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Earnings Management

Earnings Management. Class Announcements. Assignment #9 due March 24 th ; available on-line Assignment #10 due March 31st; available on-line Assignment #8 returned at the end of class Research paper #3 returned at the end of class Research Paper Part #4 and bonus due April 3 rd

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Earnings Management

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  1. Earnings Management

  2. Class Announcements • Assignment #9 due March 24th; available on-line • Assignment #10 due March 31st; available on-line • Assignment #8 returned at the end of class • Research paper #3 returned at the end of class • Research Paper Part #4 and bonus due April 3rd • Final Exam 7:00pm April 19th, Main Gym, Oland Centre • Business Banquet - April 2nd – 5:45-8pm, Catering - Gabrieau's Bistro; Keynote Speaker - Annette Verschuren, Past President of Home Depot for Canada and Asia

  3. Class Objectives • Earnings management defined in terms of an agency contract • Earnings management patterns • Reasons for managers to actively participate in earnings management • Evidence of earnings management

  4. Earnings Management • “Earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company to influence contractual outcomes that depend on reported accounting numbers” (Healy and Wahlen 1999, p. 368) • “Earnings management is the choice by a manager of accounting polices, or real actions, affecting earnings so as to achieve some specific reported earnings objective. (p. 423)

  5. Earnings Management (EM) • Definition • Choice of accounting policies to achieve some specific manager objective • 1.Accounting Policy Choice • Choice of accounting policy • Discretionary accruals • 2. Operational Change • R&D, advertising, maintenance • Timing of disposals • (note: affects cash flow as well and compromises longer term performance.)

  6. Earnings Management • Given managers can choose accounting polices from a set of polices it is natural to expect that they will choose polices so as to help achieve their objectives. • Choices can be motivated either by efficient markets and contracts or by opportunism and rejection of market efficiency. • Accruals reverse (iron law)- earnings management can not “indefinitely postpone the day of reckoning”.

  7. Earnings Management: Reasons • Financial Reporting • To meet investors’ earnings expectations • To credibly communicate inside information about earnings expectations • To smooth earnings to communicate core earnings • Contractual • Bonus [Healy (1985)] • Debt covenant [Sweeney (1994)] • Implicit Contract • Political [Jones (1991)] • IPOs [Teoh et al (1998)]

  8. Earnings Management: Patterns • Taking a Bath • Income Minimization • Income Maximization • Income Smoothing • More volatile income, more variability in bonus • More volatile income higher probability that covenant violation will occur

  9. Earnings Management: Good • 1) Contracting perspective • manager have some ability to manage earnings in face of incomplete and rigid contracts • 2) Financial reporting perspective • earnings management is a device to convey inside information to the market enables share prices to better reflect the firm’s future prospects • unblocking the managers inside information • market appears to reward earnings management that does not overstate future earning power.

  10. Earnings Management: Bad • 1) Contracting perspective • opportunistic behavior of managers: tendency to use earnings management to maximize their bonuses • 2) Financial reporting perspective • poor disclosure keep the extent of earnings management as inside information • some managers behave as if they can beat the market (e.g. excessive non recurring income items impounded as core earnings)

  11. Earnings Management: Persist • Most people would feel that earnings management is “bad” as it implies a reduction in reliability and usefulness of financial statement information. • Management earnings persists • prohibitively costly for others to find out inside information • difficult to discover discretionary accruals • difficult for outsiders to interpret more visible earnings management (e.g. policy change, timing of capital gains and losses)

  12. Earnings Management Techniques • Revenue Recognition • Accounting Policy Change • Timing of Adoption of New Standards • Write-offs, Provisions, Etc. • Accruals (Discretionary) • Direct Charges to Retained Earnings • Cookie Jar Accounting • Stuffing the Channels

  13. Earnings Management: Understanding • Regulators and standard setters identify areas most in need of regulatory change • Auditors evaluate and report on their clients’ quality of earnings, and train novice auditors about earnings management • CEO’s, CFO’s, audit committees and investors focus attention on those areas of the financial statements where they should be most skeptical • Managers and audit committees anticipate the transaction that investors will view most skeptically • Educators teach students about earnings management • Researchers focus their analysis on areas of high-earnings management activity

  14. Earnings Management Techniques: Nelson et al (2003) • Aggressive earning management has been of concern to regulators for several years • There exist little systematic research concerning the specific methods by which earnings management is attempted. • Nelson et al (2003) tried to capture the types of earning management and the impact on net income through a survey to 532 auditors (partners and managers).

  15. Earnings Management Techniques: Nelson et al (2003) • Expenses & Other losses – recognizing too much or too little reserve in the current year. • Revenue & Other gains – approaches include cutoff manipulation, deferring to much or too little revenue , etc. • Business Combinations – over or understatement assets with the charge to goodwill • Other approaches – approaches include income statement classification issues, inappropriate disclosures, off balance sheet financing, etc.

  16. Earnings Management Techniques: Nelson et al (2003)

  17. Class Objectives - Revisited • Earnings management defined in terms of an agency contract • Earnings management patterns • Reasons for managers to actively participate in earnings management • Evidence of earnings management

  18. Research Paper Part #4 • Discuss relationship to accounting theory - e.g. information perspective, measurement perspective, agency theory, positive accounting theory, etc.; (pick one theory and apply to Handbook section) • Due: April 3, 2014 • Worth: 2.5% • Length: One page submission (double spaced) with cover page, Introduction (bonus) Part#1, Part#2, Part #3 an Part #4, Conclusion (bonus), Reference page and Marking Keys #1, Part#2 Part#3 attached to the back.

  19. Research Paper Part #4 • Bonus: Provide a one paragraph introduction (maximum 1/3 of page) and one paragraph conclusion (maximum 1/3 of page) on separate pages. Due: April 3, 2014 • Worth: 1.0%/10% (Maximum of 1%; 0.5% for each of each of introduction and conclusion) • Length: One page submission (double spaced) with cover page, Introduction (bonus) Part#1, Part#2, Part #3 an Part #4, Conclusion (bonus), Reference page and Marking Keys #1, Part#2 Part#3 attached to the back.

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