Chapter 11: Earnings Management Matthew Blostein Michael Choi Kurtis Holmes Eric Martin Trevor Stickl

Earnings Management Overview Defined as: The choice by a manager of accounting policies, or real actions, affecting earnings so as to achieve some specific reported earnings objective Understanding of Earnings Management is important as it enables an improved understanding of the usefulness of net income, both for reporting to investors and for contracting

Patterns of Earnings Management Taking a Bath Income Minimization Income Maximization Income Smoothing

Taking a Bath Usually takes place during periods of organizational stress or restructuring. The main idea is that if a firm is to report a loss, managers may feel it might as well report a large one as it has little to lose. Large write-offs but future earnings “in the bank”.

Income Minimization Similar to taking a bath but less extreme. Usually a politically visible firm chooses this pattern during periods of high profitability. (Example: United States vs. AT&T) Income minimization includes rapid write-offs of capital assets, and intangibles, and the expensing of advertising and R&D expenditures.

Income Maximization Managers engage in a pattern of maximization of reported net income for bonus purposes, so long as it does not put them above the cap. A firm close to a debt covenant violation may use this strategy.

Income Smoothing First, Risk-adverse managers prefer a less variable onus stream, other things equal. Consequently, managers may smooth reported earnings over time so as to receive relatively constant compensation. Efficient compensation contracting may exploit this effect, and condone some income smoothing as a low-cost way to attain the manager’s reservation utility. Second, when considering covenants in long-term agreements, the more volatile the stream of reported net earnings, the higher probability that covenant violation will occur.

Income Smoothing Cont. Third, managers may feel as if they will be fired when earnings are low, income smoothing reduces the likelihood of reporting low earnings. Finally, firms may smooth reported net income for external reporting purposes. If used responsibly, smoothing can convey inside information to the market by enabling the firm to communicate its expected persistent earning power.

Evidence of Earnings Management for Bonus Purposes “The Effects of Bonus Schemes on Accounting Decisions” – Healy Hypothesis: Managers will find opportunities in which they could manage net income in an attempt to maximize their bonuses under the firm’s compensation plans.

Evidence of Earnings Management for Bonus Purposes Only if income is between the bogey and cap will managers find an incentive to acquire accounting policies that increase net income

Evidence of Earnings Management for Bonus Purposes Sample: 94 firms Period: 50 years Between bogey and cap: positive avg. accruals Outside bogey and cap: negative avg. accruals Consistent with hypothesis of managers incentive to lower current income when it does not affect their current year bonus

Evidence of Earnings Management for Bonus Purposes Argues that changes in policies are not as income-influencing as the use of accruals Changes in policies tend to be implemented just after the introduction/amendment of a bonus plan If income is anticipated to be high in upcoming years, a manager will choose to implement a policy that encourages higher reported net income

But Wait… There’s More! Cash flow, as per cash flow statement $1,000 Less: Amortization expense Δ Useful Life (50) Add: Increase in (net) AR during year Δ AFDA 40 Add: Increase in INV during year Δ Overhead charge 100 Add: Decrease in AP and Accruals Δ Expected WTY claims 30 120 Net Income, as per income statement $1,120

Other Motivations

Contractual Motivation Many companies have covenants in place to protect lenders Violating this covenant is dangerous to a manager This causes managers to choose accounting policies to avoid covenant violation

Contractual Motivation Con’t Sweeny looks at this in a 1994 study and finds two things: Firms already violating covenants will make drastic changes to accounting policies to boost income Firms approaching violation will make pre-mature changes to accounting policies to boost income

Contractual Motivation Con’t This is a dangerous motivation due to the significant damage a covenant violation causes Managers may be overly aggressive which may ultimately lead to fraud

Contractual Motivation Con’t Another motivation is implicit contracts which arises from the relationship of firm and its stakeholders This is the idea that a firm will receive benefits from stakeholders based on previous contracts Allows parties to work cooperatively rather than at the Nash equilibrium

Political Motivations When a company will make policy changes to intentionally lower its income This is done to escape government scrutiny For example a company making large profits in a given year may altar its amortization policy from straight line to declining to recognize greater expenses to match these profits

Meet Earnings Expectations This is when estimated earnings for future periods meet and exceed expectations of investors This will ultimately increase share price due to the strong positive correlation between expected earnings and share price

Meet Earnings Expectations Con’t 2010 study looking at 1992-2006 proves that small earnings surprises actually leads a decrease in share price Investors are aware that earnings surprises are caused by earnings management Proves that expectations must be met, but surprises are not beneficial due to rational investors

Meet Earnings Expectations Con’t This creates a case of conflict of interest as most managers hold stock options It gives a greater incentive for managers to meet expectations using earnings management to avoid share price decreases May not be the best option for the firm Can also lead to fraudulent behaviour

IPO The issue with an IPO is that there is no market price for a firms shares This gives management incentive to increase estimates of futures earnings to get a higher price for their shares

IPO Con’t Studies in 1997 and 2007 look at companies going public and their accruals The main result found is that companies boost their accruals prior to the IPO, then reverse these accruals in later years causing losses Shows this type of earnings management is successful as it works even with rational investors

Good Side of Earnings Management Blocked Communication Managers have inside information that is costly to communicate = blocked information Managers can use provisions to smooth earnings to desired levels and unblock information It would be foolish to overstate earnings since the market will react severely when there is a subsequent reduction

Good Side- Blocked Communication Inside Information New firm strategies Change in firm characteristics Market conditions All complex information, but proven to be communicated through discretionary accruals and disclosures.

Good Side- Contracts EM can be used to maintain investor expectations and avoid market penalties for fluctuations If markets have rational expectations then both management and investors benefit from a consistent tracking and flow of earnings Upward earning management decreased contract efficiency, but is a must for investors

Good Side- Conservative Accounting Decreases contract efficiency as higher manager effort = lower earnings Also reduces need for upward earnings management = increased contract efficiency Net effect of the two reactions is positive on firm value

The Bad Side of Earning Management Opportunistic EM Tendency for managers to try to maximize their bonus Debt Constraints Firms that are highly levered need EM to control if they violate loan covenants Supported by Dechow, Sloan and Sweeney study of 92 firms that firms do practice this technic

Bad Side Cont’d Raise new capital EM can be used to maximize proceeds of new issues Discretionary accruals can increase SR earnings Techniques: Speed revenue recognition Lengthen cap. Asset life Under reserve for environmental costs

Bad Side Cont’d Transitory items Unusual items so they do not affect manager bonus’ Increase future earnings by reducing future amortization and absorption of costs that would normal go through operating expenses

Standard Setters Reflect the bad earnings management view IAS 37- provision as a liability if timing of payments is uncertain Must be probable Must be reliably estimated Must be at fair value

Measures of Earning Management Variability of operating income Lower = income smoothing Correlation between accruals and cash flow Low correlation =early revenue recognition Magnitude of total accruals Higher accruals = higher discretionary accruals Small Loss/Gain ratio Low ratio = EM to avoid small losses

Implications Ways to reduce bad earning management Don’t reject market efficiency Improve disclosures Reduces behavioural biases Lower management incentive to exploit poor governance and market inefficiencies Report effects of current earnings on prior write-offs

Earnings Management Conclusions Earnings management is justified through the theory that true net income does not exist GAAP does not completely constrain managers choices of accounting policies Complex and challenging Motivated by strategic considerations Meeting earnings expectations Specific contracts and their covenants IPO’s or SPO’s Discourage potential competition Unblock inside information

Earnings Management Conclusions Changes in accounting policy are becoming a game for companies Managers will react against rule changes that reduce their flexibility of accounting choice Need to be aware of legitimate needs of management, investors, and be aware of opportunistic strategies Accompanying earnings management is reduction in reliability and sensitivity of info

Earnings Management Conclusions Earning Management gives managers flexibility to react to unanticipated realizations Earnings Managements can be a vehicle for the credible communication of inside info to investors Both arguments above are consistent with efficient securities markets and the efficiency version of positive accounting theory when contracts are rigid and incomplete

Earnings Management Conclusions Managers can abuse communication potential of GAAP Result in failure to accept securities market efficiency or from an ability to hide bad earnings management behind poor disclosure Reduce Earnings Management by bringing it to public, out in the open Improve disclosure of low persistence items and reporting effect of previous write offs on current earnings Assist corporate governance, help better reward good manager performance and discipline managers who shirk Improvements in allocation of scarce investment capital and firm productivity increase social welfare

Taking a Bath and RIM RIM Stock has plummeted over 70% in the past year, netting to roughly $8/Share It recently announced $518 million quarterly loss Plans to lay off 5,000 employees RIM is trying to maximize it’s losses to prepare for future reported profitability with the Launch of Blackberry 10.

Income Minimization and AT&T United States v. AT&T Antitrust case that led to the 1984 Bell Systems divestiture AT&T accused of using monopoly profits to subsidize the costs of its own network Had they chosen an income minimization pattern, AT&T may not have caught the public eye and scrutiny

Enron This is a perfect example for income maximization earnings management Due to the stock option based compensation managers receive, there was constant incentive to inflate earnings Most of the earnings management was done using complex accruals and estimations Inflating earnings could be done by manipulating accounting policies, making new companies to hold debt and meet covenants and also by manipulating estimates and accruals

Enron Con’t With this type of earnings management comes risk of government scrutiny The income was never smoothed out and governing bodies took interest in consistently high growth This ultimately lead to Enron’s downfall and many regulations and accounting bodies put in place to avoid this in the future

Income Smoothing Case Company overviews (2007) American International Group (AIG) World’s largest insurance and financial services company Net Income - $6.2 billion Premiums written - $59.8 billion GenRe One of worlds largest reinsurers Owned by Berkshire Hathaway Premiums written - $6.0 billion

Income Smoothing Case Regulatory Scrutiny 2001 – SEC learned AIG assisted client in manipulating the balance sheet through bogus insurance transaction 2003 – SEC and Justice Department settle civil case with AIG in amount of $10 million 2004 – Federal investigation of AIG’s income smoothing products

Income Smoothing Case Deal between AIG and GenRe GenRe was to transfer loss reserves to AIG in exchange for premium payment Contracts for loss reserves to total between $500 and $600 million GenRe “obligated” to pay AIG “premium” of $1 billion GenRe was to receive $5 million transaction fee for deal Contract to last 24 months, at which time it would be reversed

Income Smoothing Case Improper Accounting and Public Perception AIG finally admitted that this deal should have been accounted for as a deposit Restatement of AIG’s income following this announcement amounted to a reduction in net income of $1.32 Billion Public Perception Reckless efforts of senior corporate officers that were designed solely for the unlawful purpose of achieving a specific and false accounting effect on issuers financial statements

Questions? Comments? Then on to the game! Thank you for your Time! Questions? Comments? Then on to the game!