Earnings Management

1. Earnings Management

2. What is earnings management? • It is the choice by a manager of accounting policies or real actions, affecting earnings so as to achieve some specific reported earnings objective Earnings Management

3. What are some examples of earnings management?

4. Why is understanding earnings management important to accountants?

5. It is important because: • It enables an improved understanding of the usefulness of net income • both for reporting to investors and contracting • Helps avoid some of the serious legal and reputation consequences that arise when firms become financially distressed.

6. Choice of accounting policy has broad interpretations • No clear cut dividing line between the two choices • Choice of accounting policies (straight line versus declining balance amortization) • Discretionary accruals ( provisions for credit losses, warranty costs, inventory values, writeoffs and provisions for restructuring • Earnings management can be a vehicle for the communication so managements inside information investors. Earnings Management

7. Fine line between earnings management and earnings mismanagement • The locations of “the line” is determined by • Effective corporate governance • Reinforced by securities and managerial labour markets • Standard setters • Securities commissions • Courts

8. Accruals reverse • For ex: a manager who manage earnings upwards will suffer a lower earning in later periods • Therefore earnings management should not be used to rationalize misleading or fraudulent reporting Iron law of accruals

9. 4 different earnings management patterns • Taking a bath • Income minimization • Income maximization • Income smoothing Patterns of Earnings Management

10. Takes place during periods of organizational stress or restructuring • Might as well report a large loss (nothing to lose) • Write off assets (“clear the decks”) • Enhances the probability of future reported profits because of accrual reversal Taking a Bath

11. Similar to taking a bath but less intense • Chosen by firms during periods of high profitability • Policies that suggest income minimization • Rapid writeoffs of capital assets and intangibles • Expensing of advertisement and R&D • Income tax considerations Income Minimization

12. If a firms is close to debt covenant violations may use income maximization • Engage in this pattern for bonus purposes • Provided that this does not put them above the cap Income Maximization

13. Incentives • Risk averse managers prefer a less variable bonus stream • Smooth out reported earnings over time to gain relatively constant compensation • Efficient compensation contracting may exploit this effect • Incentive to reduce volatility of reported net income to smooth out covenant ratios over time • Reduce the possibility of reporting low earnings • Firms smooth reported net income for external purposes • “If used responsibly smoothing can convey inside information to the market by enabling the firm to communicate its expected persistent earning power” Income Smoothing

14. Healy 1985 wrote a paper on “The Effect of Bonus Scheme Decisions” • Based on positive accounting theory, which attempts to explain and predict managers choices of accounting policies • Conclusion: Managers would be able to manage net income to maximize their bonuses under their firms compensation plans 11.3 Evidence of Earnings Management for Bonus Purposes

15. Typical Bonus Scheme Significance Bonus is constant for net income greater than the cap No cap in the bonuses, the bonus would increase along the dotted line No bonus to be received, the manager might as well adopt accounting policies to further reduce the net income If net income is between the bogey and cap the manager is motivated to adopt accounting policies to increase the net income Typical Bonus Scheme

16. Discretionary Accruals : Accruals which the manager can exercise some control • Non - Discretionary Accruals: Manager does not have control Discretionary and Non- Discretionary Accruals

17. Amortization Expense: • Discretionary: Company changes the policy for the calculation of the amortization expense by modifying estimated useful life measurement • Non- Discretionary: Amortization expense number changes • Increase in net account receivables • Discretionary : Management makes changes by selecting a less conservative estimate for allowance for doubtful accounts, increase through earlier recognition, more generous credit policy or keeping the books open beyond the year end • Non- Discretionary: Increase in volume of business Discretionary and Non- DiscretionaryAccruals

18. Increase in Inventory • Non-Discretionary increases include inventory buildup due to anticipation of increased demand • Discretionary increases would include charging fixed overhead costs to inventory rather than charging them off as expenses Decrease in accounts payable and accrual liabilities - Discretionary decisions are used in making these estimates such the firm being more optimistic about warranty claims than in previous years. Also regarding certain borderline liabilities as contingences rather than as accruals Other Accruals

19. Manager has considerable discretion when recording net income • Did not have access to the books and records of his sample firms therefore unable to determine specific discretionary accruals made by the firm’s managers • Observations fit into one of the three categories • Portfolio UPP: Observations where earnings were above the cap • Portfolio Mid: Observations between the bogey and the cap • Portfolio LOW : Observations where earnings were below the bogey Observations with both a Bogey and Cap

20. Major difficulty is that discretionary accruals cannot be directly observed • Kaplan (1985) • Pointed out a firm with reported net income above the cap of its bonus plan may have low non-discretionary accruals • The high income is due to an unexpected increase in demand that runs down inventory. • Low total accruals are due to: • Level of the firm’s real economic activity • Not to low discretionary accruals. • Healy addressed Kaplan issues and performed additional tests to confirm the results Healy Conclusion

21. McNichols and Wilson(1988) • Studied the behavior in a bonus context • Results consistent with Healy • Confirmed the provision for bad debts on the grounds that a precise estimate for what the bad debt allowance should be (non-discretionary portion) made • Discretionary accruals = Estimate bad debt provision -Actual bad debt provision • Below bogeys and above caps: Significant income reducing both for firms that were profitable and unprofitable • Between profitability extremes: Firms discretionary accruals were lower among income increasing Discretionary Accruals Bad Debt

22. Jones (1991) • Estimate non-discretionary accruals, using better data • Non- discretionary accruals found that managers who received 0 bonus did not use accruals to manage earnings downwards which different from Healy’s findings, in row 1. • Managers who were at their bonus maxima accruals so as the lower reported earnings which is different from Healy’s findings- row 3 Jones: Non-discretionary Accruals

23. Managers use accruals to manage earnings to influence their bonuses, particularly when they are high consistent with bonus plan hypothesis of positive accounting theory • 2 ways to think about bonus plans • 1)Opportunistic behavior • Managers exploit their power in the organization by maximizing their utility at the expense of the firms shareholders and investors who may find it costly to unravel discretionary accruals. • 2) Efficient contracting perspective • When setting compensation contracts firms will rationally anticipate managers incentives to manage earnings and will allow for this in the amount of compensation they offer • It is less costly to an organization to offer it • Either way it does create earnings management incentives Earning management incentive conclusions

24. OTHER MOTIVATIONS FOR EARNINGS MANAGEMENT

25. WHAT IS A DEBT COVENANT? WHY DO LENDERS USE THEM?

26. Covenants: Protect against actions by managers that are against the lenders’ best interest • Excessive dividends • Additional borrowing • Letting working capital or shareholders’ equity fall below specified levels • All of these actions dilute the security of existing lenders 11.4.1 Other Contracting Motivations

27. WHAT IMPACT CAN COVENANT VIOLATION HAVE ON A FIRM?

28. Covenant violation • High costs firms • Raise the going concern issues for the business • Earnings management can arise as a device to reduce the probability of violation of debt contracts • Sweeney 1994 • Discovered significantly greater use of income-increasing accounting • And the early adoption of new accounting standards to increase net income 11.4.1 Other Contracting Motivations

29. Other studies found: • Use of discretionary accruals to increase reported income in the year prior to and to a lesser extent in the year of the convent violation • Many companies had to cut dividends which makes lenders, shareholders, unions feel that they are financially unstable 11.4.1 Other Contracting Motivations

30. Earning management incentives • Relational contracts these are not normal contracts such as compensation or debt contracts • For example: Meeting contract commitments with suppliers will allow one to receive better terms from suppliers and lower interest rates from lenders • Bowen etc 1995 investigated implicit contracting where companies have represented high profits • Increase stakeholder confidence that the manager will continue to meet the contract obligations. • For example business with high COGS or notes payable will use FIFO and straight line amortization as it appears to be income increasing. 11.4.1 Other Contracting Motivations

31. Investor’s earnings expectation can be formed in variety of ways • Based on earnings in same period last year or recent analysis or company forecasts • Skinner and Sloan 2002 • Firms penalize more for failing short of expectations • Manage earnings upwards ensure that earnings expectations are met • Keung etc. 2010 • Market reaction to a zero or even a small positive earning surprise turned negative during 2002-2006, compared to positive response received in previous years 11.4.2 Meeting Shareholders Expectations

32. Mercer 2005 • Plausible: Earnings and forecasts as well as their opinions increase • Not plausible: Earnings and forecasts as well as their opinions decrease • Failure to meet investors earnings expectations has serious consequences • Direct effect: Firm’s share price and cost of capital as investors are expected to be lower • Indirect effect: Manager reputation can be negatively impacted if explanation appears as an excuse 11.4.2 Meeting Shareholders Expectations

33. Which companies have recently gone public?

34. IPO’s do not have a established market price • Question is: What is the value of the shares in such firms? • Financial accounting information is a useful source • Ex: Forecasts • Clarkson etc. 1992 • Evidence the market responds positively to earnings forecasts as a signal of firms value 11.4.3 Initial Public Offerings

35. Teoh 1998 • Discretionary accruals around the IPO date are concentrated on working capital accruals • High discretionary accruals was significantly negative relative to IPO’s firms with low accruals • Currently it is unclear whether investors are “fooled” by opportunistic earnings management in IPO’s or rationally price the IPO 11.4.3 Initial Public Offerings

36. The Good Side to Earnings Management

37. Agents obtaining specialized information as part of their expertise, and this information can be prohibitively costly to communicate to the principle that is its communication is blocked • The presence of blocked communication can reduce the efficiency of agency contracts, since the agent may shirk on information acquisition and compensate by taking an act that, from the principle’s point is sub-optimal • Earnings management can be a device to reduce blockage Blocked Communication

38. Such as: • An increased positive market reaction to disclosure of business strategy in high tech firms when the disclosures are proceeded by a credible gesture of confidence in the firm by management namely insider stock purchases • Disaggregation of good news forecast (i.e. forecasting sales and expenses as well as net income) increases its credibility • Earnings management can be a device to reduce information blockage Reducing Information Blockage

39. Does the stock market react to earnings management as if it were good? • The answer to this question is important to an accountant since they are prominently involved in the technique and implementation of earnings management and will and get drawn into the negative publicity and lawsuits that inevitably follow the revelation of bad earnings management practices Empirical Evidence of Good Earnings Management

40. Earnings management can both inform investors and enable more efficient contracting • However the opportunistic earnings management is mixed in with the good cannot be ruled out

41. Subramanyam – the stock market responded positively to the current period's discretionary accruals, consistent with managers, on average using earnings management responsibly to reveal inside information about future earnings power Empirical Evidence Examples

42. Xie – found that rather than reacting to discretionary accruals as if they were good, the market appears to over value them Empirical Evidence Examples

43. Tucker and Zarowin – conclude that greater income smoothing behaviour is accompanied with good earnings management argument Empirical Evidence Examples

44. THE BAD SIDE OF EARNINGS MANAGEMENT

45. Despite theory and evidence of responsible use of earnings management, there is also evidence of bad earnings management • Opportunistic Manager Behaviour: the tendency of managers to use earnings management to maximize their bonuses Opportunistic Earnings Management

46. Examined the earnings management practices of 92 firms charged in the USA by the SEC with alleged violation of GAAP, compared to a control sample of firms of similar size and industry • Revealed a number of motivations for such earnings management • Firms in test sample had, significantly greater leverage and significantly more debt covenant violations than the control sample • Raising new share capital and want to maximize the proceeds from the new issue Study by Dechow, Sloan, and Sweeney

47. Studied the financing decisions of sample firms • Charged firms issued, on average, significantly more securities during the period of earnings manipulation than the control sample Study by Dechow, Sloan, and Sweeney

48. Market does appear to react to earnings management • ERC for a dollar of quarterly core earnings is lower for firms that have frequently recorded large unusual and non-recurring charges • Consistent with the market using the frequency of non-recurring charges as a proxy for the extent to which core earnings may be overstated Market Reaction to Earnings Management

49. Leuz, Nanda, and Wysocki evaluated the extent of earnings management in each of 31 countries during 1990–1999 • Measures used: • Variability of operating income • Correlation between accruals and cash flow • Magnitude of total accruals • Country’s ratio of small earnings losses to small gains Earnings Management in an International Context

50. Measures were combined to create a score for each country • Lower scores imply less earnings management • Canada - 5 • USA - 2 • Germany - 21.5 • Scores were related to country institutional characteristics • For example: Lower investor protection is associated with more earnings management Earnings Management in an International Context