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Chapter 11 Earnings Management

11.1 OVERVIEW

  • Earnings management is viewed from both financial reporting and contracting perspectives.
  • Financial Reporting Perspective:
    • Managers may manipulate earnings to:
      • Avoid reporting losses
      • Meet analysts' earnings forecasts.
        • Failure to meet expectations can lead to reputation damage and negative share price reactions.
      • Record excessive write-offs.
      • Emphasize "pro-forma" earnings.
      • Managers may believe investors won't detect these tactics.
    • Zakolyukina (2018) found that approximately 4% of U.S. companies revise their earnings each year.
      • This figure represents detected and corrected cases.
      • The undetected rate of serious earnings management (violations of GAAP) is likely higher.
      • Analysis suggests at least 60% of managers may violate GAAP earnings at least once, with only 14% detection rate.
      • Earnings management costs shareholders about 2% in share returns.
    • Alternatively, earnings management can be used to report a stream of smooth and growing earnings.
      • Requires inside information.
      • Aims for sustainable earnings levels.
      • Can be a vehicle for communicating management’s expectations to investors.
      • Income smoothing can be useful from a financial reporting perspective.
  • Contracting Perspective:
    • Earnings management can protect the firm from unforeseen events when contracts are rigid and incomplete.
    • Compensation contracts allowing earnings management can be more efficient, particularly when managers control the accounting system.
    • Excessive earnings management can reduce the usefulness of financial reports for both investors and contracting.
    • May affect the manager’s motivation to exert effort, if used to smooth compensation, reducing compensation risk.
    • Managers need to bear some risk to motivate hard work.
  • Managers have a strong interest in the bottom line. They will choose accounting policies (within GAAP) to help achieve their objectives.
  • Managers may take real actions affecting earnings (e.g., cutting R&D).
  • Motivations for earnings management can be efficiency or opportunism.
  • Earnings management is manipulating accounting to achieve a goal other than clear consistent reporting.

Accounting Implications

  • Accountants should understand earnings management to:
    • Improve understanding of net income's usefulness for reporting and contracting.
    • Avoid legal and reputation consequences when firms become financially distressed, often preceded by earnings management abuse.
  • Earnings management is the manipulation by a manager of accounting variables or real actions to achieve a specific reported earnings objective.
    • Includes both accounting choices and real actions.
    • Classification shifting (e.g., shifting core expenses to non-recurring items) gives the impression of increased earnings persistence.
    • Choice of accounting policies (e.g., straight-line vs. declining-balance amortization, revenue recognition policies).
    • Manipulation of discretionary accruals (e.g., credit losses, warranty costs, inventory values, restructuring provisions, write-offs).
    • One category of discretionary accruals is manipulation of special items, such as writeoffs, which have low persistence.
  • Accruals reverse:
    • Managing earnings upward through accruals leads to accrual reversal in subsequent periods, forcing future earnings downward.
    • More earnings management would then be needed to maintain inflated earnings.
    • Accrual-based earnings management cannot indefinitely postpone the "day of reckoning".
    • Earnings management through accruals cannot indefinitely postpone the day of reckoning for a poorly performing firm.
    • The accountant treads a fine line between earnings management and earnings mismanagement.
    • This line is determined by corporate governance and reinforced by securities and managerial labour markets, standard setters, securities commissions, and the courts.
    • Multi-period horizons reveal further earnings management potential, such as income smoothing and “big bath.”
    • However, multi-period horizons can also inhibit earnings management since accrual-based manipulations reverse.
  • Real earnings management involves real choices, such as cutting advertising, R&D, or maintenance.
    • Real earnings management is not contrary to GAAP but may be costly if it affects the firm’s longer-run interests.
    • Managers may use real earnings management since the costs of accounting-based management can be high (e.g., Enron, WorldCom, Sarbanes-Oxley Act).

Respondents prefer to moderately manage real variables,
rather than risk the legal and reputation consequences of aggressive accounting policies
Earnings management by real variables affects cash flows as well as earnings.

Empirical Evidence

  • Roychowdhury (2006) reported that firms with earnings close to zero would increase reported earnings by managing real variables.

Chapter Focus

  • Rest of chapter focuses primarily on earnings management based on accounting, rather than real variables, due to:
    *Historical importance.
    *Relevance to accounting.
    *Probability that the lessons learned from reporting failures will grow dim over time.

11.2 PATTERNS OF EARNINGS MANAGEMENT

  1. Taking a bath:
  • Occurs during periods of organizational stress or restructuring.
  • Management reports a large loss using negative special items, such as writing off assets, to generally "clearing the decks.