2Earnings Management What is earnings management? It is the choice by a manager of accounting policies or real actions, affecting earnings so as to achieve some specific reported earnings objectiveWhat is earnings management?
4Why is understanding earnings management important to accountants?
5It is important because: It enables an improved understanding of the usefulness of net incomeboth for reporting to investors and contractingHelps avoid some of the serious legal and reputation consequences that arise when firms become financially distressed.Why is earnings management important?
6Earnings ManagementChoice of accounting policy has broad interpretationsNo clear cut dividing line between the two choicesChoice of accounting policies (straight line versus declining balance amortization)Discretionary accruals ( provisions for credit losses, warranty costs, inventory values, writeoffs and provisions for restructuringEarnings management can be a vehicle for the communication so managements inside information investors.
7Fine line between earnings management and earnings mismanagement The locations of “the line” is determined byEffective corporate governanceReinforced by securities and managerial labour marketsStandard settersSecurities commissionsCourtsLocation of the line is determined by who?All of the above)
8Iron law of accruals Accruals reverse For ex: a manager who manage earnings upwards will suffer a lower earning in later periodsTherefore earnings management should not be used to rationalize misleading or fraudulent reportingWhat is the iron law of accruals? What is the key aspect of iron law of accruals
9Patterns of Earnings Management 4 different earnings management patternsTaking a bathIncome minimizationIncome maximizationIncome smoothingWhat are the 4 patterns in earnings managementTaking a bathIncome minimizationIncome maximizationIncome smoothin
10Taking a BathTakes place during periods of organizational stress or restructuringMight 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
11Income Minimization Similar to taking a bath but less intense Chosen by firms during periods of high profitabilityPolicies that suggest income minimizationRapid writeoffs of capital assets and intangiblesExpensing of advertisement and R&DIncome tax considerations
12Income MaximizationIf a firms is close to debt covenant violations may use income maximizationEngage in this pattern for bonus purposesProvided that this does not put them above the cap
13Income Smoothing Incentives Risk averse managers prefer a less variable bonus streamSmooth out reported earnings over time to gain relatively constant compensationEfficient compensation contracting may exploit this effectIncentive to reduce volatility of reported net income to smooth out covenant ratios over timeReduce the possibility of reporting low earningsFirms 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”
1411.3 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 policiesConclusion: Managers would be able to manage net income to maximize their bonuses under their firms compensation plansQuestion 1: Managers would be able to manage __________ to maximize their bonuses under their firms compensation plansAnswer: Net income
15Typical Bonus Scheme Significance Typical Bonus Scheme Bonus is constant for net income greater than the capNo cap in the bonuses, the bonus would increase along the dotted lineNo bonus to be received, the manager might as well adopt accounting policies to further reduce the net incomeIf net income is between the bogey and cap the manager is motivated to adopt accounting policies to increase the net incomeQuestion 2: No bonus to received, the manager might as well adopt accounting policies to further _______the net incomeAnswer: reduce
16Discretionary and Non- Discretionary Accruals Discretionary Accruals : Accruals which the manager can exercise some controlNon - Discretionary Accruals: Manager does not have control
17Discretionary and Non- Discretionary Accruals Amortization Expense:Discretionary: Company changes the policy for the calculation of the amortization expense by modifying estimated useful life measurementNon- Discretionary: Amortization expense number changesIncrease in net account receivablesDiscretionary : 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 endNon- Discretionary: Increase in volume of business.
18Other Accruals Increase in Inventory Non-Discretionary increases include inventory buildup due to anticipation of increased demandDiscretionary increases would include charging fixed overhead costs to inventory rather than charging them off as expensesDecrease 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
19Observations with both a Bogey and Cap Manager has considerable discretion when recording net incomeDid not have access to the books and records of his sample firms therefore unable to determine specific discretionary accruals made by the firm’s managersObservations fit into one of the three categoriesPortfolio UPP: Observations where earnings were above the capPortfolio Mid: Observations between the bogey and the capPortfolio LOW : Observations where earnings were below the bogeyQuestion: In Healy ‘s evaluation how many portfolios are there?Answer3
20Healy ConclusionMajor difficulty is that discretionary accruals cannot be directly observedKaplan (1985)Pointed out a firm with reported net income above the cap of its bonus plan may have low non-discretionary accrualsThe high income is due to an unexpected increase in demand that runs down inventory.Low total accruals are due to:Level of the firm’s real economic activityNot to low discretionary accruals.Healy addressed Kaplan issues and performed additional tests to confirm the results
21Discretionary Accruals Bad Debt McNichols and Wilson(1988)Studied the behavior in a bonus contextResults consistent with HealyConfirmed the provision for bad debts on the grounds that a precise estimate for what the bad debt allowance should be (non-discretionary portion) madeDiscretionary accruals = Estimate bad debt provision - Actual bad debt provisionBelow bogeys and above caps: Significant income reducing both for firms that were profitable and unprofitableBetween profitability extremes: Firms discretionary accruals were lower among income increasing
22Jones: Non-discretionary Accruals Estimate non-discretionary accruals, using better dataNon- discretionary accruals found that managers who received 0 bonus did not use accruals to manage earnings downwards which different from Healy’s findings, in row 1.Managers who were at their bonus maxima accruals so as the lower reported earnings which is different from Healy’s findings- row 3
23Earning 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 theory2 ways to think about bonus plans1)Opportunistic behaviorManagers 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) Efficient contracting perspectiveWhen setting compensation contracts firms will rationally anticipate managers incentives to manage earnings and will allow for this in the amount of compensation they offerIt is less costly to an organization to offer itEither way it does create earnings management incentivesTwo types of bonus plans _____________ and ____________AnswerOpportunistic behaviorEfficient contraction perspective
25WHAT IS A DEBT COVENANT? WHY DO LENDERS USE THEM?
2611.4.1 Other Contracting Motivations Covenants: Protect against actions by managers that are against the lenders’ best interestExcessive dividendsAdditional borrowingLetting working capital or shareholders’ equity fall below specified levelsAll of these actions dilute the security of existing lenders
27WHAT IMPACT CAN COVENANT VIOLATION HAVE ON A FIRM?
2811.4.1 Other Contracting Motivations Covenant violationHigh costs firmsRaise the going concern issues for the businessEarnings management can arise as a device to reduce the probability of violation of debt contractsSweeney 1994Discovered significantly greater use of income- increasing accountingAnd the early adoption of new accounting standards to increase net income
2911.4.1 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 violationMany companies had to cut dividends which makes lenders, shareholders, unions feel that they are financially unstable
3011.4.1 Other Contracting Motivations Earning management incentivesRelational contracts these are not normal contracts such as compensation or debt contractsFor example: Meeting contract commitments with suppliers will allow one to receive better terms from suppliers and lower interest rates from lendersBowen etc 1995 investigated implicit contracting where companies have represented high profitsIncrease 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.Question: A company with high COGS is likely to use _______?Answer’:FIFO
3111.4.2 Meeting Shareholders Expectations Investor’s earnings expectation can be formed in variety of waysBased on earnings in same period last year or recent analysis or company forecastsSkinner and Sloan 2002Firms penalize more for failing short of expectationsManage earnings upwards ensure that earnings expectations are metKeung etc. 2010Market reaction to a zero or even a small positive earning surprise turned negative during , compared to positive response received in previous years
3211.4.2 Meeting Shareholders Expectations Mercer 2005Plausible: Earnings and forecasts as well as their opinions increaseNot plausible: Earnings and forecasts as well as their opinions decreaseFailure to meet investors earnings expectations has serious consequencesDirect effect: Firm’s share price and cost of capital as investors are expected to be lowerIndirect effect: Manager reputation can be negatively impacted if explanation appears as an excuse
33Which companies have recently gone public? Group OnMichael KorsFacebook
3411.4.3 Initial Public Offerings IPO’s do not have a established market priceQuestion is: What is the value of the shares in such firms?Financial accounting information is a useful sourceEx: ForecastsClarkson etc. 1992Evidence the market responds positively to earnings forecasts as a signal of firms value
3511.4.3 Initial Public Offerings Teoh 1998Discretionary accruals around the IPO date are concentrated on working capital accrualsHigh discretionary accruals was significantly negative relative to IPO’s firms with low accrualsCurrently it is unclear whether investors are “fooled” by opportunistic earnings management in IPO’s or rationally price the IPO
36The Good Side to Earnings Management This section talks about how theoretical and empirical evidence supports the fact that earnings management can be good
37Blocked 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 blockedThe 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 principle’s point is sub-optimalEarnings management can be a device to reduce blockage
38Reducing 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 purchasesDisaggregation of good news forecast (i.e. forecasting sales and expenses as well as net income) increases its credibilityEarnings management can be a device to reduce information blockage
39Empirical 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
40Earnings 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
41Empirical 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
42Empirical Evidence Examples Xie – found that rather than reacting to discretionary accruals as if they were good, the market appears to over value them
43Empirical Evidence Examples Tucker and Zarowin – conclude that greater income smoothing behaviour is accompanied with good earnings management argument
45Opportunistic Earnings Management Despite theory and evidence of responsible use of earnings management, there is also evidence of bad earnings managementOpportunistic Manager Behaviour: the tendency of managers to use earnings management to maximize their bonuses
46Study 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 industryRevealed a number of motivations for such earnings managementFirms in test sample had, significantly greater leverage and significantly more debt covenant violations than the control sampleRaising new share capital and want to maximize the proceeds from the new issue
47Study by Dechow, Sloan, and Sweeney Studied the financing decisions of sample firmsCharged firms issued, on average, significantly more securities during the period of earnings manipulation than the control sample
48Market Reaction to Earnings Management Market does appear to react to earnings managementERC for a dollar of quarterly core earnings is lower for firms that have frequently recorded large unusual and non-recurring chargesConsistent with the market using the frequency of non-recurring charges as a proxy for the extent to which core earnings may be overstated
49Earnings Management in an International Context Leuz, Nanda, and Wysocki evaluated the extent of earnings management in each of 31 countries during 1990–1999Measures used:Variability of operating incomeCorrelation between accruals and cash flowMagnitude of total accrualsCountry’s ratio of small earnings losses to small gains
50Earnings Management in an International Context Measures were combined to create a score for each countryLower scores imply less earnings managementCanada - 5USA - 2GermanyScores were related to country institutional characteristicsFor example: Lower investor protection is associated with more earnings management
51Nortel April 2004 – Nortel fires CEO & controller Share price falls from $11 to $5.26Nortel overstated 2003 net incomeCollapse of technology boom in early 2000sExcessive accruals made for cost of contract cancellations, bad debts, layoffs & plant closuresNortel reverses 2003 accrualsDoes not disclose to investorsCredited to operating expense
52Nortel’s compensation plan provided for bonuses if the company returned to profitability CEO received $3.6 million bonus in 2003After the effects of excessive accrual reversals are taken into account, it appears that the first two quarters of may have been loss quarters
53Nortel – The Consequences January 2005: Nortel issued restated results reporting lossesFebruary 2005: Nortel sues three former executives to recover bonusesMarch 2007: SEC begins civil proceedings against four executivesMarch 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.
54Do Managers Accept Securities Market Efficiency? Market favours firms with steadily increasing earnings patternsInefficient Market Interpretation: momentum trading in response to the increasing earnings pattern drives the favourable market reactionSame-quarter earnings of the previous year are a very important earnings benchmark for managersLowest possible prior period benchmark emphasized, thereby showing the change in earnings from the prior quarter in the most favourable light
55Doyle, Lundholm, and Soliman Investor reaction to pro-forma earnings was studied by Doyle, Lundholm, and SolimanFound that many expenses excluded from GAAP net income had significant future effects on operating cash flowsAbnormal share returns over a three-day window surrounding the date of quarterly earnings announcementsFound that the greater the difference between pro- forma and GAAP earnings the lower the abnormal share return over the three daysSuggests that the market does not ignore the excluded items
56Doyle, Lundholm, and Soliman Market reaction is not completeLower share returns for firms with greater pro- forma–GAAP discrepancies continued for up to three yearsIf the market was fully efficient, all of the negative reaction would have taken place within the three-day windowThese earnings management policies make little sense if securities markets are efficientConsequently, managers who engage in them must not fully accept efficiency
57Implications for Accountants The implication for accountants who wish to reduce bad earnings management is not to reject market efficiency, but to improve disclosureReduces their susceptibility to behavioural biases and managers’ ability to exploit poor corporate governance and market inefficienciesOther 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.
58CONCLUSIONEarnings Management is possible because TRUE net income does not existGAAP does not completely constrain managers choice of accounting policies and proceduresOften we see managers’ accounting policy choices are motivated by strategic considerations, such as meeting earnings expectationsThe bad of earnings management is that managers may abuse to the extent that earning power is persistently overstatedThe 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