Chapter 11 | Earnings Management – Flashcards

Earnings management is the choice by a manager of accounting policies (accruals), or real actions, that affect earnings so as to achieve some specific reported earnings objective

- Cutting or increasing R&D and advertising - Manufacturing for stock

- Managing allowance for bad debts - Changing amortization policy

If accruals increase earnings this period, their reversal lowers earnings in future periods

1. Non-discretionary: mgmt has little discretion to control amounts 2. Discretionary: mgmt has discretion to control amounts - To discover role of accruals in EM, accountant needs to separate these two types (Jone model used)

- Bath - Income minimization - Income maximization - Income smooth ***

1. Manager earnings to maximize cash bonus (evidence: Healy 1985 - confined to manager bonuses based on net income; bogey and cap; evidence of upward EM when NI between bogey and cap) 2. To Avoid violation of debt covenants (Evience: Dichev & Skinner (2002); report evidence of earnings mgmt to maintain debt convenient ratios) 3. To avoid political costs (Evidence: Jones (1991) created Jones model to separate two types of accruals; reports firms used income-reducing discretionary accruals to bolster their case for tariff protection) 4. To meet investors' earnings expectations (strong negative share price reaction if expectations are not met + damage to manager reputation) 5. Initial public offering (to increase proceeds of new share issues) i.e. through use of income-increasing discretionary accruals

1. To credibly communicate inside information to investors - Blocked communication may inhibit direct disclosure of earnings expectations (shows inside info about future profitability of firm)

1. To give firm some flexibility in face of rigid, in complete contracts - Bonus contracts based on net income (new accounting standards may lower net income; may adversely affect manager effort) - Debt covenant contracts (new accounting standards may increase probability of debt covenant violation) 2. Contract violation is costly, EM may be low-cast way to work around it

1. Demski ; Sappington (1987a ;Bb) - To unblock inside info 2. Tucker ; Zarowin (2006) - Greater use of income smoothing positively associated with share returns; suggests that investors value EM that smooths out non-persistent items

Healy (1985): Reports evidence of mgmt use of accruals to maximize their cash bonuses

1. Hanna (1999): Argues investors + analysts look to core earnings, ignore provisions for non-core extraordinary and non-recurring items (implies manager not penalized for those areas); Result: managers tempted to "overdose" on non-core provisions, thereby putting earnings "in the bank" A.k.a. cookie jar accounting*** 2. Note securities market reaction - Elliott ; Hanna (1996) found evidence that investors use frequency of such provisions as proxy for their misuse - they found lower ERC when greater frequency

- Leuz, Nanda ; Wysocki (2003): countries with poor investor protection experience more earnings mgmt - Mcinnes ; collins (2011): increase in accrual quality (i.e. less bad earnings mgmt) following availability of cash flow forecasts

1. IAS 37 - Before recording provision, payments must be probable and capable of reliable estimation; measured at FB; no excess provision as a result of uncertainty; only to absorb costs for which provision is originally set up 2. ASC 420-10-25 - No provision until liability incurred HOWEVER... Does not necessarily solve the problem of abuse of provisions b/c i) mgmt controls timing ii) FV requires estimation

- Perhaps (poor disclosure enables earnings mgmt even if markets are efficient) - Perhaps not (theory + evidence that securities markets may not be fully efficient supports a "no" answer // pro-forma earnings, managing same-quarter earnings of previous year

1. Cognitive dissonance (arises when persons behave contrary to their opinion of themselves - e.g. misleading statement produces guilty feeling; react by changing their beliefs) Hobson, Mayhew & Venkatachalam (2012): analyzed managers' speech during earnings announcements, obtaining cognitive dissonance score for each manager; found higher dissonance score associated with future earnings revisions

- Yes, if full disclosure of - Revenue recognition policies - Unusual, non-recurring and extraordinary events - Effect of previous write-offs on current core earnings (Hanna 1999)

- EM can be good if used responsibly - Full disclosure helps to control bad EM

A/R : mostly non-discretionary Inventory : both qualities (b/c of valuation) Customer advances - Non-discretionary (mostly in hands of customers) Taxes - some is discretionary (controlled through EM) and non-discretionary Long term debt - non-discretionary Provisions - discretionary (everything in your control such as timing, amount, etc.)