ACCT 332 Lecture 11
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Transcript of ACCT 332 Lecture 11
Lecture 11ACCT 332 – Accounting Thought and PracticeACCT 332 Accounting Thought and Practice
Earnings Management
- Chapters 11p- Levitt. The Earnings Game- Cheng and Warfield. Equity Incentives and Earnings
ManagementManagement- Healy. The Effect of Bonus Schemes on Accounting
Decisions
Objectives for Today’s Class
- Tools of Earnings Management
E i M t I ti- Earnings Management Incentives
• Bonus, Debt Covenant, Political Cost
• Healy (1985)
• Beat/Meat Earnings Targets
• Market-based considerations
• Cheng & Warfield (2005)
- Consequences of Earnings Management
• The Blockage Probleme oc age ob e
Definition of Earnings Management
• Scott: Earnings management is the choice (related to accounting policies or accruals) made by a manager that affects earnings sopolicies or accruals) made by a manager that affects earnings so as to achieve some specific reported earnings objective
• Schipper (1989): Earnings management is a purposeful intervention in the external financial reporting process with the intent of obtaining some private gainintent of obtaining some private gain – The importance of exit strategy
How to Manage Accounting Earnings?
•Income Statement Management:
Restr ct ring charges-Restructuring charges
-Revenue recognition
-Allowance for doubtful accounts
-Warranty provisions
-Hedge accounting for derivatives
-Pension plan assumptions
-Capitalization of expenses
••Balance Sheet Management:
-Off-balance sheet financing
-Window dressing at reporting datesg p g
•Real Transactions Management:
-Investment policy, R&D spendingy g
-Marketing spending, sales timing
Why Do Firms Manage Earnings?
-Capital market motivations (premium for meeting analysts’ forecasts or reporting increase in earnings)forecasts or reporting increase in earnings)
-Contracting incentives (covenant hypothesis, compensation contracts)contracts)
-Behavioral biases (managerial overconfidence, self-attribution bias)bias)
Earnings Management Example (1)- Burgstahler and Dichev (1997): Meeting Earnings Targets
Earnings Management Example (2)- Bhojraj et al. (2009): Meeting Earnings Targets
Making Sense of Cents: An Examination of Firms that Marginally Miss or Beat Analysts’ Forecasts (Bhojraj, Hribar, Picconi, and McInnis, Journal of Finance 2009)
Earnings Management Example (3)- Healy (1985): Bonus
• Bonus plan hypothesis: to manage cash bonus • Healy (1985)• Confined to bonuses based on net income• The concepts of bogey and cap
• Evidence of upward earnings managementEvidence of upward earnings management when net income between bogey and cap
• Earnings management measure• Earnings management measure • Healy used total accruals as the proxy
Figure 11.2 Typical Bonus Scheme
us
unt�o
f�Bonu
Amou
B ( ) C (U)Bogey (L) Cap (U)
Reported Net Income
Earnings Management Example (4)- Cheng and Warfield (2005): Equity Incentivesg ( ) y
• Main findings: The incidence of meeting or just beating analysts’ forecasts is positively correlated with equity incentives
Earnings Management Example (5)- Efendi et al. (2007): Equity Incentives
Why do corporate managers misstate financial statements? The role of option compensation and other factors. (Efendi, Srivasta, and Swanson, Journal of Financial Economics 2007Ȍ
( ) y
Earnings Management Example (6): Behavioral Biases
The Bad Side of Earnings Management
• Reduces the reliability and information usefulness of accounting reports.reports.
• Can lead to earnings restatements (why is that bad?)• Lower credibility among investorsLower credibility among investors • Higher cost of obtaining capital (equity or debt)
The Good Side of Earnings Management
• To credibly communicate inside information to investorsinvestors
• Contract violation is costly, earnings management may be low-cost way to work aroundy
Earnings Management- Strategic Aspects of Accounting Policy Choice
• Managers may choose policies to achieve certain objectives.
- Efficient Contracting vs Opportunism- Efficient Contracting vs. Opportunism
- These choices may not provide the best information for investor / creditor decisionsinvestor / creditor decisions.
• Thus, managers care about changes in accounting rules Æ may participate in standard-setting debates Æ Chapters 12 / 13.p p g p
Group Questions
• 40 minutes to complete group questions
• A i t f di i l di• Assignment of discussion-leading groups