Professional Report



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Accounting Theory 9.403

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Accounting Theory

Chapter 11 Notes

What is Earnings Management

Earnings management is the selection of accounting policies to achieve a specific objective. You can do this in two ways:

1) Choice of accounting policy

2) Discretionary use of accruals

3) Classification

4) Engaging in or avoiding transactions (ex. Reducing spending)

Evidence of Earnings Management for Bonus Purposes

Despite challenges in methodology, Healy’s study certainly provides evidence that managers maximize their bonuses by using accruals to manage earnings. His findings were also consistent with the bonus plan hypothesis of positive accounting theory.

Other Motivations for Earnings Management

■ Contractual Motivations – 2 types of contracts provide incentive for earnings management. The first is the contract between the firm and its managers. This contract sets out the bonus scheme, which is usually tied to net income. This provides an incentive to manage earnings in such a way that maximizes the bonus. The second is earnings management for debt covenant purposes. To the extent that firm managers have an incentive to avoid the costs of violating their long-term debt covenants they will manage earnings.

■ Political Motivations – Jones and Cahan found that firms under investigation for monopolistic practices used earnings management to revise reported net income downward. Their studies showed that this type of earnings management happened more frequently in years that these politically visible firms were under investigation than in other years.

■ Taxation Motivations – Generally, tax avoidance is not a large motivator for earnings management because taxation authorities have created policies that restrict manipulation in this area. However, evidence evidence suggests that tax savings are the primary motivator when deciding between LIFO and FIFO for inventory valuation

■ CEO changes – There is no evidence that CEO’s approaching retirement used earnings management to maximize income

■ Initial Public Offering –Firms that are going public are interested in signaling a positive value of their firm to the market. Evidence to support this was found by Friedlan. He noted that that managers’ used income-increasing accruals to boost firm value in the period before the IPO. No other comparable period other than the one just before the IPO showed the same level of accrual usage.

■ Communicating information to investors – Earnings management, if used properly brings information from inside the corporation to outside and in so doing makes the market more efficient.

Patterns of Earnings Management

Here are some examples of what a manager using each of these types of earnings management might say:

Taking a bath…

“If we’re going to have a bad number, let’s make it a really bad one. We have nothing more to lose.”

This practice enhances the probability of profits in the future.

Income Minimization…

“We need help from the government, but they think we’re making too much money. If we can revise these numbers downward, they may be more sympathetic.”

This practice may be used by high profile, politically visible firms during periods of high profitability..

Income Maximization…

“We’re in trouble Ken, we need to report a high net income to get the lenders off our trail”

There is evidence that Enron attempted to inflate earnings as it came closer to violating its debt covenants.

Income Smoothing

“We don’t want growth of 30% this year and 3 % next year. Investors like firms that demonstrate persistent earnings power. Let’s save some of this growth for next year…”

Healy’s research showed that this practice is used to keep income between the bogey and the cap (P. 353)

If Earnings Management is so bad….

Why don’t boards of directors, regulatory agencies, lenders, government and investors band together and get rid of it?

■ The cost of correcting earnings management far outweighs the benefit

■ Amounts of discretionary accruals are very difficult to determine.

■ It is difficult for outsiders to decipher legitimate business decisions from self motivated business decisions. How can one know if an accounting policy changes resulted from business necessity or opportunistic earnings management.

■ In some ways earnings management is efficient because it counteracts the “blocked communication” problem. (p.367)

Stock Market Reaction to Earnings Management

Subramanyam found that the market responded positively to discretionary accruals that appeared to come from responsible earnings management. However, his research is subject to different interpretations since it is inconclusive as to whether the model separates accruals into discretionary and non-discretionary components in the same way that the market does.

Chapter 11 Quiz

1) What is earnings management?

Earnings management is the selection of accounting policies to achieve a specific objective

2) In what 2 ways can earnings management be positive?

Earnings management can be a vehicle for communicating inside information to investors and it gives managers the flexibility to protect themselves and the firm in the face of unexpected events.

3) How can earnings management be negative?

It can reduce the reliability of the financial statements by distorting the true earnings of the firm.

4) What is the “iron law” of earnings management? What implication does it have for the earnings manager?

All accruals eventually reverse themselves is the “iron law”. The implication is that earnings management cannot indefinitely postpone “the day of reckoning”. Just as earnings were high due to the accruals they will be pushed downward as the accruals reverse.

5) Why do some firms forego tax savings in favour of higher reported earnings under FIFO?

Because their bonuses are tied to profits and they may get more utility from a higher bonus or a reduced probability of debt covenant violation than they do from reduced taxes.

6) Earnings management is not illegal and it’s not immoral as it complies with GAAP so what if any is the problem with earnings management?

The financial statements are not transparent and not reliable.

Discussion Questions

7) Read the attached article on GE. GE has reported 101 quarters of consecutive revenue growth. Is the author correct in saying we have been lied to? Would you recommend GE stock to someone? Why or why not?

8) Should firms be required to show EBS? “Earnings before Smoothing”?

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