Chapter 11

Nicole GagnierSarah King

Fanny KwanBettina Reyes

Earnings Management

Outline

IntroductionPatterns of Earnings

Management

Evidence of Earnings

Management for Bonus Purposes

Other Motivations for Earnings Management

The Bad Side of

Earnings Management

The Good Side of

Earnings Management

Conclusion

Introduction

Earnings Management is: The choice by a manager of accounting

policies, or actions affecting earnings, so as to achieve some specific reported earnings objective. (textbook)

The manipulation of a company’s financial earnings either directly or through indirect accounting methods. (www.investorwords.com)

Referring to accounting practices that may follow the letter of the rules of standard accounting practices, but certainly deviate from the spirit of those rules. (www.wikipedia.org)

Introduction

Earnings management includes both:

1) Accounting policy choice (indirect) Choice of accounting policy includes

revenue recognition, amortization, etc. but also discretionary accruals

2) Real actions (direct) Real variables such as advertising, R&D,

maintenance, timing of purchases and disposals of capital assets

Introduction

The Iron Law of Accruals Reversal: Accruals always reverse.

Managing earnings upwards will force future earnings downwards

Even more earnings management is needed to postpone losses

Result: Earnings management cannot indefinitely postpone a firms day of reckoning

Introduction

The Financial Reporting and Contracting Perspectives of Earnings Management:

Financial reporting perspective: To meet analyst’s earnings forecasts or To report a stream of smooth and growing

earnings over time

Contracting perspective: To protect the firm from the consequences of

unforeseen events when contracts are rigid and incomplete

Patterns of Earnings Management

Taking a BathIncome MinimizationIncome MaximizationIncome Smoothing

Taking a Bath

Common during periods of organizational stress or reorganization

Mindset: If we report a loss, might as well report a large one Write-off assets Provide for future costs

This enhances probability of future reported profits due to accrual reversal

Income Minimization

Similar to Taking a Bath but less extreme

Practised during periods of high profitability

Policies include: Rapid write-offs of capital assets and

intangibles Expensing of Advertising and R&D

expenditures Other incentives include income tax

consideration

Income Maximization

Pattern may be chosen for bonus purposes

Firms may also maximize income if close to debt covenant violation

Income Smoothing

Chosen by risk-averse managers Incentives to choose this pattern

include: Avoid covenant violation that may occur

from a volatile stream of reported Net Income

Reduce likelihood of reporting low earnings For external reporting purposes

Motivations to Earnings Management

Healy’s Bonus Schemes Theory

CapBogey

Reported Net Income

Am

oun

t of

Bon

us

①

②

③

Managing Net Income....

Net income = Cash flow from operations ± net accruals

Net accruals = ± net non-discretionary accruals ± net discretionary

accruals

Evidences on Healy’s theory

McNichols and Wilson Actual bad debts provision Vs. Precise

estimate of what the bad debts allowance should be

Discretionary accruals = difference of the two

Results: Significant discretionary bad debt for those years

that the firms were very unprofitable and those that were profitable

Lower discretionary bad debt in between bogey and cap

Healy’s Bonus Scheme Theory Revisit

CapBogey

Reported Net Income

Am

oun

t of

Bon

us

①

②

③

Evidences on Healy’s Theory

JonesLooked at 3 types of managers:

Zero bonuses Didn’t use accruals0 < bonus < Max. > Max.

Other Motivations to Earnings Management

Other Contracting Motivations

Earnings Management is used to reduce the probability of covenant violation in debt contracts

Investigated by Sweeny and DeFond & Jiambalvo Findings include:

Firms tend to adopt new accounting standards when the policy increases reported net income (vice versa)

Evidence of the use of discretionary accruals to increase reported income

Other Motivations to Earnings Management

To Meet Investor’s Earnings Expectations and Maintain Reputation

Firms that report earnings greater than expected enjoy share price increase

Conversely, firms that fail to meet expectations suffer a significant share price decrease Investors should be aware of this incentive

Other Motivations to Earnings Management

Initial Public Offerings (IPOs)

Managers of firms going public may manage the earnings reported in their prospectuses in the hope of receiving a higher price for their shares

Many IPO firms manage their earnings upward Lower earnings contribute to poor share performance

Bad Side of Earnings Management

Opportunistic earnings management

Maximizing their bonuses Raising new share capital

Maximizing the proceeds from the new issue Frequent recording of non-recurring items

Do not affect manager bonuses Do not take away from the ability to meet earnings forecast Increases future core earnings which the manager is being

evaluated

Good Side of Earnings Management

UnBlocking Communication Blocked communication concept by Demski

and Sappington Managers have insider information Public wants credible way to be informed

Using Earnings Management to Unblock Communication

Good Side of Earnings Management

Stocken and Verrecchia Benefit of Revealing Insider Information must

out way the costs When net income is adjusted through earnings

management it can no longer effectively predict future performance

Manager will be held responsible for excessive earnings management

Earnings Management is good when the firm’s environment is volatile and there is lots of

insider information.

Good Side of Earnings Management

Efficient Market Expectation Rational expectations of the market

understand earning management incentives and compensate accordingly

Therefore irresponsible not to manage earnings Many different studies have come up with different

results on the truth behind these statements

From the evidence it can be concluded that earnings management can both inform

investors and enable more efficient contracting.

Conclusion

Implications for Accountants: To reduce bad earnings management improve

disclosure: Clear reporting of revenue recognition policies Detailed descriptions of major

discretionary accruals Reporting the effects on core earnings

of previous write-offs Diagnosing low persistence items

Bringing bad earnings management into the open will reduce manager’s ability to bias the financial statements

Conclusion

The Effect of Improved Disclosure:

Share prices would more closely reflect fundamental firm value

Easier to assess management stewardship

Social welfare would increase

Conclusion

Financial reporting represents a compromise between the needs of managers and investors:

Managers want flexibility of accounting choice: Ability to react to unanticipated state realizations

when contracts are rigid and incomplete Vehicle for credible communication of inside

information to investors (can be useful) Smooth compensation over time

However, it reduces reliability for investors: Earnings power may be persistently overstated (at

least temporarily)

Whether earnings management is good or bad depends on how it is used

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