Unveiling Earnings Management: Patterns, Motivations, and Implications

1. Chapter 11 Earnings Management Nicole Gagnier Sarah King Fanny Kwan Bettina Reyes

2. Outline Introduction Patterns of Earnings Management Evidence of Earnings Management for Bonus Purposes Other Motivations for Earnings Management Conclusion The Good Side of Earnings Management The Bad Side of Earnings Management

3. Introduction Earnings Managementis: • The choice by a manager of accounting policies, or actions affecting earnings, so as to achieve some specific reported earnings objective. (textbook) • The manipulation of a company’s financial earnings either directly or through indirect accounting methods. (www.investorwords.com) • Referring to accounting practices that may follow the letter of the rules of standard accounting practices, but certainly deviate from the spirit of those rules.(www.wikipedia.org)

4. Introduction Earnings management includes both: 1) Accounting policy choice (indirect) • Choice of accounting policy includes revenue recognition, amortization, etc. but also discretionary accruals 2) Real actions (direct) • Real variables such as advertising, R&D, maintenance, timing of purchases and disposals of capital assets

5. Introduction The Iron Law of Accruals Reversal: • Accruals always reverse. • Managing earnings upwards will force future earnings downwards • Even more earnings management is needed to postpone losses • Result: Earnings management cannot indefinitely postpone a firms day of reckoning

6. Introduction The Financial Reporting and Contracting Perspectives of Earnings Management: • Financial reporting perspective: • To meet analyst’s earnings forecasts or • To report a stream of smooth and growing earnings over time • Contracting perspective: • To protect the firm from the consequences of unforeseen events when contracts are rigid and incomplete

7. Patterns of Earnings Management • Taking a Bath • Income Minimization • Income Maximization • Income Smoothing

8. Taking a Bath • Common during periods of organizational stress or reorganization • Mindset: If we report a loss, might as well report a large one • Write-off assets • Provide for future costs • This enhances probability of future reported profits due to accrual reversal

9. Income Minimization • Similar to Taking a Bath but less extreme • Practised during periods of high profitability • Policies include: • Rapid write-offs of capital assets and intangibles • Expensing of Advertising and R&D expenditures • Other incentives include income tax consideration

10. Income Maximization • Pattern may be chosen for bonus purposes • Firms may also maximize income if close to debt covenant violation

11. Income Smoothing • Chosen by risk-averse managers • Incentives to choose this pattern include: • Avoid covenant violation that may occur from a volatile stream of reported Net Income • Reduce likelihood of reporting low earnings • For external reporting purposes

12. Amount of Bonus Bogey Cap Reported Net Income Motivations to Earnings Management Healy’s Bonus Schemes Theory ③ ② ①

13. Managing Net Income.... Net income = Cash flow from operations ± net accruals Net accruals = ± net non-discretionary accruals ±net discretionary accruals

14. Evidences on Healy’s theory • McNichols and Wilson • Actual bad debts provision Vs. Precise estimate of what the bad debts allowance should be • Discretionary accruals = difference of the two • Results: • Significant discretionary bad debt for those years that the firms were very unprofitable and those that were profitable • Lower discretionary bad debt in between bogey and cap

15. Amount of Bonus Bogey Cap Reported Net Income Healy’s Bonus Scheme Theory Revisit ③ ② ①

16. Evidences on Healy’s Theory • Jones • Looked at 3 types of managers: • Zero bonuses Didn’t use accruals 0 < bonus < Max. > Max.

17. Other Motivations to Earnings Management Other Contracting Motivations • Earnings Management is used to reduce the probability of covenant violation in debt contracts • Investigated by Sweeny and DeFond & Jiambalvo • Findings include: • Firms tend to adopt new accounting standards when the policy increases reported net income (vice versa) • Evidence of the use of discretionary accruals to increase reported income

18. Other Motivations to Earnings Management To Meet Investor’s Earnings Expectations and Maintain Reputation • Firms that report earnings greater than expected enjoy share price increase • Conversely, firms that fail to meet expectations suffer a significant share price decrease • Investors should be aware of this incentive

19. Other Motivations to Earnings Management Initial Public Offerings (IPOs) • Managers of firms going public may manage the earnings reported in their prospectuses in the hope of receiving a higher price for their shares • Many IPO firms manage their earnings upward • Lower earnings contribute to poor share performance

20. Bad Side of Earnings Management Opportunistic earnings management • Maximizing their bonuses • Raising new share capital • Maximizing the proceeds from the new issue • Frequent recording of non-recurring items • Do not affect manager bonuses • Do not take away from the ability to meet earnings forecast • Increases future core earnings which the manager is being evaluated

21. Good Side of Earnings Management UnBlocking Communication • Blocked communication concept by Demski and Sappington • Managers have insider information • Public wants credible way to be informed • Using Earnings Management to Unblock Communication

22. Good Side of Earnings Management Stocken and Verrecchia • Benefit of Revealing Insider Information must out way the costs • When net income is adjusted through earnings management it can no longer effectively predict future performance • Manager will be held responsible for excessive earnings management Earnings Management is good when the firm’s environment is volatile and there is lots of insider information.

23. Good Side of Earnings Management Efficient Market Expectation • Rational expectations of the market understand earning management incentives and compensate accordingly • Therefore irresponsible not to manage earnings • Many different studies have come up with different results on the truth behind these statements From the evidence it can be concluded that earnings management can both inform investors and enable more efficient contracting.

24. Conclusion Implications for Accountants: • To reduce bad earnings management improve disclosure: • Clear reporting of revenue recognition policies • Detailed descriptions of major discretionary accruals • Reporting the effects on core earnings of previous write-offs • Diagnosing low persistence items • Bringing bad earnings management into the open will reduce manager’s ability to bias the financial statements

25. Conclusion The Effect of Improved Disclosure: • Share prices would more closely reflect fundamental firm value • Easier to assess management stewardship • Social welfare would increase

26. Conclusion Financial reporting represents a compromise between the needs of managers and investors: • Managers want flexibility of accounting choice: • Ability to react to unanticipated state realizations when contracts are rigid and incomplete • Vehicle for credible communication of inside information to investors (can be useful) • Smooth compensation over time • However, it reduces reliability for investors: • Earnings power may be persistently overstated (at least temporarily) • Whether earnings management is good or bad depends on how it is used

27. Connect-3-Tac-Toe