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Homework answers / question archive / Identify conditions that would lead an analyst to expect that management might attempt to manage earnings upward
Identify conditions that would lead an analyst to expect that management might attempt to manage earnings upward. Provide a specific example that illustrates this scenario. Do not use items already addressed by your peers. In replies to peers, provide additional supporting examples for this scenario.
Assume that a corporation needs to enter the private debt market to raise funds for plant expansion. The corporation expects debt covenants to place restrictions on the levels of its current ratio and total-liabilities-to-assets ratio. Considering the accounts that comprise these ratios, provide examples of accounting estimates, accounting judgments, and structured transactions that the lender should examine closely and explain why each is important. In replies to peers, discuss additional information the lender should consider.
The simplest way for a company to manage earnings upward is by changing dates of revenue and expenses. It highers the earnings in which the current period is in. According to Healy and Wahlen, “earnings management occurs when management uses judgement in financial reporting and can alter financial reports to either influence stakeholders or influence contractual outcomes” (Whalen, Baginski, & Bradshaw, 2018, P. 355). There are several examples in which engaging in earnings management upward can be beneficial. “Might increase manager’s under compensation contracts, enhance job security for senior management by influencing the outcomes of transactions, allow firms to obtain debt financing at a lower cost, might influence stock prices, and increase gains from sales” (P.356). With upward influences of earnings management there is also downward earnings. “Some of the downward earnings might reduce the probability of antitrust actions against firms, might discourage entry, suppress stock prices, share prices might decrease and maximize manager gains from future share sales, and it might create opportunities to report higher earnings in future periods” (P356). An example of managing earnings upward could be using the last-in, first-out method to higher inventory for the first period of the year. For instance, at Costco they get a lot of inventory and to adjust earnings they can add more inventory to one period to project future period earnings for their sales.
Current ratio is used between current assets and current liabilities. Current liabilities can include accruals in which items are calculated based on accounting estimates. For instance, at our work we use accruals to calculate items that where not posted in their current period. “Current ratio indicates the amount of cash available at the balance sheet is relative to obligations coming during a specific period” (Whalen, Baginski, & Bradshaw, 2018, P.295). Current assets include trade debtors calculating deduction of bad debt. Balance sheets have structured transactions for sales. Depreciation is a matter of accounting judgement and assumptions. In this case assuring the transactions used to calculate current assets and liabilities for the balance sheet.
