DECISION USEFULNESS and
EARNINGS MANAGEMENT
Accounting Theory
Lecture 4 – Summer 2004
Decision Usefulness
Rational – want a reasonable return
Investors make investment decisions
– how much, when to invest, how long
Need information to estimate probable returns
– choose among alternative investments
Financial information helps investors
– assess likelihood of future returns, cash flow, dividends
Investors & Uncertainty (Ch 3)
Decisions under conditions of uncertainty
Investor is risk averse => diversifies portfolio
– market-wide risk
– firm-specific risk
F/S => assess probability of future states
– predict future investment returns
– predict whether good/bad news will persist
– predict future cash-flows
FASB Perspective
Objectives stem primarily from the needs of
external users
Measures are often approximate, not exact
Largely reflects events of the past
But one source of information about the firm
The information is provided & used at a cost
Relate to financial reporting, not just f/s
Main Objective
Decision-usefulness approach
Provide useful information
– to present & potential investors & creditors
– to make rational investment & credit decisions
Assumes reader is reasonable intelligent &
thoughtful
Secondary Objectives
Assess the amounts, timing & uncertainty of
prospective cash receipts
– balance sheet, income statement, statement of
retained earnings & statement of cash flows
Assess management stewardship/performance
Investors & creditors are most important users
– this approach is useful to all other user groups
CICA Approach
Section 1000.15 – joint perspective
Communicate information that is useful:
– in making investment & resource decisions
and/or
– assessing management stewardship
Unlike U.S., both are equally important
Decision Usefulness
Provide information useful in making
investing & credit decisions
Reflect expectations about the future
– often based on evaluation of the past
Financial reporting:
– focus on earnings & its components
– does not directly measure value
– provides information to estimate value
Earnings Management (Ch 11)
Managers can ‘smooth’ reported earnings
• Opportunistic
– increase accounting-based bonus (Healy 1985)
• Efficient contracting
– low cost way to protect firm from negative
consequences of economic events (Scott 11.6)
– increase value of firm, probability of survival?
How are Earnings Managed?
Discretionary accruals
– no impact on cash flows; they reverse next
period
– working capital, amortization, write-downs
Discretionary expenditures
– they affect cash flows
– advertising, R&D, capital asset disposals,
corporate donations
Management or Manipulation?
Is this earnings management or manipulation?
• Levitt 1998 – cookie jar reserves
When does earnings management become
fraudulent financial reporting?
Ethical implications
Earnings Disclosure
What kind of disclosure will help investors?
• Provide information to estimate amount,
timing & uncertainty of future cash flows
– full disclosure of non-recurring items
– effect on core earnings & its components
• Differentiate accounting policies with cash
flow implications from those without