Chap 11 (Earnings Management)

Earnings management
mgrs will choose policies to maximize their own utility and/or market value of the firm

(net income is useful for reporting to investors & for contracting purposes) Mgr can use the ability to manage earnings to help reduce risk.
Why do managers engage in earnings management?
1) Mgrs want to maximize their utility because of compensation and debt contracts

2) Mgrs may want to create impression of smooth & growing earnings over time (affects market value)

3) Mgrs also cat as vehicles to communicate inside info to investors
Why is controlling Moral Hazard important?
Controlling the moral hazard problem is important to a market-based economy because social welfare is enhanced if managers work hard to create efficient production and capital investment decisions.
Why do accountants need to understand Earnings Management?
enables an improved understanding of the usefulness of net income, both for reporting to investors and for use in contracting.
How and & who do efficient contracts benefit?
efficient contracting benefits: the firm and its shareholders.

In so doing, the operation of the managerial labour market is improved, with resulting improvements in productivity and social welfare for the economy
List the patterns of earnings management
Taking a bath
Income minimization
Income maximization
income smoothing
Taking a bath
Investors whose shares have declined significantly or experienced a large loss are said to have taken a bath.

Motivation is that is enhances probability of future reported profits

when you are below the bogey, because you are already below the amount and will not receive a bonus, it does not matter whether your company does even worse and is at a loss because either way you will NOT get a bonus
(reducing net income)
when does taking a bath occur?
when there is a reorganization or change of top mgmt

Because mgrs have nothing to lose & report a loss position, they write off assets etc

ex. this guy who managed bootlegger became the manager at tip top (change in management) his bonus was dependent on sales and income so what he did was:
he wrote down the inventory so maybe to $10, but the ticket price in the store did not change (so still selling it ay $5) so it looks like you're making a profit (so it enhanced his future profits)
Income Minimization
you are at the cap, so any income/amount that is the above the cap you will not receive any more bonus. so you want to get to back down to the cap amount and defer that excess to next year

Motivation: income tax reduction, politically visible with high profits concerned about regulations and taxation
Political Cost hypothesis
The political cost hypothesis assumes that firms will tend to show their profits lower by using different accounting methods and procedures so that the firm does not attract the attention of politicians, who will have an eye on high profit industries.

Allowing lower profits steers away any attention by the public and the eyes of the government who will place higher regulation on high earning firms.
Income maximization
Motivation: increase bonus (up to cap) Bonus hypothesis

reduce concerns about being close to debt covenant breach
Bonus Hypothesis
managers who have accounting incentives, or their remuneration that is tied up with the firm's accounting performance will tend to manipulate accounting method and figures to show the accounting performance better than it should be.

Such as managers electing to use different depreciation method allowing lower profits at the start and higher profits towards the end. Older managers will tend to ignore any research and development costs because it will lower current year profits affecting their income.
Debt to equity hypothesis
Debt/equity ratio is total liabilities over total shareholders, its how much the if the company is financed through liability & equity. The lower the number the lower the risk
Income Smoothing
accounting techniques to level out net income fluctuations from one period to the next. Companies indulge in this practice because investors are generally willing to pay a premium for stocks with steady and predictable earnings streams, compared with stocks whose earnings are subject to wild fluctuations

Keep income btwn bogey & cap

risk averse mgrs would prefer a less variable bonus stream

reduce volatility of reported income (reduces probability of debt covenant violation)

could be used to disguise an underlying cash flow volatility
Healy (1985)
Evidence of Earnings mgmt for bonus Purpose

earnings mgmt is used by mgr to increase amount/timing of his/her bonus.

If net income is below bogey mgr was motivated to lower it even further ("take a bath") -> increases probability of receiving a bonus in the subsequent year.

If net income is above cap mgr was motivated to reduce net income to the extent that they didn't lose bonus on that net income -> increases probability of receiving a bonus in the subsequent year.

If net income is b/w bogey & cap mgr is motivated to increase net income
-> increases current year bonus
Bonus schemes (also Healy)
incentive plan based on current reported net income only
2 approaches to control Net Income (Healy)
1. Control Various accruals (Short run earnings mgmt technique)

(AFDA, Allowance for obsolesce, amortization, accrued liability portion)
Not discretionary:
(Govt grants receivable, deferred income taxes, dividends)

manager who manages earnings upwards to a level greater than he/she can sustain will find that the reversal of these accruals in subsequent periods will force future earnings downwards.

2. Change accounting policies (longer run earnings mgmt)

Healy (Results)
Support the bonus plan hypothesis.

Managers use discretionary accruals to manage earnings upwards when earnings are between the bogey and cap.

Outside of these two limits, average accruals were negative (earnings decreasing)

consistent with his argument that when earnings are below the bogey or above the cap, the rational manager will want to decrease earnings, not increase them.
Holthausen, Larcker, and Sloan
found managers who had zero bonus did not use accruals to manage earnings downward (diff. than Healy).

found managers who were at maximum bonus used accruals to decrease earnings (same as Healy)
Net Income
(separating discretionary from non-discretionary accruals)

Hint : formula
cash flow from operations ± net non-discretionary accruals ± net discretionary accruals
Approaches to separate discretionary from non-discretionary accruals
1. Item-by-item approach (using info from B/S & SCF, analyzing each accrual to get discretionary component)

2. use total accruals as a proxy for discretionary accruals

3. Don't estimate total discretionary accruals, but instead, pick a specific account for which it is relatively easy to estimate the discretionary portion (if earnings mgmt found in 1 account, will also be in other accounts)
Other motivations for earnings mgmt
1. Meeting Investors' earnings expectations

Studies show that Market appears to punish the firms that fail to meet expectations more than it rewards those who exceed earnings expectation - thus there is incentive for managers to ensure earnings expectations are met by managing earnings upward

failure to meet investors' earnings expectations has serious consequences (direct negative impact on share price and cost of capital as investors revise downwards probabilities of good future firm performance).

2. IPO's

Hughes (1986) net income can be useful to signal firm value to investors.

It is more likely that managers of firms going public may manage earnings reported in their prospectus to gain higher share price.

3. To communicate info to Investors

increase earnings in the short run or could smooth earnings in order to create an impression of strong & steady growth
Why does earnings management persist?
In order for earnings mgmt to succeed it must be based on inside information.
Mgrs have inside info that is prohibitively costly for others to find out; also difficult to interpret:

1) Accruals: Difficult to differentiate b/w discretionary & non-discretionary accruals

2) Other earnings mgmt techniques: Accounting policy changes; timing of capital gains & losses ; provisions for restructuring - difficult to interpret.
Reasons behind use of discretionary accruals which could provide inside info
1. Maximize current reported net income
(management could be concerned about meeting earnings forecasts, about events such as violation of debt covenants, or may be planning an initial public offering)

2. Minimize reported net income
(management might be expecting a period of reduced earnings and may be trying to move earnings from current to future periods. )
what is the good side of earnings management?
efficient contracting
efficient contracting
some room to maneuver in rigid & incomplete contracts (debt covenants; bonus plans)
Efficient information flows
investors may benefit from ability of earnings mgmt to convey inside info to capital markets, enabling share prices to better reflect the firm's future prospects.
Demski & Sappington
Blocked communication concept

If costly to communicate info, then considered to be blocked information. The presence of blocked information can reduce the efficiency of agency contracts, since the agent may shirk on info acquisition and take a sub optimal act.
Blocked communication
arises when costly to communicate info

contains complex inside information about firm's long term earnings potential that the market is prevented from knowing because it is costly to verify. As a result, it reduces the efficiency of the contract. Manager may shirk because the market does not know this inside information
what is the implication of blocked communication?
Investors may expect that there is hidden information and bid down share prices accordingly (regardless of whether the news is good or bad, investors assume its bad)
what is the solution to blocked communication?
Use earnings management to communicate blocked inside information about future earnings prospects to investors and to avoid the consequences of rigid and incomplete contracts.
what is the bad side of earnings management?
selfish (opportunistic) manager behaviour

Note: The market punishes wrong actions by driving down the share price
Solution for bad earnings management?
Full disclosure!
Beneficial Effects of Earnings Mgmt
GAAP provides some flexibility to mgrs to deal with situations that were not anticipated when certain contracts were entered into (i.e. provides some ability to manage earnings in the face of incomplete or rigid contracts)

Earnings mgmt cans serve as a vehicle for credible communication of inside info.
Adverse Effects of Earnings Mgmt
Mgr can take advantage of the ability in order to maximize bonus (personal gain)

Earnings mgmt affects the reliability of F/S info - net income can be biased

Could be difficult to assess persistence of earnings