EARNINGS MANAGEMENT

Class AnnouncementsAssignment #9 due March 24th; available on-lineAssignment #10 due March 31st; available on-lineAssignment #8 returned at the end of classResearch paper #3 returned at the end of classResearch Paper Part #4 and bonus due April 3rdFinal Exam 7:00pm April 19th, Main Gym, Oland CentreBusiness Banquet - April 2nd 5:45-8pm, Catering - Gabrieau's Bistro; Keynote Speaker - Annette Verschuren, Past President of Home Depot for Canada and Asia

Class ObjectivesEarnings management defined in terms of an agency contractEarnings management patternsReasons for managers to actively participate in earnings managementEvidence of earnings management

Earnings ManagementEarnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company to influence contractual outcomes that depend on reported accounting numbers (Healy and Wahlen 1999, p. 368)Earnings management is the choice by a manager of accounting polices, or real actions, affecting earnings so as to achieve some specific reported earnings objective. (p. 423)

Earnings Management (EM)DefinitionChoice of accounting policies to achieve some specific manager objective1.Accounting Policy ChoiceChoice of accounting policyDiscretionary accruals2. Operational ChangeR&D, advertising, maintenanceTiming of disposals(note: affects cash flow as well and compromises longer term performance.)

Earnings ManagementGiven managers can choose accounting polices from a set of polices it is natural to expect that they will choose polices so as to help achieve their objectives. Choices can be motivated either by efficient markets and contracts or by opportunism and rejection of market efficiency.Accruals reverse (iron law)- earnings management can not indefinitely postpone the day of reckoning.

Earnings Management: ReasonsFinancial Reporting To meet investors earnings expectationsTo credibly communicate inside information about earnings expectationsTo smooth earnings to communicate core earningsContractualBonus [Healy (1985)]Debt covenant [Sweeney (1994)]Implicit ContractPolitical [Jones (1991)]IPOs [Teoh et al (1998)]

Earnings Management: PatternsTaking a BathIncome MinimizationIncome MaximizationIncome SmoothingMore volatile income, more variability in bonusMore volatile income higher probability that covenant violation will occur

Earnings Management: Good1) Contracting perspectivemanager have some ability to manage earnings in face of incomplete and rigid contracts2) Financial reporting perspectiveearnings management is a device to convey inside information to the market enables share prices to better reflect the firms future prospectsunblocking the managers inside informationmarket appears to reward earnings management that does not overstate future earning power.

Earnings Management: Bad1) Contracting perspectiveopportunistic behavior of managers: tendency to use earnings management to maximize their bonuses2) Financial reporting perspectivepoor disclosure keep the extent of earnings management as inside informationsome managers behave as if they can beat the market (e.g. excessive non recurring income items impounded as core earnings)

Earnings Management: PersistMost people would feel that earnings management is bad as it implies a reduction in reliability and usefulness of financial statement information.Management earnings persistsprohibitively costly for others to find out inside informationdifficult to discover discretionary accrualsdifficult for outsiders to interpret more visible earnings management (e.g. policy change, timing of capital gains and losses)

Earnings Management TechniquesRevenue RecognitionAccounting Policy ChangeTiming of Adoption of New StandardsWrite-offs, Provisions, Etc.Accruals (Discretionary)Direct Charges to Retained EarningsCookie Jar AccountingStuffing the Channels

Earnings Management: UnderstandingRegulators and standard setters identify areas most in need of regulatory changeAuditors evaluate and report on their clients quality of earnings, and train novice auditors about earnings managementCEOs, CFOs, audit committees and investors focus attention on those areas of the financial statements where they should be most skepticalManagers and audit committees anticipate the transaction that investors will view most skepticallyEducators teach students about earnings management Researchers focus their analysis on areas of high-earnings management activity

Earnings Management Techniques: Nelson et al (2003)Aggressive earning management has been of concern to regulators for several yearsThere exist little systematic research concerning the specific methods by which earnings management is attempted.Nelson et al (2003) tried to capture the types of earning management and the impact on net income through a survey to 532 auditors (partners and managers).

Earnings Management Techniques: Nelson et al (2003)Expenses & Other losses recognizing too much or too little reserve in the current year.Revenue & Other gains approaches include cutoff manipulation, deferring to much or too little revenue , etc. Business Combinations over or understatement assets with the charge to goodwillOther approaches approaches include income statement classification issues, inappropriate disclosures, off balance sheet financing, etc.

Earnings Management Techniques: Nelson et al (2003)

Class Objectives - RevisitedEarnings management defined in terms of an agency contractEarnings management patternsReasons for managers to actively participate in earnings managementEvidence of earnings management

Research Paper Part #4Discuss relationship to accounting theory - e.g. information perspective, measurement perspective, agency theory, positive accounting theory, etc.; (pick one theory and apply to Handbook section)Due: April 3, 2014Worth: 2.5%Length: One page submission (double spaced) with cover page, Introduction (bonus) Part#1, Part#2, Part #3 an Part #4, Conclusion (bonus), Reference page and Marking Keys #1, Part#2 Part#3 attached to the back.

Research Paper Part #4Bonus: Provide a one paragraph introduction (maximum 1/3 of page) and one paragraph conclusion (maximum 1/3 of page) on separate pages. Due: April 3, 2014Worth: 1.0%/10% (Maximum of 1%; 0.5% for each of each of introduction and conclusion) Length: One page submission (double spaced) with cover page, Introduction (bonus) Part#1, Part#2, Part #3 an Part #4, Conclusion (bonus), Reference page and Marking Keys #1, Part#2 Part#3 attached to the back.

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