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Internal auditors can help organizations avoid the risks associated with inappropriate earnings management by understanding the symptoms and sharing their knowledge.
FINANCIAL MARKETS REWARD
companies with steadily growing income streams. However, when operating results are disappointing or uneven from quarter to quarter, the pressure on chief financial officers and controllers to fabricate or "smooth" earnings can be intense. The plethora of recent financial frauds in the United States bears witness to the harm that can come when financial executives give in to such temptation.
Studies consistently show that more frauds are uncovered by employee tip-offs than by any other means. Internal auditors can help their organizations manage the potentially catastrophic risk of fraudulent financial reporting by understanding the most common methods of earnings management and by sharing this knowledge with employees - who occupy positions where they might see, but not necessarily recognize, the symptoms.
COOKIE JAR RESERVES
"Cookie jar" reserves - sometimes labeled general reserves, rainy day reserves, or contingency reserves --enable companies to beat earnings estimates by a controlled amount no matter how the business actually performs. In periods of strong financial performance, cookie jar reserves enable companies to reduce earnings by overstating reserves, over-- accruing expenses, and using one-time write-offs. In periods of weak financial performance, cookie jar reserves can be used to increase earnings by reversing accruals and reserves to reduce current period expenses. This accounting strategy obviously misleads investors.
The most prominent example of the use of cookie jar reserves is WorldCom Inc. In August 2002, an internal review revealed improperly booked items that totaled roughly $2.5 billion. Some of these related to a series of so-called reserve reversals, which are funds that companies typically set aside to cover the estimated cost of a future event. Once the cost is incurred, any additional funds can be reversed back into earnings. Reserves at WorldCom related to litigation, uncollectible receivables, and taxes.
BIG BATH CHARGES
"Big bath" charges are one-time restructuring charges. Current earnings will be reduced by over estimating these one-time charges. By reversing the excessive reserve, future earnings will increase. For example, the U.S. Generally Accepted Accounting Principles (GAAP) require a company, in year one, to estimate the costs it will eventually incur in the restructuring for severance...