Earnings Management

Definition Earnings management:  Purposeful intervention in the external financial reporting process, with the intent of obtaining some private gain (as opposed to, say, merely facilitating the neutral operation of the process) (Schipper, 1989)  Is the choice by a manager of accounting policies so as to achieve some specific objective (Scott, 2009)

Two Ways to Think about Earnings Management Opportunistic behaviour  To maximize management utility in the face of compensation and debt contracts and political costs Efficient contracting perspective  A vehicle for the communication of management’s inside information to investors

Patterns of Earnings Management Taking a bath Income minimization Income maximization Income smoothing

Measurement Total Accruals Discretionary Accruals  Jones (1991)  Modified Jones model

Accrual Accounting Recognizes the financial benefits and obligations accruing to an enterprise over the reporting period - regardless of cash inflows and outflows. Objective: Better indication of performance than current cash receipts and payments.

Accrual Accounting Subjectivity Assumptions Discretion

Why allow reporting discretion? Rigid rulesFlexible rules trade-off Reporting Discretion  Enables better reporting of larger number of businesses.  Prone to manipulation  Reporting biases  No discretion

What Motivates Managers’ Choice of Discretionary Accruals? Victor L. Bernard Douglas J. Skinner

Introduction Subramanyam (1996) and Kasanen, Kinnunen, and Niskanen (1996) both considers why managers choose to manipulate accounting accruals  Subramanyam concludes hat managers choose accruals to enhance the informativeness of accounting earnings  KKN find strong support that Finnish managers set earnings to satisfy the demand for dividends by their keiretsu-like institutional investors

Subramanyam (1996) Central research question:  Whether managers choose discretionary accruals to convey information or whether their choices are opportunistic He concludes that discretionary accruals are used by managers to increase the informativeness of accounting earnings Alternative explanation for this findings is that the ‘Jones model’ systematically misclassifies nondiscretionary accruals as discretionary

Subramanyam (1996) How well does the ‘Jones model’ work?  Dechow et al (1995) indicate none of Jones model (or their ‘modified’ Jones model) works very well in detecting earnings management  The estimated discretionary accruals will likely contain some nondiscretionary items

Subramanyam (1996) How does misclassification of discretionary accruals affect the interpretation?  At best lower the power of the research to detect earnings management  At worst cause the researcher to conclude that there is earnings management when none actually exist

Subramanyam (1996) Some conclusions and suggestions  The only way to resolve the problem is to develop better specified models of the accruals process Focus on narrower settings (particular industry) or particular components of accruals)  Try and use tools from financial statement analysis to better model accruals  Separately analyze the informativeness of different categories of accruals

Kasanan, Kinnunen, and Niskanen (1996) In Finland, the demand for dividends by institutional investors is so strong that dividend policy is effectively set outside the firm, so that earnings have to be managed to justify the requisite dividend payout

Kasanan, Kinnunen, and Niskanen (1996) Institutional features and evidence of earnings management  Important features: Stock ownership is dominated by large institutional holders and cross-holdings are common. Finnish regulations are such that only realized income (i.e. dividend) may be included as part of the capital base of these institutional stockholders  Institutions demand relatively large dividend payments Managers of Finnish firms are restricted by law to paying dividends out of earnings, including retained earnings  Provides managers with incentive to report earnings that are sufficiently high to justify the required dividend Managers of Finnish firms have an unusual amount of flexibility in the reporting process

Kasanan, Kinnunen, and Niskanen (1996) Institutional features and evidence of earnings management  Reported earnings and dividends track each other so closely Provide strong evidence of earnings management

Kasanan, Kinnunen, and Niskanen (1996) What do we learn?  KKn’s results provide strong evidence of earnings management  Provides an interesting experiment, but it may be hard to generalize this conclusion to other countries

Conclusion We need more reliable ways of measuring earnings management A potentially fruitful alternative: may be to analyze financial statements in more detail