9.403 Lesson Summary Chapter 11 Earnings Management
Lesson Preparation Project
Chapter 11: Earnings Management
11.1 Overview
“Earnings management is the choice by a manger of accounting policies so as to achieve some specific objective”
There are two ways to think about earnings management: as an opportunistic behaviour by managers to maximize their utility and from an efficient contracting perspective.
Issues arise in regards to earnings management due to the choice of accounting policies, discretionary accruals, and finally the line where management becomes mismanagement.
11.2 Evidence of Earnings Management for Bonus Purposes
In 1985 earnings management was researched to see if managers would manage net income so as to maximize their bonuses under their firm’s compensation plans. Healy examined firms whose compensation plans are based on current reported net income only, this is also known as bonus schemes. With a typical bonus scheme, reported net income will have a lower bound called bogey and upper bound called cap. A manager’s bonus will increase as reported net income increases, unless there is a cap at which point the bonus will remain the same as net income continues to increase beyond the cap. A manager will not receive any bonus when income is below the bogey. Healy predicted that when net income is between the bogey and cap is the manager motivated to adopt accounting policies to increase reported net income. Net income that is below the bogey or above the cap would motivate managers to “take a bath” whereby they will try to reduce or minimize net income. By taking a bath below the bogey, managers will then increase the probability of receiving a bonus the following year since current write-offs will reduce future amortization charges. Likewise, managers would take a bath (to a lesser extent) to decrease net income since a bonus would be permanently lost on reported net income greater than the cap.
One way managers may manage net income is by the controlling of various accruals. Accruals such as accounts receivables, inventory, accounts payable and accrual liabilities are discretionary in that they allow for some flexibility by management to control. For example, a manager may decide to become more optimistic about warranty claims on its products its current year than in previous years to decrease the accounts payable and accrual liabilities thereby increasing reported net income. This in turn would be difficult for an auditor to discover as part of earnings management since the technique just described falls within GAAP.
Given that Healy did not have access to the books and records to view the specific discretionary accruals made by firm managers, Healy examined the total accruals of 94 industrial companies from the period of 1930-1980 of which 447 observations of firm years contained a bogey and a cap, Healy found empirical evidence supporting his predictions. That is, firm managers whose net incomes are below the bogey and above the cap will tend to adopt income decreasing accruals and only managers with net income between the two will tend to adopt income-increasing accruals.
A second way for managers to engage in earnings management is the changing of accounting policies. Healy believed that managers would change accounting policies just after an introduction or amendment of a bonus plan. For example, a manager may be motivated at that time to adopt an income-increasing accounting policy change if a period of healthy earnings is forecasted. From the same sample as his previous study, Healy examined 242 accounting policy changes over the 12 years 1968 to 1980 for which the effect of net income could be determined and divided them into two portfolios. One consisted of firms that adopted or modified their bonus plan in the year and the other consisted of firms that did not. Healy found that in 9 of the 12 years, the portfolio of firms with bonus plans changes had more accounting policy changes. This provides significant evidence that managers also use such changes as an earnings management vehicle.
11.3 Other Motivations for Earnings Management
11.3.1 Other 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.
Long-term contracts normally contain covenants to protect the lenders from the actions of managers. EM for covenant purposes is predicted by the debt covenant hypothesis of positive accounting theory (PAT). Covenant violations can impose heavy costs so EM can arise as a device to reduce the probability of covenant violation.
Sweeney (1994) found greater use of income-increasing accounting changes relative to a control sample and defaulting firms tended to undertake early adoption of new accounting standards when these increased reported net income. DeFond and Jiambalvo (1994) found firms using discretionary accruals to increase reported income in the year prior to and in the year of the covenant violation.
DeAngelo, DeAngelo, and Skinner (1994) found somewhat different results. Rather than firms using accruals to manage earnings upwards, they were exhibiting large earnings-reducing accruals.
11.3.2 Political Motivations
Many companies are quite politically visible and may manage earnings to reduce their visibility, achieved through accounting practices and procedures to minimize reported net income, especially in highly prosperous periods. If they do not, public pressures may lead to increased government regulation or other means to lower profitability. This motivation underlies the size hypothesis of PAT.
Jones (1991) found use of greater income-decreasing accruals during the year of ITC investigation than in years outside the investigation. Cahan (1992) found that firms under investigation for monopolistic practices used more income-decreasing accruals during investigation years relative to other years sampled.
11.3.3 Taxation Motivations
Taxation authorities impose their own accounting rules for calculation of taxable income, reducing the firm’s ability to manoeuvre. Taxation should not play a major role in EM decisions in general. An exception occurs with respect to the choice of LIFO versus FIFO inventory method. During periods of rising prices, LIFO will usually result in lower reported profits and lower taxes, relative to FIFO.
Much PAT research has tried to explain and predict firms’ inventory policy choices. Dopuch and Pincus (1988) reported evidence that tax savings are high for LIFO firms and that firms keep using FIFO do not suffer large tax consequences, for reasons including low amounts of inventory, high variability of inventory levels, high inventory turnover, and low effective tax rates.
11.3.4 Changes of CEO
The bonus plan hypothesis predicts that CEOs approaching retirement would be particularly likely to engage in a strategy of income-maximization. CEOs of poorly performing firms may income-maximize to postpone termination. This motivation also applies to new CEOs, especially if large write-offs can be blamed on the previous CEO.
Murphy and Zimmerman (1993) (MZ) examined the behaviour of four discretionary variables: research and development, advertising, capital expenditures, and accruals. MZ found that reducing R&D, advertising, and capital expenditures might be effective to increase current earnings but can potentially be quite costly. The accrual and accounting policy variables are less costly, since for the most part they are strictly paper devices.
These studies face difficult methodological problems. (1) Could be difficult to tell whether lower discretionary variable values are due to EM or poor operation performance. (2) Could be difficult to tell whether any apparent EM is due to the new CEO or the old.
It is possible that some managers use EM successfully to avoid termination. DeFond and Park (1997) found evidence of managers’ use of discretionary accruals to “borrow” earnings from future periods when future earnings are expected to be relatively good and “save” current earnings when future earnings were expected to be relatively poor. Consequently, income smoothing to avoid reporting poor earnings enhances job security.
11.3.5 Initial Public Offerings
Firms making initial public offerings (IPOs) do not have an established market price, which raises the question of how to value the shares. Evidence found by Clarkson, Dontoh, Richardson, and Sefcik (1992) raises the possibility that managers of firms going public may manage the earnings reported in their prospectuses in the hope of receiving a higher price for their shares.
Friedlan (1994) concluded that IPO firms did indeed make income-increasing discretionary accruals in the latest period prior to the IPO, relative to accruals in a comparable previous period. Accrual management seemed to be concentrated in the poorer-performing sample firms and in the smaller sample firms.
11.3.6 To Communicate Information to Investors
Earnings management used to communicate information to investors may seem questionable in view of efficient securities market theory. However, markets are only efficient in terms on publicly available information so if earnings management can reveal inside information, it can actually improve the informative nature of financial reporting.
Management has the best (inside) information about future earnings prospects. So, responsible use of EM can increase the main diagonal probabilities of the information system.
11.4 Patterns of Earnings Management
- Taking a Bath
Can take place during periods of organizational stress or reorganizations
If a firm must report a loss, management might think it is beneficial to report a large loss, which will enhance the probability of future profits.
May also occur when net income is below the bogey of the bonus plan; it may enhance the probability of future bonuses.
- Income Minimization
May be chosen by a politically visible firm during periods of high profitability
Policies that include income minimization: rapid write-offs of capital assets and intangibles, expensing of advertising and R&D, successful-efforts, etc.
- Income Maximization
Managers may do this for bonus purposes if it does not put them over the cap
May occur when firms are close to debt covenant violations
- Income Smoothing
So that they don’t lose bonuses or so that they can reduce the chance of being fired, managers have incentive to smooth income so it remains between the bogey and the cap
To reduce volatility of reported net income so as to smooth covenant ratios
For external reporting purposes
11.5Is Earnings Management “Good” or “Bad”?
“Whether earnings management is good or bad depends on how it is used”
There are various examples of why earnings management is good and why it is bad, but as with other accounting issues there are tradeoffs and no definitive answer. In this case, earnings management may increase the relevance of the publicly available information due to the increased availability of information previously limited only to insiders. At the same time, the information lacks reliability due to the presence of management bias.
11.6 Stock Market Reaction to Earnings Management
Does the market react to earnings management information as if it were good or bad? Sburamanyam (1996) separated accruals into discretionary and non-discretionary components and found that the stock market responded positively to discretionary accruals, consistent with managers, using earnings management responsibly to reveal inside information about future earning power.
Quiz
The quiz consists of 5 multiple-choice questions (5 marks), 3 short answer questions (9 marks), and one long answer question (6 marks)
Multiple Choice (5 minutes)
- Healy found empirical evidence supporting his predictions. Which of the following did he find?
a)Firm managers whose net incomes are above the cap will tend to adopt income-decreasing accruals
b)Firm managers whose net incomes below the bogey will tend to adopt income-increasing accruals
c)Firms managers with net incomes between the bogey and cap will tend adopt income-increasing accruals
d)A) and C)
e)All of the above
- Which one of the following is not one of the ways a manager can manage net income?
a)Changing accounting policies.
b)Increase or decrease inventory
c)Controlling various accruals
d)All of the above
e)None of the above
- Managers are motivated to manipulate income with earnings management. Which of the following is a (are) reason(s) for them engaging in this kind of behaviour?
a)Reduce the probability of covenant violation
b)Reduce the companies visibility
c)Raise price of initial public offering
d)All of the above
e)None of the above
- Income maximization is one of the earnings management patterns that managers employ. Which of the following is an (are) other earnings management pattern(s) that managers engage in?
a)Income smoothing
b)Income levelling
c)Taking a bath
d)A) and B)
e)A) and C)
f)None of the above
- Which of the following is (are) not true regarding earnings management?
a)Earnings management increases reliability of financial statements
b)Earnings management reflects the desires of management rather than the performance of the company
c)It is cost effective for others to attain insider information that is revealed in earnings management
d)A) and B)
e)A) and C)
f)None of the above
Short Answer (10 minutes)
- Explain why earnings management is difficult for an auditor to discover.
- One reason for managers to engage in earnings management is to communicate information to investors. Explain how this can be viewed as a good thing by relating your answer from the rational investor perspective.
- Besides a bonus scheme, list the other reasons that would motivate managers to engage in earnings management.
Long Answer (15 minutes)
From previous readings and the following article, Twenty Pressures to Manage Earnings, discuss the pressure to manage earnings and why earnings management can be viewed as both good and bad.
Twenty pressures to manage earnings
The CPA Journal; New York; Jul 2001; James R Duncan;
Issue: / 7
Start Page: / 32-37
ISSN: / 07328435
Subject Terms: / Earnings
Financial reporting
Corporate culture
Problems
Financial statements
Classification Codes: / 9190: United States
4120: Accounting policies & procedures
Geographic Names: / United States
US
Abstract:
SEC Chairman Arthur Levitt's attack on corporate earnings management turned up the heat on the quality of financial reporting that underpins the success of US capital markets. The results so far have included an examination of the audit process for public companies, stronger guidelines for corporate audit committees, and 3 staff accounting bulletins to circumscribe interpretations of materiality, guide restructuring and impairment charges, and restrict improper revenue recognition. Increasing awareness of earnings management will promote its identification and treatment and enhance financial statement users' trust in the accounting system.
Copyright New York State Society of Certified Public Accountants Jul 2001
[Headnote]
A Cluster of Contributing Factors
SEC Chairman Arthur Levitt's attack on corporate earnings management turned up the heat on the quality of financial reporting that underpins the success of U.S.capital markets. The results so far have included an examination of the audit process for public companies, stronger guidelines for corporate audit committees, and three staff accounting bulletins (SAB) to circumscribe interpretations of materiality, guide restructuring and impairment charges, and restrict improper revenue recognition.
Studies show that, rather than having a single cause, earnings pressure results from multiple factors in a company's environment culture, or management and can lead to erosion in the quality of financial reporting. Increasing awareness of earnings management will promote its identification and treatment and enhance financial statement users’ trust in the accounting system.
[Illustration]
Caption:
Since SEC Chairman Arthur Levitt's "Numbers Game" speech before the NYU Center for Law and Business in September 1998, earnings management has been the focus of regulatory attention. Levitt attacked accounting "hocus-pocus" as a serious threat to the viability of the financial reporting that underpins the U.S. capital markets. His speech contained a nine-point attack on earnings management and provided the impetus for three new Staff Accounting Bulletins (SAB; see Sidebar), a report from the Public Oversight Board's (POB) Panel on Audit Effectiveness, and new recommendations from the Blue Ribbon Panel on Improving the Effectiveness of Corporate Audit Committees.
Levitt defined earnings management as practices by which "earnings reports reflect the desires of management rather than the underlying financial performance of the company." Companies use various devices to influence earnings outcomes, including "big bath" charges, "cookie jar" reserves, and the abuse of materiality and revenue recognition principles. These practices tend to erode the quality of earnings and financial reporting and deceive financial statement users.
A 1998 Business Week poll reported that 12% of CFOs had managed earnings at the request of their superiors and an additional 55% of CFOs said they were asked to manage earnings but refused to do so. According to CFO Magazine (September 1999), 60% of CFOs have felt pressure to manage earnings. This pressure is often most strongly felt by those in middle management, including controllers and divisional personnel. This author's own research ("Investigating Behavioral Antecedents of Earnings Management," Research on Accounting Ethics, v.6) found that earnings pressure was by far the most significant factor affecting earnings management behavior.
Pressure to manage earnings does not stem from a single source. Pressure to influence reported results can arise from forces outside the company, from conditions and programs within the company, or from motivations held by individuals that choose to engage in earnings management activity.
External Forces
Analysts' forecasts. Companies that fail to reach analysts' estimates for multiple quarters can see their stocks drop precipitously. When Procter & Gamble warned that it would not meet analysts' consensus forecast in the first quarter of 2000, its stock price fell 30%. When P&G issued further warnings just before the end of the second quarter of 2000, the stock price fell another 10% and P&G's CFO was fired. As reported in CFO Magazine (December 1998), one CFO told SEC Chief Accountant Lynn Turner that when the CFO warned an analyst that the company might just miss consensus estimates, the analyst told him, "You're a bright guy; you'll figure out how to make it."