Chapter 11

Earnings Management

Overview
Earnings management (EM)
Concept (11.1)
Patterns (11.2)
Why EM? (11.3; 11.4)
Is EM good or bad? (11.5; 11.6)
Conclusion (11.7)

Earnings Management
Concept (11.1)
Earnings management (EM) is the
choice by a manager of accounting
policies (accruals) or real actions, that
affect earnings so as to achieve some
specific reported earnings objectives
What? Who? How? Why?

EM at GE (Q9, p.476)
GEs Reported Net Income
2008 $17,235
2007 22,208
2006 20,700
2005 16,353
2004 16,593
2003 15,002
2002 14,118
2001 13,684

2000 $12,735
1999 10,717
1998
9,296
1997
8,203
1996
7,280
1995
6,573
1994
4,726
1993
4,315
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In-Class Discussion
1) From what you observe, do you believe GE has been
managing earnings or not?
2) Assume the actual net income in 1996, 1997, and
1998 is $8,203, give two techniques (one through
accruals and the other through real actions) that help
managers to
a) Reduce net income from $8203 to $7280 in 1996
b) Boost net income from $8203 to $9,296 in 1998
3) Is earnings management good or bad for GE? For
investors?
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EM at GE (Q8, p.476)
Techniques used by GE to smooth earnings
1. Change expected rate of return on pension plan
assets
Pension costs = pension services costs return on plan assets

2. Sale of divisions
Generally lead to large non-recurring gains

3. Restructuring charges
Used to offset non-recurring gains
The timing and amount of 2&3 are tactically managed

4. Buying profitable businesses

5. Conservative accounting
Use DDB instead of SLM, then
Manage the timing of the sale of PP&E and leased assets

6. Allocation of goodwill on purchase of subsidiaries

e.g. 1986 acquisition of RCA (NBC vs. non-NBC units) next slide

One of GE's most intriguing moves to boost its net

income was in its accounting for its $6.4 billion acquisition of
RCA Corp. in 1986. One former GE executive recalls that GE
allocated a disproportionate amount of this price to NBC,
increasing the TV network's book value while reducing that of
other RCA assets. The higher book value for NBC and the
resulting lower value for other RCA assets raised GE's profits on
sales of some of RCA's non-NBC assets.
Among the RCA units sold, GE recorded a $110 million
gain on the disposition in 1991 of NBC's interest in an RCAColumbia home-video joint venture. And the aerospace business
was sold in 1993 at a pretax profit of $1.43 billion. That leaves
NBC as the last major piece of RCA still on GE's books.
(Source: Wall Street Journal, Nov 3, 1994, Managing profits: how General Electric
damps fluctuations in its annual earnings)
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Two Types of Accruals

Non-discretionary accruals
Management has little discretion to control amounts
e.g. utility expenses

Discretionary accruals
Management has discretion to control amounts
e.g. the GE case: note GE uses both accruals and real
actions to manage earnings
Slide #6: What are EM through accruals?

The iron law of accruals reversal: if accruals

increase earnings this period, their reversal
lowers earnings in future periods
e.g. Decrease in GE 2008 net income
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Patterns of Earnings Management

(11.2)

Big bath
Income minimization
Income maximization
Income smoothing
etc.

Why EM? (11.3; 11.4)

1. To meet contractual goals
a) Bonus incentives (slide #11)
b) Debt covenants (Slide #12)
2. To lower political costs (Slide #12)
3. To meet investors earnings expectations (Slide
#13)

4. To earn abnormal return at IPO or SEO (Slide #13)

5. To maintain managers reputation and job
security
6. To maintain continuing business
relationships
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11.3 Evidence of EM
for Bonus Purposes
1. To meet contractual goals
(a) Bonus incentives
Evidence: Healy (1985)
Examines firms in which manager bonuses based on net
income
Concepts of bogey and cap (Figure 11.2, p.448)
Evidence of upward earnings management when net
income between bogey and cap

Measuring earnings management

Net income = CFO + Non-DA + DA (Equation 11.1, p.449)
DA = Net Income CFO Non-DA
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11.4 Other EM Motivations

1. To meet contractual goals
(b) Debt covenants incentives
Dichev & Skinner (2002, text Section 8.5, p.321)
Covenant slack = actual current ratio contracted current
ratio
Quarters with zero or slightly positive slack are significantly
greater than expected
Quarters with negative slack is significantly less than
expected.

2. To lower political costs

Jones (1991, text Section 11.3)
Reports firms used income-reducing discretionary accruals
to bolster their case for tariff protection
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11.4 Other EM Motivations (Contd)

3. To meet investors earnings expectations
If expectations not met
Strong negative share price reaction
Damage to manager reputation
Jackson & Liu (2010) find evidence of management of bad debt
allowances to avoid missing markets earnings expectations

4. To increase proceeds from new share issues

Cohen & Zarowin (2010) find evidence of use of income-increasing
discretionary accruals in years of SEOs (i.e. Second Equity Offering).

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11.5 The Good Side of EM

Investor-based arguments for good EM
To credibly communicate inside information to
investors
Blocked communication may inhibit direct disclosure of
earnings expectations
Discretionary accrual management as a way to credibly
reveal managements inside information about earnings
expectations
Manager foolish to report more earnings than can be
maintained. Why? -> iron law
Manage reported earnings to an amount management expects
will persist
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The Good Side of EM

Contract-based arguments
To give firm some flexibility in the face of rigid,
incomplete contracts
Contract violation is costly, earnings
management may be low-cost way to work
around

There exist empirical evidence supporting

good EM
Demski & Sappington (1987a & b), Chen,
Hemmer, & Zhang (2007), etc.
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11.6 The Bad Side of EM

Contracting perspective
Opportunistic manager behavior
e.g. to maximize bonuses (Healy 1985, Figure 11.2)

Financial Reporting Perspective

Hanna (1999) found
Investors and analysts look to core earnings,
ignoring provisions for extraordinary and nonrecurring items
Implies manager not penalized for non-core provisions

Managers engaged in cookie jar accounting

Lower ERC when greater frequency of EM use
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11.6.2 EM and Market Efficiency

EM is not necessarily inconsistent with EMH
Poor disclosure keeps managers opportunistic behavior
as inside information

Managers may not accept EMH

That is, managers may believe market is inefficient
e.g. Schrand and Walther (2000)
Investigate firms with G/L on disposal of PP&E in prior
quarter, but none in current quarter
Find that when compare current quarter performance
with previous quarter performance,
managers is more likely to remind investors when there is a
one-time gain in prior quarter than when there is a one-time
loss in prior quarter
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11.6.3 Dealing with EM

Role of GAAP and auditor
Manager can observe real (unmanaged) net income,
but owner cant
Reported net income is jointly observable by owners
and managers
Standard setter and auditor help ensure the quality of
reported net income

Controlling length of manager decision horizon (short

vs. long horizon)
e.g. Bonus vs. stock options

Increase quality of net income

Fair value accounting (but decrease precision)
Full disclosure

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11.7 Conclusions
Some earnings management can be
good if not abused
However, managers may abuse or
opportunistically use such flexibility
Its hard to differentiate good and bad
motivations underlying earnings
management
Full disclosure helps to control bad
earnings management
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