Chapter 11:
Matthew Blostein
Michael Choi
Kurtis Holmes
Eric Martin
Trevor Stickl
Earnings Management
 Defined
as: The choice by a manager of
accounting policies, or real actions,
affecting earnings so as to achieve some
specific reported earnings objective
 Understanding of Earnings Management is
important as it enables an improved
understanding of the usefulness of net
income, both for reporting to investors
and for contracting
Patterns of Earnings
 Taking
a Bath
 Income Minimization
 Income Maximization
 Income Smoothing
Taking a Bath
 Usually
takes place during periods of
organizational stress or restructuring. The
main idea is that if a firm is to report a loss,
managers may feel it might as well report
a large one as it has little to lose. Large
write-offs but future earnings “in the
Income Minimization
 Similar
to taking a bath but less extreme.
Usually a politically visible firm chooses this
pattern during periods of high profitability.
(Example: United States vs. AT&T)
 Income minimization includes rapid writeoffs of capital assets, and intangibles, and
the expensing of advertising and R&D
Income Maximization
 Managers
engage in a pattern of
maximization of reported net income for
bonus purposes, so long as it does not put
them above the cap. A firm close to a
debt covenant violation may use this
Income Smoothing
First, Risk-adverse managers prefer a less variable
onus stream, other things equal. Consequently,
managers may smooth reported earnings over
time so as to receive relatively constant
compensation. Efficient compensation
contracting may exploit this effect, and condone
some income smoothing as a low-cost way to
attain the manager’s reservation utility.
Second, when considering covenants in long-term
agreements, the more volatile the stream of
reported net earnings, the higher probability that
covenant violation will occur.
Income Smoothing Cont.
 Third,
managers may feel as if they will be
fired when earnings are low, income
smoothing reduces the likelihood of
reporting low earnings.
 Finally, firms may smooth reported net
income for external reporting purposes. If
used responsibly, smoothing can convey
inside information to the market by
enabling the firm to communicate its
expected persistent earning power.
Evidence of Earnings
for Bonus Purposes
 “The
Effects of Bonus Schemes on
Accounting Decisions” – Healy
 Hypothesis:
Managers will find opportunities in which
they could manage net income in an
attempt to maximize their bonuses under
the firm’s compensation plans.
Evidence of Earnings Management
for Bonus Purposes
Only if income is between the bogey and cap will
managers find an incentive to acquire accounting
policies that increase net income
Evidence of Earnings
for Bonus Purposes
 Sample:
94 firms
 Period: 50 years
 Between bogey and cap: positive avg.
 Outside bogey and cap: negative avg.
 Consistent with hypothesis of managers
incentive to lower current income when it
does not affect their current year bonus
Evidence of Earnings
for Bonus Purposes
 Argues
that changes in policies are not as
income-influencing as the use of accruals
 Changes in policies tend to be
implemented just after the
introduction/amendment of a bonus plan
 If income is anticipated to be high in
upcoming years, a manager will choose
to implement a policy that encourages
higher reported net income
But Wait… There’s More!
Cash flow, as per cash flow statement
Less: Amortization expense
Δ Useful Life
Add: Increase in (net) AR during year
Add: Increase in INV during year
Δ Overhead charge
Add: Decrease in AP and Accruals
Δ Expected WTY claims
Net Income, as per income statement
Contractual Motivation
 Many
companies have covenants in
place to protect lenders
 Violating this covenant is dangerous to a
 This causes managers to choose
accounting policies to avoid covenant
Contractual Motivation Con’t
 Sweeny
looks at this in a 1994 study and
finds two things:
Firms already violating covenants will make
drastic changes to accounting policies to
boost income
Firms approaching violation will make premature changes to accounting policies to
boost income
Contractual Motivation Con’t
 This
is a dangerous motivation due to the
significant damage a covenant violation
 Managers may be overly aggressive
which may ultimately lead to fraud
Contractual Motivation Con’t
 Another
motivation is implicit contracts
which arises from the relationship of firm
and its stakeholders
 This is the idea that a firm will receive
benefits from stakeholders based on
previous contracts
 Allows parties to work cooperatively
rather than at the Nash equilibrium
Political Motivations
 When
a company will make policy
changes to intentionally lower its income
 This is done to escape government
 For example a company making large
profits in a given year may altar its
amortization policy from straight line to
declining to recognize greater expenses
to match these profits
Meet Earnings Expectations
 This
is when estimated earnings for future
periods meet and exceed expectations
of investors
 This will ultimately increase share price
due to the strong positive correlation
between expected earnings and share
Meet Earnings Expectations
 2010
study looking at 1992-2006 proves
that small earnings surprises actually leads
a decrease in share price
 Investors are aware that earnings surprises
are caused by earnings management
 Proves that expectations must be met,
but surprises are not beneficial due to
rational investors
Meet Earnings Expectations
 This
creates a case of conflict of interest
as most managers hold stock options
 It gives a greater incentive for managers
to meet expectations using earnings
management to avoid share price
 May not be the best option for the firm
 Can also lead to fraudulent behaviour
 The
issue with an IPO is that there is no
market price for a firms shares
 This gives management incentive to
increase estimates of futures earnings to
get a higher price for their shares
IPO Con’t
Studies in 1997 and 2007 look at companies
going public and their accruals
The main result found is that companies boost
their accruals prior to the IPO, then reverse
these accruals in later years causing losses
Shows this type of earnings management is
successful as it works even with rational
Good Side of Earnings
 Blocked
Managers have inside information that is
costly to communicate = blocked
Managers can use provisions to smooth
earnings to desired levels and unblock
It would be foolish to overstate earnings
since the market will react severely when
there is a subsequent reduction
Good Side- Blocked
 Inside
New firm strategies
Change in firm characteristics
Market conditions
 All
complex information, but proven to be
communicated through discretionary
accruals and disclosures.
Good Side- Contracts
EM can be used to maintain investor
expectations and avoid market penalties for
If markets have rational expectations then
both management and investors benefit from
a consistent tracking and flow of earnings
Upward earning management decreased
contract efficiency, but is a must for investors
Good Side- Conservative
 Decreases
contract efficiency as higher
manager effort = lower earnings
 Also reduces need for upward earnings
management = increased contract
 Net effect of the two reactions is positive
on firm value
The Bad Side of Earning
 Opportunistic
Tendency for managers to try to maximize
their bonus
 Debt
Firms that are highly levered need EM to
control if they violate loan covenants
Supported by Dechow, Sloan and Sweeney
study of 92 firms that firms do practice this
Bad Side Cont’d
 Raise
new capital
EM can be used to maximize proceeds of
new issues
Discretionary accruals can increase SR
 Speed
revenue recognition
 Lengthen cap. Asset life
 Under reserve for environmental costs
Bad Side Cont’d
 Transitory
Unusual items so they do not affect
manager bonus’
Increase future earnings by reducing future
amortization and absorption of costs that
would normal go through operating
Standard Setters
 Reflect
the bad earnings management
 IAS 37- provision as a liability if timing of
payments is uncertain
Must be probable
Must be reliably estimated
Must be at fair value
Measures of Earning
Variability of operating income
Correlation between accruals and cash flow
Low correlation =early revenue recognition
Magnitude of total accruals
Lower = income smoothing
Higher accruals = higher discretionary accruals
Small Loss/Gain ratio
Low ratio = EM to avoid small losses
 Ways
to reduce bad earning
Don’t reject market efficiency
Improve disclosures
 Reduces
behavioural biases
 Lower management incentive to exploit poor
governance and market inefficiencies
Report effects of current earnings on prior
Earnings Management
Earnings management is justified through the
theory that true net income does not exist
GAAP does not completely constrain managers
choices of accounting policies
Complex and challenging
Motivated by strategic considerations
Meeting earnings expectations
Specific contracts and their covenants
IPO’s or SPO’s
Discourage potential competition
Unblock inside information
Earnings Management
Changes in accounting policy are becoming
a game for companies
Managers will react against rule changes that
reduce their flexibility of accounting choice
Need to be aware of legitimate needs of
management, investors, and be aware of
opportunistic strategies
Accompanying earnings management is
reduction in reliability and sensitivity of info
Earnings Management
Earning Management gives managers
flexibility to react to unanticipated realizations
Earnings Managements can be a vehicle for
the credible communication of inside info to
Both arguments above are consistent with
efficient securities markets and the efficiency
version of positive accounting theory
Earnings Management
Managers can abuse communication potential of GAAP
Reduce Earnings Management by bringing it to public, out
in the open
Result in failure to accept securities market efficiency or from an
ability to hide bad earnings management behind poor
Improve disclosure of low persistence items and reporting effect
of previous write offs on current earnings
Assist corporate governance, help better reward good
manager performance and discipline managers who shirk
Improvements in allocation of scarce investment capital
and firm productivity increase social welfare
Taking a Bath and RIM
RIM Stock has plummeted over 70% in the
past year, netting to roughly $8/Share
It recently announced $518 million quarterly
Plans to lay off 5,000 employees
RIM is trying to maximize it’s losses to prepare
for future reported profitability with the
Launch of Blackberry 10.
Income Minimization and AT&T
 United
States v. AT&T
 Antitrust case that led to the 1984 Bell
Systems divestiture
 AT&T accused of using monopoly profits
to subsidize the costs of its own network
 Had they chosen an income minimization
pattern, AT&T may not have caught the
public eye and scrutiny
 This
is a perfect example for income
maximization earnings management
 Due to the stock option based
compensation managers receive, there
was constant incentive to inflate earnings
 Most of the earnings management was
done using complex accruals and
Enron Con’t
 With
this type of earnings management
comes risk of government scrutiny
 The income was never smoothed out and
governing bodies took interest in
consistently high growth
 This ultimately lead to Enron’s downfall
and many regulations and accounting
bodies put in place to avoid this in the
Income Smoothing Case
Company overviews (2007)
 American
International Group (AIG)
World’s largest insurance and financial services
Net Income - $6.2 billion
Premiums written - $59.8 billion
 GenRe
One of worlds largest reinsurers
Owned by Berkshire Hathaway
Premiums written - $6.0 billion
Income Smoothing Case
Regulatory Scrutiny
 2001
– SEC learned AIG assisted client in
manipulating the balance sheet through
bogus insurance transaction
 2003
– SEC and Justice Department settle
civil case with AIG in amount of $10 million
 2004
– Federal investigation of AIG’s
income smoothing products
Income Smoothing Case
Deal between AIG and GenRe
GenRe was to transfer loss reserves to AIG in
exchange for premium payment
Contracts for loss reserves to total between
$500 and $600 million
GenRe “obligated” to pay AIG “premium” of
$1 billion
GenRe was to receive $5 million transaction
fee for deal
Contract to last 24 months, at which time it
would be reversed
Income Smoothing Case
Improper Accounting and Public
AIG finally admitted that this deal should have
been accounted for as a deposit
Restatement of AIG’s income following this
announcement amounted to a reduction in net
income of $1.32 Billion
Public Perception
Reckless efforts of senior corporate officers that
were designed solely for the unlawful purpose of
achieving a specific and false accounting effect
on issuers financial statements
Thank you for
your Time!
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