Chapter 11 Earnings Management

Chapter 11Earnings ManagementI

What is Earnings Management?Earnings management is the choice by a manager of accounting policies, or real actions that affect earnings, so as to achieve some specific reported earnings objective

11.2 Patterns of Earnings Management

BathIncome minimizationIncome maximizationIncome smooth

11.3, 4 Motivations for Earnings ManagementContractual motivationsBonus plan hypothesis: to manage cash bonus Evidence: [Healy (1985)]Debt covenant hypothesis: to manage debt covenants Evidence: Dichev & Skinner (2002), text Section 8.5.3Political cost hypothesisTo lower political heatEvidence: Jones (1991), text Section 8.5.3

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11.3, 4 Motivations for Earnings Management (continued)

To meet earnings expectationsSignificant negative effects on share price and manager reputation if expectations not met

Other motivationsInitial public offerings

11.5 The Good Side of Earnings ManagementContract-based argumentsTo give firm some flexibility in the face of rigid, incomplete contractsBonus contracts based on net incomeNew accounting standards may lower net income and/or increase volatility. May adversely affect manager effortDebt covenant contractsNew accounting standards may increase probability of debt covenant violationContract violation is costly, earnings management may be low-cost way to work around

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11.5 The Good Side of Earnings Management (continued)Investor-based argumentsTo credibly communicate inside information to investorsBlocked communication may inhibit direct disclosure of earnings expectationsDiscretionary accrual management as a way to credibly reveal managements inside information about earnings expectationsManager foolish to report more earnings than can be maintainedManage reported earnings to an amount management expects will persist

11.5.2 Theory & Evidence of Good Earnings ManagementTheoretical models supporting good earnings managementDemski & Sappington (1987)Stocken & Verrecchia (2004)Evans & Sridhar (1996)Dye (1988)Chen, Hemmer, & Zhang (2007)

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11.5.2 Theory & Evidence of Good Earnings Management (continued)Empirical studies supporting good earnings managementSubramanyam (1996)Xie (2001) questionsTucker & Zarowin (2006)Liu, Ryan, & Whalen (1997)Barth, Elliott, & Finn (1999)Callen & Segal (2004)Francis, LaFond, Olsson, & Schipper (2005)

Problem 11.9 Earnings Management at General ElectricEarnings management devices used by GEAssumed rate of return on pension fundsRestructuring chargesAcquisitions, sales of divisionsConservative accounting practicesSales of leased aircraftAllocation of goodwill on purchase of subsidiariesEarnings management devices used in harmony to report steadily increasing earnings

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Problem 11.9 Earnings Management at General Electric (continued)GE Reported Net Income (Millions)2007 $22,2082006 20,700 2005 16,3532004 16,5932003 15,0022002 14,1182001 13,6842000 12,735

1999 $10,7171998 9,2961997 8,2031996 7,2801995 6,5731994 4,7261993 4,3151992 4,725Continued

Problem 11.9 Earnings Management at General Electric (continued)Note argument that even under securities market efficiency, GE is so large and complex that even analysts cannot prepare accurate earnings forecastsManagement has best inside information about expected persistent earningsDirect communication blockedCreates role for earnings management to reveal managements expected persistent earnings Is this good or bad (i.e., opportunistic) earnings management?

11.6 The Bad Side of Earnings ManagementContracting PerspectiveHealy (1985)Is this good or bad earnings management?Dechow, Sloan, and Sweeney (1996)Is this good or bad earnings management?

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11.6 The Bad Side of Earnings Management (continued)Financial Reporting PerspectiveHanna (1999)Investors and analysts look to core earnings, ignoring extraordinary and non-recurring itemsImplies manager not penalized for non-core charges, such as writedowns, provisions for restructuringBut current non-core charges increase core earnings in future years, through lower amortization and absorption of future costs

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11.6 The Bad Side of Earnings Management (continued)Hanna, contd.As a result, managers tempted to overdose on non-core charges, thereby putting earnings in the bank also called cookie jar accountingNote securities market reactionHanna found evidence that market uses frequency of such charges as proxy for their misuse--lower ERC when greater frequencyExample: Nortel (Theory in Practice 11.1)

Problem 11.10 Earnings Management at Sunbeam Corp.See Liang (1998) articleDevices used by Sunbeam to manage earnings upwardsSee next slideNote loss reported earnings 1st Q. 1998Illustrates iron law of accrual reversalWhere was auditor?

Problem 11.10 Earnings Management at Sunbeam Corp.

11.6.2 Do Managers Accept Securities Market Efficiency?PerhapsPoor disclosure enables earnings management even if markets efficientPerhaps NotTheory and evidence that securities markets may not be fully efficient supports a no answerEvidence that efficiency not acceptedPro-forma earningsDoyle, Lundholm, & Soliman (2003)Managing same-quarter earnings of previous yearSchrand and Walther (2000)

11.6.3 Can Accountants Control Bad Earnings Management?Full disclosureRevenue recognition policiesUnusual, non-recurring and extraordinary eventsEnables investors to better evaluate earnings persistenceEffect of previous writeoffs on current core earningsHanna ( 1999)

11.7 ConclusionsEarnings management can be good if used responsiblyFull disclosure helps to control bad earnings management