Chapter 11



Chapter 11

Earnings Management

Summary and Quiz

9.403 Accounting Theory

L02

March 5, 2002

Chapter 11—Earnings Management

Summary

Defining Earnings Management

“Earnings management is the choice by a manger of accounting policies so as to achieve some specific objective.” By nature, the accounting policies set out in GAAP do not stipulate specific accounting policies for managers to follow. For example, GAAP allows a company to choose the amortization policy that best reflects the use of an asset; this flexibility allows managers to accurately reflect the earning potential of the asset. Therefore, while the results of earnings management may not represent the actual cash flows for the period, it should reflect the period’s revenues and expenses. Provided that management stays within the regulations of GAAP, this type of earnings management is allowed. Because managers have the discretion to choose those accounting policies that best reflect the business of the firm, it can be assumed that managers will choose those accounting policies that can put themselves and their companies in the best possible light. That is, mangers can use earnings management for personal reasons (for example, increasing current period earnings to receive a bonus) and managers can use earnings management to influence the market value of the company (for example, claiming less amortization expense in order to increase net income for that period).

Earnings management can help firms communicate insider information to the public, but financial statement users need to understand earnings management in order to make good use of management prepared financial statements. A firm’s choice of accounting policies signals to the public whatever future expectations the firm may have. For example, a firm changing from straight-line to double declining amortization signals to the public that the earning potential of the asset lies more in its earlier years of use.

There are two key types of earnings management: adjusting individual accounting policies and using different accrual methods. In turn, these two methods can be used to either increase or decrease a firm’s current earnings. First, managers can adjust any number of accounting policies to affect the value of a firm. Common accounting policy changes can include adjusting amortization expense or revenue recognition methods. Second, mangers can set up different accruals to spread revenue and expense recognition over several periods. For example, a construction company receiving revenue up front for a 10-year project can accrue revenue over the period to match expenses.

There is a limit to the benefits of earnings management. While responsible earnings management allows a firm to communicate insider information to financial statement users, abusing earnings management can reduce the long-term reliability of the financial statements. Earnings management should help financial statement users understand the earnings of the company. Managers must remember that earnings management has no cash flow effect; all accruals will eventually have to be reversed.

Motivations for Earnings Management

There can be a strong motivation for managers to play with earnings figures since bonuses are often based on the bottom line. Managers may be tempted to increase the earnings figure since their bonuses may be a direct result of this amount. On the other hand, a manager may be willing to “take a bath” in a year where net income is expected to be low since they will not reach the earnings figure required to receive a bonus. Healy (1985) noted that a cap and bogey is often applied when bonuses are determined. The bogey is the minimum net income figure required for the manager to receive a bonus; the cap is the maximum net income figure for which a bonus will be paid out. Therefore, managers realizing that they will not be able to reach the targeted minimum net income figure may be enticed to “take a bath”. Likewise, if income were considerably higher than the cap, the manager would be willing to absorb additional losses since the amount of their bonus will not be affected. Ultimately, managers who take losses in the current year to reduce net income below the cap will place the firm in a better position to perform well in future years.

As discussed by Sweeney (1994), managers may use earnings management when involved in contractual agreements. Many contractual agreements within the corporation revolve around the debt covenant hypothesis. This hypothesis implies that lenders to the corporation may include requirements in the debt contracts that net income, the current ratio, the debt to equity ratio, and dividend policies must not change or fall below a certain level. Since the costs of violating a debt covenant can be extremely high, a manager’s interests lie in keeping the corporation at a level that does not jeopardize the contractual agreement. In order to do so, the manager could use earnings management to create the illusion that the company has not violated the debt covenant.

A third reason for earnings management stems from political motivations. Many industries in the economy operate under a monopoly or an oligopoly. Firms in these industries may be tempted to use earnings management to decrease net income because profits that are too high may prompt a public outcry for government intervention in the industry. Minimizing net income allows the industries to continue operations without government interference. Jones’s study in 1991 found evidence of “income smoothing”, especially in years where firms are under government investigation.

The fourth reason for earnings management is to take advantage of taxation policies. The manager of a corporation may be willing to manage earnings to decrease net income, which will in turn decrease taxes payable. The decision to use LIFO or FIFO provides US firms with the biggest opportunity for tax savings. Dopuch and Pincus (1988) noted that it is common for US companies to use LIFO instead of FIFO because they can report lower net income in periods of increasing prices. While all Canadian firms must use FIFO, the use of earnings management to decrease or defer taxes must not be overlooked in Canadian firms.

A fifth reason why corporations may wish to practise earnings management occurs when there is a change in CEOs. As discussed by DeAngelo et al. (1994), new CEOs may be tempted to “take a bath” on earnings in the first year and blame the results on the prior CEO. Also, CEOs nearing retirement will be more willing to increase earnings now so that their bonus will be higher at the time of retirement.

A sixth reason for earnings management occurs when a firm is considering an IPO. Firm will be tempted to report higher income in the years preceding the offering so that they will receive a higher bid for their IPO. Clarkson, Dontoh, Richardson, and Shefix (1992) noted that “the market responds positively to earnings forecasts and this can be a measure of the firms value”.

As previously mentioned, managers can also participate in earnings management to communicate insider information to investors. This theory implies that a firm’s accounting policies may reveal insider information to investors, in turn helping investors evaluate the firm and make useful decisions regarding the firm’s profitability.

Conclusions

As soon as managers have the ability to alter accounting numbers, there is a decrease in the reliability of the financial statements. However, despite its effects on reliability, earnings management can still be beneficial. Earnings management is a value-added practice as long as managers act in the best interest of financial statement users (i.e. mangers do not abuse earnings management for personal gain). Demski and Sappington (1987) noted that expensive communication channels could block communication. Earnings management can try to reduce these communication barriers but only to a certain extent. If extracting insider information from financial statements is too difficult or costly, then financial statement users do not derive any benefits from earnings management practices. Ultimately, the benefits of earnings management depend on the motivation behind its use; research by Subramanyam (1996) indicates that markets do react positively to financial statements meant to provide insider information about future income potential.

Chapter 11

Earnings Management Quiz

Part One – Multiple Choice (5 points, 3 minutes)

Select the best alternative for each question.

1. What tools do managers have at their disposal to manage net income?

a) Accruals and discretionary accruals

b) Fraud and “under-the-table” transactions

c) Discretionary accruals and accounting policy

d) Inventory sell-offs and accounts receivable write-downs

e) Discretionary accruals and corporate bonuses tied to net income

2. Which of the following is not a reason that management would use earnings management to decrease net income?

a) Net income has exceeded management’s bonus cap.

b) Net income is significantly lower that management’s bonus bogey.

c) A firm under investigation for monopolistic practices.

d) Net income is slightly below management’s bonus bogey.

3. Which of the following is an example of an earnings management pattern?

a) Taking a bath

b) Taking a shower

c) Income manipulation

d) Juggling the books

e) Income balancing

4. Earnings management is:

a) The decision to pay dividends or not.

b) Marketing during slow periods to try and increase sales.

c) A financial ratio used to better understand the relationship between earnings and sales.

d) The choice by a manager of accounting policies so as to achieve some specific objective.

e) Predicting the effects of new accounting standards on earnings.

5. Why does earnings management still persist if it allows managers to manipulate earnings?

a) It is not cost effective to eliminate.

b) It provides investors with insider information.

c) It allows investors to choose between honest and dishonest companies.

d) Both a) and b)

e) All of the above

Part Two – True and False (5 points, 3 minutes)

1. Research has found that stock markets do not react to earnings management.

True False

2. One would expect that the changes to GAAP regarding extraordinary items (Jan 1990) would increase the use of earnings management.

True False

3. Earnings management is irrelevant for taxation purposes because taxation authorities impose their own accounting rules for calculation of taxable net income.

True False

4. The “iron law” surrounding earnings management suggests that managing current earnings upwards will lead to higher future net income.

True False

5. The market would better reflect insider information if earnings management was eliminated through standardization.

True False

Part Three – Long Answer Questions (40 points)

Question One (14 points, 9 minutes)

How does earnings management help to mitigate the fundamental problem of financial accounting theory, which suggests that accounting information attempts to meet both managers’ and investors’ interests? Provide an example.

Question Two (14 points, 9 minutes)

What implications does the attached article “Investors won’t get fooled again” (Jonathan Chevreau, Financial Post, February 22, 2002), which discusses the investor confidence effects of earnings management, have for accountants?

February 22, 2002

Investors won't get fooled again

Companies can no longer play games with earnings

Jonathan Chevreau

Financial Post

It's the earnings, dummy. Before taking offence, let me clarify I am merely parodying the famous Bill Clinton election campaign: "It's the economy, stupid."

If ever there were a book title crying out for inclusion in IDG Books' ubiquitous Dummies series, it would be Earnings for Dummies.

If indeed average investors have been dummies when it comes to swallowing corporate earnings reports, it appears their collective innocence has been shattered. If so, it could spell the end of the corporate shell game of "beating earnings by a penny."

A bellwether in the shift in mood may be the current [Feb. 25] cover story in Business Week magazine. 'The Betrayed Investor" describes the shattered retirement dreams of middle-class suburban Americans who uncritically bought into the 1990s cult of equity.

Their rage over growing stock market losses is hardly assuaged by the knowledge that executives at Enron and other failed enterprises made millions as the rank and file watched their pensions vanish.

Similarly, those who took flyers on vanished Internet IPOs can only gnash their teeth at the pied pipers on Wall Street who lured them to their financial destruction. Former Internet queen Mary Meeker and king Henry Blodgett made millions for themselves, despite massive losses suffered by investors who followed their recommendations.

Investor distrust of stated official earnings is now migrating from the dot cons and isolated frauds like Enron to such blue chips as General Electric and IBM.

Writing at Grant's Investor, bear Bill Fleckenstein dubs IBM "the poster boy for misleading accounting." But Big Blue is only one example of "how corporations cut every conceivable corner to try to puff up their earnings." He suggests the "next Enron" may well be all of corporate America.

Admittedly, Fleckenstein is on the short side of the market, since he runs a hedge fund. But his comments are echoed by other prominent observers of Wall Street.

Richard Russell, the seasoned editor of Dow Theory Letters, says "I don't think in my half century of watching the stock market that I've ever seen anything like the circus, the phony circus, that is taking place today." There are two types of earnings, Russell says. One is the "downright deceitful earnings" of enterprises like Enron or Global Crossing.

The other is what he calls "deceptive earnings," masquerading as operating earnings. These are earnings before interest, taxes, depreciation and amortization, and often before extraordinary losses. These losses can often be defined as "exactly enough to make operating earnings beat expectations by a penny."

In a similar vein, former Deutsche Bank chief investment strategist Ed Yardeni penned an essay titled "Are profits a mirage?"

"Profits growth was great from 1992 through 1998, but was increasingly difficult to sustain. So earnings management became a widespread practice during the late 1990s. Mostly, it was legitimate and legal, but it pushed the envelope of good sound accounting practices ... "

It's bad enough that, measured by price/earnings ratios, the U.S. market is still arguably overvalued. It's even worse that the E's in the P/E ratios could be overstated, which is what Robert Barbera, chief economist at Hoenig & Co., told Business Week.

Barbera calculates most of the 26% operating earnings growth reported by S&P 500 companies from 1997 through 2000 was the result of accounting shenanigans.

So how to act on such depressing analysis? Short of beating a belated retreat to the safety of cash, bonds and gold, it tells me that if you don't have the skills to assess earnings on your own, you need to find an advisor who can.

Alternatively, mutual fund investors need advisors who can select funds run by veterans steeped in traditional fundamentals of valuation. This list might include fund managers like Irwin Michael at ABC Funds; Peter Cundill or the managers of the Ivy funds at Mackenzie; Charles Brandes or John Arnold at AGF; Kim Shannon at Spectrum Investments; Larry Sarbit at AIC; and Bill Kanko and others at the Trimark division of AIM Funds.

By voting with your wallet for managers with a sane perspective on valuation, you will in turn put pressure on the corporations they invest in to clean up their acts and end the accounting shenanigans.

jchevreau@

Question Three – (12 points, 6 minutes)

Describe four motivations for earnings management.

Chapter 11

Earnings Management Quiz

(Solutions)

Part One – Multiple Choice (5 points)

Select the best alternative for each question.

1. What tools do managers have at their disposal to manage net income?

f) Accruals and discretionary accruals

g) Fraud and “under-the-table” transactions

h) Discretionary accruals and accounting policy

i) Inventory sell-offs and accounts receivable write-downs

j) Discretionary accruals and corporate bonuses tied to net income

2. Which of the following is not a reason that management would use earnings management to decrease net income?

a) Net income has exceeded management’s bonus cap.

b) Net income is significantly lower that management’s bonus bogey.

c) A firm under investigation for monopolistic practices.

d) Net income is slightly below management’s bonus bogey.

3. Which of the following is an example of an earnings management pattern?

a) Taking a bath

b) Taking a shower

c) Income manipulation

d) Juggling the books

e) Income balancing

4. Earnings management is:

f) The decision to pay dividends or not.

g) Marketing during slow periods to try and increase sales.

h) A financial ratio used to better understand the relationship between earnings and sales.

i) The choice by a manager of accounting policies so as to achieve some specific objective.

j) Predicting the effects of new accounting standards on earnings.

5. Why does earnings management still persist if it allows managers to manipulate earnings?

f) It is not cost effective to eliminate.

g) It provides investors with insider information.

h) It allows investors to choose between honest and dishonest companies.

i) Both a) and b)

j) All of the above

Part Two – True and False (5 points)

1. Research has found that stock markets do not react to earnings management.

True False

2. One would expect that the changes to GAAP regarding extraordinary items (Jan 1990) would increase the use of earnings management.

True False

3. Earnings management is irrelevant for taxation purposes because taxation authorities impose their own accounting rules for calculation of taxable net income.

True False

4. The “iron law” surrounding earnings management suggests that managing current earnings upwards will lead to higher future net income.

True False

5. The market would better reflect insider information if earnings management was eliminated through standardization.

True False

Part Three – Long Answer Questions (40 points)

Question One (14 points)

How does earnings management help to mitigate the fundamental problem of financial accounting theory, which suggests that accounting information attempts to meet both managers’ and investors’ interests? Provide an example.

Solution

- Earnings management addresses the fundamental problem of financial accounting theory because it serves a dual purpose. That is, earnings management caters to both investors’ and managers’ interests.

- Earnings management serves managers’ interests because it provides managers with the tools to manage reported earnings towards their goals, whether they are long-term or short-term. Managers can use accounting policy decisions such as taking a bath, income maximization or minimization, and income smoothing to better reflect managements abilities and efforts in running the firm.

- Earnings management serves the investors’ interests through the conveyance of insider information. Insider information is provided by management through their ability to manage earnings and better reflect the future earning potential of the firm.

- For example, a firm purchases a costly capital asset using internal funds. Management has a choice of amortization policies for this asset. Management can serve their interests by choosing the amortization policy that best matches expenses to expected revenues, providing consistent earnings over the life of the asset. Management’s decision also serves investors interests because it provides them with insider information through the expected future earning potential of the asset.

Question Two (14 points)

What implications does the attached article “Investors won’t get fooled again” (Jonathan Chevreau, Financial Post, February 22, 2002), which discusses the investor confidence effects of earnings management, have for accountants?

Solution

- The article suggests that earnings management has lead to a decrease in investors’ ability to trust stated net income and makes it difficult to use this information in evaluating a firm.

- In order for accountants work, especially that of public accountants, to be meaningful investors’ must be able to trust accounting information. Investors’ rely on accountants to provide them with useful information and the information accountants provide is useless if investors do not have faith in the accounting profession. The investor reluctance to rely on reported earnings reflects a mistrust of accounting information and negatively affects the public’s view of accounting professionals. This in turn reduces the reliability of the information provided in the financial statements.

- Accountants must be aware of the potential effects that their decisions will have to investors when setting accounting standards, auditing and preparing financial statements.

Question Three – (12 points)

Describe four motivations for earnings management.

Solution (Any four of the six listed)

1. Contractual Motivations. Earnings management may be used to take advantage of covenants or avoid the violation of covenants in contracts. For instance, management’s bonuses may be structured so that they are reflective of reported net income for the current year. As such a management may use earnings management to raise net income in the current year.

2. Political Motivations. Firms whose actions affect many individuals may use earnings management to reduce their visibility to the public. An example of this would be a regulated company, such as MTS or Centra Gas, which uses income-decreasing accruals to avoid a reduction in regulated service rates.

3. Taxation Motivations. Some countries allow the choice of accounting policies that may lead to a lower taxable income. This is not the case in Canada; however, in the U. S. firms have the ability to choose between the LIFO and FIFO inventory valuation methods. Relative to the FIFO method, LIFO results in a lower reported net income in periods of rising prices.

4. Changes of CEO. Earnings management may be used to manipulate earnings in the manner that is most beneficial to the Chief Executive Officer’s goals. A CEO may use earnings management to avoid being fired if he or she feels that a lower net income may lead to his or her firing.

5. Initial Public Offerings. In order to receive a higher price for their shares, a firm may use earnings management to improve current reported income. The higher share price will allow the firm to raise more capital for an equal number of shares.

6. To communicate information to investors. The managers may use earnings management to provide investors with the information that best reflects the future earning potential of the firm. Earnings management can be used to reveal inside information to investors and improve their ability to evaluate the firm.

................
................

In order to avoid copyright disputes, this page is only a partial summary.

Google Online Preview   Download