Earnings Management

Earnings management is the choice by a manager of accounting policies, or real actions, affecting earnings so as to achieve some specific reported earnings
objective. (Scott, p. 423)

Manager's earnings management choice can be motivated by efficient markets and contracts, or by opportunism and rejection of market efficiency
May record excessive writeoffs or emphasize earnings constructs other than net income, such as pro-forma earnings
Suggests that managers do not accept securities market efficiency
Managers may use earnings management to meet analysts' earnings forecasts, thereby avoid the reputation damage and strong negative share
price reaction that quickly follows a failure to meet investor expectations

Given securities market efficiency, this requires management to draw on its inside information
Thus, earnings management can be a vehicle for the communication of management's inside information to investors
Earnings management can be used to report stream of smooth and growing earnings over time
Financial reporting
Earnings management can be used a way to protect the firm from the consequences of unforeseen events when contracts are rigid and incomplete
Managerial compensation contracts that allow some earnings management can be more efficient than ones that do not, due to the high costs of
eliminating earnings management completely

Contracting perspective
In the case that opportunistic earnings management is not fully disclosed
However, managers need to bear some risk if they are to work hard
Earnings management affects the manager's motivation to exert effort, because managers can use earnings management to smooth their
compensation over time, thereby reducing compensation risk

Too much earnings management may reduce the usefulness of financial reports for investors
Managers will choose accounting policies that would help them achieve their objective
Managers can also take real actions affecting earnings, such as cutting R&D costs
Temporarily boosting current year net income or lowers it using accounting policies and behaviors
I.e., straight line versus declining balance amortization, provision for credit losses, warranty costs, etc.
Leading to more earnings management if reporting of those losses is to be further postponed
Managers who manage earnings upwards to an amount greater than can be sustained will find that the reversal of these
accruals in subsequent periods will force future earnings downwards just as surely as current earnings were raised

However, there will be accrual reverses (long term effect)

Choice of accounting policy
Short term effect
Losses will be really big in bad year
I.e., writing down inventory and capital assets, so that in the future expenses on these assets will be lower in the future,
resulting in higher net income

If already having a bad year anyway, then write down many assets that can justify to set up the company for much more successful
future

Big bath
Income smoothing
Three hypothesis of positive accounting theory
Policies and behaviors chosen will have long term impact
Less depreciation in current period, more income this year, will have less income in future
Accruals will reverse, thus reverse income effect (accrual reverses)
Reducing R&D this period will boost income this period, but less income in the future due to less products developed
Benefiting the current period will impose a cost in future period
Long term effect
Earnings management by means of accounting policy choice is feasible only if there is a sufficiently rich set of accounting policy within GAAP
from which to choose

Accounting policy choices; two categories

I.e., advertising, R&D, maintenance, timing of purchases and disposals of capital assets, etc.
These devices may be costly, since they directly affect the firm's longer-run interests
Earnings management by real variables manages cash flows as well as earnings
Firms with earnings close to zero opportunistically manage real variables, such as sales discounts, production levels, R&D and other
discretionary expenditures, so as to increase reported earnings

Such firms use both accrual-based and real earnings management strategies, and that real earnings management does indeed
compromise longer-term performance

Temptation to manage earnings is high, namely when firms issue additional shares
Real variables/action
Earnings management include accounting policy choices and real action
Methods of Earnings Management
Reduce reported net income for political reasons
Increase reported net income to meet analysts' forecasts
Smooth reported net income for borrowing purposes
Take place during periods of organizational stress or restructuring
If a firm must report a loss, management may feel it might as well report a large one - it has little to lose at this point
Write off assets, provided for expected future cost.
Accruals will reverse and increases profit in the future
Taking a bath
Smooth income over years
Long term pattern
From a contracting perspective, risk averse managers prefer a less variable bonus stream
Managers may smooth reported earnings over time so as to receive relatively constant compensation
Income smoothing
Patterns of Earnings Management
Chapter 11 - EARNINGS MANAGEMENT
Wednesday, November 20, 2013
4:16 PM
Chapter 11 Page 1
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

This provides an incentive to reduce volatility of reported net income so as to smooth covenant ratio over time
The more volatile the stream of reported net income, the higher the probability that covenant violation will occur
Income smoothing reduce the likelihood of reporting low earnings
Managers may feel that they may be fired when reported earnings are low
Smoothing can convey inside information to the market by enabling the firm to communicate its expected persistent earning power
Managers may smooth reported net income for external reporting purposes
Short term pattern
Chosen by a politically visible firm during periods of high profitability
Policies that suggest income minimization include rapid writeoffs of capital assets and intangibles, and the expensing of advertising and R&D
expenditures

Income tax considerations, such as LIFO for inventory provide another set of motivations for this pattern
Income minimization
Short term pattern
Managers may engage in a pattern of maximization of reported net income for bonus purposes, providing this does not put them above the cap
Firm that are close to debt covenant violations may also maximize income
Income maximization
Management has inside information on the firm's net income before earnings management
Managers will maximize current earnings for their bonuses
Managers would manage net income so as to maximize their bonuses under their firms' compensation plans
Below the bogey, bonus is zero
If no cap -> bonus will continue to increase
With cap -> bonus becomes a constant for net income greater than the cap
No bonus. Management will try to manage earnings downwards
If net income is low, manager has an incentive to lower it even further (i.e., take a bath)
This will increase the chances of receiving bonus in the following year since current writeoffs will reduce future amortizati on charges
Because manager wont receive a bonus anyway, the manager might as well adopt accounting policies to further reduce reported net income
Income below bogey
Bonus is some function of income, but is capped at a certain level of net income. Management will manage earnings downwards once cap is
met

Managers are motivated to adopt income minimization policies, because bonus is permanently lost on reported net income greater than the
cap

Income above bogey

Management will try to manage earnings upwards
Managers are motivated to adopt accounting policies to increase reported net income
Thus, bonus plan hypothesis (PAT) applies only when net income is between bogey and cap
Income between bogey and cap
Piecewise linear
Net income = cash flow from operations + net accruals
Net discretionary accruals are controllable by managers
Net income = cash flow from operations + net non-discretionary accruals + net discretionary accruals
Estimation of useful life is a discretionary component
Discretionary component
Amortization policy (i.e., can change it, but cant really manipulate the numbers except changing useful life)
Non-discretionary component
Amortization expenses
Controlling AFDA amount / bad debts
Earlier revenue recognition
A more generous credit policy
Keeping the books open beyond the year end
Discretionary component
An increase in volume of business
Non-discretionary component
Increase in net accounts receivable
Include fixed overhead costs in inventory rather than charging them off to expense as unfavorable volume variances
Discretionary component
Inventory buildup in anticipation of a strike, or increase in demand
Non-discretionary component
Increase in inventory
Being more optimistic about warranty claims
Regarding certain borderline items as contingencies rather than accruals
Discretionary component
Decrease in accounts payable and accrual liabilities
Examples of accruals
Income between bogey and cap: management manage earnings upward using accruals to increase income for bonus
Income below bogey: manage earnings down in current year using accruals, in hope of increasing chances for bonus in future year
Income above cap: manage accruals down in current year, in hope that they will reverse net year and raise income
Aligns with bonus plan hypothesis of PAT
Managers exploit their power in the organization by maximizing their utility at the expense of the firm's shareholders and other investors who
may find it prohibitively costly to unravel discretionary accruals

Opportunistic behavior view

When setting compensation contracts, firms will rationally anticipate managers' incentives to manage earnings and will allow for this in the
Efficient contracting view
Use of total accruals in research
Evidence of Earnings Management
Chapter 11 Page 2
amount of compensation they offer
Other Motivations
Earnings management depends on bogey/cap range, for bonus purposes
Given that covenant violation can impose heavy costs, firm managers will be expected to avoid them
Or even try to avoid being close to violation because this will constrain their freedom of action in operating the firm
Thus earnings management can arise as a device to reduce the probability of covenant violation in debt contracts
Defaulting firms tended to undertake early adoption of new accounting standards when these increased reported net income
There are evidence of the use of discretionary accruals to increase reported income in the year prior to and, to a lesser extent, in the year of the
covenant violation

Earnings management is more likely if debt covenant is close to being violated

Earnings management depends on political costs
Also known as relational contracts
The manager and the firm's stakeholders trust each other sufficiently that they play the cooperative solution rather than the Nash
equilibrium

I.e., if the firm and its manager develop a reputation for always meeting formal contract commitments, they will receive better terms from
suppliers, lower interest rates from lends, etc.

Arise from continuing relationships between the firm and its stakeholders and represent expected behavior based on past business dealings
Manager's implicit contracting reputation can be bolstered by high reported profits, which increase stakeholders' confidence that the manager will
continue to meet contractual obligations

Ultimately, firms want to preserve their reputation

Implicit contracts
PAT Hypotheses
When big bath hypothesis really applies
Good time to use big bath when CEO changes, so that writeoffs can be justified by blaming the mistake on the previous CEO
Change in CEO
IPOs 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

Therefore, no further share price decline takes place as firms report lower earnings in future
However, rational investors will anticipate the extent of an IPO firm's earnings management and build this anticipation into the amount they pay
for IPO shares

Many IPO firms do manage earnings upwards and that lower reported earnings in subsequent years, driven by accrual reversals, contribute to poor share
return performance

When company wants to issue shares, there is a huge incentive for good results.
Encouragement to income maximize
IPO & SEO
Information is much more believable if there is a cost to it (i.e., using financial statements, which is costly); as opposed to just a press release
Communicate Information
Analysts prepare forecast of forecasted earnings
Failure to meet forecast results in share price drop
The company wants to meet those earnings forecast
Firms that report earnings greater than expected have typically enjoyed a significant share price increase, as investors revi se upwards their probabilities
of good future performance

Negative share returns for firms that failed to meet earnings expectations
There are greater abnormal share returns for firms that exceeded their most recent analysts' earnings forecasts, relative to firms that failed to meet their
forecasts

As a result, managers have a strong incentive to ensure that earnings expectations are met, particularly if they hold ESOs or other share related
compensation

Market penalized firms that fall short of expectations by more than it rewards firms that exceed them
If actual result doesnt meet forecast, then the company's situation is beyond worse that managers cannot even manage earnings enough to meet
forecast

Analysts have the belief managers can manage earnings to meet forecast.
There is direct effect on the firm's share price and cost of capital as investors revise downwards their probabilities of good future performance
There can also be an indirect effect through manager reputation, particularly if the shortfall is small and if manager explanations are perceived as
excuses

Capital Market Effects

Earnings Management
Information that can be prohibitively costly to communicate to the principal
Blocked communication can reduce the efficiency of agency contracts, since the agent may shirk on information acquisition and compensate by
taking an act that, from the principal's standpoint, is not optimal

Disclosure of line items reduces the ability of managers to use earnings management to attain the forecast, thereby offsetting investor
suspicions that the forecast may be biased upwards

Disaggregation of good news forecast (i.e., forecasting sales and expenses as well as net income) increases its credibility
Earnings management can also be used to reduce blockage
To reduce block communication
Block communication (reduces it)
If managers only announce information, investors might not believe it
Therefore, management may use discretionary accruals to manage earnings to $1M persistently
I.e., if a firm announces an earnings potential of $1M, it might not be believable
The use of earnings management to present an earnings that meets announcement has credibility and is sustainable
Shows investors management can be trusted and new announcements will be available
The market can use the earnings management to infer what this inside information is
If over time, managers are able to use earnings management to establish a patter of earnings, show that they are able to meet what they
announced, they build a reputation over time

Operating cash flows, or some other relatively unmanaged performance measure such as earnings before unusual items, convey some information
Revealing information to investors
Good Side of Earnings Management
Chapter 11 Page 3
Operating cash flows, or some other relatively unmanaged performance measure such as earnings before unusual items, convey some information
about future firm performance

However, to the extent that relying on semi-strong market efficiency and information such as choice of asset useful life will not be disclosed,
which can be seen through by investors, thus reveals the firm's true performance

Also the firm can reveal inside information through disclosures (i.e., disclosing accounting policies)
Contract are fixed, and if unusual effect comes up, there will be negative events and cost the firm
Earnings management may allow a firm to avoid violating the debt covenants
If the firm did not previously manage earnings, and in the period of sale, the firm manages earnings, the investors will adjust their valuation of
the firm knowing that management has the incentive to manage earnings, and will bid down the price

Also will act as incentive for managers to shirk but still receive high compensations, based on the fact that they can manage earnings to meet
expectations

Decreases contract efficiency since it is now more likely that high manager effort will result in low reported net income and
compensation

Reduces the need for upward earnings management (to rational investors, a low reported net income generated by conservatism i s not
really as bad as it looks)

A reduction in upward earnings management increases contract efficiency by reducing the manager's incentive to shirk
Solution: use of conservative accounting (as a form of earnings management)
Example: sale of firm to outside investor
Lower contracting cost
The tendency of managers to use earnings management to maximize their bonuses
Some firms follow the opportunistic version of the debt covenant hypothesis
Try to manipulate the earnings numbers to take advantage of investors/lenders
Makes the firm look a lot more prosperous than they really are
Managers can use earnings management in an opportunistic way
Use of discretionary accruals such as to speed up revenue recognition, lengthening the useful life of capital assets, under-providing for
environmental and restoration costs, etc.

Manager intends to raise new share capital and wants to maximize the proceeds from the new issue
Inflate the share price prior to issuing new shares
Bring in more equity into the firm and benefits existing shareholders, at the disadvantage of new shareholders
IAS 37 limits managers on write downs that are probable to try to prevent managers to making an excess provision
Therefore, one time transitory/non-persistent items should be ignored by investors
Prior to equity offerings
Transitory provisions do not affect manager bonuses and do not take away from the ability to meet earnings forecasts
However, excessive provisions increase future earnings by putting them in the bank through reduced future amortization charges and absorption of
future costs that would otherwise be charged to operating expense when incurred

Benefits managers in both ways: transitory provisions do not affect bonuses or the ability to meet earnings forecasts, and the future expense
reduction increase future earnings on which the manager is evaluated

Frequent recording of excessive provisions for transitory (low persistence) items such as write-downs under ceiling test standards, and costs of
restructuring

ERC decline in quarters following the reporting of a large unusual item

Consistent with the market interpreting the frequency of recording unusual and non-recurring items as a proxy for their potential misuse
ERC further decline if the firm reported numerous large special items over time
Nevertheless, market does reflect the bad earnings management view
I.e., prohibits recording a liability for restructuring until the liability was incurred
Standard setters also reflect the manage earnings management view
Bad Side of Earnings Management
Strategic Aspects of Policy Choice
Debt contracts
Compensation contracts
Want to get efficient contracts
At the same time provide useful information to investors
These two objectives can conflict
Policies that provide for smooth contracts may not provide optimal information to investors
Management Objectives
Affects the quality of investors decisions
Affects the quality of the securities market
Reporting to Investors
Important to assess the quality of manager performance
Important to assess the efficient labour market
Leads to standard setting
Reporting on Manager Performance
Roles for Financial Reporting
Chapter 11 Page 4