Earnings Management with Accruals and Financial Engineering

When a business suffers from unsuccessful competitive strategies, poor products, or pricing disadvantages, it generally tends to suffer a steady erosion of corporate value and credit quality, but no abrupt death. By contrast, revelation of large-scale earnings manipulation usually results in a quick and abrupt failure of the corporation, often in a span of just weeks or months. Thus the sudden and spectacular failures of once-admired and powerful companies like Enron Corp. and WorldCom, Inc. clearly point to large-scale earnings manipulation and fraud rather than business causes as the culprit. In the wake of these corporate disasters, investors and managers are trying to understand whether there is widespread Enron-like manipulation of financial results among corporations or whether the recent corporate scandals are just an aberration. A related issue for financial analysts, investors and corporate executives is how to distinguish between earnings manipulation that ultimately proves to be fraudulent and the day-today struggles of managers to keep costs within budgets or to get revenues to meet desired sales targets. A closer examination of the types of financial engineering techniques used by Enron and others in recent accounting scandals gives us several useful pointers and lessons to understand the differences between fraud and earnings management. In particular, the financial engineering techniques used by the Enron and other companies are fundamentally different and more complex with respect to their impact on financial statements than the traditional earnings management techniques observed in past