Income smoothing: management consequences and auditor responsibilites in the case of Beazer Homes.

Schneider, Gary P. ; Sheikh, Aamer ; Simione, Kathleen 等

CASE DESCRIPTION

The primary subject matter of this case concerns auditor responsibilities when their clients engage in earnings management to achieve income smoothing. Secondary issues examined include internal controls, the accounting for sale-leaseback transactions, the impact of Sarbanes-Oxley (SOX), and the role of industry-level risk assessment in audit planning. The case requires students to access and review U.S. Securities and Exchange Commission (SEC) documents filed by and regarding Beazer Homes USA, Inc. The case has a difficulty level of four or five and can be used in either undergraduate or graduate auditing courses. The case can also be used in advanced financial accounting, financial statement analysis, or accounting research courses in accounting masters degree programs. The case is designed to be taught in two class hours and is expected to require four hours of outside preparation by students.

CASE SYNOPSIS

This case provides students with a real world example of alleged income smoothing and its consequences. Students learn how earnings were allegedly manipulated, why they were allegedly manipulated, and what the ultimate results of these alleged tactics were for the company. They are asked to analyze the earnings management techniques used and identify ways in which the auditors might have identified the activity and how their audit planning could have been modified given the industry-specific risks and the requirements of SOX. The case raises issues related to internal controls, auditor responsibility and professional and ethical principles and standards.

INSTRUCTORS' NOTES

RECOMMENDATIONS FOR TEACHING APPROACHES

This case can be used as the basis for classroom discussion or to motivate a written report. In either case, the questions are direct and elicit fairly specific information as part of the discussion. The information students need to find is located in several U.S. Securities and Exchange Commission (SEC) documents that are referenced in the case. Annual reports and proxy statements can be found on the Beazer Homes USA, Inc. (Beazer Homes) Web site.

Students will need a level of understanding of financial statements that generally obtains on the completion of two semesters of intermediate financial accounting. They should also have some understanding of audit planning and audit risk assessment. These knowledge and skills are typically obtained in the first part of an introductory course in auditing. Since the case requires students to access and read SEC documents, professional standards, and information about the company, it can be used effectively in an accounting research course at the senior undergraduate or graduate levels.

Questions in the case can be discussed in a general class session, with all students participating, or they can be individually assigned to student teams, who can prepare a presentation of their proposed answers as a springboard for full class discussion.

QUESTIONS FOR DISCUSSION (WITH SUGGESTED ANSWERS)

1. Did the company, its independent audit firm, or any of its officers, other than the CAO, face consequences as a result of the company's settlement with the SEC?

A comparison of the executive officers listed on pages 15-16 of Beazer's September 30, 2006 Form 10-K with the listing of executive officers available on pages 113-114 of the September 30, 2007 Form 10-K reveals that the Chief Executive Officer (CEO) and the Chief Operating Officer (COO) are the same. All the other officers appear to have been replaced.

This question could serve as the starting point for a discussion of what the consequences of earnings management should be compared with what they typically are. Chokkavelu (2008) reports that in November 2006, before the accounting issues came to light, the CEO sold $7.7 million worth of Beazer common stock. When given this information, some students might argue that the CEO should be fired or should resign. Others may argue that firing the CAO, especially in this case, is sufficient punishment.

In 2007, a class-action lawsuit was filed on behalf of people who bought Beazer common stock between January, 2005 and May, 2008. The lawsuit alleged that the company and its executives made false statements about its business that caused shareholders to be misled about the company's prospects and invest in the company. The lawsuit named the company, the top managers of the company, and the company's independent audit firm, Deloitte & Touche, LLP. The defendants agreed to settle the case in 2009 out of court, and without admitting any wrongdoing, for $30.5 million. The bulk of the settlement was paid by the Beazer's insurance provider, but $950,000 of the settlement was paid by the audit firm (Reuters, 2009).

You could lead a discussion of this question toward raising broader issues of corporate governance, such as the question of who really wields the power in our system of corporate governance. Is true power in the hands of managers (the officers of the corporation) or the shareholders? For further reading, the instructor may want to refer students to Monks and Minnow (2008) and Rezaee (2009). Students that take the view that managers exercise more power than shareholders will find Bebchuk and Fried (2004) to be an interesting book.

2. Why did Beazer Homes' management fire their CAO for destruction of documents rather than for carrying out the alleged accounting irregularities?

Any answer to this question is going to require speculation, but good answers would include one or more of the following: (1) At the time management wanted to remove the CAO from his position, the exact nature and extent of the accounting issues had not yet been identified, (2) destruction of documents is a more tangible activity and one that the company would find easier to prove, or (3) the company wanted to fire the CAO, but did not want to use a reason that could later be used to establish a legal cause of action against the company itself (which would be the case with any allegations of specific accounting improprieties).

3. Most auditing textbooks outline procedures for identifying accounting irregularities that overstate income, such as recording revenue from fictitious sales. How are the alleged earnings manipulation schemes at Beazer different from the irregularities you have discussed in your auditing classes?

Most auditing students have heard of companies where earnings were managed upwards to portray the company as being more profitable than it was or where outright fraud, such as the recording of revenues from fictitious sales, was committed. Most students are not, however, familiar with income smoothing, which is what the SEC alleged was occurring at Beazer Homes.

4. What are the most likely reasons that Beazer engaged in the alleged accounting irregularities?

The most likely reason to engage in this would be to meet or exceed the expectations of Wall Street analysts for quarterly and annual net income and earnings per share (EPS). This is the explicit reason referenced by the SEC on pages 3-4 of its Administrative Proceeding (SEC, 2008).

At this point, it would be useful to ask students about common incentives managers might have for manipulating earnings, then ask whether any of those incentives existed at Beazer Homes. Accounting researchers have identified two broad reasons that managers engage in earnings management or fraud, valuation and contracting (see Watts and Zimmerman, 1986 and Lev, 2003 for details). Corporations manage earnings to meet or beat analyst forecasts of EPS since these forecasts serve as inputs into valuation models used to price these companies. Research has established that the share price of companies that miss analyst forecasts, even by a small amount, decline drastically on the news that their actual EPS fell short of what Wall Street was expecting.

The other main incentive for managing earnings is that accounting numbers are used in contracts such as loan agreements, and executive compensation contracts etc. If students look at the proxy statements of Beazer Homes, they will see that accounting numbers are, in fact, used in their executive compensation contracts. This could provide another strong incentive for managers at Beazer to manipulate earnings. You can refer students to Lev (2003) and Weil (2009) for background reading on the compensation contracts issue.

5. Is it possible to identify a pattern of earnings management in Beazer's restated earnings?

Yes, income smoothing is most clearly evident in the fiscal 2005 and fiscal 2006 restatements. Restated fiscal 2006 net income was about five percent lower (from $389 million to $369 million) and restated fiscal 2005 net income was about five percent higher (from $263 million to $276 million). Thus, it appears that Beazer had smoothed its income by recognizing fiscal year 2006 expenses in fiscal 2005, which increased fiscal 2006 net income.

6. Did the passage of the Sarbanes-Oxley Act of 2002 appear to have any impact on the alleged accounting manipulations at Beazer Homes?

Apparently not. Section 302 of the Sarbanes-Oxley Act requires the principal officers (typically interpreted as those officers whose title begins with or includes the word "Chief) to certify that the financial statements accurately portray economic reality. Also, section 402 of the Act requires the senior financial officers to follow a Code of Ethics to ensure that financial statements are an accurate reflection of economic reality. If students look at the annual reports of Beazer Homes during the period from 2002 through 2006, they will find that the CEO and CAO both certified the financial statements even though the SEC alleged the company was managing its earnings throughout that time period.

7. Why did Beazer's independent auditor raise concerns over the accounting for the sale-leaseback transactions that had written side agreements giving Beazer an interest in the appreciation of the model homes it sold and leased back?

In a sale-leaseback transaction, the owner of the asset sells it to a third party and then leases it back. The original owner may be referred to as the seller-lessee, while the new owner is typically referred to as the buyer-lessor. Current accounting rules state that for a transaction to be accounted for as a sale and leaseback, the seller-lessee must not have any "continuing involvement" in the sale-leaseback transaction (SFAS 98, see also SFAS 66). If any such "continuing involvement" exists, then the transaction cannot be recorded as a sale. Instead, the transaction is to be recorded as a financing (borrowing) transaction.

An example of "continuing involvement" that is explicitly stated in SFAS 98 is "the buyer-lessor is obligated to share with the seller-lessee any portion of the appreciation of the property" (SFAS 98, Paragraph 13). Beazer Homes entered into sale-leaseback arrangements for a number of its model homes. According to the SEC, by the end of fiscal year 2006, Beazer had increased the number of model homes that it leased back to approximately 70 percent of all of its model homes, up from approximately 30 percent in prior years. Moreover, Beazer (the seller-lessee) required the third party buyer-lessor to share in any portion of the appreciation of the model home. This qualifies as a "continuing involvement" under SFAS 98, and thus recording these transactions as sale-leasebacks violates GAAP.

Of course, Beazer is alleged to have worked around the auditor's stipulation by making the side agreements that provided the continuing involvement oral instead of written and then hiding their existence from their auditor.

8. What could the independent auditors have done to detect the alleged earnings management at Beazer Homes?

Regarding the land inventory accounts, the auditors could have dug deeper into the details of the inventory accounts and thus discovered the negative balances. Regarding the sale-leaseback transaction accounting, it appears that the auditors did alert Beazer's management to a possible GAAP violation. However, according to the SEC, Beazer's management made sure that all references to Beazer's participation in the model homes' appreciation (the prohibited "continuing involvement") were omitted from the written sale-leaseback agreements. The auditors based their conclusions on these written agreements, and since they did not include any indication of "continuing involvement" concluded that sale-leaseback was an appropriate accounting treatment.

According to the SEC, Beazer entered into oral side agreements that gave it a share of any price appreciation. It would be very difficult for the auditors to have discovered the existence of these oral side agreements. The auditors would have had to question the third parties directly and the third parties would need to have been honest with the auditors.

Given the issues with income smoothing in this case, it is worth considering whether audit firms train their staff to be aware of income smoothing and give them specific guidance in how to identify it when conducting an audit. Akers et al. (2007) surveyed the top 100 accounting firms and found that most of these firms do not have formal training courses that address the topic of earnings management. The survey focused on how audit firms train staff to identify abusive earnings-management practices. When Akers et al. (2007) reviewed the continuing education courses offered by each of the state CPA societies (including Washington, D.C.) and the AICPA, they found that of the 52 organizations, 34 did not offer courses with earnings management content. The other 18 offer a combined total of eight courses that include earnings management topics. Only three of those 18 courses were focused on revenue recognition and dealt with earnings management issues.

It appears that the pervasiveness of earnings management is not convincing audit firms (or the providers of continuing education programs for audit firms) to educate and train their staff regarding the issue. Class discussion could include exploring possible reasons why audit firms do not appear to train their staff in this area.

9. What specific audit standards apply to earnings management and what is the auditor's responsibility under those standards?

The auditor has responsibilities for detecting earnings management under SAS 53, SAS 82 and SAS 99. The auditor is responsible for planning and performing the audit in a manner that yields reasonable assurance that the financial statements are free of material misstatement, even if that misstatement is caused by fraud. SAS 82 provides specific guidance to auditors to help them detect material misstatements resulting from fraud.

10. What were the specific effects on the financial statements of the restatements to which Beazer agreed?

Beazer restated its financial statements to reflect adjustments for fiscal 1998 through 2006, as well as the first two quarters of fiscal 2007. Beazer restated its fiscal 2006 net income from $389 million to $369 million (a reduction of $20 million or five percent). Beazer also restated its fiscal 2005 net income from $263 million to $276 million (an increase of $13 million or five percent) and increased its beginning retained earnings for fiscal 2005 by $34 million (from $742 million to $776 million or five percent) to reflect the cumulative effect of adjustments for fiscal 1998 through fiscal 2004. Finally, Beazer also restated its net loss for the first quarter of fiscal 2007 from $59 million to $80 million (an increased loss of $21 million or 36 percent), and its net loss for the second quarter of fiscal 2007 from $43 million to $57 million (increasing the reported loss by $14 million or 33 percent).

11. Some accounting researchers have argued that companies in some industries might be more likely than companies in other industries to engage in income smoothing. Do you believe that companies in the home building industry would be more likely tempted to engage in income smoothing? If so, explain why. Also outline how a higher likelihood of firms engaging in income smoothing should affect audit planning.

Income smoothing is especially tempting to an industry that is highly vulnerable to business cycles. The home building industry is certainly such an industry. The section of the case that outlines the past two decades of the home building industry contains several suggestions that this industry reacts strongly to changes in the general economy and to specific conditions that affect business in the industry itself. Pincus and Shivaram (2002) found that managers of oil and gas producing firms manage residual earnings volatility by using abnormal accruals to smooth income.

Auditors should evaluate whether a particular client is in an industry that is highly volatile with respect to changes in the business cycle. Clients in such industries will be tempted to a much greater degree than other clients to engage in income smoothing earnings manipulations. This will increase the level of inherent risk for these clients. Audit plans should identify likely areas for such manipulation and the study and evaluation of internal control in those areas, as well as the extent of substantive testing in those areas, will be affected by the overall increase in the inherent risk of irregularities for these clients. You can lead the discussion of this question in the direction of SAS 42 and the assessment of risk and how the audit can be designed to achieve an acceptable level of achieved audit risk.

REFERENCES

Akers, M., D. Giacomino, and J. Bellovary. (2007). Earnings management and its implications: Educating the accounting profession. The CPA Journal, 77 (8), 64-68.

American Institute of Certified Public Accountants (AICPA). (2003). Summary of the Sarbanes-Oxley Act of 2002. http://thecaq.aicpa.org/Resources/Sarbanes+Oxley/ Summary+of+the+Provisions+of+the+Sarbanes Oxley+Act+of+2002.htm, Retrieved on June 18, 2009

Bebchuk, L. and J. Fried. (2004). Pay without performance: The unfulfilled promise of executive compensation. Cambridge, MA: Harvard University Press.

Chokkavelu, A. (2008). Worst stock for 2008: Beazer Homes. Motley Fool. January 14. Retrieved on June 15, 2009 from: http://www.fool.com/investing/value/2008/01/ 14/worst-stock-for-2008-beazer-homes.aspx.

Financial Accounting Standards Board. (1988). Accounting for Leases: Sale-leaseback transactions involving real estate, sales-type leases of real estate, definition of the lease term, and initial direct costs of direct financing leases. Statement of Financial Accounting Standards (SFAS) No. 98. Norwalk, CT: FASB.

Financial Accounting Standards Board. 1982. Accounting for sales of real estate. Statement of Financial Accounting Standards (SFAS) No. 66. Norwalk, CT: FASB.

Lev, B. (2003). Corporate earnings: Facts and fiction. Journal of Economic Perspectives, 17: 27-50.

Monks, R. and N. Minow. (2008). Corporate governance. 4th edition. Chichester, West Sussex, England: Wiley.

Pincus, M. and R. Shivaram. (2002). The interaction between accrual management and hedging: Evidence from oil and gas firms. Accounting Review, 77(1), 127-160.

Reuters. (2009). Beazer settles class-action suit. May 5. Retrieved on September 12, 2009 from: http://www.reuters.com/article/ marketsNews/idUSN0550714420090505

Rezaee, Z. (2009). Corporate governance and ethics. Hoboken, NJ: Wiley.

Securities and Exchange Commission (SEC). (2008). Beazer Homes USA, Inc., Administrative Proceeding 33-8960, September 24. Retrieved on June 15, 2009 from: http://sec.gov/litigation/admin/2008/33-8960.pdf

Securities and Exchange Commission (SEC). (2009). Complaint 21114. Beazer Homes USA, Inc. July 1. Retrieved on July 5, 2009 from: http://www.sec.gov/litigation/complaints/ 2009/comp21114.pdf

Watts, R., and J. Zimmerman. (1986). Positive Accounting Theory. Englewood Cliffs, NJ: Prentice-Hall.

Weil, R. (2009). Quality of earnings and earnings management: A primer for audit committee members. New York: American Institute of Certified Public Accountants.

Gary P. Schneider, Quinnipiac University

Aamer Sheikh, Quinnipiac University

Kathleen Simione, Quinnipiac University