Chapter 11: Earnings ManagementMatthew BlosteinMichael Choi Kurtis HolmesEric MartinTrevor Stickl

Earnings Management Overview Defined as: The choice by a manager of

accounting policies, or real actions, affecting earnings so as to achieve some specific reported earnings objective

Understanding of Earnings Management is important as it enables an improved understanding of the usefulness of net income, both for reporting to investors and for contracting

Patterns of Earnings Management Taking a Bath Income Minimization Income Maximization Income Smoothing

Taking a Bath Usually takes place during periods of

organizational stress or restructuring. The main idea is that if a firm is to report a loss, managers may feel it might as well report a large one as it has little to lose. Large write-offs but future earnings “in the bank”.

Income Minimization Similar to taking a bath but less

extreme. Usually a politically visible firm chooses this pattern during periods of high profitability. (Example: United States vs. AT&T)

Income minimization includes rapid write-offs of capital assets, and intangibles, and the expensing of advertising and R&D expenditures.

Income Maximization Managers engage in a pattern of

maximization of reported net income for bonus purposes, so long as it does not put them above the cap. A firm close to a debt covenant violation may use this strategy.

Income Smoothing First, Risk-adverse managers prefer a less variable

onus stream, other things equal. Consequently, managers may smooth reported earnings over time so as to receive relatively constant compensation. Efficient compensation contracting may exploit this effect, and condone some income smoothing as a low-cost way to attain the manager’s reservation utility.

Second, when considering covenants in long-term agreements, the more volatile the stream of reported net earnings, the higher probability that covenant violation will occur.

Income Smoothing Cont. Third, managers may feel as if they will be

fired when earnings are low, income smoothing reduces the likelihood of reporting low earnings.

Finally, firms may smooth reported net income for external reporting purposes. If used responsibly, smoothing can convey inside information to the market by enabling the firm to communicate its expected persistent earning power.

Evidence of Earnings Management for Bonus Purposes “The Effects of Bonus Schemes on

Accounting Decisions” – Healy Hypothesis: Managers will find opportunities in which

they could manage net income in an attempt to maximize their bonuses under

the firm’s compensation plans.

Evidence of Earnings Management

for Bonus Purposes

Only if income is between the bogey and cap will managers find an incentive to acquire accounting

policies that increase net income

Evidence of Earnings Management for Bonus Purposes Sample: 94 firms Period: 50 years Between bogey and cap: positive avg.

accruals Outside bogey and cap: negative avg.

accruals Consistent with hypothesis of managers

incentive to lower current income when it does not affect their current year bonus

Evidence of Earnings Management for Bonus Purposes Argues that changes in policies are not as

income-influencing as the use of accruals Changes in policies tend to be implemented

just after the introduction/amendment of a bonus plan

If income is anticipated to be high in upcoming years, a manager will choose to implement a policy that encourages higher reported net income

But Wait… There’s More!Cash flow, as per cash flow statement $1,000 Less: Amortization expense Δ Useful Life (50)Add: Increase in (net) AR during year Δ AFDA 40 Add: Increase in INV during year Δ Overhead charge 100 Add: Decrease in AP and Accruals Δ Expected WTY claims 30 120

Net Income, as per income statement $1,120

Other Motivations

Contractual Motivation Many companies have covenants in

place to protect lenders Violating this covenant is dangerous to a

manager This causes managers to choose

accounting policies to avoid covenant violation

Contractual Motivation Con’t Sweeny looks at this in a 1994 study

and finds two things: Firms already violating covenants will

make drastic changes to accounting policies to boost income

Firms approaching violation will make pre-mature changes to accounting policies to boost income

Contractual Motivation Con’t This is a dangerous motivation due to

the significant damage a covenant violation causes

Managers may be overly aggressive which may ultimately lead to fraud

Contractual Motivation Con’t Another motivation is implicit contracts

which arises from the relationship of firm and its stakeholders

This is the idea that a firm will receive benefits from stakeholders based on previous contracts

Allows parties to work cooperatively rather than at the Nash equilibrium

Political Motivations When a company will make policy

changes to intentionally lower its income This is done to escape government

scrutiny For example a company making large

profits in a given year may altar its amortization policy from straight line to declining to recognize greater expenses to match these profits

Meet Earnings Expectations This is when estimated earnings for

future periods meet and exceed expectations of investors

This will ultimately increase share price due to the strong positive correlation between expected earnings and share price

Meet Earnings Expectations Con’t 2010 study looking at 1992-2006 proves

that small earnings surprises actually leads a decrease in share price

Investors are aware that earnings surprises are caused by earnings management

Proves that expectations must be met, but surprises are not beneficial due to rational investors

Meet Earnings Expectations Con’t This creates a case of conflict of interest

as most managers hold stock options It gives a greater incentive for

managers to meet expectations using earnings management to avoid share price decreases

May not be the best option for the firm Can also lead to fraudulent behaviour

IPO The issue with an IPO is that there is no

market price for a firms shares This gives management incentive to

increase estimates of futures earnings to get a higher price for their shares

IPO Con’t Studies in 1997 and 2007 look at

companies going public and their accruals The main result found is that companies

boost their accruals prior to the IPO, then reverse these accruals in later years causing losses

Shows this type of earnings management is successful as it works even with rational investors

Good Side of Earnings Management Blocked Communication

Managers have inside information that is costly to communicate = blocked information

Managers can use provisions to smooth earnings to desired levels and unblock information

It would be foolish to overstate earnings since the market will react severely when there is a subsequent reduction

Good Side- Blocked Communication Inside Information

New firm strategies Change in firm characteristics Market conditions

All complex information, but proven to be communicated through discretionary accruals and disclosures.

Good Side- Contracts EM can be used to maintain investor

expectations and avoid market penalties for fluctuations

If markets have rational expectations then both management and investors benefit from a consistent tracking and flow of earnings

Upward earning management decreased contract efficiency, but is a must for investors

Good Side- Conservative Accounting Decreases contract efficiency as higher

manager effort = lower earnings Also reduces need for upward earnings

management = increased contract efficiency

Net effect of the two reactions is positive on firm value

The Bad Side of Earning Management Opportunistic EM

Tendency for managers to try to maximize their bonus

Debt Constraints Firms that are highly levered need EM to

control if they violate loan covenants Supported by Dechow, Sloan and

Sweeney study of 92 firms that firms do practice this technic

Bad Side Cont’d Raise new capital

EM can be used to maximize proceeds of new issues

Discretionary accruals can increase SR earnings

Techniques: Speed revenue recognition Lengthen cap. Asset life Under reserve for environmental costs

Bad Side Cont’d Transitory items

Unusual items so they do not affect manager bonus’

Increase future earnings by reducing future amortization and absorption of costs that would normal go through operating expenses

Standard Setters Reflect the bad earnings management

view IAS 37- provision as a liability if timing

of payments is uncertain Must be probable Must be reliably estimated Must be at fair value

Measures of Earning Management Variability of operating income

Lower = income smoothing Correlation between accruals and cash flow

Low correlation =early revenue recognition Magnitude of total accruals

Higher accruals = higher discretionary accruals

Small Loss/Gain ratio Low ratio = EM to avoid small losses

Implications Ways to reduce bad earning

management Don’t reject market efficiency Improve disclosures

Reduces behavioural biases Lower management incentive to exploit

poor governance and market inefficiencies Report effects of current earnings on prior

write-offs

Earnings Management Conclusions Earnings management is justified through the

theory that true net income does not exist

GAAP does not completely constrain managers choices of accounting policies Complex and challenging Motivated by strategic considerations

Meeting earnings expectations Specific contracts and their covenants IPO’s or SPO’s Discourage potential competition Unblock inside information

Changes in accounting policy are becoming a game for companies Managers will react against rule changes that

reduce their flexibility of accounting choice Need to be aware of legitimate needs of

management, investors, and be aware of opportunistic strategies

Accompanying earnings management is reduction in reliability and sensitivity of info

Earnings Management Conclusions

Earning Management gives managers flexibility to react to unanticipated realizations

Earnings Managements can be a vehicle for the credible communication of inside info to investors

Both arguments above are consistent with efficient securities markets and the efficiency version of positive accounting theory

Earnings Management Conclusions

Managers can abuse communication potential of GAAP Result in failure to accept securities market efficiency or from

an ability to hide bad earnings management behind poor disclosure

Reduce Earnings Management by bringing it to public, out in the open Improve disclosure of low persistence items and reporting

effect of previous write offs on current earnings Assist corporate governance, help better reward good

manager performance and discipline managers who shirk

Improvements in allocation of scarce investment capital and firm productivity increase social welfare

Earnings Management Conclusions

Taking a Bath and RIM RIM Stock has plummeted over 70% in the

past year, netting to roughly $8/Share It recently announced $518 million quarterly

loss Plans to lay off 5,000 employees

RIM is trying to maximize it’s losses to prepare for future reported profitability with the Launch of Blackberry 10.

Income Minimization and AT&T United States v. AT&T Antitrust case that led to the 1984 Bell

Systems divestiture AT&T accused of using monopoly

profits to subsidize the costs of its own network

Had they chosen an income minimization pattern, AT&T may not have caught the public eye and scrutiny

Enron This is a perfect example for income

maximization earnings management Due to the stock option based

compensation managers receive, there was constant incentive to inflate earnings

Most of the earnings management was done using complex accruals and estimations

Enron Con’t With this type of earnings management

comes risk of government scrutiny The income was never smoothed out

and governing bodies took interest in consistently high growth

This ultimately lead to Enron’s downfall and many regulations and accounting bodies put in place to avoid this in the future

Income Smoothing CaseCompany overviews (2007)

American International Group (AIG) World’s largest insurance and financial services

company Net Income - $6.2 billion Premiums written - $59.8 billion

GenRe One of worlds largest reinsurers Owned by Berkshire Hathaway Premiums written - $6.0 billion

2001 – SEC learned AIG assisted client in manipulating the balance sheet through bogus insurance transaction

2003 – SEC and Justice Department settle civil case with AIG in amount of $10 million

2004 – Federal investigation of AIG’s income smoothing products

Income Smoothing CaseRegulatory Scrutiny

GenRe was to transfer loss reserves to AIG in exchange for premium payment

Contracts for loss reserves to total between $500 and $600 million

GenRe “obligated” to pay AIG “premium” of $1 billion

GenRe was to receive $5 million transaction fee for deal

Contract to last 24 months, at which time it would be reversed

Income Smoothing CaseDeal between AIG and GenRe

Income Smoothing CaseImproper Accounting and Public Perception

AIG finally admitted that this deal should have been accounted for as a deposit

Restatement of AIG’s income following this announcement amounted to a reduction in net income of $1.32 Billion

Public Perception Reckless efforts of senior corporate officers that were

designed solely for the unlawful purpose of achieving a specific and false accounting effect on issuers financial statements

Thank you for your Time!Questions? Comments?Then on to the game!