Chapter 11
Earnings Management
Nicole Gagnier
Sarah King
Fanny Kwan
Bettina Reyes
Outline
Introduction
Patterns of
Earnings
Management
Conclusion
Evidence of
Earnings
Management
for Bonus
Purposes
The Good
Side of
Earnings
Management
Other
Motivations
for Earnings
Management
The Bad
Side of
Earnings
Management
Introduction
Earnings Management is:

The choice by a manager of accounting
policies, or actions affecting earnings,
so as to achieve some specific reported
earnings objective. (textbook)

The manipulation of a company’s financial earnings
either directly or through indirect accounting
methods. (www.investorwords.com)

Referring to accounting practices that may follow the
letter of the rules of standard accounting practices,
but certainly deviate from the spirit of those rules.
(www.wikipedia.org)
Introduction
Earnings management includes both:
1) Accounting policy choice (indirect)

Choice of accounting policy includes revenue
recognition, amortization, etc. but also
discretionary accruals
2) Real actions (direct)

Real variables such as advertising, R&D,
maintenance, timing of purchases and disposals of
capital assets
Introduction
The Iron Law of Accruals Reversal:

Accruals always reverse.

Managing earnings upwards will
force future earnings downwards

Even more earnings management is needed to
postpone losses

Result: Earnings management cannot indefinitely
postpone a firms day of reckoning
Introduction
The Financial Reporting and Contracting
Perspectives of Earnings Management:

Financial reporting perspective:



To meet analyst’s earnings forecasts or
To report a stream of smooth and growing earnings
over time
Contracting perspective:

To protect the firm from the consequences of
unforeseen events when contracts are rigid and
incomplete
Patterns of Earnings Management
Taking a Bath
 Income Minimization
 Income Maximization
 Income Smoothing

Taking a Bath
Common during periods of organizational
stress or reorganization
 Mindset: If we report a loss, might as well
report a large one




Write-off assets
Provide for future costs
This enhances probability of future reported
profits due to accrual reversal
Income Minimization
Similar to Taking a Bath but less extreme
 Practised during periods of high profitability
 Policies include:




Rapid write-offs of capital assets and intangibles
Expensing of Advertising and R&D expenditures
Other incentives include income tax
consideration
Income Maximization
Pattern may be chosen for bonus purposes
 Firms may also maximize income if close to
debt covenant violation

Income Smoothing
Chosen by risk-averse managers
 Incentives to choose this pattern include:




Avoid covenant violation that may occur from a
volatile stream of reported Net Income
Reduce likelihood of reporting low earnings
For external reporting purposes
Motivations to Earnings Management
Healy’s Bonus Schemes Theory
Amount of Bonus
③
②
①
Bogey
Cap
Reported Net Income
Managing Net Income....
Net income = Cash flow from operations ± net accruals
Net accruals = ± net non-discretionary accruals
± net discretionary accruals
Evidences on Healy’s theory

McNichols and Wilson



Actual bad debts provision Vs. Precise estimate of
what the bad debts allowance should be
Discretionary accruals = difference of the two
Results:


Significant discretionary bad debt for those years that the
firms were very unprofitable and those that were
profitable
Lower discretionary bad debt in between bogey and cap
Healy’s Bonus Scheme Theory Revisit
Amount of Bonus
③
②
①
Bogey
Cap
Reported Net Income
Evidences on Healy’s Theory

Jones

Looked at 3 types of managers:

Zero bonuses
0 < bonus < Max.
> Max.
Didn’t use accruals
Other Motivations to Earnings Management
Other Contracting Motivations


Earnings Management is used to reduce the probability of
covenant violation in debt contracts
Investigated by Sweeny and DeFond & Jiambalvo
 Findings include:


Firms tend to adopt new accounting standards when the policy increases
reported net income (vice versa)
Evidence of the use of discretionary accruals to increase reported income
Other Motivations to Earnings Management
To Meet Investor’s Earnings Expectations and
Maintain Reputation


Firms that report earnings greater than expected enjoy share
price increase
Conversely, firms that fail to meet expectations suffer a
significant share price decrease

Investors should be aware of this incentive
Other Motivations to Earnings Management
Initial Public Offerings (IPOs)



Managers of firms going public may manage the earnings
reported in their prospectuses in the hope of receiving a higher
price for their shares
Many IPO firms manage their earnings upward
Lower earnings contribute to poor share performance
Bad Side of Earnings Management
Opportunistic earnings management
Maximizing their bonuses
 Raising new share capital



Maximizing the proceeds from the new issue
Frequent recording of non-recurring items



Do not affect manager bonuses
Do not take away from the ability to meet earnings forecast
Increases future core earnings which the manager is being evaluated
Good Side of Earnings Management
UnBlocking Communication

Blocked communication concept by Demski and
Sappington



Managers have insider information
Public wants credible way to be informed
Using Earnings Management to Unblock
Communication
Good Side of Earnings Management
Stocken and Verrecchia

Benefit of Revealing Insider Information must out way
the costs


When net income is adjusted through earnings management it
can no longer effectively predict future performance
Manager will be held responsible for excessive earnings
management
Earnings Management is good when the firm’s
environment is volatile and there is lots of insider
information.
Good Side of Earnings Management
Efficient Market Expectation


Rational expectations of the market understand
earning management incentives and compensate
accordingly
Therefore irresponsible not to manage earnings

Many different studies have come up with different results on
the truth behind these statements
From the evidence it can be concluded that earnings
management can both inform investors and enable
more efficient contracting.
Conclusion
Implications for Accountants:

To reduce bad earnings management improve
disclosure:





Clear reporting of revenue recognition policies
Detailed descriptions of major
discretionary accruals
Reporting the effects on core earnings
of previous write-offs
Diagnosing low persistence items
Bringing bad earnings management into the open will
reduce manager’s ability to bias the financial
statements
Conclusion
The Effect of Improved Disclosure:

Share prices would more closely reflect
fundamental firm value

Easier to assess management stewardship

Social welfare would increase
Conclusion
Financial reporting represents a compromise
between the needs of managers and investors:

Managers want flexibility of accounting choice:
 Ability to react to unanticipated state realizations when
contracts are rigid and incomplete
 Vehicle for credible communication of inside information to
investors (can be useful)
 Smooth compensation over time

However, it reduces reliability for investors:
 Earnings power may be persistently overstated (at least
temporarily)

Whether earnings management is good or bad depends on how it
is used
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