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AC 420 Assignment 1: Earnings Management
In this exercise, we are interested in whether detection of earnings management is possible. The Security
and Exchange Commission (SEC) was created to protect investors, and part of their mission is to prevent
securities fraud. The SEC issues press releases highlighting recent actions
.
Some press releases disclose accounting frauds that have been perpetrated by a firm. For example, here is
a press release for Weatherford International, which inflated earnings by using deceptive income tax
accounting .
Data provided to you: You will receive a press release from the SEC. This company is known to have
conducted revenue recognition related accounting fraud.
Required:
1. Data collected by you: You will need to access the SEC Edgar Database
Find the appropriate quarterly
report (10-Q) and annual report (10-K) and collect the relevant data.
2. Describe the business operation of your company.
3. Who are the top executives of the firm? (Please provide pictures if possible).
4. Do the managers seem to have incentives to engage in earnings management?
5. Describe the fraud perpetrated and the fraud period.
6. You will need to perform the ratios analysis (include all ratios discussed in the class from both the
Accounts Receivable and Unearned Revenue) for the firm for all of the quarters that earnings
management has occurred according to the SEC report. Collect 8 quarters (e.g. 2 years) of pre-
fraud data, fraud period data, and 4 quarters of post-fraud data. Discuss which ratios could possibly
indicate any fraud and which ones do not.
a. In this section, please have 4 quarters of ratios before the fraud available; fraud period; and
4 periods after. Clearly label all graphs (as seen in example below).
7. After the fraud was discovered, what happened to the managers who engaged in the fraud?
8. After the fraud happened, what happened to the firm?
Common Issues:
(1) Cannot find unearned or deferred revenue.
a. Sometimes, unearned revenue is buried within “accrued expenses” in the current liabilities
section. You can use “accrued expenses” as a very rough proxy for unearned revenue. For
some firms, they will disclose deferred revenue in the footnotes of the 10-K but not the 10-
Q. You can still use the “accrued expenses.” After all, it is just a proxy.
(2) Cannot find the number of employees in 10-Qs.
a. You should use the number of employees that appear in the 10-K and assume that the
number of employees didn’t change for the year. For example, if 2023 10-K has 1,000
employees, then for the Q1, Q2, and Q3, assume that the company has 1,000 employees.
(3) Should we use the original 10-K/Q or restated 10-K/Q?
a. You should use the original data because those are the data that have been manipulated.
Moreover, at the time of investigation, you would not have access to the restated 10-K/Q,
which would often occur one to two years later than the reporting period.
(4) Some years have no data.
a. Scenario 1: Have all available data for all periods. No adjustments necessary.
b. Scenario 2: Firms did not always report data in the pre-fraud period. In this case, take a
screen shot of the SEC Edgar database to show the NT-10Q or NT-10K’s, and explain why
you cannot compute ratios for certain time period. (see below).
c. Scenario 3: Firms went bankrupt and there is no post-fraud period data. In this case, discuss
this in presentation.
(5) Cannot find information on some executives.
a. Some executives will not be persecuted (think Robert S. Vater, the CEO of Orthofix). If
you don’t find any information after an exhaustive search, it might be that your CEO was
not indicted on any charges.
Deliverables:
One submission per group:
1. Via Blackboard, Excel spreadsheet of the 10-Q/10-K data that you have collected along with
relevant ratios calculated
2. Via Blackboard, PPT or PDF of your presentation. Please name your document “Section
Company” e.g. “A1 ComScore.”
3. Via Google Sheets, fill in whether you can detect earnings management using these ratios (Yes,
No, Maybe) and fill in the consequences for your executives and consequences for the firm (Fine,
bankruptcy, delist).
4. Please make sure that your submission has your group member names in alphabetical order.
5. In class, prepare a 5-10 minute presentation on your findings.