1. Chapter 11 Earnings Management
Copyright © 2009 by Pearson Education Canada

2. Chapter 11 Earnings Management
Copyright © 2009 by Pearson Education Canada

3. What is Earnings Management?
Earnings management is the choice by a manager of accounting policies, or real actions that affect earnings, so as to achieve some specific reported earnings objective
Copyright © 2009 by Pearson Education Canada

4. 11.2 Patterns of Earnings Management
Bath
Income minimization
Income maximization
Income smooth
Copyright © 2009 by Pearson Education Canada

5. 11.3, 4 Motivations for Earnings Management
Contractual motivations
Bonus plan hypothesis: to manage cash bonus
Evidence: [Healy (1985)]
Debt covenant hypothesis: to manage debt covenants
Evidence: Dichev & Skinner (2002), text Section 8.5.3
Political cost hypothesis
To lower political “heat”
Evidence: Jones (1991), text Section 8.5.3
Continued
Copyright © 2009 by Pearson Education Canada

6. 11.3, 4 Motivations for Earnings Management (continued)
To meet earnings expectations
Significant negative effects on share price and manager reputation if expectations not met
Other motivations
Initial public offerings
Copyright © 2009 by Pearson Education Canada

7. 11.5 The Good Side of Earnings Management
Contract-based arguments
To give firm some flexibility in the face of rigid, incomplete contracts
Bonus contracts based on net income
New accounting standards may lower net income and/or increase volatility. May adversely affect manager effort
Debt covenant contracts
New accounting standards may increase probability of debt covenant violation
Contract violation is costly, earnings management may be low-cost way to work around
Continued
Copyright © 2009 by Pearson Education Canada

8. 11.5 The Good Side of Earnings Management (continued)
Investor-based arguments
To credibly communicate inside information to investors
Blocked communication may inhibit direct disclosure of earnings expectations
Discretionary accrual management as a way to credibly reveal management’s inside information about earnings expectations
Manager foolish to report more earnings than can be maintained
Manage reported earnings to an amount management expects will persist
Copyright © 2009 by Pearson Education Canada

9. 11.5.2 Theory & Evidence of Good Earnings Management
Theoretical models supporting good earnings management
Demski & Sappington (1987)
Stocken & Verrecchia (2004)
Evans & Sridhar (1996)
Dye (1988)
Chen, Hemmer, & Zhang (2007)
Continued
Copyright © 2009 by Pearson Education Canada

10. 11.5.2 Theory & Evidence of Good Earnings Management (continued)
Empirical studies supporting good earnings management
Subramanyam (1996)
Xie (2001) questions
Tucker & Zarowin (2006)
Liu, Ryan, & Whalen (1997)
Barth, Elliott, & Finn (1999)
Callen & Segal (2004)
Francis, LaFond, Olsson, & Schipper (2005)
Copyright © 2009 by Pearson Education Canada

11. Problem 11.9 Earnings Management at General Electric
Earnings management devices used by GE
Assumed rate of return on pension funds
Restructuring charges
Acquisitions, sales of divisions
Conservative accounting practices
Sales of leased aircraft
Allocation of goodwill on purchase of subsidiaries
Earnings management devices used in harmony to report steadily increasing earnings
Continued
Copyright © 2009 by Pearson Education Canada

12. Problem 11.9 Earnings Management at General Electric (continued)
GE Reported Net Income (Millions)
$22,208
,700
,353
,593
,002
,118
,684
,735
1999 $10,717
,296
,203
,280
,573
,726
,315
,725
Continued
Copyright © 2009 by Pearson Education Canada

13. Problem 11.9 Earnings Management at General Electric (continued)
Note argument that even under securities market efficiency, GE is so large and complex that even analysts cannot prepare accurate earnings forecasts
Management has best inside information about expected persistent earnings
Direct communication blocked
Creates role for earnings management to reveal management’s expected persistent earnings
Is this good or bad (i.e., opportunistic) earnings management?
Copyright © 2009 by Pearson Education Canada

14. 11.6 The Bad Side of Earnings Management
Contracting Perspective
Healy (1985)
Is this good or bad earnings management?
Dechow, Sloan, and Sweeney (1996)
Continued
Copyright © 2009 by Pearson Education Canada

15. 11.6 The Bad Side of Earnings Management (continued)
Financial Reporting Perspective
Hanna (1999)
Investors and analysts look to core earnings, ignoring extraordinary and non-recurring items
Implies manager not penalized for non-core charges, such as writedowns, provisions for restructuring
But current non-core charges increase core earnings in future years, through lower amortization and absorption of future costs
Continued
Copyright © 2009 by Pearson Education Canada

16. 11.6 The Bad Side of Earnings Management (continued)
Hanna, cont’d.
As a result, managers tempted to “overdose” on non-core charges, thereby putting earnings “in the bank”
also called cookie jar accounting
Note securities market reaction
Hanna found evidence that market uses frequency of such charges as proxy for their misuse--lower ERC when greater frequency
Example: Nortel (Theory in Practice 11.1)
Copyright © 2009 by Pearson Education Canada

17. Problem 11.10 Earnings Management at Sunbeam Corp.
See Liang (1998) article
Devices used by Sunbeam to manage earnings upwards
See next slide
Note loss reported earnings 1st Q. 1998
Illustrates “iron law” of accrual reversal
Where was auditor?
Copyright © 2009 by Pearson Education Canada

18. Problem 11.10 Earnings Management at Sunbeam Corp.
Copyright © 2009 by Pearson Education Canada

19. 11.6.2 Do Managers Accept Securities Market Efficiency?
Perhaps
Poor disclosure enables earnings management even if markets efficient
Perhaps Not
Theory and evidence that securities markets may not be fully efficient supports a “no” answer
Evidence that efficiency not accepted
Pro-forma earnings
Doyle, Lundholm, & Soliman (2003)
Managing same-quarter earnings of previous year
Schrand and Walther (2000)
Copyright © 2009 by Pearson Education Canada

20. 11.6.3 Can Accountants Control Bad Earnings Management?
Full disclosure
Revenue recognition policies
Unusual, non-recurring and extraordinary events
Enables investors to better evaluate earnings persistence
Effect of previous writeoffs on current core earnings
Hanna ( 1999)
Copyright © 2009 by Pearson Education Canada

21. 11.7 Conclusions Earnings management can be good if used responsibly
Full disclosure helps to control bad earnings management
Copyright © 2009 by Pearson Education Canada