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

2. 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

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

4. 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”.

5. 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.

6. 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.

7. 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.

8. 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.

9. 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.

10. 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

11. 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

12. 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

13. 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

14. Other Motivations

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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

21. Meet Earnings Expectations Con’t
2010 study looking at 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

22. 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

23. 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

24. 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

25. 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

26. 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.

27. 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

28. 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

29. 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

30. 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

31. 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

32. 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

33. 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

34. 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

35. 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

36. 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

37. 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

38. 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

39. 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.

40. 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

41. 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

42. 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

43. 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

44. 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

45. 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

46. 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

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