What is cookie jar accounting?

1. Nature of cookie "jar accounting"

Cookie jar accounting is an accounting practice of creating excessive accounting reserves in one year and using them to improve earnings in another one.

Cookie jar accounting is related to quality of earnings.  Quality of earnings is an indication of where company’s earnings are coming from.  If the earnings are coming from normal business activities and accepted accounting practices, then the earnings are said to be of higher quality.  Contrary, if earnings are caused by aggressive accounting practices and are not related to management’s actions to improve the bottom line, the earnings are said to be of lower quality.  Cookie jar accounting is a company’s attempt to manage their earnings by using accounting reserves, and it may not result in the good quality of earnings.

Why would somebody use cookie jar accounting?  A good example is a public company that is covered by analysts.  The analysts build expectations about the company’s performance over the next several years.  Say, Company ABC’s earnings are said to be growing 15% each year for the next five years.  Company ABC’s meeting this growth expectation impacts the company’s stock price.  If Company ABC meets the target (e.g. 15% growth), then the company’s stock will most likely grow.  However, if Company ABC does not meet it, then the stock may go down.  Obviously, the company’s management is interested in the stock price increases.

Suppose that during the first three years the company is able to meet the analysts’ expectations, and during the fourth, very favorable year (earnings expected to grow 30%) the management realizes that the fifth year will not be as profitable (earnings expected to grow only 5%) due to a new competitor entering the market with advanced technologies.  In order to smooth the uneven earnings growth between the fourth and fifth years, the company can establish an unrealistically high bad debt reserve (charge to the bottom line) and still meet the analysts’ expectations. During the fifth year, the company can revise its assumptions for the bad debt reserves, create an artificial income by reversing bad debt reserves, and thus, again meet the analysts’ expectations.

Sometimes, companies may also apply cookie jar accounting in a year when they have a net loss. In such a year a company may establish higher bad debt reserves because: a) it has already incurred a net loss and hasn’t met analysts’ expectations that year; and thus, an extra loss would not make “a big difference”; b) the company could reverse its bad debt reserves in the following year to “improve” the company’s earnings by increasing its net income (less bad debt expense) or decreasing its net loss; and c) if the company actually improves its earnings in the following year, the company’s management could “take credit” for taking the situation under control and improving the company’s performance. Of course, some of this “improvement” comes from the bad quality of earnings (i.e. cookie jar accounting).

Different reserves may be used to create cookie jar accounting.  The easiest to use, in such cases, would be “judgmental” reserves, where it’s hard to establish one level of reserve without significant management assumptions.  Such reserves may include bad debt reserves, warranty accruals, legal reserves, etc.

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