Lecture 11

ACCT 332 Accounting Thought and Practice

Earnings Management

- Chapters
p
11
- Levitt. The Earnings Game
- Cheng and Warfield. Equity Incentives and Earnings
Management
- Healy. The Effect of Bonus Schemes on Accounting
Decisions

Objectives for Todays Class

Tools of Earnings Management

E i
Earnings
M
Managementt Incentives
I
ti

Bonus, Debt Covenant, Political Cost

Healy (1985)

Beat/Meat Earnings Targets

Market-based considerations

Cheng & Warfield (2005)

Consequences of Earnings Management

The
e Blockage
oc age Problem
ob e

Definition of Earnings Management

Scott: Earnings management is the choice (related to accounting
policies or accruals) made by a manager that affects earnings so
as to achieve some specific reported earnings objective
Schipper (1989): Earnings management is a purposeful
intervention in the external financial reporting process with the
intent of obtaining some private gainIf managers have no exit strategy, or do not actually sell their
in the market, then there may be no grounds to argue
The importance of exit strategy shares
that their EM is for private gain.
Commonality:
1. Purposeful intervention/choice
2. Objective
Difference:
1. Schipper asserts that there is an intent for private gain (opportunism)

How to Manage Accounting Earnings?

Income Statement Management:
-Restructuring
Restr ct ring charges Big Bath - recognising one-time expenses/losses
-Revenue recognition
-Allowance for doubtful accounts Uses estimates
-Warranty provisions
AEM:
1. Have to eventually reverse
-Hedge accounting for derivatives 2.
REM:
-Pension plan assumptions
1. Actual economic effects
2. Effects persist into LT
-Capitalization of expenses

Balance Sheet Management:

-Off-balance sheet financing
-Window dressingg at reporting
p
g dates

Real Transactions Management: While the above 2 are accrual EM, these are real EM.
-Investment policy,
y R&D spending
g
-Marketing spending, sales timing
- Employee expenses

These are not mutually exclusive

Why Do Firms Manage Earnings?

-Capital market motivations

(premium for meeting analysts

forecasts or reporting increase in earnings)

-Contracting incentives (covenant hypothesis, compensation

contracts)

e.g. I wont get caught

Attributing successes to oneself,

and failures to others

-Behavioral biases (managerial overconfidence, self-attribution

bias)

Earnings Management Example (1)

- Burgstahler and Dichev (1997): Meeting Earnings Targets
If we have a large enough sample, a
normal distribution should be observed.
However, there is a kink. This is attributed
to managers knowing that they cannot
report zero earnings, or report a loss. They
therefore manage their earnings in order to

0 is the markets expectation, based on 3 criteria:

1. Zero earnings (Is there a Loss / Gain?)
2. Analyst Forecast for EPS (Is it less / more than
analyst forecasts?)
3. Last years earnings (Is it less / more than last years
earnings)
If > 0, it exceeds expectations. If < 0, its below
expectations.
The reason the phenomenon is observed at the 0 mark
is because its less costly to move to 0 or beyond if its a
marginal difference.
Furthermore, Information Asymmetry is present as well.
The cost of missing expectations versus the benefit of
beating expectations by just a little more greatly differs.
Furthermore, many investors use simple heuristics to
make investment decisions, one of which may simply be
is there a profit/loss?

20 years on, the kink has shifted to the right, given that every one now understands that they need to beat earnings by a larger
proportion in order

Earnings Management Example (2)

- Bhojraj et al. (2009): Meeting Earnings Targets
Making Sense of Cents: An Examination of Firms that Marginally Miss or Beat Analysts
Forecasts (Bhojraj, Hribar, Picconi, and McInnis, Journal of Finance 2009)
Capital market
motivation: using
the capital
market as an
incentive for
decisions.

Missers did not cut R&D, and

did not use AEM. They
therefore did not manage
earnings, and did not beat
forecasts.
Beaters cut R&D, or used
AEM. They therefore managed
earnings, and beat forecasts.
Consistent with the hypothesis
that AEM incurs cost, it was
found that the beaters of
analyst forecasts tend to
generate lower CARs in the
LT.

Earnings Management Example (3)

- Healy (1985): Bonus

Bonus plan hypothesis: to manage cash bonus

Healy (1985)
Confined to bonuses based on net income
The concepts of bogey and cap
Evidence of upward earnings management
when net income between bogey and cap

Earnings management measure

Healy used total accruals as the proxy
(He assumed that any accrual is considered EM)

E.g. Sales of 200, COGS of 100

Dr COGS 100, A/R 200
Cr Revenue 200, Inventory 100
Net income = Accruals + Cash Flows = 100 + 0 (no cash flows)
Healy used total accruals (100) as a proxy for EM

Figure 11.2 Typical Bonus Scheme

Amou
unt of Bonu
us

Bogey: The minimum amount of NI managers have to have in order to receive a bonus
Cap: The maximum amount of NI beyond which no additional bonus is awarded

Findings:
- Most EM occurs at levels just below the Bogey
- EM also found between Bogey and Cap, given that
managers want to increase their bonus
- Downward (negative) EM observed beyond the cap, given
that managers want to smooth income and make it easier for
them to obtain their bonuses in the following years.

B
Bogey
( )
(L)

Reported Net Income

C (U)
Cap

Earnings Management Example (4)

- Cheng
g and Warfield ((2005):
) Equity
y Incentives

Main findings: The incidence of meeting or just beating analysts forecasts is positively
correlated with equity incentives Unlike the previous study, which looked at cash bonuses

More likely to have sales of shares in the

future, suggesting that there are benefits

Ability to exit is important, as otherwise

managers receive no benefit.

Earnings Management Example (5)

- Efendi et al. ((2007):
) Equityy Incentives
Why do corporate managers misstate financial statements? The role of option compensation
and other factors. (Efendi, Srivasta, and Swanson, Journal of Financial Economics 2007

Efficient contracting view: Nothing to do with managers managing earnings to increase the stock price so they
can have in-the-money options. These may just be internet companies where the accounting standards are
somewhat vague because the standard setters did not know at that point in time how to recognise revenue. at
the same time, investors were very exuberant about these companies, resulting in the valuations being very
high.

Opportunistic View: Managers

manage earnings during the period
to make options deep in-the-money,
which they can then exercise and
sell. This was as a lot of them were
awarded options as compensation.

Earnings Management Example (6): Behavioral Biases

The Bad Side of Earnings Management

Reduces the reliability and information usefulness of accounting

restatements can be due to errors or irregularities. Errors imply an unintentional mistake, whereas
reports. Earnings
irregularities imply an intentional bias. Either way, its bad, as it indicates either poor controls, or dishonesty,
which causes companies to lose credibility
Can lead to earnings restatements (why is that bad?)
Lower credibility among investors
Higher cost of obtaining capital (equity or debt) Due to being perceived as riskier

The Good Side of Earnings Management

To credibly communicate inside information to

Income smoothing is more believable by investors, who are typically suspicious of sudden, huge gains. It
investors also confers more predictability to earnings.
Contract violation is costly, earnings management may
be low-cost wayy to work around E.g. EM as a low-cost way of avoiding violating debt covenants,
which would result in higher interest rates or even bankruptcy.
Managers are therefore acting in SH benefit.

Earnings Management
- Strategic Aspects of Accounting Policy Choice

Managers may choose policies to achieve certain objectives.

Efficient Contracting vs
vs. Opportunism
These choices may not provide the best information for
investor / creditor decisions
decisions.

Thus, managers care about changes in accounting rules

may
participate
p
p
in standard-setting
g debates
Chapters
p
12 / 13.

Group Questions

40 minutes to complete group questions

A i
Assignment
t off di
discussion-leading
i l di groups