Red Flag and accounting warning

CFA Level I FRA
#1

Hello Everyone,

Please help me with the following:

What is aggressive pension plan assumptions?

how they contribute in fraud?

Thanks

#2

Aggressive accounting practices, in general, are those that result in higher net income in the current period and lower net income in the future. They increase current revenues or decrease current expenses.

Thus, aggressive pension assumptions will reduce current pension expense:

  • Low salary growth rate
  • High discount rate
  • High expected return on plan assets
  • Short employee lifespan
  • and so on

If the assumptions are unjustifiably aggressive, they’ll way overstate current earnings, to which management bonuses may be tied, for example.

#3

There’s some really nice work on earnings management via pension assumptions by Joshua Ruah. He finds that aggressive pension assumptions “seem to be more prevalent” when firms are just at the bubble (i.e. zero eps, close to last year’s eps, just below consensus forecasts, etc…).

It’s almost like managers were gaming the system :wink:

#4

Almost.

#5

Thanks Magician.

Please also explain how LIFO liquidation and less CFO falling short of net earnings will flatten earnings.

Thanks