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EARNINGS

MANAGEMENT

Class Announcements

Assignment #9 due March 24th; available on-line


Assignment #10 due March 31st; available on-line
Assignment #8 returned at the end of class
Research paper #3 returned at the end of class
Research Paper Part #4 and bonus due April 3rd
Final Exam 7:00pm April 19th, Main Gym, Oland
Centre
Business Banquet - April 2nd 5:45-8pm, Catering
- Gabrieau's Bistro; Keynote Speaker - Annette
Verschuren, Past President of Home Depot for Canada and
Asia

Class Objectives
1.

2.
3.

4.

Earnings management defined in terms


of an agency contract
Earnings management patterns
Reasons for managers to actively
participate in earnings management
Evidence of earnings management

Earnings Management

Earnings management occurs when


managers use judgment in financial reporting
and in structuring transactions to alter
financial reports to either mislead some
stakeholders about the underlying economic
performance of the company to influence
contractual outcomes that depend on reported
accounting numbers (Healy and Wahlen
1999, p. 368)
Earnings management is the choice by a
manager of accounting polices, or real actions,
affecting earnings so as to achieve some
specific reported earnings objective. (p. 423)

Earnings Management (EM)

Definition

Choice of accounting policies to achieve some


specific manager objective
1.Accounting Policy Choice
Choice

of accounting policy
Discretionary accruals

2. Operational Change
R&D,

advertising, maintenance
Timing of disposals
(note: affects cash flow as well and compromises
longer term performance.)

Earnings Management

Given managers can choose accounting


polices from a set of polices it is natural to
expect that they will choose polices so as
to help achieve their objectives.
Choices can be motivated either by
efficient markets and contracts or by
opportunism and rejection of market
efficiency.
Accruals reverse (iron law)- earnings
management can not indefinitely
postpone the day of reckoning.

Earnings Management:
Reasons

Financial Reporting

Contractual

To meet investors earnings expectations


To credibly communicate inside information
about earnings expectations
To smooth earnings to communicate core
earnings
Bonus [Healy (1985)]
Debt covenant [Sweeney (1994)]

Implicit Contract
Political [Jones (1991)]
IPOs [Teoh et al (1998)]

Earnings Management:
Patterns

Taking a Bath
Income Minimization
Income Maximization
Income Smoothing

More volatile income, more variability in


bonus
More volatile income higher probability
that covenant violation will occur

Earnings Management: Good

1) Contracting perspective

manager have some ability to manage earnings in


face of incomplete and rigid contracts

2) Financial reporting perspective

earnings management is a device to convey inside


information to the market enables share prices to
better reflect the firms future prospects
unblocking the managers inside information
market appears to reward earnings management
that does not overstate future earning power.

Earnings Management: Bad

1) Contracting perspective

opportunistic behavior of managers:


tendency to use earnings management to
maximize their bonuses

2) Financial reporting perspective

poor disclosure keep the extent of earnings


management as inside information
some managers behave as if they can beat
the market (e.g. excessive non recurring
income items impounded as core earnings)

Earnings Management: Persist

Most people would feel that earnings


management is bad as it implies a reduction
in reliability and usefulness of financial
statement information.
Management earnings persists

prohibitively costly for others to find out inside


information
difficult to discover discretionary accruals
difficult for outsiders to interpret more visible
earnings management (e.g. policy change,
timing of capital gains and losses)

Earnings Management
Techniques

Revenue Recognition
Accounting Policy Change
Timing of Adoption of New Standards
Write-offs, Provisions, Etc.
Accruals (Discretionary)
Direct Charges to Retained Earnings
Cookie Jar Accounting
Stuffing the Channels

Earnings Management:
Understanding
1)

2)

3)

4)

5)
6)

Regulators and standard setters identify areas most in need


of regulatory change
Auditors evaluate and report on their clients quality of
earnings, and train novice auditors about earnings
management
CEOs, CFOs, audit committees and investors focus
attention on those areas of the financial statements where
they should be most skeptical
Managers and audit committees anticipate the transaction
that investors will view most skeptically
Educators teach students about earnings management
Researchers focus their analysis on areas of high-earnings
management activity

Earnings Management Techniques:


Nelson et al (2003)

Aggressive earning management has been of


concern to regulators for several years
There exist little systematic research
concerning the specific methods by which
earnings management is attempted.
Nelson et al (2003) tried to capture the types
of earning management and the impact on
net income through a survey to 532 auditors
(partners and managers).

Earnings Management
Techniques: Nelson et al (2003)

Expenses & Other losses recognizing too much


or too little reserve in the current year.
Revenue & Other gains approaches include
cutoff manipulation, deferring to much or too
little revenue , etc.
Business Combinations over or
understatement assets with the charge to
goodwill
Other approaches approaches include income
statement classification issues, inappropriate
disclosures, off balance sheet financing, etc.

Earnings Management Techniques:


Nelson et al (2003)

Class Objectives - Revisited


1.

2.
3.

4.

Earnings management defined in terms


of an agency contract
Earnings management patterns
Reasons for managers to actively
participate in earnings management
Evidence of earnings management

Research Paper Part #4

Discuss relationship to accounting theory - e.g.


information perspective, measurement perspective,
agency theory, positive accounting theory, etc.;
(pick one theory and apply to Handbook section)
Due: April 3, 2014
Worth: 2.5%
Length: One page submission (double spaced) with
cover page, Introduction (bonus) Part#1, Part#2,
Part #3 an Part #4, Conclusion (bonus), Reference
page and Marking Keys #1, Part#2 Part#3 attached
to the back.

Research Paper Part #4

Bonus: Provide a one paragraph introduction


(maximum 1/3 of page) and one paragraph
conclusion (maximum 1/3 of page) on separate
pages. Due: April 3, 2014
Worth: 1.0%/10% (Maximum of 1%; 0.5% for
each of each of introduction and conclusion)
Length: One page submission (double spaced)
with cover page, Introduction (bonus) Part#1,
Part#2, Part #3 an Part #4, Conclusion (bonus),
Reference page and Marking Keys #1, Part#2
Part#3 attached to the back.