Introduction to Financial Reporting
Financial reporting is the best method for the firm to report the economic condition of the company to the external entities such as creditor, employees, shareholders and customers. All the organizations prepare these statements with an aim to provide financial information of the firm to the users, so that it becomes easy for them to determine the financial health of the company which will help them in decision making. Earlier different firms adopted different techniques of accounting and reporting to present their monetary data, but due to globalization it became necessary for all the companies to adopt a standard way of reporting and accounting which can be understood by all. In order to achieve this objective, Generally Accepted Accounting Principle and International accounting Standards were formulated. The main aim behind the formulation of International Accounting Standards was to make accounting and reporting of financial statement more transparent so that external parties can understand them easily and can compare them with the financial information of other organizations (Altamuro, Beatty, and Weber, 2005).
The first case is about Bristol Myers Squibb Co. (BMS) which is a multi-national pharmaceutical company. In 2004, Securities Exchange Commission (SEC) levied a penalty of USD 150 million against BMS as the company was involved in extreme earnings management technique like “stuff the channel” and “cookie jar”. According to the SEC, the company has adopted fraudulent ways for inflating its sales and earnings in order to meet the forecast made by the analyst. The first section will analyze why companies go for such kind of accounting activities such as “stuffing the channel” and “cookie jar” and will evaluate the effectiveness of these techniques for both short term and long term point of view.
Reasons behind using Extreme Earnings Management Techniques
Before getting into earnings management, let’s first be clear about the term earnings. Earnings are the profit made by the company during the financial year. It is only the earnings of the company which makes the stock attractive or unattractive in the eyes of investors. Poor earnings of the firm may result in a fall in share price of the company. Thus, the earnings of the company play a very important role in deciding the share price of the firm. In order to make the stock attractive, companies and managers adopt the technique called earnings management (Cohen and Eli, 2009). The managers use earning management techniques to manipulate the actual earnings of the company so as to match them with the forecasted figures of the company or analysts. The main aim of the managers behind adopting the earnings management techniques is to smooth the income of the company. That is, it does not matter whether the company is having good or bad earnings for years; by using these technique companies’ tries to manipulate the sales and earnings figure so as to maintain it near about a particular level and eliminating the fluctuations. The organizations achieve this by either adding or deducting the cash in their reserve accounts. This is known as “cookie jar” (Caylor, 2010).
Below are the main reasons stating the purpose for which the manager uses extreme earnings management techniques:
- For bonus purposes
- To maintain the reputation of the firm
- To meet the expectations of the investors
- For initial public offerings
- Other contracting motivations
Effectiveness of “Stuffing the Channels” and “Cookie Jar”
The channel stuffing technique is used by the company to inflate its sales. The company achieves this by knowingly delivering more stocks to its wholesaler and distributor through various distribution channels. Company practices this technique so as to increase its receivable account for a shorter period. But when the excess of stocks is returned by the wholesales or the distributors, it needs to adjust the account again. Cannel stuffing can result in some dramatic repercussions for both stakeholders and the company related to legal and financial issues (Schipper, 1989).
Chances of Impairment Loss
Impairment of the asset can be defined as a rapid fall in the fair price of the asset due to some damage occurred to it or it has become obsolescent. If it happens to fixed assets, the company has to show the decreased value machine in the balance sheet and has to report loss in the profit and loss account. Or in other terms, it can be said that an impairment loss on any assets occurs when the reported amount of the asset exceed its fair amount which in reality is not possible for the company to recover. The impairment loss can be calculated by subtracting the fair value of the asset by the asset’s carrying amount. The impairment loss reduces the carrying amount of the assets so it is advisable to charge depreciation on the assets to adjust the carrying amount (McNichols, 2002). Below are the certain circumstances which results in impairment of assets:
- Decrease in fair value of the asset: The circumstance can be a sudden decrease in fair value of the asset. It can be due to various reasons. Firstly, there may be possible some damage is occurring to the machine, secondly, it has become obsolescent, and finally, there may be case some new technology has been has been introduced in the market and due to which the price of the current technology has gone down.
- The way in which the asset has been used: It also results in impairment loss. If the assets are frequently used by the company, its fair value decreases quickly as compared when it is used rarely (Ingram, Lee and Howard, 1999).
- Significant change in the business or regulatory environment: Change in business and regulatory environment also affects the price of an asset. Suppose a company is using some asset and regulation is passed by the government or the local authority stating the ban on such asset. In that case the fair value of the machine will decrease (Johnson and Mitton, 2003).
Apart from the above stated circumstances, other possibilities which will result in impairment loss are:
- Operating loss of the current period
- If the cost of manufacturing the assets exceeds the budgeted cost
- Operating activities result in a negative flow of cash
- If the market price of the asset changes
- If the asset is disposed of much before its estimated life (Gereish, 2003).
Effects of impairment review on firm’s financial position and performance
When Vodafone conducted its impairment review, it was found there it is suffering due to volatility in its earnings. In 2005-06 it was found out that the company has written off £23.5 billion in its goodwill due to European operations. Because of the impairment loss the company suffered a loss of £21.8 billion in 2005-06, as compared to a profit of £6.5 billion made by the company in 2004-05.
Same was the case with the PSA Peugeot Citroen. When the company conducted the impairment review, it was found that there is a significant difference between the equity value reported by the company in the balance sheet and the economic value of the future discounted cash flow of its equity. The difference gave rise to the depreciation of around €3,888 million. Although this depreciation amount did not impact the operational cash flow of the company but it substantially reduced the net income of the company in 2012 (Impairment of Assets, n.d).
Suppose the book value of any asset is 100 before impairment and the tax rate is 40%. Now if the company sales the asset of scrap value of 10, in that case the assets of the company will be reduced by 100, its accumulate depreciation will be reduced by 60 while its receivable or cash will increase by only 10. Thus it will reduce the earnings of the company as the profit and loss statement will report a loss on sale of 30. Finally, if the company receives the scrap value of the asset, it will increase the cash flow in the cash flow statement (RTT News, 2013).
After working on the above report it can be concluded that it is very important the companies to follow GAAP and international accounting principle in order to standardize its financial statements. Further, the companies must try to avoid the fraudulent practices for reaping short term benefits.
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