a. Firstly, investors tend to invest in companies with stable earnings rather than one with volatile earnings. With stable earnings, there will be more likely an issuance of dividends and investors could easily predict the company’s future earnings compared to one with unstable earnings. With consistent earnings generated, it gives investors a secured feeling that it will again generate earnings as predicted. Confidence in the growth of rate of earnings is crucial because stable earnings growth further may increase further business prospective and are translated into higher stock and dividend returns. It is also crucial to have stable earnings as the growth in stock price is closely dependent on the growth of its earnings per share, a main indicator which investors used to invest in a company. b. Step-1: Massaging the numbers or income smoothing
Business managers can control the timing of some expenses and sales revenue to some extent and therefore boost or dampen recorded profit for the year. In this way managers ”put a thumb on the scale”, the scale being net income for the year. When managers cross the line and go too far it’s called cooking the books. Cooking the books constitutes fraud and is probably illegal. The most common way of massaging the numbers involves the discretionary expenses of a business. Consider repair and maintenance expenses, for instance. Until the work is done, no expense is recorded. A manager can simply move back or move up the work orders for these expenditures, and thus either avoid recording some expense in this period or record more expense in the period. In this way the manager controls the timing of these expenses. Managers control the timing of discretionary expenses, it is thought, to smooth profit from period to period. Instead of permitting the profit numbers to pop out of the process of the accounting system, and letting the chips fall where they may, managers ask the company’s controller to let them know in advance how profit for the period is shaping up, to get a preview of the final profit number for the year. Step-2: Cooking the books, is very serious stuff, and goes beyond massaging the numbers or doing some profit smoothing. It’s fundamentally different from taking advantage of discretionary expenses to give profit a boost up or a shove down. Cooking the books is not just “fluffing the pillows” to make profit look a little better or worse for the period. Cooking the books means that sales revenue is recorded when in fact no sales were made, or that actual expenses or losses during the period were not recorded. Cooking the books requires falsification of the accounting records. To put it as bluntly as I can, cooking the books constitutes fraud—the deliberate design of deceptive financial statements. CPA auditors search for any evidence fraud. But they may not find it when managers are adept at concealing the fraud.
Case 5-2 Earnings Quality
a. Earnings quality refers to the ability of reported earnings to reflect the company's true earnings, as well as the usefulness of reported earnings to predict future earnings. Earnings quality also refers to the stability, persistence, and lack of variability in reported earnings. The evaluation of earnings is often difficult, because companies highlight a variety of earnings figures: revenues, operating earnings, net income, and pro forma earnings. In addition, companies often calculate these figures differently. The income statement alone is not useful in predicting future earnings.
b. Dell's (DELL) earnings of 28 cents per share (including 4 cents per share for cost reduction expenses) beat the consensus estimate of 23 cents. The earnings...