SUMMARY OF CH.

11 EARNINGS MANAGEMENT

Earnings Management
A Summary

SUMMARY OF CH. 11 EARNINGS MANAGEMENT

Overview
Earnings management is a managers choice of accounting policies that achieves some
specific objective. Even under GAAP, managers still 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.
Accounting policy choice can be divided into two categories: accounting policies per se
and discretionary accruals. Examples of the latter include the timing and amounts of
extraordinary items such as write-offs and provisions for reorganization, credit losses, inventory
values, etc., whereby managers are able to determine when and how much of revenue and
expense to classify on a current income statement. The former, accounting policies per se, are
more rigid in the sense that they dictate when and how much revenue and expense to classify in a
certain period. Examples of these include amortization policies and revenue recognition.

Evidence of Earnings Management for Bonus Purposes

A 1985 paper entitled The Effect of Bonus Schemes on Accounting Decisions by Healy
serves as the most popular research study on earnings management. In his study, Healy attempts
to explain and predict managers choices of accounting theory. He hypothesizes that managers
would find opportunities in which they could manage net income in an attempt to maximize their
bonuses under the firms compensation plans.
Healy refers to a bonus scheme (a contract between the firm and its managers that sets
forth the basis of managerial compensation) whereby a managers bonus is calculated based on a
linear relationship to current reported net income. The bonus, however, will begin at a minimum
amount of net income (called a bogey) and either level off at a maximum amount of net income

SUMMARY OF CH. 11 EARNINGS MANAGEMENT

(called a cap) or continue infinitely. Healy argues that only if income is between the bogey and
the cap will managers find an incentive to acquire accounting policies that increase net income
and, thus, increase a managers bonus. Managers are not motivated to increase income when
income is below the bogey or above the cap, because there is no potential to gain a higher bonus
(Exhibit 1).
Healy chose a sample of 94 firms, over a period of 50 years, with bonus compensation
plans and empirically proved that those, which reported net income in between the bogey and the
cap, had positive average accruals. The accruals increased reported net income, which ultimately
increased a managers bonus. Conversely, the firms that had bonus compensation plans but
reported net income either below the bogey or above the cap had negative average accruals.
These accruals were income-decreasing, which is consistent with Healys hypothesis of a
managers incentive to lower current income when it does not affect his/her current years bonus.
Whereas Healy argues that changes in accounting policies are not as income-influencing
as the use of accruals, if changes in accounting policies were made, the sample firms tended to
implement them just after the introduction or amendment of a bonus plan. At that time, a
managers bonus is dependent upon the future level of reported net income. If income is
anticipated to be high in upcoming years, a manager will choose to implement an accounting
policy (such as a departure from accelerated to straight-line amortization) that encourages a
higher reported net income.

SUMMARY OF CH. 11 EARNINGS MANAGEMENT

Other Motivations for Earnings Management

Contractual Motivation
Covenants in a long-term lending contract exist to protect the lender from the potentially
adverse actions of managers. Earnings management can serve as motivation to steer managers
away from violating the terms of a debt contract (known as covenant violation), since such a
violation 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.
For example, Sweeny (1994) observed that a sample of firms defying covenant
obligations actually took measures to implement income-increasing accounting changes, in
comparison to those sample firms that did not violate contractual terms. Moreover, these firms
tended to prematurely switch to new accounting policies, as they felt an obligation to inflate
reported net income and err on the side of the lenders best interests.
Political Motivations
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. These findings are supported by empirical evidence from Jones (1991) and Cahan
(1992).
Taxation Motivations
Due to the already stringent regulations on the calculation of taxable net income, firms
have less flexibility in applying earnings management to income taxation. However, there is a

SUMMARY OF CH. 11 EARNINGS MANAGEMENT

tendency for firms to switch inventory methods to LIFO in the face of rising prices because
under LIFO, reported net income will be lower and so will be the calculated taxes. This reflects
positively in the securities market, as investors are more likely to invest in firms with lowered
taxes when market prices rise.
Changes of CEO
CEOs engage in behaviour that maximizes their utility. The following are consistent with
the bonus plan hypothesis: a CEO of a poorly performing firm will use earnings management to
avoid being fired; another will use it to maximize his/her income prior to retirement; and a new
CEO will manage earnings so as to increase his/her future income potential.
Murphy and Zimmermans study (1993) reinforced that a new CEO entering a poorly
performing firm will tend to manage earnings in such a way that it reduces current income, but
more importantly, will boost the firms performance in subsequent years. This behaviour is
known as taking a bath. Thus, affluent future performance will reflect positively on a new CEO.
DeFond and Park (1997), on the other hand, found that a manager will be judged by current firm
performance, and thus will try to smooth reported income. Income smoothing involves using
discretionary accruals to borrow earnings from prosperous future periods, and save on
earnings for lean future periods. Managing current firm performance augments the likelihood of
job security.
Initial Public Offerings
Firms that have never entered the securities market will lack an established market price.
In order to best communicate a firms earnings power to investors, the firm will likely use
prospectuses. If an investor sees a favourable reported net income in the prospectuses, he/she is

SUMMARY OF CH. 11 EARNINGS MANAGEMENT

likely to bid up the initial market value of the firm. These findings are supported by empirical
evidence of Friedlan (1994).

Earnings Management as a Tool for conveying Information to Investors

Investors tend to seek information about a firm that helps to predict future firm
performance. If reported earnings are managed to a number that represents managements best
estimate of persistent earning power, and the market realizes this, share price will quickly reflect
this inside information.
The major patterns of earnings management include taking a bath, income
minimization, income maximization, and income smoothing. It is important to note that
managers can be motivated by a variety of earnings management patterns but that these patterns
may often come into conflict. For instance, a firm may wish to smooth income for borrowing
purposes but at the same time reduce income for political rationales.

Is Earnings Management Good or Bad?

Earnings management is bad", in the sense that it reduces the reliability of financial
statement information. Managers tweak reported earnings for reasons that are not obvious. There
is, however, a dependence on earnings management to translate inside information into public
information, as the costs of uncovering inside information are often very high.
Earnings management does have a good side, fortunately. This relates to efficient
contracting. When a contract imposes strict or incomplete terms on a manger, earnings
management can provide an option of flexibility, so long as it excludes a managers opportunistic
(self-interested) motivations.

SUMMARY OF CH. 11 EARNINGS MANAGEMENT

Additionally, earnings management can serve as a way to unblock communication to
outsiders. Blocked communication exists when it is very difficult and costly to translate a
mangers skilful expertise about a firm to the board of directors and/or investors. By using the
financial statements to communicate the financial health of the firm, earnings management can
be used to inform outsiders of managements inside information as per their exercised expertise.

Stock Market Reaction to Earnings Management

A study performed by Subramanyam (1996) concludes that the stock market tends to
respond positively and thus efficiently to the effect of discretionary accruals. So long as
managers use earnings management responsibly, investors can infer from the financial statements
what the future earning potential of a firm is likely to be.

SUMMARY OF CH. 11 EARNINGS MANAGEMENT

Exhibit 1:

Amount of Bonus

Typical Bonus Scheme:

Bogey (L)

Cap (U)

Reported Net Income

SUMMARY OF CH. 11 EARNINGS MANAGEMENT

PRACTICE TEST

Amount of Bonus

Part 1: Multiple Choice

Bogey (L)
Cap (U)
Questions 1 and 2 refer to the above diagram
Reported Net Income
1) If the firms reported net income is at point A, the manager in charge may do which of the
following to increase future bonuses:
a)
b)
c)
d)

Use the highest possible Inventory value for some assets

Write off some questionable accounts receivable
Re-evaluate warranties payable to a lower level
None of the above

2) If the firms reported net income were at point B, what would be the main reason a manager
would want to decrease reported net income?
a) To appear more profitable to shareholders
b) To pay less tax
c) To allow for extra income to be reported in future years to hopefully increase future
bonuses
d) All of the above

SUMMARY OF CH. 11 EARNINGS MANAGEMENT

3) Healys study of companies with both a bogey and a cap on their bonus schemes showed that:
a) Most executives do not let bonuses affect how income is reported
b) Companies in the MID range (net income between the cap and bogey limits) tend to up
their reported net income to increase bonuses
c) Companies in the UPP range (net income above the cap level) almost always lower
reported net income
d) Both B and C
4) A company managing earnings by using LIFO inventory method in periods of rising prices
and FIFO inventory method in periods of falling prices is doing so for:
a)
b)
c)
d)

Taxation Motivations
Contractual Motivations
Political Motivations
Better communication of fiscal information to investors

5) Murphy and Zimmermans 1993 study of changes in discretionary variables (research and
development, advertising, capital expenditures, and accruals) as companies change CEOs
showed that:
a) Most of the unusual behaviour in these variables was due to poor operational
performance
b) CEOs do not maximize income as they approach retirement age
c) Some incoming CEOs of poor performing firms take baths during the first years
d) All of the above
6) What is NOT a reason an executive would partake in income smoothing:
a)
b)
c)
d)

To maintain reported net income between the bogey and cap levels
The manager in charge is risk-averse
To communicate the firms expected persistent earnings power to the external world
To reduce corporate income tax

SUMMARY OF CH. 11 EARNINGS MANAGEMENT

Part two: Essay Questions
Q1. An amount is said to be material if the magnitude of the item is such that it is probable that
the judgement of a reasonable person relying on the financial statements would have changed
their decision by the inclusion or correction of the amount.
(15 minutes)
a) How does this concept of materiality relate to Earnings Management?

Management can alter statements strategically that would result in immaterial

misstatements

The immaterial misstatements could prove to be significant if the management

has intentionally tried to convey a different economic picture than the one
presented

An immaterial misstatement quantitatively could be a material misstatement on

qualitative factors. Thus, management has the option of managing the earnings to
show a certain way, which would have big qualitative impact, such as showing a
key segment in a company that is linked to future growth opportunities for the
firm to be slightly profitable rather than having a slight loss.

b) What should the auditors do to protect themselves in situation where individual

misstatements are material whereas overall misstatements are not material due to some
creative earnings (mis)management?

Make satisfactory enquiries

Keep accurate and complete documentation of why the decision was made to state
that the amounts were immaterial

c) What implications would such misstatements have for the efficient markets theory?

Such misstatements are inside information if not reported by auditors publicly

The market price of the firm would not reflect the true price of the firm

The financial picture presented is different from the actual economic state of the
firm

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Q2.

When it comes to accounting firms providing audit services and non-audit services to

clients, especially when the revenues to the firm from non-audit services are greater than
revenues from audit services, at least two viewpoints exist. One viewpoint is that the provision
of non-audit services results in lower audit quality and an increased likelihood that the auditor
will waive earnings management attempts. A competing viewpoint is that provision of non-audit
services strengthens audit quality and can thus reduce earnings management. From your
knowledge of earnings management, present a discussion and analysis of these opposing
viewpoints.
(12 minutes)
Solution:
Lower Audit Quality:

Firms would be more willing to provide management a greater leeway

Management would thus engage in more creative accounting

Management would have incentives and means to manage earnings more

Reliability of financial statements, even with audit, would be low

Firms would be perceived to have conflict of interest, especially if their

consulting advice leads to the reporting of cash flows as they are in the
financial statements lowering the quality of information

Stock markets are likely to react negatively and bid down the price of
the firm to levels that would ensure a just return for the higher risk

Increased Audit Quality

Firms providing consulting have more of a reputation risk when providing

consulting services

Firms have a lot to loose business, market trust, and risk of lawsuits

As a result, firms would audit more carefully to make sure that all information
is presented fairly

Implies that all earnings management decision will be scrutinized carefully

Care will be taken in ensuring that the spirit of GAAP is followed so as to

give the investors all the relevant information to base their decision

As a result, the quality of audit would be high

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Q3. William R. Scott states that, there is a fine line between earnings management and earnings
mismanagement. Ultimately, the location of this line must be determined by standard setters,
security commissions, and the courts. Do you agree? Why?
(8 minutes)
Solution:
If Yes,

When conflict arises, it is the standard setters, security commissions and the
courts who decide between the shades of gray

If left to companies, they would want the maximum flexibility in recording how
they do things they may not be fully driven by the purpose of providing reliable
information to investors to base their investment decisions

If this level of check is taken out, investors may be prone to a lot more creative
accounting, persistent earnings management which may not be in the best
interests of the stockholders

It is these bodies that decide the way things are to be currently

All directives are issued by such bodies

Required to preserve a trust and justice system in society

If No,

Management has the best knowledge of the true state of the company

When officers have been selected, trust and reliance should be placed on their
judgments

The above would hold true if good governance structures have been set up to
ensure full accountability

If management is to follow very strict guidelines dictated by outsiders, they will

not be motivated to make the best decision or to put in their best effort as they
have no discretionary power

Adverse impact on the managerial labour market

The role of auditors would need to be changed

Low Reliability may be compensated for by a liberal justice system