1. Earnings Management

2. Class Announcements Assignment #9 due March 24th; available on-line
Assignment #10 due March 31st; available on-line
Assignment #8 returned at the end of class
Research paper #3 returned at the end of class
Research Paper Part #4 and bonus due April 3rd
Final Exam 7:00pm April 19th, Main Gym, Oland Centre
Business Banquet - April 2nd – 5:45-8pm, Catering - Gabrieau's Bistro; Keynote Speaker - Annette Verschuren, Past President of Home Depot for Canada and Asia

3. Class Objectives
Earnings management defined in terms of an agency contract
Earnings management patterns
Reasons for managers to actively participate in earnings management
Evidence of earnings management

4. Earnings Management
“Earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company to influence contractual outcomes that depend on reported accounting numbers” (Healy and Wahlen 1999, p. 368)
“Earnings management is the choice by a manager of accounting polices, or real actions, affecting earnings so as to achieve some specific reported earnings objective. (p. 423)

5. Earnings Management (EM)
Definition
Choice of accounting policies to achieve some specific manager objective
1.Accounting Policy Choice
Choice of accounting policy
Discretionary accruals
2. Operational Change
R&D, advertising, maintenance
Timing of disposals
(note: affects cash flow as well and compromises longer term performance.)

6. Earnings Management
Given managers can choose accounting polices from a set of polices it is natural to expect that they will choose polices so as to help achieve their objectives.
Choices can be motivated either by efficient markets and contracts or by opportunism and rejection of market efficiency.
Accruals reverse (iron law)- earnings management can not “indefinitely postpone the day of reckoning”.

7. Earnings Management: Reasons
Financial Reporting
To meet investors’ earnings expectations
To credibly communicate inside information about earnings expectations
To smooth earnings to communicate core earnings
Contractual
Bonus [Healy (1985)]
Debt covenant [Sweeney (1994)]
Implicit Contract
Political [Jones (1991)]
IPOs [Teoh et al (1998)]

8. Earnings Management: Patterns
Taking a Bath
Income Minimization
Income Maximization
Income Smoothing
More volatile income, more variability in bonus
More volatile income higher probability that covenant violation will occur

9. Earnings Management: Good
1) Contracting perspective
manager have some ability to manage earnings in face of incomplete and rigid contracts
2) Financial reporting perspective
earnings management is a device to convey inside information to the market enables share prices to better reflect the firm’s future prospects
unblocking the managers inside information
market appears to reward earnings management that does not overstate future earning power.

10. Earnings Management: Bad
1) Contracting perspective
opportunistic behavior of managers: tendency to use earnings management to maximize their bonuses
2) Financial reporting perspective
poor disclosure keep the extent of earnings management as inside information
some managers behave as if they can beat the market (e.g. excessive non recurring income items impounded as core earnings)

11. Earnings Management: Persist
Most people would feel that earnings management is “bad” as it implies a reduction in reliability and usefulness of financial statement information.
Management earnings persists
prohibitively costly for others to find out inside information
difficult to discover discretionary accruals
difficult for outsiders to interpret more visible earnings management (e.g. policy change, timing of capital gains and losses)

12. Earnings Management Techniques
Revenue Recognition
Accounting Policy Change
Timing of Adoption of New Standards
Write-offs, Provisions, Etc.
Accruals (Discretionary)
Direct Charges to Retained Earnings
Cookie Jar Accounting
Stuffing the Channels

13. Earnings Management: Understanding
Regulators and standard setters identify areas most in need of regulatory change
Auditors evaluate and report on their clients’ quality of earnings, and train novice auditors about earnings management
CEO’s, CFO’s, audit committees and investors focus attention on those areas of the financial statements where they should be most skeptical
Managers and audit committees anticipate the transaction that investors will view most skeptically
Educators teach students about earnings management
Researchers focus their analysis on areas of high-earnings management activity

14. Earnings Management Techniques: Nelson et al (2003)
Aggressive earning management has been of concern to regulators for several years
There exist little systematic research concerning the specific methods by which earnings management is attempted.
Nelson et al (2003) tried to capture the types of earning management and the impact on net income through a survey to 532 auditors (partners and managers).

15. Earnings Management Techniques: Nelson et al (2003)
Expenses & Other losses – recognizing too much or too little reserve in the current year.
Revenue & Other gains – approaches include cutoff manipulation, deferring to much or too little revenue , etc.
Business Combinations – over or understatement assets with the charge to goodwill
Other approaches – approaches include income statement classification issues, inappropriate disclosures, off balance sheet financing, etc.

16. Earnings Management Techniques: Nelson et al (2003)

17. Class Objectives - Revisited
Earnings management defined in terms of an agency contract
Earnings management patterns
Reasons for managers to actively participate in earnings management
Evidence of earnings management

18. Research Paper Part #4
Discuss relationship to accounting theory - e.g. information perspective, measurement perspective, agency theory, positive accounting theory, etc.; (pick one theory and apply to Handbook section)
Due: April 3, 2014
Worth: 2.5%
Length: One page submission (double spaced) with cover page, Introduction (bonus) Part#1, Part#2, Part #3 an Part #4, Conclusion (bonus), Reference page and Marking Keys #1, Part#2 Part#3 attached to the back.

19. Research Paper Part #4
Bonus: Provide a one paragraph introduction (maximum 1/3 of page) and one paragraph conclusion (maximum 1/3 of page) on separate pages. Due: April 3, 2014
Worth: 1.0%/10% (Maximum of 1%; 0.5% for each of each of introduction and conclusion)
Length: One page submission (double spaced) with cover page, Introduction (bonus) Part#1, Part#2, Part #3 an Part #4, Conclusion (bonus), Reference page and Marking Keys #1, Part#2 Part#3 attached to the back.