The comparative balance sheet of JSA Ltd. at June 30, 2013, is as follows — Calculate various accruals item- by- item basis For each accrual indicate extent

The comparative balance sheet of JSA Ltd. at June 30, 2013, is as follows:

.:.

Required

a. Calculate the various accruals on an item- by- item basis. For each accrual indicate the extent to which that accrual may contain a discretionary component and briefly explain why.

b. Briefly describe two other ways that researchers have used to estimate discretionary accruals.

c. A manager, whose bonus is related to reported net income, finds that net income for the year (before bonus) is below the bogey of the incentive plan. What type of earnings management might the manager then engage in? Which of the accruals in part a would be most suitable for this purpose? Explain.

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SOLUTION:

The various accruals for JSA Ltd. are as follows:
Add back to	Add back to	Deduct from
net income	net income	net income
- Depreciation and amortization.	$14
Mainly non-discretionary, since method
of amortization and useful lives fixed
by policy. However, manager has some
discretion to change policy on occasion.
- Reduction of liability for future income tax		$6
Non-discretionary, except to extent that
manager controls depreciation and
amortization policy.
- Provision for reorganization, layoffs		12
Discretionary, to the extent manager controls
amount and timing.
- Increase in accounts receivable		16
May be driven by increased level of
business activity. However, manager
has considerable discretion over allowance
for doubtful accounts and some discretion
over revenue recognition, credit and
collection policy.
- Decrease in inventories.	18
May be driven by lower level of business
activity, but seems unlikely since accounts
receivable have increased. Manager has

considerable discretion over valuation of obsolete, used or damaged items. Also, under lower-of-cost-or-market rule, manager has discretion over amounts of writedowns.

- Increase in prepaid expenses.										1	1	1	1
Considerable discretionary component
since manager controls capitalization
policy for many of these.
- Decrease in accounts payable.										7	7	7	7
May be driven by lower level of business
activity. However, manager controls amounts	activity. However, manager controls amounts	activity. However, manager controls amounts	activity. However, manager controls amounts	activity. However, manager controls amounts	activity. However, manager controls amounts	activity. However, manager controls amounts	activity. However, manager controls amounts	activity. However, manager controls amounts
and timing of purchases and payment policy.	and timing of purchases and payment policy.	and timing of purchases and payment policy.	and timing of purchases and payment policy.	and timing of purchases and payment policy.	and timing of purchases and payment policy.	and timing of purchases and payment policy.	and timing of purchases and payment policy.	and timing of purchases and payment policy.
Also, considerable discretion to extent
accounts payable includes accrued liabilities.	accounts payable includes accrued liabilities.	accounts payable includes accrued liabilities.	accounts payable includes accrued liabilities.	accounts payable includes accrued liabilities.	accounts payable includes accrued liabilities.	accounts payable includes accrued liabilities.	accounts payable includes accrued liabilities.	accounts payable includes accrued liabilities.
- Increase in customer advances.	5	5	5	5	5	5	5	5
Largely non-discretionary, although
manager may influence number and
amounts of advances.
- Decrease in current portion of long term debt.										1	1	1	1
Non-discretionary, since fixed by contract.	Non-discretionary, since fixed by contract.	Non-discretionary, since fixed by contract.	Non-discretionary, since fixed by contract.	Non-discretionary, since fixed by contract.	Non-discretionary, since fixed by contract.	Non-discretionary, since fixed by contract.	Non-discretionary, since fixed by contract.	Non-discretionary, since fixed by contract.
- Increase in current portion of future income
tax liability.	1	1	1
Non-discretionary, since income tax
act specifies.
	$50	$50							$31	$31	$31
		31
Net income-decreasing accruals	$19	$19
Check:
Net income	$(12)	$(12)	$(12)	$(12)
Net income-decreasing accruals	19	19	19	19
Cash flow from operations	$7	$7	$7	$7
b. i)	Use the Jones model, which is a regression equation to estimate non-discretionary accruals after allowing for the (non-discretionary) levels of business activity and capital investment. Once the regression model is estimated, use it to predict current period total accruals Discretionary accruals are then taken as the difference between this estimate and total accruals.
ii)	Use total accruals, since total accruals contain discretionary accruals.
c.	The manager may take a bath, by recording impairment writedowns for investments in capital assets and recording liabilities for future costs such as reorganization and layoffs. This will reduce reported net income this year, but the probability of high net income in future years is increased, since future amortization charges will be lower and future payments for reorganizations and layoffs can be charged against the liabilities rather than against future net income.

Furthermore, if the writeoffs and liabilities turn out to be higher than actually needed, the excess amounts can be reversed into future years’ operations. However, a tactic of deliberately overstating writedowns and provisions may not be desirable since accounting standards now prohibit such overstatements. This could result in restatements of previous financial statements and, quite possibly, lawsuits and charges from securities regulators.

Alternatively, the manager may income maximize, so as to increase net income above the bogey. However, this tactic is unlikely to be used unless pre-bonus earnings are only slightly below the bogey.

Obviously, the most suitable accruals above are those with the greatest discretion, and relative invisibility. To lower reported net income, these include maximization of accrued liabilities, more conservative revenue recognition, minimization of prepaid expenses, the allowance for doubtful accounts, and inventories. The effect on net income of these tactics may not be enough to achieve the big bath objective, however. Changes in amortization policy and useful life estimates of capital assets are possibilities. However, they are quite visible and could not be used very often. The most likely accrual is providing for reorganizations and layoffs. However, in view of current accounting standards concerning such special items, the manager would have to be careful not to overstate them.