EARNINGS MANAGEMENT

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An Overview
1
DefinitionChoice of accounting policies to achieve some specific manager objective

Under GAAP, managers retain some flexibility in accounting policy selection that may be able to positively impact their personal satisfaction and/or the market value of their firm.

3
Accounting policy choice divided into two categories: accounting policies per se and discretionary accruals

Evidence of Earnings Management for Bonus Purpose

The Manager would find opportunities The Effect of Bonus Schemes on Accounting Decisions (Healey 1985)

manage net income

maximize their bonuses

under the firms compensation plans

Bonus Scheme (Healey)

2 ways managers may manage net income (Healey 1986)

Controlling of various accruals

Accruals such as accounts receivables, inventory, accounts payable and accrual liabilities Discretionary in that they allow for some flexibility by management to control

Changing of accounting policies

That managers would change accounting policies just after an introduction or amendment of a bonus plan Manager may be motivated at that time to adopt an income-increasing accounting policy change if a period of healthy earnings is forecasted

Other Motivations for Earnings Management (besides bonus scheme)

Contractual motivations Changes of CEO

Political Motivations

Initial Public Offerings

Taxation Motivations

To Communicate Information to Investors

Contractual motivations
Contractual motivations: the incentive of earnings management (EM) arises from contracts between the firm and its managers that set forth the basis of managerial compensation.

A violation the terms of a debt contract would be highly costly to the manager and could affect his/her ability to freely operate the firm

Earnings management gives a manager the flexibility to choose those accounting policies that avoid a close proximity to covenant violation.

Political Motivations
Jones (1991) and Cahan (1992). To the extent that firms are politically visible, that is, they are often in the public eye or subject to governmental scrutiny, firms will use earnings measurement to reduce reported net income. This will circumvent external bodies from forcing a politically visible firm to lower its profitability

Taxation Motivations
Taxation Motivations

Taxation authorities impose their own accounting rules for calculation of taxable income, reducing the firms ability to manoeuvre. Ex LIFO versus FIFO inventory method

Changes of CEO
CEOs engage in behaviour that maximizes their utility. Thus a new CEO will manage earnings so as to increase his/her future income potential.

Initial Public Offerings

Firm will be tempted to report higher income in the years preceding the offering so that they will receive a higher bid for their IPO

Clarkson, Dontoh, Richardson, and Shefix (1992) noted that the market responds positively to earnings forecasts and this can be a measure of the firms value

To Communicate Information to Investors

share price will quickly reflect this inside information if the firm reported earnings are managed best estimate of persistent earning power.

Patterns of Earnings Management

Taking a Bath
If a firm must report a loss, management might think it is beneficial to report a large loss

Income Minimization
May be chosen by a politically visible firm during periods of high profitability

Income Smoothing
Managers have incentive to smooth income so it remains between the bogey and the cap

Income Maximization
Managers may do this for bonus purposes or May occur when firms are close to debt covenant violations

Is Earnings Management Good or Bad?

Bad
in the sense that it reduces the reliability of financial statement information

When a contract imposes strict or incomplete terms on a manger, earnings management can provide an option of flexibility

Good

Stock Market Reaction to Earnings Management

Managers use earnings management responsibly, investors can infer from the financial statements what the future earning potential of a firm is likely to be The stock market tends to respond positively and thus efficiently to the effect of discretionary accruals

(Subramanyam 1996)

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