2. Agenda
Earning Management
Patterns of Earnings Management
Motivation of Earnings Management
Good and Bad Side of Earnings Management
Measures of Earning Management and Conclusion
3. Creative Accounting Using the flexibility within accounting to manage
the measurement and presentation of the accounts so that they serve
the interests of preparers.
Two Quotes:
“How do you explain to an intelligent public that it is possible for two
companies in the same industry to follow entirely different accounting
principles and both get a true and fair audit report?” M. Lafferty
“Every company in the country is fiddling its profits”. I. Griffiths
CreativeAccounting
4. Earning
Management
The Definition
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
Management are • Taking a
Bath • Income Minimization
• Income Maximization •
Income Smoothing
5. TakingaBath
The Definition:
Commonly, 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 bank”.
6. Income
Minimization
The Definition:
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 write-offs of
capital assets, and intangibles, and the
expensing of advertising and R&D
expenditures.
7. Income
Maximization
The Definition:
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 strategy.
8. Income
Smoothing
The Definition:
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.
9. Evidence of Earnings Management for Bonus
Purposes “The Effects of Bonus Schemes on
Accounting Decisions” – The research of 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. Only if income
is between the bogey and cap will managers find an incentive
to acquire accounting policies that increase net income
Argues that: The 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
Other Motivations Contractual Motivation Many companies
have covenants in place to protect lenders. Violating this covenant
is dangerous to a manager. This causes managers to choose
accounting policies to avoid covenant violation.
Income
Smoothing
( C o n t . )
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.
10. 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 price
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 decreases. May not be the best option for the firm and
Can also lead to fraudulent behavior.
IPO 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
Another
Motivation
I n c o m e s m o o t h i n g
Contractual Motivation This is a dangerous
motivation due to the significant damage a covenant
violation causes. Managers may be overly aggressive
which may ultimately lead to fraud.
Political Motivations When a company will make
policy changes to intentionally lower its income • This
is done to escape government scrutiny • 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
12. Good Side:
Bad Side:
• Managers can use provisions to smooth earnings to desired levels
and unblock information. It would be foolish to overstate earnings
since the market will react severely when there is a subsequent
reduction.
• Good Side- Blocked Communication Inside Information • 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 fluctuations • 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 Accounting Decreases contract
efficiency as higher manager effort = lower earnings • Also
reduces need for upward earnings management = increased
contract efficiency • Net effect of the two reactions is positive on
firm value.
• Opportunistic EM Tendency for managers to try to
maximize their bonus • Debt Constraints • Firms that are
highly levered need EM to control if they violate loan
covenants •
• Raise new capital • EM can be used to maximize proceeds of
new issues • Discretionary accruals can increase SR earnings
• Techniques: • Speed revenue recognition • Lengthen cap.
Asset life • Under reserve for environmental costs
• Transitory items • 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 expenses.
TheGoodandBadof
IncomeManagement
13. Standard Setters Reflect the bad earnings management view • IAS 37-
provision as a liabilityif timing of payments is uncertain • Must be probable •
Mustbereliablyestimated•Mustbeatfairvalue
14. 1. Variability of operating income Lower = income smoothing
2. Correlation between accruals and cash flow Low correlation
=early revenue recognition
3. Magnitude of total accruals Higher accruals = higher
discretionary accruals
4. Small Loss/Gain ratio Low ratio = EM to avoid small losses
MeasuresofEarning
Management
16. First Point Second Point
• Earnings management is justified
through the theory that true net
income does not exist. At the
moment, the GAAP does not
completely constrain managers
choices of accounting policies.
Motivated by strategic considerations
• 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 information.
• Earning Management gives managers
flexibility to react to unanticipated
realizations
• Earnings Managements can be a
vehicle for the credible
communication of inside info to
investors.
TheConclusions
