1. Nicole Gagnier Sarah King Fanny Kwan Bettina Reyes
Chapter 11
Earnings Management
Nicole Gagnier
Sarah King
Fanny Kwan
Bettina Reyes

2. Outline Introduction Patterns of Earnings Management
Evidence of Earnings Management for Bonus Purposes
Other Motivations for Earnings Management
Conclusion
The Good Side of Earnings Management
The Bad Side of Earnings Management

3. 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. (
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. (

4. 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
Earnings management includes both accounting policy choice and real actions
Choice of accounting policy includes revenue recognition, amortization, etc. but also discretionary accruals such as provisions for credit losses, warranty costs, inventory values and timing and amounts of extraordinary items.
Real variables such as advertising, R&D, maintenance, timing of purchases and disposals of capital assets is another way to manage earnings.

5. 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
The Iron Law of Accruals Reversal:
It is important to note that accruals reverse. Thus, a manager who manages earnings upwards to an amount greater than can be sustained will find that the reversal of these accruals in subsequent periods will force future earnings downwards. Then, even more earnings management is needed if reporting losses is to be further postponed. In effect, if a firm is performing poorly, earnings management cannot indefinitely postpone the day of reckoning.

6. 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
Earnings management can be viewed from both a financial reporting and a contracting perspective.
From a financial reporting perspective managers may use earnings management to meet analyst’s earnings forecasts or to report a stream of smooth and growing earnings over time. This avoids any reputation damage or negative price reaction following a failure to meet investor expectations.
From a contracting perspective earnings management can be used as a way to protect the firm from the consequences of unforeseen events when contracts are rigid and incomplete.

7. Patterns of Earnings Management
Taking a Bath
Income Minimization
Income Maximization
Income Smoothing
Managers engage in different ways to manage their earnings. They take on a specific pattern depending on the economic condition or their characteristic – that is, whether they are risk-averse or not. In the next few slides, I will describe four different patterns of earnings management: taking a bath, income minimization, income maximization, and income smoothing.

8. 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
Taking a Bath pattern can take place during period of organizational stress or when a company is undergoing major reorganization. In this pattern, managers feel that if they must report a loss, they might as well “clear the decks” and report a large one. They do so by writing-off assets in order to provide for future costs. Because of accrual reversal, this enhances the probability of future reported profits.

9. 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
The next pattern is Income Minimization. This is similar to Taking a Bath but it’s less extreme. Firms going through periods of high profitability usually take on such a pattern. Policies that suggest income minimization include rapid write-offs of capital and intangible assets and expensing A&P and research & development expenditures. It can also be noted that Canada’s progressive tax rate provides another incentive for this pattern.

10. Income Maximization Pattern may be chosen for bonus purposes
Firms may also maximize income if close to debt covenant violation
Looking at the other end of the spectrum, managers also manage their earnings upwards. This pattern is usually common in companies where managers are driven by bonuses. Another incentive to choose this pattern is to avoid debt covenant violation which I will explain in detail later on in the presentation.

11. 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
Income smoothing is the use of accounting techniques to level out net income fluctuations from one period to the next. Companies indulge in this practice because investors are generally willing to pay a premium for stocks with steady and predictable earnings streams, compared with stocks whose earnings are subject to wild fluctuations. Managers also choose this pattern to reduce the likelihood of reporting low earnings.
Examples of income smoothing techniques include deferring revenue during a good year if the following year is expected to be a challenging one, or delaying the recognition of expenses in a difficult year because performance is expected to improve in the near future.

12. Motivations to Earnings Management
Healy’s Bonus Schemes Theory
Cap
Bogey
Reported Net Income
Amount of Bonus ① ② ③
One of the biggest incentives for earnings management is bonuses that managers will receive. A researcher named Healy wrote a paper called “the Effect of Bonus Schemes on Accounting decisions” predicted that when managers are given some sort of bonus based on the reported net income that determines his/her performances, they are usually tempted use any one of the patterns as discussed previously to maximize their bonuses. He identified 3 situations: He assumed firms will always set a certain amount of net income that needs to be reached in order for the managers to receive bonus. At that point, it is called the Bogey. Below that, managers, won’t get any bonuses, above bogey, managers will get bonuses depending on the net income that was reported, so the higher the net income, the more bonus they will receive. However, they will reach to a point where the firm sets a maximum amount of bonus that the managers can get. That point is called the “Cap”. No matter what the net income is beyond this “cap” amount, the managers will get the same amount of bonus. Now what kind of patterns of earnings management do you think the managers will most likely choose in each of these 3 situations?

13. Managing Net Income....
Net income = Cash flow from operations ± net accruals
Net accruals = ± net non-discretionary accruals
± net discretionary accruals
Then Healy started to explain how managers can manage net income. He believed that managers used accruals
Here we have to go back to the formula that was introduced in Chapter 5 where Net Income = Cash flow from operations +/- net accruals. Net accruals can then be separated between non-discretionary and discretionary accruals. Does anyone know what is the difference between the two types of accruals?
Healy explained that discretionary accruals is where management has the flexibility to manage the company’s earnings
Next I will be going through some examples of accruals, and I would need your help to tell me if they are discretionary or non-discretionary

14. 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

15. Healy’s Bonus Scheme Theory Revisit
Cap
Bogey
Reported Net Income
Amount of Bonus ① ② ③

16. Evidences on Healy’s Theory
Jones
Looked at 3 types of managers:
Zero bonuses Didn’t use accruals
0 < bonus < Max.
> Max.

17. 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
Anyone here familiar with the Lehman Brothers accounting scandal? Lehman Brothers was involved in a scheme that insiders call “Repo 105” and I have video here that explains what it is and how the company managed their earnings to inflate the company’s value. (
Over time we heard news about companies like Enron, WorldCom, Xerox and as we’ve seen earlier, Lehman Brothers, engaged in accounting irregularities that led to their downfall. So what motivated companies to act on such practices? Other than bonus purposes as Fanny discussed earlier, many companies manage their earnings upwards in order to avoid covenant violation in debt contracts. These are agreements between a company and its creditors that the company should operate within certain limits. This may mean avoiding excessive dividends, additional borrowing, or letting working capital or shareholders’ equity fall below a certain level.
Empirical studies also show that firms undertake early adoption of new accounting standards when these increase reported net income.

18. 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
The next motivation is the most common one. Many managers inflate the company’s bottom line in order to meet investor’s earnings expectation and maintain their reputation. Investor demand for company shares that meet expected earnings increase which subsequently increase share prices. On the other, share prices go down when companies miss expected revenue. For example, on September 2010, RIM stock price rose by 2.4% to $48.83 CDN when the company reported that sales for the quarter increased to $4.62B compared with analysts’ forecast of $4.49B.

19. 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
In general, firms making IPOs do not have an established market price. As we have learned in previous lectures, under the efficient market securities model, prices depend on investors’ valuation of the company which based on the information they receive. Therefore, managers of firms going public are motivated to manage the earnings reported on their statements in a way that will earn them higher prices for their shares.

20. 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
Now we will discuss a little bit about the bad side and the good side of earnings management. It is probably clear what the bad side is when managers manage their income. This is when it results in opportunistic earnings management. What this means is that the main purpose for managers to increase or decrease their income is for their own good and not for the firm’s interest.
The most obvious opportunistic earnings behaviour is when the managers use earnings management to maximize their bonuses
Another one is when managers want to raise new share capital, they will use earnings management to maximize the proceeds from the new issue. This will benefit the current shareholders at the expense of the new shareholders
Last one is when managers frequently record non-recurring items. Managers evaluation is based on core earnings, so it does not affect their bonuses, nor does it affect their ability to meet earnings forecast. This kind of recording actually benefits the managers by increasing future core earnings in which they are being evaluated on. This is because there is a reduction in future expense. For example writedowns will decrease the future amortization expense.

21. 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
Blocked Communication Concept by Demski and Sappington
Managers have information that is not available to the public, but it is difficult to communicate
Public has desire to unlock the blocked communication by gaining credible information from inside
Using Earning Management to Unblock Communication
-If a manager know the forcast for the companies earnings potential, he/she can not just declare it as it would be to costly for the market to find it credible.
-ex) If expected potiently is $1 million yearly, but current is $1.18 million because of sale of a division. If the earnings were reported at that level then it is expected that this can be maintained. So to unblock the communication between the manager and shareholders as to what to expect for future earnings, an accrual can be set up for the .18 mill so that earnings are reported at 1 mill which is sustainable.

22. 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.

23. 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.

24. 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
For accountants who wish to reduce bad earnings management the goal is to improve disclosure.
For example, clear reporting of revenue recognition policies and detailed descriptions of major discretionary accruals such as writedowns and provisions for reorganization will bring bad earnings management into the open, reducing manager’s ability to manipulate and bias the financial statements for their own advantage
Other ways to improve disclosure include reporting the effects on core earnings of previous write-offs and in general assisting investors to diagnose low-persistence items.

25. Conclusion The Effect of Improved Disclosure:
Share prices would more closely reflect fundamental firm value
Easier to assess management stewardship
Social welfare would increase
So improved disclosure will reduce bad earnings management but what will be the ultimate effects? Share prices would more closely reflect fundamental firm value. It would be easier to assess management stewardship and management would be rewarded for good performance and disciplined for shirking.
Finally, social welfare would increase due to improvements in the allocation of scarce investment capital and increases in firm productivity.

26. 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
Actual financial reporting represents a compromise between the needs of managers and investors
Managers want flexibility of accounting choice and arguments can be made that earnings management is useful if kept within bounds. It allows managers to react to unanticipated state realizations when contracts are rigid and incomplete and it can serve as a vehicle for credible communication of inside information to investors. But it can also be used by management opportunistically to smooth their compensation over time, thereby reducing their compensation risk.
For investors, earnings management reduces reliability and some managers push earnings management too far so that persistent earnings power is overstated, at least temporarily.
Whether earnings management is good or bad depends on how it is used

27. Connect-3-Tac-Toe