Earnings Management
Definition

Earnings management:
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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

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Taking a bath
Income minimization
Income maximization
Income smoothing
Measurement

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Total Accruals
Discretionary Accruals

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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.
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Objective: Better indication of performance than
current cash receipts and payments.
Accrual Accounting

Subjectivity

Assumptions

Discretion
Reporting Discretion

Why allow reporting discretion?
Rigid rules
Flexible rules
trade-off
 Reporting biases
 Enables better reporting of larger
number of businesses.
 No discretion
 Prone to manipulation
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)
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Central research question:

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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?
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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?
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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)
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Some conclusions and suggestions
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The only way to resolve the problem is to
develop better specified models of the
accruals process

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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)
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Institutional features and evidence of earnings
management
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Important features:
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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
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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)
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Institutional features and evidence of
earnings management
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Reported earnings and dividends track
each other so closely
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Provide strong evidence of earnings
management
Kasanan, Kinnunen, and
Niskanen (1996)
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What do we learn?
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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
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We need more reliable ways of
measuring earnings management
A potentially fruitful alternative: may be
to analyze financial statements in more
detail