Chapter 11: Earnings Management

1. Chapter 11: Earnings Management Matthew Blostein Michael Choi Kurtis Holmes Eric Martin Trevor Stickl

2. Earnings Management Overview • Defined as: The choice by a manager of accounting policies, or real actions, affecting earnings so as to achieve some specific reported earnings objective • Understanding of Earnings Management is important as it enables an improved understanding of the usefulness of net income, both for reporting to investors and for contracting

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

4. Taking a Bath • Usually takes place during periods of organizational stress or restructuring. The main idea is that if a firm is to report a loss, managers may feel it might as well report a large one as it has little to lose. Large write-offs but future earnings “in the bank”.

5. Income Minimization • Similar to taking a bath but less extreme. Usually a politically visible firm chooses this pattern during periods of high profitability. (Example: United States vs. AT&T) • Income minimization includes rapid write-offs of capital assets, and intangibles, and the expensing of advertising and R&D expenditures.

6. Income Maximization • Managers engage in a pattern of maximization of reported net income for bonus purposes, so long as it does not put them above the cap. A firm close to a debt covenant violation may use this strategy.

7. Income Smoothing • First, Risk-adverse managers prefer a less variable onus stream, other things equal. Consequently, managers may smooth reported earnings over time so as to receive relatively constant compensation. Efficient compensation contracting may exploit this effect, and condone some income smoothing as a low-cost way to attain the manager’s reservation utility. • Second, when considering covenants in long-term agreements, the more volatile the stream of reported net earnings, the higher probability that covenant violation will occur.

8. Income Smoothing Cont. • Third, managers may feel as if they will be fired when earnings are low, income smoothing reduces the likelihood of reporting low earnings. • Finally, firms may smooth reported net income for external reporting purposes. If used responsibly, smoothing can convey inside information to the market by enabling the firm to communicate its expected persistent earning power.

9. Evidence of Earnings Management for Bonus Purposes • “The Effects of Bonus Schemes on Accounting Decisions” – Healy • Hypothesis: Managers will find opportunities in which they could manage net income in an attempt to maximize their bonuses under the firm’s compensation plans.

10. Evidence of Earnings Management for Bonus Purposes Only if income is between the bogey and cap will managers find an incentive to acquire accounting policies that increase net income

11. Evidence of Earnings Management for Bonus Purposes • Sample: 94 firms • Period: 50 years • Between bogey and cap: positive avg. accruals • Outside bogey and cap: negative avg. accruals • Consistent with hypothesis of managers incentive to lower current income when it does not affect their current year bonus

12. Evidence of Earnings Management for Bonus Purposes • Argues that changes in policies are not as income-influencing as the use of accruals • Changes in policies tend to be implemented just after the introduction/amendment of a bonus plan • If income is anticipated to be high in upcoming years, a manager will choose to implement a policy that encourages higher reported net income

13. But Wait… There’s More!

14. Other Motivations

15. Contractual Motivation • Many companies have covenants in place to protect lenders • Violating this covenant is dangerous to a manager • This causes managers to choose accounting policies to avoid covenant violation

16. Contractual Motivation Con’t • Sweeny looks at this in a 1994 study and finds two things: • Firms already violating covenants will make drastic changes to accounting policies to boost income • Firms approaching violation will make pre-mature changes to accounting policies to boost income

17. Contractual Motivation Con’t • This is a dangerous motivation due to the significant damage a covenant violation causes • Managers may be overly aggressive which may ultimately lead to fraud

18. Contractual Motivation Con’t • Another motivation is implicit contracts which arises from the relationship of firm and its stakeholders • This is the idea that a firm will receive benefits from stakeholders based on previous contracts • Allows parties to work cooperatively rather than at the Nash equilibrium

19. Political Motivations • When a company will make policy changes to intentionally lower its income • This is done to escape government scrutiny • For example a company making large profits in a given year may altar its amortization policy from straight line to declining to recognize greater expenses to match these profits

20. Meet Earnings Expectations • This is when estimated earnings for future periods meet and exceed expectations of investors • This will ultimately increase share price due to the strong positive correlation between expected earnings and share price

21. Meet Earnings Expectations Con’t • 2010 study looking at 1992-2006 proves that small earnings surprises actually leads a decrease in share price • Investors are aware that earnings surprises are caused by earnings management • Proves that expectations must be met, but surprises are not beneficial due to rational investors

22. Meet Earnings Expectations Con’t • This creates a case of conflict of interest as most managers hold stock options • It gives a greater incentive for managers to meet expectations using earnings management to avoid share price decreases • May not be the best option for the firm • Can also lead to fraudulent behaviour

23. IPO • The issue with an IPO is that there is no market price for a firms shares • This gives management incentive to increase estimates of futures earnings to get a higher price for their shares

24. IPO Con’t • Studies in 1997 and 2007 look at companies going public and their accruals • The main result found is that companies boost their accruals prior to the IPO, then reverse these accruals in later years causing losses • Shows this type of earnings management is successful as it works even with rational investors

25. Good Side of Earnings Management • Blocked Communication • Managers have inside information that is costly to communicate = blocked information • Managers can use provisions to smooth earnings to desired levels and unblock information • It would be foolish to overstate earnings since the market will react severely when there is a subsequent reduction

26. Good Side- Blocked Communication • Inside Information • New firm strategies • Change in firm characteristics • Market conditions • All complex information, but proven to be communicated through discretionary accruals and disclosures.

27. Good Side- Contracts • EM can be used to maintain investor expectations and avoid market penalties for fluctuations • If markets have rational expectations then both management and investors benefit from a consistent tracking and flow of earnings • Upward earning management decreased contract efficiency, but is a must for investors

28. Good Side- Conservative Accounting • Decreases contract efficiency as higher manager effort = lower earnings • Also reduces need for upward earnings management = increased contract efficiency • Net effect of the two reactions is positive on firm value

29. The Bad Side of Earning Management • Opportunistic EM • Tendency for managers to try to maximize their bonus • Debt Constraints • Firms that are highly levered need EM to control if they violate loan covenants • Supported by Dechow, Sloan and Sweeney study of 92 firms that firms do practice this technic

30. Bad Side Cont’d • Raise new capital • EM can be used to maximize proceeds of new issues • Discretionary accruals can increase SR earnings • Techniques: • Speed revenue recognition • Lengthen cap. Asset life • Under reserve for environmental costs

31. Bad Side Cont’d • Transitory items • Unusual items so they do not affect manager bonus’ • Increase future earnings by reducing future amortization and absorption of costs that would normal go through operating expenses

32. Standard Setters • Reflect the bad earnings management view • IAS 37- provision as a liability if timing of payments is uncertain • Must be probable • Must be reliably estimated • Must be at fair value

33. Measures of Earning Management • Variability of operating income • Lower = income smoothing • Correlation between accruals and cash flow • Low correlation =early revenue recognition • Magnitude of total accruals • Higher accruals = higher discretionary accruals • Small Loss/Gain ratio • Low ratio = EM to avoid small losses

34. Implications • Ways to reduce bad earning management • Don’t reject market efficiency • Improve disclosures • Reduces behavioural biases • Lower management incentive to exploit poor governance and market inefficiencies • Report effects of current earnings on prior write-offs

35. Earnings Management Conclusions • Earnings management is justified through the theory that true net income does not exist • GAAP does not completely constrain managers choices of accounting policies • Complex and challenging • Motivated by strategic considerations • Meeting earnings expectations • Specific contracts and their covenants • IPO’s or SPO’s • Discourage potential competition • Unblock inside information

36. Earnings Management Conclusions • Changes in accounting policy are becoming a game for companies • Managers will react against rule changes that reduce their flexibility of accounting choice • Need to be aware of legitimate needs of management, investors, and be aware of opportunistic strategies • Accompanying earnings management is reduction in reliability and sensitivity of info

37. Earnings Management Conclusions • Earning Management gives managers flexibility to react to unanticipated realizations • Earnings Managements can be a vehicle for the credible communication of inside info to investors • Both arguments above are consistent with efficient securities markets and the efficiency version of positive accounting theory

38. Earnings Management Conclusions • Managers can abuse communication potential of GAAP • Result in failure to accept securities market efficiency or from an ability to hide bad earnings management behind poor disclosure • Reduce Earnings Management by bringing it to public, out in the open • Improve disclosure of low persistence items and reporting effect of previous write offs on current earnings • Assist corporate governance, help better reward good manager performance and discipline managers who shirk • Improvements in allocation of scarce investment capital and firm productivity increase social welfare

39. Taking a Bath and RIM • RIM Stock has plummeted over 70% in the past year, netting to roughly $8/Share • It recently announced $518 million quarterly loss • Plans to lay off 5,000 employees • RIM is trying to maximize it’s losses to prepare for future reported profitability with the Launch of Blackberry 10.

40. Income Minimization and AT&T • United States v. AT&T • Antitrust case that led to the 1984 Bell Systems divestiture • AT&T accused of using monopoly profits to subsidize the costs of its own network • Had they chosen an income minimization pattern, AT&T may not have caught the public eye and scrutiny

41. Enron • This is a perfect example for income maximization earnings management • Due to the stock option based compensation managers receive, there was constant incentive to inflate earnings • Most of the earnings management was done using complex accruals and estimations

42. Enron Con’t • With this type of earnings management comes risk of government scrutiny • The income was never smoothed out and governing bodies took interest in consistently high growth • This ultimately lead to Enron’s downfall and many regulations and accounting bodies put in place to avoid this in the future

43. Income Smoothing CaseCompany overviews (2007) • American International Group (AIG) • World’s largest insurance and financial services company • Net Income - $6.2 billion • Premiums written - $59.8 billion • GenRe • One of worlds largest reinsurers • Owned by Berkshire Hathaway • Premiums written - $6.0 billion

44. Income Smoothing CaseRegulatory Scrutiny • 2001 – SEC learned AIG assisted client in manipulating the balance sheet through bogus insurance transaction • 2003 – SEC and Justice Department settle civil case with AIG in amount of $10 million • 2004 – Federal investigation of AIG’s income smoothing products

45. Income Smoothing CaseDeal between AIG and GenRe • GenRe was to transfer loss reserves to AIG in exchange for premium payment • Contracts for loss reserves to total between $500 and $600 million • GenRe “obligated” to pay AIG “premium” of $1 billion • GenRe was to receive $5 million transaction fee for deal • Contract to last 24 months, at which time it would be reversed

46. Income Smoothing CaseImproper Accounting and Public Perception • AIG finally admitted that this deal should have been accounted for as a deposit • Restatement of AIG’s income following this announcement amounted to a reduction in net income of $1.32 Billion • Public Perception • Reckless efforts of senior corporate officers that were designed solely for the unlawful purpose of achieving a specific and false accounting effect on issuers financial statements

47. Thank you for your Time! Questions? Comments? Then on to the game!