Presentation on theme: "Earnings Management. What is earnings management? It is the choice by a manager of accounting policies or real actions, affecting earnings so as to achieve."— Presentation transcript:
Why is understanding earnings management important to accountants?
It is important because: - It enables an improved understanding of the usefulness of net income - both for reporting to investors and contracting - Helps avoid some of the serious legal and reputation consequences that arise when firms become financially distressed.
Earnings Management Choice of accounting policy has broad interpretations No clear cut dividing line between the two choices 1.Choice of accounting policies (straight line versus declining balance amortization) 2.Discretionary accruals ( provisions for credit losses, warranty costs, inventory values, writeoffs and provisions for restructuring Earnings management can be a vehicle for the communication so managements inside information investors.
Fine line between earnings management and earnings mismanagement The locations of the line is determined by Effective corporate governance Reinforced by securities and managerial labour markets Standard setters Securities commissions Courts
Iron law of accruals Accruals reverse For ex: a manager who manage earnings upwards will suffer a lower earning in later periods Therefore earnings management should not be used to rationalize misleading or fraudulent reporting
Patterns of Earnings Management 4 different earnings management patterns 1.Taking a bath 2.Income minimization 3.Income maximization 4.Income smoothing
Taking a Bath Takes place during periods of organizational stress or restructuring Might as well report a large loss (nothing to lose) Write off assets (clear the decks) Enhances the probability of future reported profits because of accrual reversal
Income Minimization Similar to taking a bath but less intense Chosen by firms during periods of high profitability Policies that suggest income minimization Rapid writeoffs of capital assets and intangibles Expensing of advertisement and R&D Income tax considerations
Income Maximization If a firms is close to debt covenant violations may use income maximization Engage in this pattern for bonus purposes Provided that this does not put them above the cap
Income Smoothing Incentives 1. Risk averse managers prefer a less variable bonus stream Smooth out reported earnings over time to gain relatively constant compensation Efficient compensation contracting may exploit this effect 2. Incentive to reduce volatility of reported net income to smooth out covenant ratios over time Reduce the possibility of reporting low earnings 3. Firms smooth reported net income for external purposes If used responsibly smoothing can convey inside information to the market by enabling the firm to communicate its expected persistent earning power
11.3 Evidence of Earnings Management for Bonus Purposes Healy 1985 wrote a paper on The Effect of Bonus Scheme Decisions Based on positive accounting theory, which attempts to explain and predict managers choices of accounting policies Conclusion: Managers would be able to manage net income to maximize their bonuses under their firms compensation plans
Typical Bonus Scheme Significance Bonus is constant for net income greater than the cap No cap in the bonuses, the bonus would increase along the dotted line No bonus to be received, the manager might as well adopt accounting policies to further reduce the net income If net income is between the bogey and cap the manager is motivated to adopt accounting policies to increase the net income Typical Bonus Scheme
Discretionary and Non- Discretionary Accruals o Discretionary Accruals : Accruals which the manager can exercise some control o Non - Discretionary Accruals: Manager does not have control
Discretionary and Non- Discretionary Accruals Amortization Expense: Discretionary: Company changes the policy for the calculation of the amortization expense by modifying estimated useful life measurement Non- Discretionary: Amortization expense number changes Increase in net account receivables Discretionary : Management makes changes by selecting a less conservative estimate for allowance for doubtful accounts, increase through earlier recognition, more generous credit policy or keeping the books open beyond the year end Non- Discretionary: Increase in volume of business
Other Accruals Increase in Inventory Non-Discretionary increases include inventory buildup due to anticipation of increased demand Discretionary increases would include charging fixed overhead costs to inventory rather than charging them off as expenses Decrease in accounts payable and accrual liabilities - Discretionary decisions are used in making these estimates such the firm being more optimistic about warranty claims than in previous years. Also regarding certain borderline liabilities as contingences rather than as accruals
Observations with both a Bogey and Cap Manager has considerable discretion when recording net income Did not have access to the books and records of his sample firms therefore unable to determine specific discretionary accruals made by the firms managers Observations fit into one of the three categories Portfolio UPP: Observations where earnings were above the cap Portfolio Mid: Observations between the bogey and the cap Portfolio LOW : Observations where earnings were below the bogey
Healy Conclusion Major difficulty is that discretionary accruals cannot be directly observed Kaplan (1985) Pointed out a firm with reported net income above the cap of its bonus plan may have low non-discretionary accruals The high income is due to an unexpected increase in demand that runs down inventory. Low total accruals are due to: Level of the firms real economic activity Not to low discretionary accruals. Healy addressed Kaplan issues and performed additional tests to confirm the results
Discretionary Accruals Bad Debt McNichols and Wilson(1988) Studied the behavior in a bonus context Results consistent with Healy Confirmed the provision for bad debts on the grounds that a precise estimate for what the bad debt allowance should be (non-discretionary portion) made Discretionary accruals = Estimate bad debt provision - Actual bad debt provision Below bogeys and above caps: Significant income reducing both for firms that were profitable and unprofitable Between profitability extremes: Firms discretionary accruals were lower among income increasing
Jones: Non-discretionary Accruals Jones (1991) Estimate non-discretionary accruals, using better data Non- discretionary accruals found that managers who received 0 bonus did not use accruals to manage earnings downwards which different from Healys findings, in row 1. Managers who were at their bonus maxima accruals so as the lower reported earnings which is different from Healys findings- row 3
Earning management incentive conclusions Managers use accruals to manage earnings to influence their bonuses, particularly when they are high consistent with bonus plan hypothesis of positive accounting theory 2 ways to think about bonus plans 1)Opportunistic behavior Managers exploit their power in the organization by maximizing their utility at the expense of the firms shareholders and investors who may find it costly to unravel discretionary accruals. 2) E fficient contracting perspective When setting compensation contracts firms will rationally anticipate managers incentives to manage earnings and will allow for this in the amount of compensation they offer It is less costly to an organization to offer it Either way it does create earnings management incentives
WHAT IS A DEBT COVENANT? WHY DO LENDERS USE THEM?
11.4.1 Other Contracting Motivations 11.4.1 Other Contracting Motivations Covenants: Protect against actions by managers that are against the lenders best interest Excessive dividends Additional borrowing Letting working capital or shareholders equity fall below specified levels All of these actions dilute the security of existing lenders
WHAT IMPACT CAN COVENANT VIOLATION HAVE ON A FIRM?
11.4.1 Other Contracting Motivations Covenant violation High costs firms Raise the going concern issues for the business Earnings management can arise as a device to reduce the probability of violation of debt contracts Sweeney 1994 1.Discovered significantly greater use of income- increasing accounting 2.And the early adoption of new accounting standards to increase net income
11.4.1 Other Contracting Motivations Other studies found: Use of discretionary accruals to increase reported income in the year prior to and to a lesser extent in the year of the convent violation Many companies had to cut dividends which makes lenders, shareholders, unions feel that they are financially unstable
11.4.1 Other Contracting Motivations Earning management incentives Relational contracts these are not normal contracts such as compensation or debt contracts For example: Meeting contract commitments with suppliers will allow one to receive better terms from suppliers and lower interest rates from lenders Bowen etc 1995 investigated implicit contracting where companies have represented high profits Increase stakeholder confidence that the manager will continue to meet the contract obligations. For example business with high COGS or notes payable will use FIFO and straight line amortization as it appears to be income increasing.
11.4.2 Meeting Shareholders Expectations Investors earnings expectation can be formed in variety of ways Based on earnings in same period last year or recent analysis or company forecasts Skinner and Sloan 2002 Firms penalize more for failing short of expectations Manage earnings upwards ensure that earnings expectations are met Keung etc. 2010 Market reaction to a zero or even a small positive earning surprise turned negative during 2002-2006, compared to positive response received in previous years
11.4.2 Meeting Shareholders Expectations Mercer 2005 Plausible: Earnings and forecasts as well as their opinions increase Not plausible: Earnings and forecasts as well as their opinions decrease Failure to meet investors earnings expectations has serious consequences Direct effect: Firms share price and cost of capital as investors are expected to be lower Indirect effect: Manager reputation can be negatively impacted if explanation appears as an excuse
11.4.3 Initial Public Offerings IPOs do not have a established market price Question is: What is the value of the shares in such firms? Financial accounting information is a useful source Ex: Forecasts Clarkson etc. 1992 Evidence the market responds positively to earnings forecasts as a signal of firms value
11.4.3 Initial Public Offerings Teoh 1998 Discretionary accruals around the IPO date are concentrated on working capital accruals High discretionary accruals was significantly negative relative to IPOs firms with low accruals Currently it is unclear whether investors are fooled by opportunistic earnings management in IPOs or rationally price the IPO
Blocked Communication Agents obtaining specialized information as part of their expertise, and this information can be prohibitively costly to communicate to the principle that is its communication is blocked The presence of blocked communication can reduce the efficiency of agency contracts, since the agent may shirk on information acquisition and compensate by taking an act that, from the principles point is sub-optimal Earnings management can be a device to reduce blockage
Reducing Information Blockage Such as: An increased positive market reaction to disclosure of business strategy in high tech firms when the disclosures are proceeded by a credible gesture of confidence in the firm by management namely insider stock purchases Disaggregation of good news forecast (i.e. forecasting sales and expenses as well as net income) increases its credibility Earnings management can be a device to reduce information blockage
Empirical Evidence of Good Earnings Management Does the stock market react to earnings management as if it were good? The answer to this question is important to an accountant since they are prominently involved in the technique and implementation of earnings management and will and get drawn into the negative publicity and lawsuits that inevitably follow the revelation of bad earnings management practices
Earnings management can both inform investors and enable more efficient contracting However the opportunistic earnings management is mixed in with the good cannot be ruled out
Empirical Evidence Examples Subramanyam – the stock market responded positively to the current period's discretionary accruals, consistent with managers, on average using earnings management responsibly to reveal inside information about future earnings power
Empirical Evidence Examples Xie – found that rather than reacting to discretionary accruals as if they were good, the market appears to over value them
Empirical Evidence Examples Tucker and Zarowin – conclude that greater income smoothing behaviour is accompanied with good earnings management argument
Opportunistic Earnings Management Despite theory and evidence of responsible use of earnings management, there is also evidence of bad earnings management Opportunistic Manager Behaviour: the tendency of managers to use earnings management to maximize their bonuses
Study by Dechow, Sloan, and Sweeney Examined the earnings management practices of 92 firms charged in the USA by the SEC with alleged violation of GAAP, compared to a control sample of firms of similar size and industry Revealed a number of motivations for such earnings management Firms in test sample had, significantly greater leverage and significantly more debt covenant violations than the control sample Raising new share capital and want to maximize the proceeds from the new issue
Study by Dechow, Sloan, and Sweeney Studied the financing decisions of sample firms Charged firms issued, on average, significantly more securities during the period of earnings manipulation than the control sample
Market Reaction to Earnings Management Market does appear to react to earnings management ERC for a dollar of quarterly core earnings is lower for firms that have frequently recorded large unusual and non-recurring charges Consistent with the market using the frequency of non-recurring charges as a proxy for the extent to which core earnings may be overstated
Earnings Management in an International Context Leuz, Nanda, and Wysocki evaluated the extent of earnings management in each of 31 countries during 1990–1999 Measures used: Variability of operating income Correlation between accruals and cash flow Magnitude of total accruals Countrys ratio of small earnings losses to small gains
Earnings Management in an International Context Measures were combined to create a score for each country Lower scores imply less earnings management Canada - 5 USA - 2 Germany - 21.5 Scores were related to country institutional characteristics For example: Lower investor protection is associated with more earnings management
Nortel April 2004 – Nortel fires CEO & controller Share price falls from $11 to $5.26 Nortel overstated 2003 net income Collapse of technology boom in early 2000s Excessive accruals made for cost of contract cancellations, bad debts, layoffs & plant closures Nortel reverses 2003 accruals Does not disclose to investors Credited to operating expense
Nortels compensation plan provided for bonuses if the company returned to profitability CEO received $3.6 million bonus in 2003 After the effects of excessive accrual reversals are taken into account, it appears that the first two quarters of 2003 may have been loss quarters
Nortel – The Consequences January 2005: Nortel issued restated 2001- 2003 results reporting losses February 2005: Nortel sues three former executives to recover bonuses March 2007: SEC begins civil proceedings against four executives March 2007: Nortel reduces 2005 earnings by $134 million putting the company into violation of certain debt covenants. 2009: Nortel announces the company will cease operations and sell of all business units.
Do Managers Accept Securities Market Efficiency? Market favours firms with steadily increasing earnings patterns Inefficient Market Interpretation: momentum trading in response to the increasing earnings pattern drives the favourable market reaction Same-quarter earnings of the previous year are a very important earnings benchmark for managers Lowest possible prior period benchmark emphasized, thereby showing the change in earnings from the prior quarter in the most favourable light
Doyle, Lundholm, and Soliman Investor reaction to pro-forma earnings was studied by Doyle, Lundholm, and Soliman Found that many expenses excluded from GAAP net income had significant future effects on operating cash flows Abnormal share returns over a three-day window surrounding the date of quarterly earnings announcements Found that the greater the difference between pro- forma and GAAP earnings the lower the abnormal share return over the three days Suggests that the market does not ignore the excluded items
Doyle, Lundholm, and Soliman Market reaction is not complete Lower share returns for firms with greater pro- forma–GAAP discrepancies continued for up to three years If the market was fully efficient, all of the negative reaction would have taken place within the three-day window These earnings management policies make little sense if securities markets are efficient Consequently, managers who engage in them must not fully accept efficiency
Implications for Accountants The implication for accountants who wish to reduce bad earnings management is not to reject market efficiency, but to improve disclosure Reduces their susceptibility to behavioural biases and managers ability to exploit poor corporate governance and market inefficiencies Other ways to improve disclosure include reporting the effects on core earnings of previous write-offs and, in general, assisting investors and compensation committees to diagnose low-persistence items.
CONCLUSION Earnings Management is possible because TRUE net income does not exist GAAP does not completely constrain managers choice of accounting policies and procedures Often we see managers accounting policy choices are motivated by strategic considerations, such as meeting earnings expectations The bad of earnings management is that managers may abuse to the extent that earning power is persistently overstated The good of earnings management can give managers the flexibility they need to react to unanticipated states realizations and give a credible means to communicated inside information to investors