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Chapter 11

Chapter 11. Earnings Management. Chapter 11 Earnings Management. I. What is Earnings Management?. Earnings management is the choice by a manager of accounting policies, or real actions that affect earnings, so as to achieve some specific reported earnings objective.

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Chapter 11

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  1. Chapter 11 Earnings Management

  2. Chapter 11Earnings Management I

  3. What is Earnings Management? • Earnings management is the choice by a manager of accounting policies, or real actions that affect earnings, so as to achieve some specific reported earnings objective

  4. 11.2 Patterns of Earnings Management • Bath • Income minimization • Income maximization • Income smooth

  5. 11.3, 4 Motivations for Earnings Management • Contractual motivations • Bonus plan hypothesis: to manage cash bonus • Evidence: [Healy (1985)] • Debt covenant hypothesis: to manage debt covenants • Evidence: Dichev & Skinner (2002), text Section 8.5.3 • Political cost hypothesis • To lower political “heat” • Evidence: Jones (1991), text Section 8.5.3 • Continued

  6. 11.3, 4 Motivations for Earnings Management (continued) • To meet earnings expectations • Significant negative effects on share price and manager reputation if expectations not met • Other motivations • Initial public offerings

  7. 11.5 The Good Side of Earnings Management • Contract-based arguments • To give firm some flexibility in the face of rigid, incomplete contracts • Bonus contracts based on net income • New accounting standards may lower net income and/or increase volatility. May adversely affect manager effort • Debt covenant contracts • New accounting standards may increase probability of debt covenant violation • Contract violation is costly, earnings management may be low-cost way to work around • Continued

  8. 11.5 The Good Side of Earnings Management (continued) • Investor-based arguments • To credibly communicate inside information to investors • Blocked communication may inhibit direct disclosure of earnings expectations • Discretionary accrual management as a way to credibly reveal management’s inside information about earnings expectations • Manager foolish to report more earnings than can be maintained • Manage reported earnings to an amount management expects will persist

  9. 11.5.2 Theory & Evidence of Good Earnings Management • Theoretical models supporting good earnings management • Demski & Sappington (1987) • Stocken & Verrecchia (2004) • Evans & Sridhar (1996) • Dye (1988) • Chen, Hemmer, & Zhang (2007) • Continued

  10. 11.5.2 Theory & Evidence of Good Earnings Management (continued) • Empirical studies supporting good earnings management • Subramanyam (1996) • Xie (2001) questions • Tucker & Zarowin (2006) • Liu, Ryan, & Whalen (1997) • Barth, Elliott, & Finn (1999) • Callen & Segal (2004) • Francis, LaFond, Olsson, & Schipper (2005)

  11. Problem 11.9 Earnings Management at General Electric • Earnings management devices used by GE • Assumed rate of return on pension funds • Restructuring charges • Acquisitions, sales of divisions • Conservative accounting practices • Sales of leased aircraft • Allocation of goodwill on purchase of subsidiaries • Earnings management devices used in harmony to report steadily increasing earnings • Continued

  12. GE Reported Net Income (Millions) 2007 $22,208 2006 20,700 2005 16,353 2004 16,593 2003 15,002 2002 14,118 2001 13,684 2000 12,735 1999 $10,717 1998 9,296 1997 8,203 1996 7,280 1995 6,573 1994 4,726 1993 4,315 1992 4,725 Continued Problem 11.9 Earnings Management at General Electric (continued)

  13. Problem 11.9 Earnings Management at General Electric (continued) • Note argument that even under securities market efficiency, GE is so large and complex that even analysts cannot prepare accurate earnings forecasts • Management has best inside information about expected persistent earnings • Direct communication blocked • Creates role for earnings management to reveal management’s expected persistent earnings • Is this good or bad (i.e., opportunistic) earnings management?

  14. 11.6 The Bad Side of Earnings Management • Contracting Perspective • Healy (1985) • Is this good or bad earnings management? • Dechow, Sloan, and Sweeney (1996) • Is this good or bad earnings management? • Continued

  15. 11.6 The Bad Side of Earnings Management (continued) • Financial Reporting Perspective • Hanna (1999) • Investors and analysts look to core earnings, ignoring extraordinary and non-recurring items • Implies manager not penalized for non-core charges, such as writedowns, provisions for restructuring • But current non-core charges increase core earnings in future years, through lower amortization and absorption of future costs • Continued

  16. 11.6 The Bad Side of Earnings Management (continued) • Hanna, cont’d. • As a result, managers tempted to “overdose” on non-core charges, thereby putting earnings “in the bank” • also called cookie jar accounting • Note securities market reaction • Hanna found evidence that market uses frequency of such charges as proxy for their misuse--lower ERC when greater frequency • Example: Nortel (Theory in Practice 11.1)

  17. Problem 11.10 Earnings Management at Sunbeam Corp. • See Liang (1998) article • Devices used by Sunbeam to manage earnings upwards • See next slide • Note loss reported earnings 1st Q. 1998 • Illustrates “iron law” of accrual reversal • Where was auditor?

  18. Problem 11.10 Earnings Management at Sunbeam Corp.

  19. 11.6.2 Do Managers Accept Securities Market Efficiency? • Perhaps • Poor disclosure enables earnings management even if markets efficient • Perhaps Not • Theory and evidence that securities markets may not be fully efficient supports a “no” answer • Evidence that efficiency not accepted • Pro-forma earnings • Doyle, Lundholm, & Soliman (2003) • Managing same-quarter earnings of previous year • Schrand and Walther (2000)

  20. 11.6.3 Can Accountants Control Bad Earnings Management? • Full disclosure • Revenue recognition policies • Unusual, non-recurring and extraordinary events • Enables investors to better evaluate earnings persistence • Effect of previous writeoffs on current core earnings • Hanna ( 1999)

  21. 11.7 Conclusions • Earnings management can be good if used responsibly • Full disclosure helps to control bad earnings management

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