ACC 311 – Intermediate Accounting I CASE STUDY: LONE STAR POWER – 3 points bonus

Question

ACC 311 – Intermediate Accounting I

CASE STUDY: LONE STAR POWER – 3 points bonus

Ward Johnson stared out the window. In the three months since he had assumed the role of chief investment officer at Lone Star Power, Johnson thought the company’s communications with the investing public had been superb, particularly with respect to its SEC filings. A single letter from an apparently upset analyst had changed that view.

Lone Star Power was a midsize power generation and power distribution company based in the Southwest. It provided electrical power to more than 750,000 homes, businesses, and government agencies. In addition to power generation and distribution, Lone Star sold and installed a wide-ranging array of products, from appliances to power-generation backup systems. It also offered service and repairs to customers throughout its territory. Total revenues for the quarter ended December 31, 2016, had topped $1 billion for the first time. With only one exception, the company had managed to grow both revenues and profits in each quarter since 2000. Put in place in early 2014, the company’s formal investor-relations function was relatively new. Prior to that, Lone Star had a small support staff that would send annual reports and similar literature in response to phone requests and handle other routine investor inquiries. In addition to his other duties, Johnson was expected to develop the investor-relations department in a way that would enhance Lone Star’s standing with the investing community.

Marianne Relzo was a senior, all-star equity analyst with Pitt Financial, a well-regarded U.S. investment bank. In a letter to Johnson, Relzo detailed her discontent with the company’s external financial communications. She complained about items as specific as Lone Star’s financial-statement footnote disclosures and as general as the company’s composite accounting policies. Johnson knew he would have to meet with Lone Star’s senior financial staff and receive input as to whether these issues had merit and how he should respond. With a red pen in hand, he read the letter once again.

Relzo’s letter raised a number of issues for Johnson to consider. In the margins of the letter, he jotted notes regarding each one. From his experience, Johnson knew it was an analyst’s objective to gather as much information about a company as possible. Regulation FD, however, defined the landscape regarding how he and other Lone Star officer should release information, but he was unsure what was implied regarding how he should deal with financial-reporting questions.

Johnson was not an accountant, and was not at all confident that he could articulate Lone Star’s position on what revenues and expenses were recorded. On the expense side, in particular, he was perplexed as to why it was even an issue if the company were to negotiate a discount that required promotional fees to be paid in advance, charging net income when paid. By recording in this fashion, he thought Lone Star was only being conservative by accelerating a loss.

The company was also being questioned on its overall financial-reporting “transparency.” Lone Star followed Generally Accepted Accounting Principles (GAAP) to the letter and filed timely reports with the SEC. Its financial statements were audited, and each major topic required in the Management Discussion and Analysis (MD&A) was dutifully disclosed. It seemed unreasonable to Johnson that the company be expected to provide real-time details on such items as negotiations with specific customers and write-offs of assets.

Required:

Define Earnings management. Provide methods of Earnings Management. In your answers to the below questions, indicate if Earnings Management applies and in what way.

What potential issues is the analyst trying to determine by raising the points in 1a, 1b, and 3? Consider each item separately. When answering these questions explain why analysts should be concerned about these particular issues.

Relzo raises issues with the consistent application of accounting methods (item 4) and the consistent classification of certain line items (item 5). Do you think it is within the rights of a company to vary accounting methods and reclassify certain line items?

Relzo is critical of Lone Star’s transparency. What is financial transparency and how would we know whether a firm has achieved it? You may need to look at the conceptual framework characteristics to answer this question.

Explanation / Answer

Earnings Managment can be defined using the Acrnoym WISE to understand the defination easily

WISE stands for: Window dressing, Internal targets, income Smoothing, External Expectations.

Window dressing refers to the company's decision to dress up the financial statements for potential investors and creditors. The goal of this is to attract new supporters by having financial statements that look like the company's doing great. The company needs to appear to have a history of being profitable, even if it means lowering profits in one accounting period to increase profits in another. Even though this seems fraudulent, it isn't. Overall, the company is still reporting the same amount of profits, but is spreading the amount evenly over a specific time period.

Internal targets are another reason that a company may choose to use earnings management techniques. Often times, the company has set its own internal goals, such as departmental budgeting, and wants to be sure to meet those goals. No department wants to be the one to blow the proposed budget, so earnings management techniques are used to balance this out.

Income smoothing comes into play here because of the fact that potential investors generally like to invest in companies that have a continuous growth pattern. Smoothing out income generated, when there may be spikes at certain times and drops at others, allows it to appear like the company has that smooth growth pattern.

External expectations comes into play when the company has already made projections as to what their profits will be and investors now expect that exact amount of profits or more. Management may feel the need to shift revenue from one accounting period to another in order to meet the projected goal. Earnings management, quite simply, takes advantage of the different ways that accounting policies and procedures can be applied to financial reporting.

Earnings Management Methods:

1. The big bath- This technique is often called a 1-time event. What happens with the big bath technique is that an out of the ordinary, or non-recurring, event occurs in a company, and expenses associated with that event are actually inflated. So, how can they inflate expenses and still be within GAAP guidelines? Easily! The company reports all of its expenses, but instead of attributing them to the correct accounts, they're all attributed to the 1-time event. Let me give you an example, and this will help you understand.

Billy owns multiple pizza restaurants. After months of struggling, one of the restaurants just has to be closed. This is a 1-time event and not one that is considered common. Since Billy knows that this loss will already cause a decrease in his reported net earnings, he decides to go ahead and charge a majority of the companies expenses to this business unit shut down.

He also knows that he doesn't want investors and creditors to think that the company is faltering, so he decides to count part of the loss in one accounting period and part in another. When the annual financial statements are printed and made available to the public, the bottom line net profit for the company will be correct.

2. Cookie jar reserves - This technique is also an income smoothing technique. It occurs when expenses are based on estimates. If the company over estimated expenses, then it may choose to use a portion of the expenses in one accounting period and save the other for future accounting periods.

Let's go back and look at Billy again. There was an electrical fire at one of Billy's pizza parlors. Billy hires a contractor to totally rewire the building and make sure that everything is up to code in the restaurant. Since all this happened at the end of the accounting period, Billy took the estimate that the contractor gave him and counted that as an expense for the current period.

When the actual payment was made to the contractor, it was for much less than the estimate, and it was paid in another accounting period. This caused there to be an overage of expenses claimed in the prior accounting period. When it came time to close the books for this accounting period, Billy sees that he made a bit more money that he actually wants to report. He decides to pull some of those expenses out of the cookie jar and apply them to the current period.

3. Operating activities - This earnings management technique occurs when managers plan certain events to occur in certain periods. This means that managers may decide to purchase new equipment in a period where income has been reasonably high. They want to ensure that the income is leveled out with prior periods so that there won't be a spike in some months and dramatic decline in others. Even though they're rearranging the timing of the purchase to best benefit the financial reports,

Facts of the Case Study:

Lone Star Power was a middle power generation and energy distribution company. The new director of the investment company must estimate the amount of financial reporting issues raised by the outside analyst. These questions relate to (1) the recognition of revenue, (2) Consistency of accounting policies, (3) the expense of time, (4) classification of reported items, (5) for additional guidance on the interpretation of the guidelines, and (6) a temporary voluntary disclosure . Using a very simple settings, the case combines questions of financial transparency, financial reporting, SEC reporting requirements, as well as reg. FD disclosure

Yes for the given scenario Earnings management will be applicable

Accounting policies for marketing and promotions include costs as and when they are incurred and for the year 2015 there was sudden increase in Expenses without any change in Promotional Policies there by Loan star Power not following accounting policies uniformly or consistenly

It is not correct on the part of Company to follow different accounting policies,methods as they wish,Booking more expenses in the year without treating as Prepaid Expenses to increase th profits in future years

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