1. Earnings Management

2. Earnings Management What is earnings management?
It is the choice by a manager of accounting policies or real actions, affecting earnings so as to achieve some specific reported earnings objective
What is earnings management?

3. What are some examples of earnings management?

4. Why is understanding earnings management important to accountants?

5. It is important because:
It enables an improved understanding of the usefulness of net income
both for reporting to investors and contracting
Helps avoid some of the serious legal and reputation consequences that arise when firms become financially distressed.
Why is earnings management important?

6. Earnings Management
Choice of accounting policy has broad interpretations
No clear cut dividing line between the two choices
Choice of accounting policies (straight line versus declining balance amortization)
Discretionary accruals ( provisions for credit losses, warranty costs, inventory values, writeoffs and provisions for restructuring
Earnings management can be a vehicle for the communication so managements inside information investors.

7. Fine line between earnings management and earnings mismanagement
The locations of “the line” is determined by
Effective corporate governance
Reinforced by securities and managerial labour markets
Standard setters
Securities commissions
Courts
Location of the line is determined by who?
All of the above)

8. Iron law of accruals Accruals reverse
For ex: a manager who manage earnings upwards will suffer a lower earning in later periods
Therefore earnings management should not be used to rationalize misleading or fraudulent reporting
What is the iron law of accruals? What is the key aspect of iron law of accruals

9. Patterns of Earnings Management
4 different earnings management patterns
Taking a bath
Income minimization
Income maximization
Income smoothing
What are the 4 patterns in earnings management
Taking a bath
Income minimization
Income maximization
Income smoothin

10. Taking a Bath
Takes place during periods of organizational stress or restructuring
Might as well report a large loss (nothing to lose)
Write off assets (“clear the decks”)
Enhances the probability of future reported profits because of accrual reversal

11. Income Minimization Similar to taking a bath but less intense
Chosen by firms during periods of high profitability
Policies that suggest income minimization
Rapid writeoffs of capital assets and intangibles
Expensing of advertisement and R&D
Income tax considerations

12. Income Maximization
If a firms is close to debt covenant violations may use income maximization
Engage in this pattern for bonus purposes
Provided that this does not put them above the cap

13. Income Smoothing Incentives
Risk averse managers prefer a less variable bonus stream
Smooth out reported earnings over time to gain relatively constant compensation
Efficient compensation contracting may exploit this effect
Incentive to reduce volatility of reported net income to smooth out covenant ratios over time
Reduce the possibility of reporting low earnings
Firms smooth reported net income for external purposes
“If used responsibly smoothing can convey inside information to the market by enabling the firm to communicate its expected persistent earning power”

14. 11.3 Evidence of Earnings Management for Bonus Purposes
Healy 1985 wrote a paper on “The Effect of Bonus Scheme Decisions”
Based on positive accounting theory, which attempts to explain and predict managers choices of accounting policies
Conclusion: Managers would be able to manage net income to maximize their bonuses under their firms compensation plans
Question 1: Managers would be able to manage __________ to maximize their bonuses under their firms compensation plans
Answer: Net income

15. Typical Bonus Scheme Significance Typical Bonus Scheme
Bonus is constant for net income greater than the cap
No cap in the bonuses, the bonus would increase along the dotted line
No bonus to be received, the manager might as well adopt accounting policies to further reduce the net income
If net income is between the bogey and cap the manager is motivated to adopt accounting policies to increase the net income
Question 2: No bonus to received, the manager might as well adopt accounting policies to further _______the net income
Answer: reduce

16. Discretionary and Non- Discretionary Accruals
Discretionary Accruals : Accruals which the manager can exercise some control
Non - Discretionary Accruals: Manager does not have control

17. Discretionary and Non- Discretionary Accruals
Amortization Expense:
Discretionary: Company changes the policy for the calculation of the amortization expense by modifying estimated useful life measurement
Non- Discretionary: Amortization expense number changes
Increase in net account receivables
Discretionary : Management makes changes by selecting a less conservative estimate for allowance for doubtful accounts, increase through earlier recognition, more generous credit policy or keeping the books open beyond the year end
Non- Discretionary: Increase in volume of business .

18. Other Accruals Increase in Inventory
Non-Discretionary increases include inventory buildup due to anticipation of increased demand
Discretionary increases would include charging fixed overhead costs to inventory rather than charging them off as expenses
Decrease in accounts payable and accrual liabilities
- Discretionary decisions are used in making these estimates such the firm being more optimistic about warranty claims than in previous years. Also regarding certain borderline liabilities as contingences rather than as accruals

19. Observations with both a Bogey and Cap
Manager has considerable discretion when recording net income
Did not have access to the books and records of his sample firms therefore unable to determine specific discretionary accruals made by the firm’s managers
Observations fit into one of the three categories
Portfolio UPP: Observations where earnings were above the cap
Portfolio Mid: Observations between the bogey and the cap
Portfolio LOW : Observations where earnings were below the bogey
Question: In Healy ‘s evaluation how many portfolios are there?
Answer 3

20. Healy Conclusion
Major difficulty is that discretionary accruals cannot be directly observed
Kaplan (1985)
Pointed out a firm with reported net income above the cap of its bonus plan may have low non-discretionary accruals
The high income is due to an unexpected increase in demand that runs down inventory.
Low total accruals are due to:
Level of the firm’s real economic activity
Not to low discretionary accruals.
Healy addressed Kaplan issues and performed additional tests to confirm the results

21. Discretionary Accruals Bad Debt
McNichols and Wilson(1988)
Studied the behavior in a bonus context
Results consistent with Healy
Confirmed the provision for bad debts on the grounds that a precise estimate for what the bad debt allowance should be (non-discretionary portion) made
Discretionary accruals = Estimate bad debt provision - Actual bad debt provision
Below bogeys and above caps: Significant income reducing both for firms that were profitable and unprofitable
Between profitability extremes: Firms discretionary accruals were lower among income increasing

22. Jones: Non-discretionary Accruals
Estimate non-discretionary accruals, using better data
Non- discretionary accruals found that managers who received 0 bonus did not use accruals to manage earnings downwards which different from Healy’s findings, in row 1.
Managers who were at their bonus maxima accruals so as the lower reported earnings which is different from Healy’s findings- row 3

23. Earning management incentive conclusions
Managers use accruals to manage earnings to influence their bonuses, particularly when they are high consistent with bonus plan hypothesis of positive accounting theory
2 ways to think about bonus plans
1)Opportunistic behavior
Managers exploit their power in the organization by maximizing their utility at the expense of the firms shareholders and investors who may find it costly to unravel discretionary accruals.
2) Efficient contracting perspective
When setting compensation contracts firms will rationally anticipate managers incentives to manage earnings and will allow for this in the amount of compensation they offer
It is less costly to an organization to offer it
Either way it does create earnings management incentives
Two types of bonus plans _____________ and ____________
Answer
Opportunistic behavior
Efficient contraction perspective

24. OTHER MOTIVATIONS FOR EARNINGS MANAGEMENT

25. WHAT IS A DEBT COVENANT? WHY DO LENDERS USE THEM?

26. 11.4.1 Other Contracting Motivations
Covenants: Protect against actions by managers that are against the lenders’ best interest
Excessive dividends
Additional borrowing
Letting working capital or shareholders’ equity fall below specified levels
All of these actions dilute the security of existing lenders

27. WHAT IMPACT CAN COVENANT VIOLATION HAVE ON A FIRM?

28. 11.4.1 Other Contracting Motivations
Covenant violation
High costs firms
Raise the going concern issues for the business
Earnings management can arise as a device to reduce the probability of violation of debt contracts
Sweeney 1994
Discovered significantly greater use of income- increasing accounting
And the early adoption of new accounting standards to increase net income

29. 11.4.1 Other Contracting Motivations
Other studies found:
Use of discretionary accruals to increase reported income in the year prior to and to a lesser extent in the year of the convent violation
Many companies had to cut dividends which makes lenders, shareholders, unions feel that they are financially unstable

30. 11.4.1 Other Contracting Motivations
Earning management incentives
Relational contracts these are not normal contracts such as compensation or debt contracts
For example: Meeting contract commitments with suppliers will allow one to receive better terms from suppliers and lower interest rates from lenders
Bowen etc 1995 investigated implicit contracting where companies have represented high profits
Increase stakeholder confidence that the manager will continue to meet the contract obligations.
For example business with high COGS or notes payable will use FIFO and straight line amortization as it appears to be income increasing.
Question: A company with high COGS is likely to use _______?
Answer’:FIFO

31. 11.4.2 Meeting Shareholders Expectations
Investor’s earnings expectation can be formed in variety of ways
Based on earnings in same period last year or recent analysis or company forecasts
Skinner and Sloan 2002
Firms penalize more for failing short of expectations
Manage earnings upwards ensure that earnings expectations are met
Keung etc. 2010
Market reaction to a zero or even a small positive earning surprise turned negative during , compared to positive response received in previous years

32. 11.4.2 Meeting Shareholders Expectations
Mercer 2005
Plausible: Earnings and forecasts as well as their opinions increase
Not plausible: Earnings and forecasts as well as their opinions decrease
Failure to meet investors earnings expectations has serious consequences
Direct effect: Firm’s share price and cost of capital as investors are expected to be lower
Indirect effect: Manager reputation can be negatively impacted if explanation appears as an excuse

33. Which companies have recently gone public?
Group On
Michael Kors
Facebook

34. 11.4.3 Initial Public Offerings
IPO’s do not have a established market price
Question is: What is the value of the shares in such firms?
Financial accounting information is a useful source
Ex: Forecasts
Clarkson etc. 1992
Evidence the market responds positively to earnings forecasts as a signal of firms value

35. 11.4.3 Initial Public Offerings
Teoh 1998
Discretionary accruals around the IPO date are concentrated on working capital accruals
High discretionary accruals was significantly negative relative to IPO’s firms with low accruals
Currently it is unclear whether investors are “fooled” by opportunistic earnings management in IPO’s or rationally price the IPO

36. The Good Side to Earnings Management
This section talks about how theoretical and empirical evidence supports the fact that earnings management can be good

37. Blocked Communication
Agents obtaining specialized information as part of their expertise, and this information can be prohibitively costly to communicate to the principle that is its communication is blocked
The presence of blocked communication can reduce the efficiency of agency contracts, since the agent may shirk on information acquisition and compensate by taking an act that, from the principle’s point is sub-optimal
Earnings management can be a device to reduce blockage

38. Reducing Information Blockage
Such as:
An increased positive market reaction to disclosure of business strategy in high tech firms when the disclosures are proceeded by a credible gesture of confidence in the firm by management namely insider stock purchases
Disaggregation of good news forecast (i.e. forecasting sales and expenses as well as net income) increases its credibility
Earnings management can be a device to reduce information blockage

39. Empirical Evidence of Good Earnings Management
Does the stock market react to earnings management as if it were good?
The answer to this question is important to an accountant since they are prominently involved in the technique and implementation of earnings management and will and get drawn into the negative publicity and lawsuits that inevitably follow the revelation of bad earnings management practices

40. Earnings management can both inform investors and enable more efficient contracting
However the opportunistic earnings management is mixed in with the good cannot be ruled out

41. Empirical Evidence Examples
Subramanyam – the stock market responded positively to the current period's discretionary accruals, consistent with managers, on average using earnings management responsibly to reveal inside information about future earnings power

42. Empirical Evidence Examples
Xie – found that rather than reacting to discretionary accruals as if they were good, the market appears to over value them

43. Empirical Evidence Examples
Tucker and Zarowin – conclude that greater income smoothing behaviour is accompanied with good earnings management argument

44. THE BAD SIDE OF EARNINGS MANAGEMENT

45. Opportunistic Earnings Management
Despite theory and evidence of responsible use of earnings management, there is also evidence of bad earnings management
Opportunistic Manager Behaviour: the tendency of managers to use earnings management to maximize their bonuses

46. Study by Dechow, Sloan, and Sweeney
Examined the earnings management practices of 92 firms charged in the USA by the SEC with alleged violation of GAAP, compared to a control sample of firms of similar size and industry
Revealed a number of motivations for such earnings management
Firms in test sample had, significantly greater leverage and significantly more debt covenant violations than the control sample
Raising new share capital and want to maximize the proceeds from the new issue

47. Study by Dechow, Sloan, and Sweeney
Studied the financing decisions of sample firms
Charged firms issued, on average, significantly more securities during the period of earnings manipulation than the control sample

48. Market Reaction to Earnings Management
Market does appear to react to earnings management
ERC for a dollar of quarterly core earnings is lower for firms that have frequently recorded large unusual and non-recurring charges
Consistent with the market using the frequency of non-recurring charges as a proxy for the extent to which core earnings may be overstated

49. Earnings Management in an International Context
Leuz, Nanda, and Wysocki evaluated the extent of earnings management in each of 31 countries during 1990–1999
Measures used:
Variability of operating income
Correlation between accruals and cash flow
Magnitude of total accruals
Country’s ratio of small earnings losses to small gains

50. Earnings Management in an International Context
Measures were combined to create a score for each country
Lower scores imply less earnings management
Canada - 5
USA - 2
Germany
Scores were related to country institutional characteristics
For example: Lower investor protection is associated with more earnings management

51. Nortel April 2004 – Nortel fires CEO & controller
Share price falls from $11 to $5.26
Nortel overstated 2003 net income
Collapse of technology boom in early 2000s
Excessive accruals made for cost of contract cancellations, bad debts, layoffs & plant closures
Nortel reverses 2003 accruals
Does not disclose to investors
Credited to operating expense

52. Nortel’s compensation plan provided for bonuses if the company returned to profitability
CEO received $3.6 million bonus in 2003
After the effects of excessive accrual reversals are taken into account, it appears that the first two quarters of may have been loss quarters

53. Nortel – The Consequences
January 2005: Nortel issued restated results reporting losses
February 2005: Nortel sues three former executives to recover bonuses
March 2007: SEC begins civil proceedings against four executives
March 2007: Nortel reduces 2005 earnings by $134 million putting the company into violation of certain debt covenants.
2009: Nortel announces the company will cease operations and sell of all business units.

54. Do Managers Accept Securities Market Efficiency?
Market favours firms with steadily increasing earnings patterns
Inefficient Market Interpretation: momentum trading in response to the increasing earnings pattern drives the favourable market reaction
Same-quarter earnings of the previous year are a very important earnings benchmark for managers
Lowest possible prior period benchmark emphasized, thereby showing the change in earnings from the prior quarter in the most favourable light

55. Doyle, Lundholm, and Soliman
Investor reaction to pro-forma earnings was studied by Doyle, Lundholm, and Soliman
Found that many expenses excluded from GAAP net income had significant future effects on operating cash flows
Abnormal share returns over a three-day window surrounding the date of quarterly earnings announcements
Found that the greater the difference between pro- forma and GAAP earnings the lower the abnormal share return over the three days
Suggests that the market does not ignore the excluded items

56. Doyle, Lundholm, and Soliman
Market reaction is not complete
Lower share returns for firms with greater pro- forma–GAAP discrepancies continued for up to three years
If the market was fully efficient, all of the negative reaction would have taken place within the three-day window
These earnings management policies make little sense if securities markets are efficient
Consequently, managers who engage in them must not fully accept efficiency

57. Implications for Accountants
The implication for accountants who wish to reduce bad earnings management is not to reject market efficiency, but to improve disclosure
Reduces their susceptibility to behavioural biases and managers’ ability to exploit poor corporate governance and market inefficiencies
Other ways to improve disclosure include reporting the effects on core earnings of previous write-offs and, in general, assisting investors and compensation committees to diagnose low-persistence items.

58. CONCLUSION
Earnings Management is possible because TRUE net income does not exist
GAAP does not completely constrain managers choice of accounting policies and procedures
Often we see managers’ accounting policy choices are motivated by strategic considerations, such as meeting earnings expectations
The bad of earnings management is that managers may abuse to the extent that earning power is persistently overstated
The good of earnings management can give managers’ the flexibility they need to react to unanticipated states realizations and give a credible means to communicated inside information to investors