some academics (e.g., Schipper 1989) believe that there are both “good” and “bad” earnings management.
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3. Students must argue from different perspectives, and as a result they come to understand that one’s perceived best interests affect the way one believes earnings should be calculated. They come to realize an argument could be made that each party (Jeffrey and Henry) is trying to manage earnings to achieve his own end. 4. As they read the case, students should keep in mind Jeffrey’s opening soliloquy, in which he pledges to improve Grey’s financial reporting. He recognizes that improvement means providing relevant and reliable information. But has he achieved his stated goal of improving the quality of Grey’s financial reporting?
TEACHING NOTES
Teaching Notes are available through the American Accounting Association’s new electronic publications system at http://aaahq.org/ic/browse.htm. Full members can use their personalized usernames and passwords for entry into the system where the Teaching Notes can be reviewed and printed. If you are a full member of AAA and have any trouble accessing this material please contact the AAA headquarters office at
[email protected] or (941) 921-7747.
REFERENCES
Bernstein, L., and J. Wild. 2000. Analysis of Financial Statements. New York, NY: McGraw-Hill. Loomis, C. 1999. Lies, damned lies, and managed earnings. Fortune (August 2): 74–92. Parfet, W. 2000. Accounting subjectivity and earnings management: A preparer perspective. Accounting Horizons 4 (December): 481–488. Schipper, K. 1989. Commentary on earnings management. Accounting Horizons 4 (December): 91–102.
