1. A Review of Earnings Management
Accounting Seminar
Week 3
Originally prepared by: Professor Farshid Navissi (Monash University) Semester 2, 2005 Updated by: Gatot Soepriyanto (Binus University) Semester 2, 2008

2. Agenda A Review of Earning Management (EM) Method of EM
Incentives for EM
Detecting EM
Jones Model
Step by Step guidance
Modification of EM studies

3. “Numbers in the abstract are just that -- numbers
“Numbers in the abstract are just that -- numbers. But relying on the numbers in a financial report are livelihoods, interests and ultimately, stories of American Investors”.
(The “Numbers Game”: Arthur Levitt – former SEC Chairman)

4. Earnings Management (EM) Defined
Use of judgment in financial reporting and in structuring transactions to alter financial reports to influence the perceptions of stakeholders about the underlying economic performance of the company and / or influence outcomes that depend of the reported accounting numbers

5. EM and Corporate Fraud
Virtually all managerial activities affect earnings  constitute EM
EM covers a wide variety of legitimate and illegitimate managerial actions that affect earnings
EM may manifest in terms of the extremities of either conservatism or optimism
Fraud typically comes into existence when firms try to paint an extremely optimistic picture of their operations through aggressive use of illegitimate practices

6. EM: Example Behaviours
“Conservative” Accounting
“Neutral” Accounting
“Aggressive” Accounting
“Fraudulent” Accounting
WITHIN
GAAP
VIOLATES
Tendency to understate Tendency to overstate
earnings and to overstate liabilities earnings and to understate liabilities
Overly aggressive recognition of provisions
Unbiased or neutral representation of the firm’s financial operations
Understatement of provisions
Recording fictitious transactions e.g. Sales

7. Patterns of EM Income Maximisation Income Minimisation
Extreme case known as “taking a bath”
Income Smoothing
Keeping earnings consistent over a long

8. Methods of EM Accounting Method Choice
Choice of accounting method affects the timing of when revenues and expenses are recognised in income
For example the “percentage of completion” method permits the recognition of revenue on an ongoing basis, while the “completed-contract method” recognises revenue only at the completion of projects

9. Methods of EM Application of Discretionary Estimates
Even after the selection of accounting methods there remains the discretion of how the method is applied
For example when depreciating assets using the straight-line method there still remains the issue of estimating the useful lives and the residual value  using a longer useful life and larger residual value estimate will increase revenue in current accounting period

10. Methods of EM Accounting Method Timing
Exercising discretion over when and how to carry out activities that affect financial statements
For example when to write-off impaired assets or recognise a liability as a contingent liability
Control of Major Expenses / Revenues
For example how much to invest in R&D, advertising and maintenance expenses. Also firms can delay or accelerate the delivery shipments of goods to customers

11. Incentives for EM Behavioral Incentives Market Based Incentives
Lending Contracts
Accounting-Based Bonus Plans
Political Costs
Management Transition
Market Based Incentives
Dividend Payout Rates
Management Buyouts
Equity Offerings
Analyst Expectations
Share Repurchases
Management Share Option Plans

12. Behavioural Incentives
Lending Contracts
Many debt arrangements contain restrictions relating to interest coverage, debt-to-equity, etc
The desire to prevent the violation of these restrictions presents an incentive for the firm to manage earnings upwards in periods where the firm is close to breaching those restrictions
Accounting-Based Bonus Plans
Firms often reward managers on the basis of reported earnings or other accounting-based performance measures
The desire to receive higher bonuses presents an incentive for the manager to manage earnings upwards in some periods

13. Behavioural Incentives
Political Costs
Large firms are often under scrutiny for their large profits
The desire to circumvent increased regulatory intervention presents an incentive for the firm to manage earnings downwards
Management Transition
Poor performing managers often replaced with new management
The possibility of “taking a bath” and attributing the poor performance to its predecessors presents an incentive for the manager to manage earnings downwards in the period immediately after appointment

14. Market-Based Incentives
Dividend Payout Rates
Shareholders may expect steady stream of dividends
The desire to maintain its historical dividend payout rates presents an incentive for the firm to manage earnings smoothly
Management Buyouts
In an attempt to acquire more control managers may purchase a substantial equity stake in the company they manage
The desire to purchase as many shares as possible presents an incentive for the manager to manage earnings downwards in the period prior to the buyouts

15. Market-Based Incentives
Equity Offerings
Earnings commonly used to value a firm going to public for the first time
The desire to acquire more funds (via a high offering price) presents an incentive for the firm to manage earnings upwards in the periods prior to the offerings
Analysts Expectations
Financial Analysts (and/or management) often provide public forecasts of earnings
The desire to meet or better those forecasts presents an incentive for the manager to manage earnings upwards in periods where it is anticipated that actual “unmanaged” earnings will fall short of the forecasted earnings

16. Market-Based Incentives
Share Repurchases
Firms with excess cash sometimes purchase their own shares for a variety of reasons
The desire purchase these shares at a lower price presents an incentive for the firm to manage earnings downwards in the period prior to the repurchase
Management Share Option Plans
Firms often issue managers with share options as part of their remuneration package
The desire to maximise their “profits” from these options presents an incentive for the manager to manage earnings downwards in the period prior to the award of the options and to manage earnings upwards in the period prior to the exercise of the options

17. Detecting EM
It is impossible to detect every accounting choice that is made by every firm and to evaluate whether the choice has been made for opportunistic reasons
Researchers have tended to focus on measures that provide an aggregate measure of earnings management
Earnings is composed of two components
Cash Flow from Operations
Accruals

18. Detecting EM
Operating cash flows are very difficult to exercise discretion over
Researchers typically focus on the levels of total accruals made by firms
Accruals are typically used by firms to recognise the consequences of transactions in the periods in which they occur
Since accruals commonly involve discretion, accruals are more susceptible to manipulation

19. Detecting EM
Many models exist to detect levels of abnormal accruals (discretionary accruals)
Healy (1985), DeAngelo (1988), Jones (1991), Dechow, Sloan and Sweeney (1995) and Kothari, Leone and Wasley (2005).
Basic idea is to use past firm accruals and financial information to estimate normal levels of accruals (non-discretionary accruals) in the period of investigation. The non-discretionary accruals in the period of investigation are then subtracted from the actual accruals to derive a measure of discretionary accruals

20. Jones (1991) Model
Step 1: Calculate total accruals in time t
TACt = [(∆CA - ∆Cash)/ TAt-1]–[(∆CL - ∆STD)/ TAt-1]–(Dep/ TAt-1) (1)
Where
∆CA = change in current assets,
∆Cash = change in cash/cash equivalent,
∆CL = change in current liability,
∆STD = change in short-term debt included in current liabilities,
∆TP = change in income taxes payable,
Dep = depreciation and amortization expense, and
TA = total assets.
Short-term debt is excluded from current liabilities because it relates to financing activities, as opposed to operating activities.

21. Jones (1991) Model
Step 2: Estimate the coefficient of normal accruals in estimation period. Jones assumes that normal accruals are related to changes in revenue (sales) and by the level of plant, property and equipment (PPE):
TACt/At-1= α0 + α1 (ΔREVt/At-1) + α2 (PPEt/At-1) + υt (2)
Where:
TAct is the total accruals of firm i in period t
Ait-1 is the total assets of firm i at the end of period t-1
 REVit is the change in revenue of firm i in period t
Period t revenue for firm i - Period t-1 revenue for firm i
PPEit is the balance of plant, property and equipment of firm i at the end of period t

22. Jones (1991) Model
Step 3:The coefficients estimates from model (2) are then applied to the event years to predict the normal accruals
NAt= ά0 + ά 1 ((ΔREVt /TAt-1) + ά 2 (PPEt/TAt-1) (3)
Step 4:
Finally, the magnitude of abnormal accruals (AN) is then obtained as the difference between total accruals computed in model (2) and the estimated (equation 3), that is:
ANt = TACt – NAt (4)

23. Example?
Lets assume that we would like to investigate whether a sample of 24 firms manipulated earnings upwards in 2004
2003
1993
10 Year Estimation Period

24. So what next?
For each of the 24 firms we have to collect historical data (used in model 1) which will enable us to estimate the expected level of normal accruals in Lets assume we decide to gather 10 years of data for estimation purposes

25. Putting it all together
For each firm we run regression (1) in the estimation period and obtain the parameter estimates of 1, 2, and 3
2004
2003
1993
10 Year Estimation Period

26. Putting it all together
The parameter estimates are then applied to the event year to provide an estimate of expected normal accruals.
Using discretionary accruals of the 50 sample firms, the mean and the statistical significance of the discretionary accruals is calculated

27. Evidence on Specific Accruals
Models such as Jones (1991) use abnormal accruals as a proxy for earnings management
But standard setters are more interested in which specific accruals are used in earnings management
Depreciation estimates
Bad debt provisions
Deferred tax valuations

28. Modification of EM Research
EM as the measure of financial reporting quality
EM as the dependent variables is tested with others independent variables (e.g. GCG proxies and audit quality proxies)

29. Review Questions Using Jones (1991) model, please:
Design the research methodology to investigate whether firm manage their earnings before a significant share repurchases.
Design the research methodology to examine whether firm manage their earnings after management transition.
Design the research methodology to test whether Big 4 CPA firms provide higher audit quality (lower EM) than non Big 4 CPA firms.

30. Assignments