Earnings Management

¶ … Accounting Principles were designed to be flexible in an ever-changing business environment. No two industries are exactly alike in regards to their operations, capital structure, or organization. Likewise, no two companies within the same industry are exactly alike with respect to their overall capital structure and product offering. Accounting principles must account for this disparity with flexibility in application. It is this flexibility however, that allows management to manipulate the financial figures provided to present a rosy scenario. This rosy scenario may or may not reflect economic reality.

It is due to this earnings management, that many companies attempt to hide or otherwise obfuscate the truth regarding company performance. While reviewing the annual report of Patton-Fuller Community Hospital, it appears that management is using aggressive account to hide the overall truth within the operations of the company. Aspect such as inadequate reserving, loosening of credit terms, and dubious inventory accounting appear to mask the true performance of the company (Akers, 2011). To begin, the financial statements are often riddled with management assumptions and beliefs.

These beliefs are usually based on management's beliefs on the future of the business. These beliefs however, can be overly aggressive. The first major question mark regarding management assumptions occurs with the allowance for doubtful accounts line item. The balance sheet reveals a 56% increase in accounts receivable. The line item increased from $38 million in 2008 to $59 million in 2009. Meanwhile revenue only grew 10% over this period. With accounts receivable growing by such a large amount relative to revenue it appears that the company has significantly loosened credit terms for customers.

By providing more favorable credit terms, the company is attempting to entice customers to purchase products now. When customers, realizing the great deal presented today purchase products, they are less likely to purchase product in the future. Therefore, the company is only shifting consumption that would have occurred in a future period, into today. This is particularly troubling as the company experienced large net income losses in both 2008 and 2009 despite its aggressive use of credit. Healthcare is particularly stable.

The industry itself does not experience wide swings in demand like many of the more cyclical industries (autos, retail, etc.). The company appears to be managing to the short-term, but attempting to artificially create demand in an industry that is very predictable and stable. In actuality however, all the company is doing is sacrificing future growth for the present. Even more questionable, even though accounts receivable increased by more than 50%, the allowance for doubtful accounts without the audit adjustment only increased by 3%.

When the audit adjustment is taken into account, the figure rises to 11%. This indicates that the company is not reserving properly against its receivables. Without the adjustment the allowance would have been flat with receivables increasing by 56%. This disparity, even with the audit adjustment is very questionable considering management's assessment of the overall state of the economy. Economy is experiencing a downturn, according to management. With the severe downturn that management indicated in its opening remarks, accounts receivable are less likely to be repaid.

Typically, during a severe economic downturn, unemployment rises as consumers are laid off. This results in less income for the typical consumer. They are now unable to pay for items they could otherwise have purchased while they were working. Many consumers therefore elect to pay for items with debt, savings or a combination of the two. Future uncertainty regarding job prospects for these consumers makes collection of receivables doubtful.

Management through manipulation of this reserve appears to be attempting to temporarily inflate earnings to appear more profitable than they actually are (Schipper. 2011). Expenses are yet another area where management has considerable discretion with respect to assumptions. In the case of PFCH that are being aggressive with expense recognition by underestimating expenses. Much like the reserving example above, but understating expenses, management is attempting to look more profitable than it actually is. With expense recognition however, management must realize it is a zero sum game.

Although expense will be less in the current year, they will only increase by that amount in the future years. Management, by hiding the expense, appears to be hoping for a more favorable operating environment in the future, so they can better conceal the $1,000,000 expense when revenues and profits are higher. By doing this management believes investors won't notice or will not care as revenue and profit are high.

Even more interesting, if the company was allowed to keep the $1,000,000 of expense off its income statement, the company would have reported an increase in net income $600,000 as oppose to an $400,000 loss. It appears that management and executive bonuses are tied directly to how profitable the company is. Leadership attitude towards expense recognition may indicate that management incentives are misaligned with those of the long-term shareholder (Dechow, 2010). Management looking short-term is attempting to manipulate current earnings to receive bonuses, while ultimately mortgaging off the companies future performance.

Management through accounting chicanery only appears to care about immediate performance with their accounting decisions. Therefore, it can be argued that the bonuses received by executives and top management were not warranted nor deserved. It can also be argued that the revenue line item in the financial statements is overstated as well. The annual report states that the company received a $1,000,000 donation. This donation is included as revenue in the "other revenue" line item. The report states that other revenue included donations.

These donations should not be included in revenue as they are non-recurring in nature. By including them in revenue, investors are likely to believe these revenues will continue in the future and are apart of the core operations of the business. However, these donations are not. Management appears to be acting against the best interest of the shareholders of the firm. Of note, the hospitals internal controls over financial reporting were not audited. This brings to question the over quality of the earnings of the firm.

Why didn't the firm ask the auditor to actually audit the internal controls that generate the numbers on the financial statements. This undermines the entire process as investors are unable to verify or believe the numbers reported. This problem is exacerbated given the very aggressive accounting already mentioned above. It appears that none of the numbers within the financial statements can be used to make informed investing decisions with. Further proof of this lack of trustworthy information can be gleamed from management's commentary.

In management commentary, the CEO states that the "…previous years losses were turned in.