SUMMARY OF CH. 11 – EARNINGS MANAGEMENT
Earnings management is a manager’s choice of accounting policies that achieves some specific objective. Even under GAAP, managers still retain some flexibility in accounting policy selection that may be able to positively impact their personal satisfaction and/or the market value of their firm.
Accounting policy choice can be divided into two categories: accounting policies per se and discretionary accruals. Examples of the latter include the timing and amounts of extraordinary items such as write-offs and provisions for reorganization, credit losses, inventory values, etc., whereby managers are able to determine when and how much of revenue and expense to classify on a current income statement. The former, accounting policies per se, are more rigid in the sense that they dictate when and how much revenue and expense to classify in a certain period. Examples of these include amortization policies and revenue recognition.
A 1985 paper entitled “The Effect of Bonus Schemes on Accounting Decisions” by
Healy serves as the most popular research study on earnings management. In his study, Healy attempts to explain and predict managers’ choices of accounting theory. He hypothesizes that managers would find opportunities in which they could manage net income in an attempt to maximize their bonuses under the firm’s compensation plans.
Healy refers to a bonus scheme (a contract between the firm and its managers that sets forth the basis of managerial compensation) whereby a manager’s bonus is calculated based on a linear relationship to current reported net income. The bonus, however, will begin at a minimum amount of net income (called a bogey) and either level off at a maximum amount of net income

SUMMARY OF CH. 11 – EARNINGS MANAGEMENT
(called a cap) or continue infinitely. Healy argues that only if income is between the bogey and the cap will managers find an incentive to acquire accounting policies that increase net income and, thus, increase a manager’s bonus. Managers are not motivated to increase income when income is below the bogey or above the cap, because there is no potential to gain a higher bonus
(Exhibit 1).
Healy chose a sample of 94 firms, over a period of 50 years, with bonus compensation plans and empirically proved that those, which reported net income in between the bogey and the cap, had positive average accruals. The accruals increased reported net income, which ultimately increased a manager’s bonus. Conversely, the firms that had bonus compensation plans but reported net income either below the bogey or above the cap had negative average accruals.
These accruals were income-decreasing, which is consistent with Healy’s hypothesis of a manager’s incentive to lower current income when it does not affect his/her current year’s bonus.
Whereas Healy argues that changes in accounting policies are not as income-influencing as the use of accruals, if changes in accounting policies were made, the sample firms tended to implement them just after the introduction or amendment of a bonus plan. At that time, a manager’s bonus is dependent upon the future level of reported net income. If income is anticipated to be high in upcoming years, a manager will choose to implement an accounting policy (such as a departure from accelerated to straight-line amortization) that encourages a higher reported net income.

SUMMARY OF CH. 11 – EARNINGS MANAGEMENT
Contractual Motivation
Covenants in a long-term lending contract exist to protect the lender from the potentially adverse actions of managers. Earnings management can serve as motivation to steer managers away from violating the terms of a debt contract (known as covenant violation), since such a violation would be highly costly to the manager and could affect his/her ability to freely operate the firm. Earnings management gives a manager the flexibility to choose those accounting policies that avoid a close proximity to covenant violation.
For example, Sweeny (1994) observed that a sample of firms defying covenant obligations actually took measures to implement income-increasing accounting changes, in comparison to those sample firms that did not violate contractual terms. Moreover, these firms tended to prematurely switch to new accounting policies, as they felt an obligation to inflate reported net income and err on the side of the lenders’ best interests.
Political Motivations
To the extent that firms are politically visible, that is, they are often in the public eye or subject to governmental scrutiny, firms will use earnings measurement to reduce reported net income. This will circumvent external bodies from forcing a politically visible firm to lower its profitability. These findings are supported by empirical evidence from Jones (1991) and Cahan
(1992).
Taxation Motivations
Due to the already stringent regulations on the calculation of taxable net income, firms have less flexibility in applying earnings management to income taxation. However, there is a

SUMMARY OF CH. 11 – EARNINGS MANAGEMENT tendency for firms to switch inventory methods to LIFO in the face of rising prices because under LIFO, reported net income will be lower and so will be the calculated taxes. This reflects positively in the securities market, as investors are more likely to invest in firms with lowered taxes when market prices rise.
Changes of CEO
CEOs engage in behaviour that maximizes their utility. The following are consistent with the bonus plan hypothesis: a CEO of a poorly performing firm will use earnings management to avoid being fired; another will use it to maximize his/her income prior to retirement; and a new
CEO will manage earnings so as to increase his/her future income potential.
Murphy and Zimmerman’s study (1993) reinforced that a new CEO entering a poorly performing firm will tend to manage earnings in such a way that it reduces current income, but more importantly, will boost the firm’s performance in subsequent years. This behaviour is known as taking a bath . Thus, affluent future performance will reflect positively on a new CEO.
DeFond and Park (1997), on the other hand, found that a manager will be judged by current firm performance, and thus will try to “smooth” reported income. Income smoothing involves using discretionary accruals to “borrow” earnings from prosperous future periods, and “save” on earnings for lean future periods. Managing current firm performance augments the likelihood of job security.
Initial Public Offerings
Firms that have never entered the securities market will lack an established market price.
In order to best communicate a firm’s earnings power to investors, the firm will likely use prospectuses. If an investor sees a favourable reported net income in the prospectuses, he/she is

SUMMARY OF CH. 11 – EARNINGS MANAGEMENT likely to bid up the initial market value of the firm. These findings are supported by empirical evidence of Friedlan (1994).
Investors tend to seek information about a firm that helps to predict future firm performance. If reported earnings are managed to a number that represents management’s best estimate of persistent earning power, and the market realizes this, share price will quickly reflect this inside information.
The major patterns of earnings management include “taking a bath”, income minimization, income maximization, and income smoothing. It is important to note that managers can be motivated by a variety of earnings management patterns but that these patterns may often come into conflict. For instance, a firm may wish to smooth income for borrowing purposes but at the same time reduce income for political rationales.
Earnings management is “bad", in the sense that it reduces the reliability of financial statement information. Managers tweak reported earnings for reasons that are not obvious. There is, however, a dependence on earnings management to translate inside information into public information, as the costs of uncovering inside information are often very high.
Earnings management does have a “good” side, fortunately. This relates to efficient contracting. When a contract imposes strict or incomplete terms on a manger, earnings management can provide an option of flexibility, so long as it excludes a manager’s opportunistic (self-interested) motivations.

SUMMARY OF CH. 11 – EARNINGS MANAGEMENT
Additionally, earnings management can serve as a way to “unblock” communication to outsiders. Blocked communication exists when it is very difficult and costly to translate a manger’s skilful expertise about a firm to the board of directors and/or investors. By using the financial statements to communicate the financial health of the firm, earnings management can be used to inform outsiders of management’s inside information as per their exercised expertise.
A study performed by Subramanyam (1996) concludes that the stock market tends to respond positively and thus efficiently to the effect of discretionary accruals. So long as managers use earnings management responsibly, investors can infer from the financial statements what the future earning potential of a firm is likely to be.

SUMMARY OF CH. 11 – EARNINGS MANAGEMENT
Exhibit 1:
Typical Bonus Scheme:
Bogey (L) Cap (U)
Reported Net Income

SUMMARY OF CH. 11 – EARNINGS MANAGEMENT
PRACTICE TEST
Part 1: Multiple Choice
Bogey (L) Cap (U)
Reported Net Income
Questions 1 and 2 refer to the above diagram
1) If the firm’s reported net income is at point A, the manager in charge may do which of the following to increase future bonuses: a) Use the highest possible Inventory value for some assets b) Write off some questionable accounts receivable c) Re-evaluate warranties payable to a lower level d) None of the above
2) If the firm’s reported net income were at point B, what would be the main reason a manager would want to decrease reported net income? a) To appear more profitable to shareholders b) To pay less tax c) To allow for extra income to be reported in future years to hopefully increase future bonuses d) All of the above

SUMMARY OF CH. 11 – EARNINGS MANAGEMENT
3) Healy’s study of companies with both a bogey and a cap on their bonus schemes showed that: a) Most executives do not let bonuses affect how income is reported b) Companies in the MID range (net income between the cap and bogey limits) tend to up their reported net income to increase bonuses c) Companies in the UPP range (net income above the cap level) almost always lower reported net income d) Both B and C
4) A company managing earnings by using LIFO inventory method in periods of rising prices and FIFO inventory method in periods of falling prices is doing so for: a) Taxation Motivations b) Contractual Motivations c) Political Motivations d) Better communication of fiscal information to investors
5) Murphy and Zimmerman’s 1993 study of changes in discretionary variables (research and development, advertising, capital expenditures, and accruals) as companies change CEOs showed that: a) Most of the unusual behaviour in these variables was due to poor operational performance b) CEOs do not maximize income as they approach retirement age c)
Some incoming CEOs of poor performing firms “take baths” during the first years d) All of the above
6) What is NOT a reason an executive would partake in income smoothing: a) To maintain reported net income between the bogey and cap levels b) The manager in charge is risk-averse c)
To communicate the firm’s expected persistent earnings power to the external world d) To reduce corporate income tax

SUMMARY OF CH. 11 – EARNINGS MANAGEMENT
Part two: Essay Questions
Q1. An amount is said to be material if the magnitude of the item is such that it is probable that the judgement of a reasonable person relying on the financial statements would have changed their decision by the inclusion or correction of the amount.
(15 minutes) a) How does this concept of materiality relate to Earnings Management?
 Management can alter statements strategically that would result in immaterial
 misstatements
The immaterial misstatements could prove to be significant if the management
 has intentionally tried to convey a different economic picture than the one presented
An immaterial misstatement quantitatively could be a material misstatement on qualitative factors. Thus, management has the option of managing the earnings to show a certain way, which would have big qualitative impact, such as showing a key segment in a company that is linked to future growth opportunities for the firm to be slightly profitable rather than having a slight loss. b) What should the auditors do to protect themselves in situation where individual misstatements are material whereas overall misstatements are not material due to some creative earnings (mis)management?
 Make satisfactory enquiries
 Keep accurate and complete documentation of why the decision was made to state that the amounts were immaterial c) What implications would such misstatements have for the efficient markets theory?
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Such misstatements are inside information if not reported by auditors publicly
The market price of the firm would not reflect the true price of the firm
 The financial picture presented is different from the actual economic state of the firm

SUMMARY OF CH. 11 – EARNINGS MANAGEMENT
Q2. When it comes to accounting firms providing audit services and non-audit services to clients, especially when the revenues to the firm from non-audit services are greater than revenues from audit services, at least two viewpoints exist. One viewpoint is that the provision of non-audit services results in lower audit quality and an increased likelihood that the auditor will waive earnings management attempts. A competing viewpoint is that provision of non-audit services strengthens audit quality and can thus reduce earnings management. From your knowledge of earnings management, present a discussion and analysis of these opposing viewpoints.
(12 minutes)
Solution:
Lower Audit Quality:
 Firms would be more willing to provide management a greater leeway
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Management would thus engage in more creative accounting
Management would have incentives and means to manage earnings more
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Reliability of financial statements, even with audit, would be low
Firms would be perceived to have conflict of interest, especially if their consulting advice leads to the reporting of cash flows as they are in the financial statements lowering the quality of information
 Stock markets are likely to react negatively and bid down the price of the firm to levels that would ensure a just return for the higher risk
Increased Audit Quality
 Firms providing consulting have more of a reputation risk when providing
 consulting services
Firms have a lot to loose – business, market trust, and risk of lawsuits
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As a result, firms would audit more carefully to make sure that all information is presented fairly
Implies that all earnings management decision will be scrutinized carefully
Care will be taken in ensuring that the spirit of GAAP is followed so as to
 give the investors all the relevant information to base their decision
As a result, the quality of audit would be high

SUMMARY OF CH. 11 – EARNINGS MANAGEMENT
Q3. William R. Scott states that, “there is a fine line between earnings management and earnings mismanagement. Ultimately, the location of this line must be determined by standard setters, security commissions, and the courts.” Do you agree? Why?
(8 minutes)
Solution:
If Yes,
 When conflict arises, it is the standard setters, security commissions and the


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 courts who decide between the shades of gray
If left to companies, they would want the maximum flexibility in recording how they do things – they may not be fully driven by the purpose of providing reliable information to investors to base their investment decisions
If this level of check is taken out, investors may be prone to a lot more creative accounting, persistent earnings management which may not be in the best interests of the stockholders
It is these bodies that decide the way things are to be currently
All directives are issued by such bodies
Required to preserve a trust and justice system in society
If No,


Management has the best knowledge of the true state of the company
When officers have been selected, trust and reliance should be placed on their




 judgments
The above would hold true if good governance structures have been set up to ensure full accountability
If management is to follow very strict guidelines dictated by outsiders, they will not be motivated to make the best decision or to put in their best effort as they have no discretionary power
Adverse impact on the managerial labour market
The role of auditors would need to be changed
Low Reliability may be compensated for by a liberal justice system