Key way the management alters financial statements: Earnings management.

Earnings management as defined is the “purposeful intervention/alteration/manipulation by management in the earnings determination process, usually to satisfy selfish objectives”

Kenya having gone through the election period, managers and business leaders may take this opportunity to manage the income of their respective companies shifting the blame to the safe haven of slowdown of the economy due to a long election period.

Such a discretion provides an opportunity for managers to reveal a more informative picture of a company’s business activities, it also allows them to window-dress financial statements and manage earnings.

While many investor in the NSE are irrational, the rational investors who represent a small percentage of the total traders, my find themselves digging into financial records that are already erroneous.

There are several reasons for managing earnings, including increasing manager compensation tied to reported earnings, increasing stock price, and lobbying for government subsidies.

Areas that offer maximum opportunities for earnings management include revenue recognition (accruals and matching concepts), inventory valuation (interchange in use of LIFO and FIFO to increase or decrease on cost), increase and decrease in estimates of provisions such as bad debts expense and deferred taxes, and one-time charges such as restructuring and asset impairments (capitalizing expenses that may not be significant in that specific industry such as R&D in retail industry and depreciating through them in the next periods, even so, a company may chose to capitalize expenses below the amount that their policy indicates below which they are supposed to be expensed)

So, what that are the strategies used to manage earnings? We look at the three main strategies.

(1) Big Bath. This strategy involves taking as many write-offs as possible in one period. The period chosen is usually one with markedly poor performance (often in a recession or bad political environment when most other companies also report poor earnings) or one with unusual events such as a management change, a merger, or a restructuring. This strategy also is often used in conjunction with an income-increasing strategy for other years. Because of the unusual and nonrecurring nature of a big bath, users tend to discount its financial effect. This affords an opportunity to write off all past sins and also clears the deck for future earnings increases. This is what will mostly apply to the Kenyan case should any of the company’s management decide to manage their income.

(2) Increasing Income. One earnings management strategy is to increase a period’s reported income to portray a company more favourably. It is possible to increase income in this manner over several periods. In a growth scenario, the accrual reversals are smaller than current accruals that increase income. This leads to a case where a company can report higher income from aggressive earnings management over long periods of time. Also, companies can manage earnings upward for several years and then reverse accruals all at once with a one-time charge. This one-time charge is often reported “below the line” (i.e., below the income from continuing operations line in the income statement) and, therefore, might be perceived as less relevant.

(3) Income Smoothing/ Cookie Jar Accounting. Income smoothing is a common form of earnings management. Under this strategy, managers’ decrease or increase reported income so as to reduce its volatility. Income smoothing involves not reporting a portion of earnings in good years through creating reserves or earnings “banks,” and then reporting these earnings in bad years. Many companies use this form of earnings management. For example, a company that sells products on which they offer warrant, they may have a policy to create a reserve of Ksh 5,000,000 for every Ksh 100,000,000 sales that they make. The said company, upon realising that they have had a good year, they can chose to increase the amount that they expense for reserves to pay out future claims of warranty to Ksh 20,000,000 for the same amount of sales that they make. This, in return will increase the reserve account also called Cookie Jar Reserves to significant amount that the company may chose to reverse the accumulated reserves in the year that they have not performed well. This will in turn reduce the warrant provision expense ledger.

While I’d wish to expound on the specific alterations that happen in the statutory financial statements, I do hope this offers a little, if not most, insight to potential and current analysts and investors in the simplest explanations possible to mitigate their risk of falling for unscrupulous corporate leadership.