Earnings Management

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 some specific reported earnings objective

What are some examples of earnings management?

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 ManagementChoice 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 patterns1. Taking a bath

2. Income minimization

3. Income maximization

4. Income smoothing

Taking 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

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 MaximizationIf 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 SmoothingIncentives

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 SchemeSignificance

◦ 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- DiscretionaryAccruals 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 AccrualsIncrease 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 firm’s 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 firm’s 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 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

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) Efficient 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

OTHER MOTIVATIONS FOR EARNINGS MANAGEMENT

WHAT IS A DEBT COVENANT?

WHY DO LENDERS USE THEM?

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 19941. 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

Investor’s earnings expectation can be formed in variety of ways ◦ Based on earnings in same period last year or recent analysis or

company forecastsSkinner 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: Firm’s 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

Which companies have recently gone

public?

11.4.3 Initial Public Offerings

IPO’s 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 IPO’s firms with low accruals

Currently it is unclear whether investors are “fooled” by opportunistic earnings management in IPO’s or rationally price the IPO

The Good Side to Earnings Management

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 principle’s 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 ExamplesSubramanyam – 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

THE BAD SIDE OF EARNINGS MANAGEMENT

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◦Country’s 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

NortelApril 2004 – Nortel fires CEO & controller

◦Share price falls from $11 to $5.26Nortel 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

Nortel’s 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 AccountantsThe 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