Quality of Earnings and Earnings Management

1. Quality of Earnings and Earnings Management FIR 7410 Fall 2002

2. How to define earnings quality? • refers to understanding the economic substance of a transaction, then reflecting it properly in the books and records of the company; • often measured by its information content, or its value-relevance. Practically, the association between earnings and stock prices (or stock returns) is often used as the proxy for earnings quality. FIR 7410 Fall 2002

3. Until the mid-1960s, scientific evidence regarding whether accounting earnings contained or conveyed information about a firms’ financial performance did not exist. Pioneering studies by Ball and Brown (1968) and Beaver (1968) represent a start of positive capital market research in accounting. Ball and Brown (1968) examine the relation between the earnings surprise and the abnormal return around earning announcement, and show clear evidence that accounting earnings capture a portion of the information set that is reflected in security returns. Beaver (1986) tests whether the flow of information is higher during earnings announcement period than non-earnings announcement period. The evidence supports the hypothesis that information flow is higher around earnings announcements. FIR 7410 Fall 2002

4. Management can manage the level or (and) trend of reported earnings! • Heard of earnings management? • Earnings reports reflect the desire of management rather than the underlying financial performance of the company. • Use of 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, or to influence contractual outcomes that depend on reported accounting judgments. • Purposeful intervention in the external financial reporting process with the intent of obtaining private gains. FIR 7410 Fall 2002

5. In countries such as France, Germany, Italy, and Japan, GAAPs allow greater discretion in reporting earnings. For example, it is legal and a common practice for managers to set up several hidden reserves accounts. In good years managers hide some profits in these reserve accounts, and in bad years they move some profits out of these accounts to smooth earnings. WHY? FIR 7410 Fall 2002

6. Shareholders Auditors Creditors Profit Pie Government Customers Managers Employees FIR 7410 Fall 2002

7. In the UK, US, Canada, etc, managers also have incentives to manipulate earnings. According to the 2001 Controllers Council Ethics Survey in the US, 73% of respondents (financial controllers) feel pressured to manage earnings at their companies, 56% reports that they have experienced some kind of ethical dilemma on the job. Pressure to manage earnings does not stem from a single source. It can arise from forces outside the company, from conditions and programs within the company, or from motivations held by individuals that choose to engage in earnings management activity. FIR 7410 Fall 2002

8. Factor 1: To meet analysts’ forecasts. Companies that fail to meet analysts’ forecasts can see their stocks drop precipitously. When Procter & Gamble warned that it would not meet analysts’ consensus forecast in the first quarter of 2000, its stock price fell 30%. When P&G issued further warnings just before the end of the second quarter of 2000, the stock price fell another 10% and the CFO was fired. Factor 2: Debt rating. Debt rating agencies use much of the same information as stock analysts to establish a business’s creditworthiness. A slight drop in earnings or negative expectations about future prospects could cause a decline in a company’s debt rating, increasing its cost of capital and diminishing prospects for new debt issues. FIR 7410 Fall 2002

9. Factor 3: Contractual obligations. Many debt and lease agreements contain covenants in which a company agrees to attain certain earnings, debt ratio, or limit payments to shareholders. When a company is in danger of missing one of the covenants, the agreement may require immediate payments. Manipulating earnings slightly can improve ratios enough to avert such dangers. Factor 4: Management compensation. Companies frequently tie executive stock option and bonus programs to earnings performance, attempting to align management’s objectives with shareholders’ objectives. But this creates powerful incentives for managers to manipulate earnings to maximize compensations. FIR 7410 Fall 2002

10. Factor 5: Negotiations with unions. Managers have incentives to reduce earnings to support a claim that the company cannot grant wage increases. Factor 6: Merger attractiveness. Good financial performance can enhance the attractiveness of merger target companies. Factor 7: Promotion and job security. Managers who meets financial targets are more likely to be promoted to higher positions. On the other hand, those who miss the targets are likely to have higher risk of losing jobs. FIR 7410 Fall 2002

11. How do managers manipulate earnings in countries such as Canada, the UK, and the US? • There are many ways that managers can exercise judgment in financial reporting: • Judgment is required to estimate numerous future economic events such as expected lives and salvage values of long-term assets, obligations for pension benefits and other post-employment benefits, and losses from bad debts as well as asset impairments. • Managers must choose among acceptable accounting methods for reporting the same economic transactions, such as the straight-line or accelerated depreciation methods or the LIFO, FIFO, or weighted-average inventory valuation methods. FIR 7410 Fall 2002

12. Managers must exercise judgment in working capital management, such as inventory levels, the timing of inventory shipments or purchases, the receivable policies, which affects cost allocations and net revenues. • Managers must choose to expense or defer expenditures, such as R&D, advertising, or maintenance. • Managers must decide how to structure corporate transactions. For example, lease contracts can be structured so that lease obligations are on-or-off-balance sheet, and equity investments can be structured to avoid or require consolidation. FIR 7410 Fall 2002

13. Evidence of Earnings Managements (from academic research) Many studies use abnormal (unexpected or discretionary) accruals as the proxy for earnings management. Burgstahler and Dichev (1997) find that firms manage earnings to avoid losses or earnings decreases. Guenther (1994) finds that firms manage earnings to pay less taxes. Healy (1985) finds that managers manipulate earnings to maximize their bonuses. Teoh, Welch, and Wong (1998) find that firms report positive (income-increasing) accruals prior to seasoned equity offers and initial public offers. FIR 7410 Fall 2002

14. Can Investors See Through Earnings Management? Several recent studies indicate that there are situations in which investors do not see through earnings management. However, in other cases, notably in the banking and property-casualty industries, it appears that investors do see through earnings management. One explanation for these apparently conflicting findings is that, as a result of regulation, investors in banking and insurance firms have access to extensive disclosures that are closely related to the key accruals. These disclosures may help investors make more informed estimates of the likelihood of any earnings management. FIR 7410 Fall 2002

15. In general, research shows that earnings are more value-relevant in • countries with • 1. common law as the origin of the legal system, • 2. market-oriented financial system, • 3. strong shareholder protection, • 4. low conformity between financial and tax accounting rules, • 5. strong external audit FIR 7410 Fall 2002

16. Examples of A Controller’s Challenges • Sales: • When to recognize current sales made on installment contracts? • Inventory: • FIFO (higher reported profits) versus LIFO • Depreciation: • Straight-line method • Sum-of-the-digits method • Pension cost: • Defined contribution (profit sharing, current business expenses) • Defined benefit • If pension assets are under funded for more than 10%, deduct that amount from current year’s earnings. Otherwise, report in a footnote FIR 7410 Fall 2002

17. Examples of A Controller’s Challenges • Potential dilution of earnings per share: Primary EPS versus fully diluted EPS • Various parties have options to purchase common stock from the operation • Convertible bonds, convertible preferred stocks, executive stock options, and warrants • If the dilution results in an EPS decline of less than 3%, no need to report. • Extraordinary gains and losses: • Should be reported separately in income statement FIR 7410 Fall 2002