A Review of
Earnings Management
Accounting Seminar
Week 3
Originally prepared by:
Professor Farshid Navissi (Monash University)
Semester 2, 2005
Updated by:
Gatot Soepriyanto (Binus University)
Semester 2, 2008
Agenda
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A Review of Earning Management (EM)
Method of EM
Incentives for EM
Detecting EM
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Jones Model
Step by Step guidance
Modification of EM studies
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“Numbers in the abstract are just that -numbers. But relying on the numbers in a
financial report are livelihoods, interests and
ultimately, stories of American Investors”.
(The “Numbers Game”: Arthur Levitt – former SEC Chairman)
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Earnings Management (EM)
Defined

Use of judgment in financial reporting and in
structuring transactions to alter financial
reports to influence the perceptions of
stakeholders about the underlying economic
performance of the company and / or
influence outcomes that depend of the
reported accounting numbers
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EM and Corporate Fraud

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Virtually all managerial activities affect earnings 
constitute EM
EM covers a wide variety of legitimate and
illegitimate managerial actions that affect earnings
EM may manifest in terms of the extremities of
either conservatism or optimism
Fraud typically comes into existence when firms try
to paint an extremely optimistic picture of their
operations through aggressive use of illegitimate
practices
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EM: Example Behaviours
“Conservative”
Accounting
“Neutral”
Accounting
“Aggre
ssive”
Accoun
ting
WITHIN
GAAP
VIOLATES
GAAP
Tendency to understate
earnings and to overstate liabilities
Overly aggressive
recognition of
provisions
Unbiased
or neutral
representat
ion of the
firm’s
financial
operations
“Fraudulent” Accounting
Tendency to overstate
earnings and to understate liabilities
Under
statem
ent of
provisi
ons
Recording fictitious transactions e.g. Sales
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Patterns of EM
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Income Maximisation
Income Minimisation
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Extreme case known as “taking a bath”
Income Smoothing
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Keeping earnings consistent over a long
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Methods of EM
Accounting Method Choice
1.
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Choice of accounting method affects the timing
of when revenues and expenses are
recognised in income
For example the “percentage of completion”
method permits the recognition of revenue on
an ongoing basis, while the “completedcontract method” recognises revenue only at
the completion of projects
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Methods of EM
Application of Discretionary Estimates
2.
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Even after the selection of accounting methods there
remains the discretion of how the method is applied
For example when depreciating assets using the
straight-line method there still remains the issue of
estimating the useful lives and the residual value 
using a longer useful life and larger residual value
estimate will increase revenue in current accounting
period
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Methods of EM
Accounting Method Timing
3.
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Exercising discretion over when and how to carry out
activities that affect financial statements
For example when to write-off impaired assets or
recognise a liability as a contingent liability
Control of Major Expenses / Revenues
4.
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For example how much to invest in R&D, advertising
and maintenance expenses. Also firms can delay or
accelerate the delivery shipments of goods to
customers
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Incentives for EM
1.
Behavioral Incentives
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2.
Lending Contracts
Accounting-Based Bonus Plans
Political Costs
Management Transition
Market Based Incentives
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Dividend Payout Rates
Management Buyouts
Equity Offerings
Analyst Expectations
Share Repurchases
Management Share Option Plans
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Behavioural Incentives

Lending Contracts
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Many debt arrangements contain restrictions relating to interest
coverage, debt-to-equity, etc
The desire to prevent the violation of these restrictions presents an
incentive for the firm to manage earnings upwards in periods where
the firm is close to breaching those restrictions
Accounting-Based Bonus Plans
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Firms often reward managers on the basis of reported earnings or
other accounting-based performance measures
The desire to receive higher bonuses presents an incentive for the
manager to manage earnings upwards in some periods
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Behavioural Incentives
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Political Costs
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Large firms are often under scrutiny for their large profits
The desire to circumvent increased regulatory intervention presents
an incentive for the firm to manage earnings downwards
Management Transition
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Poor performing managers often replaced with new management
The possibility of “taking a bath” and attributing the poor performance
to its predecessors presents an incentive for the manager to manage
earnings downwards in the period immediately after appointment
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Market-Based Incentives
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Dividend Payout Rates
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Shareholders may expect steady stream of dividends
The desire to maintain its historical dividend payout rates presents an
incentive for the firm to manage earnings smoothly
Management Buyouts
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In an attempt to acquire more control managers may purchase a
substantial equity stake in the company they manage
The desire to purchase as many shares as possible presents an
incentive for the manager to manage earnings downwards in the
period prior to the buyouts
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Market-Based Incentives
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Equity Offerings
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Earnings commonly used to value a firm going to public for the first
time
The desire to acquire more funds (via a high offering price) presents
an incentive for the firm to manage earnings upwards in the periods
prior to the offerings
Analysts Expectations
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Financial Analysts (and/or management) often provide public
forecasts of earnings
The desire to meet or better those forecasts presents an incentive for
the manager to manage earnings upwards in periods where it is
anticipated that actual “unmanaged” earnings will fall short of the
forecasted earnings
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Market-Based Incentives
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Share Repurchases
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Firms with excess cash sometimes purchase their own
shares for a variety of reasons
The desire purchase these shares at a lower price presents
an incentive for the firm to manage earnings downwards in
the period prior to the repurchase
Management Share Option Plans
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Firms often issue managers with share options as part of
their remuneration package
The desire to maximise their “profits” from these options
presents an incentive for the manager to manage earnings
downwards in the period prior to the award of the options
and to manage earnings upwards in the period prior to the
exercise of the options
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Detecting EM
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It is impossible to detect every accounting choice
that is made by every firm and to evaluate whether
the choice has been made for opportunistic reasons
Researchers have tended to focus on measures that
provide an aggregate measure of earnings
management
Earnings is composed of two components
1.
2.
Cash Flow from Operations
Accruals
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Detecting EM
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Operating cash flows are very difficult to exercise
discretion over
Researchers typically focus on the levels of total
accruals made by firms
Accruals are typically used by firms to recognise the
consequences of transactions in the periods in
which they occur

Since accruals commonly involve discretion, accruals are
more susceptible to manipulation
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Detecting EM

Many models exist to detect levels of abnormal
accruals (discretionary accruals)
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Healy (1985), DeAngelo (1988), Jones (1991),
Dechow, Sloan and Sweeney (1995) and Kothari,
Leone and Wasley (2005).
Basic idea is to use past firm accruals and financial
information to estimate normal levels of accruals
(non-discretionary accruals) in the period of
investigation. The non-discretionary accruals in the
period of investigation are then subtracted from the
actual accruals to derive a measure of discretionary
accruals
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Jones (1991) Model
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Step 1: Calculate total accruals in time t
TACt = [(∆CA - ∆Cash)/ TAt-1]–[(∆CL - ∆STD)/ TAt-1]–
(Dep/ TAt-1)
(1)
Where
∆CA = change in current assets,
∆Cash = change in cash/cash equivalent,
∆CL = change in current liability,
∆STD = change in short-term debt included in current liabilities,
∆TP = change in income taxes payable,
Dep = depreciation and amortization expense, and
TA = total assets.
Short-term debt is excluded from current liabilities because it relates
to financing activities, as opposed to operating activities.
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Jones (1991) Model

Step 2: Estimate the coefficient of normal accruals in estimation
period. Jones assumes that normal accruals are related to
changes in revenue (sales) and by the level of plant, property
and equipment (PPE):
TACt/At-1= α0 + α1 (ΔREVt/At-1) + α2 (PPEt/At-1) + υt

(2)
Where:
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TAct is the total accruals of firm i in period t
Ait-1 is the total assets of firm i at the end of period t-1
 REVit is the change in revenue of firm i in period t
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Period t revenue for firm i - Period t-1 revenue for firm i
PPEit is the balance of plant, property and equipment of firm i at the
end of period t
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Jones (1991) Model
Step 3:The coefficients estimates from model (2) are
then applied to the event years to predict the normal
accruals
NAt= ά0 + ά 1 ((ΔREVt /TAt-1) + ά 2 (PPEt/TAt-1)
(3)
 Step 4:
Finally, the magnitude of abnormal accruals (AN) is
then obtained as the difference between total
accruals computed in model (2) and the estimated
(equation 3), that is:
 ANt = TACt – NAt
(4)
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Example?
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Lets assume that we would like to
investigate whether a sample of 24 firms
manipulated earnings upwards in 2004
1993
2003
10 Year Estimation Period
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So what next?
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For each of the 24 firms we have to collect historical data
(used in model 1) which will enable us to estimate the
expected level of normal accruals in 2004. Lets assume
we decide to gather 10 years of data for estimation
purposes
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Putting it all together
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For each firm we run regression (1) in the
estimation period and obtain the parameter
estimates of 1, 2, and 3
1993
2003 2004
10 Year Estimation Period
TAit / Ait1  ˆ1.(1/ Ait1 )  ˆ 2 .(REVit / Ait1 )  ˆ3.(PPEit / Ait1 )   it
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Putting it all together
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The parameter estimates are then applied to
the event year to provide an estimate of
expected normal accruals.
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Using discretionary accruals of the 50 sample
firms, the mean and the statistical
significance of the discretionary accruals is
calculated
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Evidence on Specific Accruals
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Models such as Jones (1991) use abnormal
accruals as a proxy for earnings
management
But standard setters are more interested in
which specific accruals are used in earnings
management
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Depreciation estimates
Bad debt provisions
Deferred tax valuations
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Modification of EM Research
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EM as the measure of financial reporting
quality
EM as the dependent variables is tested with
others independent variables (e.g. GCG
proxies and audit quality proxies)
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Review Questions
Using Jones (1991) model, please:
 Design the research methodology to investigate
whether firm manage their earnings before a
significant share repurchases.
 Design the research methodology to examine
whether firm manage their earnings after
management transition.
 Design the research methodology to test whether
Big 4 CPA firms provide higher audit quality (lower
EM) than non Big 4 CPA firms.
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Assignments
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