Earning Management.......... CA RAJIV SINGH FCA, LIFA(USA),CISA(USA) CO-FOUNDER EXPLICO CONSULTING An idea that delivers …..

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Presentation transcript:

Earning Management CA RAJIV SINGH FCA, LIFA(USA),CISA(USA) CO-FOUNDER EXPLICO CONSULTING An idea that delivers …..

Earnings Management Management Actions to Achieve desired Earnings Level Accounting Choice ABEM Lower the quality of earnings and mislead investors Departure from GAAP Operating decisions or economic earning Management OBEM More costly with respect to future firm Value Departure from normal operating practices

Key Facts about ABEM & OBEM ABEM decreases with stringent investor protection because it is more likely to draw scrutiny by auditor & regulator Managers prefer OBEM over ABEM where investor protection is stronger because auditors and regulators are not interested in operating decisions ABEM & OBEM are restrained when large number of quality analysts follow the company Effects to “Meet or Beat” analyst forecast by ABEM & OBEM have a negative effect on a firm’s future ROA and stock price

Measures of ABEM (i) ABEM 1 = Where S.D. (OI) = Standard deviation of operating Income S.D. (CFO) = Standard deviation of Cash from Operations (ii) ABEM 2 = Where ΔAccruals = Change in Accruals ΔCFO = Change in operating Cash flow r = Correlation Coefficient S.D. (OI) S.D. (CFO) r(Δ Accruals,Δ CFO)

Measures of ABEM (iii) ABEM 3 = Where Accruals = (ΔCA-Δcash-ΔSTL) – ( ΔCL-ΔSTD-ΔTP) – Dep CFO = Earnings – Accruals Absolute Value of Accruals Absolute Value of CFO

Measures of OBEM (i) OBEM 1 = Where Δ Production = Change in Production Cost Production Cost = COGS + Δ inventories Δ Sales = Change in sales (ii) OBEM 2 = Where Δ DE = Change in Discretionary Expenses = Change in selling, general & administrative expenses r(Δ DE,Δ Sales) r(Δ Production,Δ Sales)

Interpretation (i) Lower ABEM1 and ABEM 2 score imply that accounting based EM is used to reduce the variation of earnings and conceal economic shocks to the CFO. (ii) ABEM 3 reflects manager’s behaviour in their attempt to achieve specific earning target. (iii) OBEM 1 measures sales and production manipulation. A lower score indicates sales and production manipulation has been carried out. (iv) If ‘DE’ is used for ‘ÉM’ OBEM 2 value should be lower. A high OBEM indicates that ‘DE’ is rarely managed. A negative correlation indicates high element of EM