Earning Management ..........

CA RAJIV SINGHFCA, LIFA(USA),CISA(USA) CO-FOUNDER EXPLICO CONSULTINGrajivsinghfca@gmail.com

An idea that delivers …..

Earnings Management

Management Actions to Achieve desired Earnings Level

Accounting Choice

ABEM

Lower the quality of earnings and mislead investors

Departure from GAAP

Operating decisions or economic earning Management

OBEM

More costly with respect to future firm Value

Departure from normal operating practices

Key Facts about ABEM & OBEM

• ABEM decreases with stringent investor protection because it is

more likely to draw scrutiny by auditor & regulator

• Managers prefer OBEM over ABEM where investor protection is

stronger because auditors and regulators are not interested in

operating decisions

• ABEM & OBEM are restrained when large number of quality

analysts follow the company

• Effects to “Meet or Beat” analyst forecast by ABEM & OBEM have a

negative effect on a firm’s future ROA and stock price

Measures of ABEM

(i) ABEM 1 =

Where

S.D. (OI) = Standard deviation of operating Income

S.D. (CFO) = Standard deviation of Cash from Operations

(ii) ABEM 2 =

Where

ΔAccruals = Change in Accruals

ΔCFO = Change in operating Cash flow

r = Correlation Coefficient

S.D. (OI)

S.D. (CFO)

r(Δ Accruals ,Δ CFO)

Measures of ABEM

(iii) ABEM 3 =

Where

Accruals = (ΔCA-Δcash-ΔSTL) – ( ΔCL-ΔSTD-ΔTP) – Dep

CFO = Earnings – Accruals

Absolute Value of Accruals

Absolute Value of CFO

Measures of OBEM

(i) OBEM 1 =

Where

Δ Production = Change in Production Cost

Production Cost = COGS + Δ inventories

Δ Sales = Change in sales

(ii) OBEM 2 =

Where

Δ DE = Change in Discretionary Expenses

= Change in selling, general & administrative expenses

r(Δ DE ,Δ Sales)

r(Δ Production,Δ Sales)

Interpretation

(i) Lower ABEM1 and ABEM 2 score imply that accounting based EM is

used to reduce the variation of earnings and conceal economic shocks to

the CFO.

(ii) ABEM 3 reflects manager’s behaviour in their attempt to achieve specific

earning target.

(iii) OBEM 1 measures sales and production manipulation. A lower score

indicates sales and production manipulation has been carried out.

(iv) If ‘DE’ is used for ‘ÉM’ OBEM 2 value should be lower. A high OBEM

indicates that ‘DE’ is rarely managed. A negative correlation indicates

high element of EM