Earnings Management

Definition

Earnings management: Purposeful intervention in the external financial

reporting process, with the intent of obtaining some private gain (as opposed to, say, merely facilitating the neutral operation of the process) (Schipper, 1989)

Is the choice by a manager of accounting policies so as to achieve some specific objective (Scott, 2009)

Two Ways to Think about Earnings Management

Opportunistic behaviour To maximize management utility in the

face of compensation and debt contracts and political costs

Efficient contracting perspective A vehicle for the communication of

management’s inside information to investors

Patterns of Earnings Management

Taking a bath Income minimization Income maximization Income smoothing

Measurement

Total Accruals Discretionary Accruals

Jones (1991) Modified Jones model

Accrual Accounting

Recognizes the financial benefits and obligations accruing to an enterprise over the reporting period - regardless of cash inflows and outflows.

Objective: Better indication of performance than current cash receipts and payments.

Accrual Accounting

Subjectivity

Assumptions

Discretion

Why allow reporting discretion?

Rigid rules Flexible rules trade-off

Reporting Discretion

Enables better reporting of larger number of businesses.

Prone to manipulation

Reporting biases

No discretion

What Motivates Managers’ Choice of Discretionary Accruals?

Victor L. Bernard

Douglas J. Skinner

Introduction

Subramanyam (1996) and Kasanen, Kinnunen, and Niskanen (1996) both considers why managers choose to manipulate accounting accruals Subramanyam concludes hat managers choose

accruals to enhance the informativeness of accounting earnings

KKN find strong support that Finnish managers set earnings to satisfy the demand for dividends by their keiretsu-like institutional investors

Subramanyam (1996) Central research question:

Whether managers choose discretionary accruals to convey information or whether their choices are opportunistic

He concludes that discretionary accruals are used by managers to increase the informativeness of accounting earnings

Alternative explanation for this findings is that the ‘Jones model’ systematically misclassifies nondiscretionary accruals as discretionary

Subramanyam (1996)

How well does the ‘Jones model’ work? Dechow et al (1995) indicate none of

Jones model (or their ‘modified’ Jones model) works very well in detecting earnings management

The estimated discretionary accruals will likely contain some nondiscretionary items

Subramanyam (1996)

How does misclassification of discretionary accruals affect the interpretation? At best lower the power of the research

to detect earnings management At worst cause the researcher to

conclude that there is earnings management when none actually exist

Subramanyam (1996) Some conclusions and suggestions

The only way to resolve the problem is to develop better specified models of the accruals process Focus on narrower settings (particular industry)

or particular components of accruals) Try and use tools from financial statement

analysis to better model accruals Separately analyze the informativeness of

different categories of accruals

Kasanan, Kinnunen, and Niskanen (1996)

In Finland, the demand for dividends by institutional investors is so strong that dividend policy is effectively set outside the firm, so that earnings have to be managed to justify the requisite dividend payout

Kasanan, Kinnunen, and Niskanen (1996)

Institutional features and evidence of earnings management Important features:

Stock ownership is dominated by large institutional holders and cross-holdings are common. Finnish regulations are such that only realized income (i.e. dividend) may be included as part of the capital base of these institutional stockholders Institutions demand relatively large dividend

payments Managers of Finnish firms are restricted by law to

paying dividends out of earnings, including retained earnings Provides managers with incentive to report earnings

that are sufficiently high to justify the required dividend

Managers of Finnish firms have an unusual amount of flexibility in the reporting process

Kasanan, Kinnunen, and Niskanen (1996)

Institutional features and evidence of earnings management Reported earnings and dividends track

each other so closely Provide strong evidence of earnings

management

Kasanan, Kinnunen, and Niskanen (1996)

What do we learn? KKn’s results provide strong evidence of

earnings management Provides an interesting experiment, but it

may be hard to generalize this conclusion to other countries

Conclusion

We need more reliable ways of measuring earnings management

A potentially fruitful alternative: may be to analyze financial statements in more detail