TOPIC 7(Earnings Mgt)_Mac 2013

8/12/2019 TOPIC 7(Earnings Mgt)_Mac 2013

1/18

5/31/20141

5/31/2014 1

Accounting

Theory & PracticeFAR 600

EARNINGS MANAGEMENT (EM)

By:

Dr Suhaily Hasnan

Faculty of Accountancy

UiTM


2/18

5/31/20142

Learning Objectives

At the end of this lesson, students should beable to understand :

Discuss the motivations for earnings management

(EM)

Describes the patterns of earnings management (EM)

Discuss the advantages & disadvantages of earnings

management (EM)


3/18

5/31/20143

Earnings Management

EMIs the choice by a manager of accounting policies, oractions affecting earnings, so as to achieve some specificobjective. (Scott, 2003, p.369)

GAAP are not a set of rigid rules and procedures. They are

standards and guidelines that are applied through the use ofprofessional judgment.

Since not all firms are required to have the same accountingpolicies, each firm can manage its earnings through theaccounting policies that it chooses; i.e. straight-line vs. reducing

balance amortization.

Another way to manage earnings is by means of realvariables;i.e. R&D, maintenance, timing of purchases and disposal ofcapital assets. These devices maybe costly since such actions may

compromise long term objectives.


4/18

5/31/20144

Fraudulent Financial Reporting (FFR)

as an Extension of EM

Although legal, the practice of EM can make the financialstatements difficult for investors and analysts to interpret.

Management of earnings suggests tinkering with earnings toachieve a more favorable reporting outlook, but with apresumption that the financial results are not fraudulentlymisrepresented. However, tinkering may lead to cooking.

Over time, this constraints within-GAAP EM options, and furtherEM crosses into non-GAAP reporting.

FFR starts out small with no intent to deceive, but grows overtime as the pressures build until it is full-blown cooking thebooks.

Accruals are comparatively high in most fraud cases in the years

preceding fraud discovery.(Lee, Ingram & Howard, 1999)


5/18

Discuss the motivations for

earnings management (EM)

5/31/20145


6/18

Motivations for earnings management?

1. Profit-based incentive compensation bonus

purposes

2. Avoid debt covenant violations

3. Reduce political visibility4. Maximize proceeds from IPOs

5. Taxation motivations

6. Changes of CEO

7. Communicate blocked inside information to

investors

5/31/20146


7/18

Profit-based incentive Compensation-

Bonus Purposes

Managers have incentive to select accounting methods

and exercise discretions over accounting estimates to

improve their compensation

Studies by Dechow & Sloan (1991) showed that CEOs

increase their compensation in their final years in

office by cutting research & development (R&D)

expenditures

5/31/20147


8/18

5/31/20148

Avoid Debt Covenant Violations

Managements incentive to opportunistically manage

earnings is driven by contractual agreements and/or

change in economic environments

Contractual agreements are in the form of management

compensation or debt covenants

Example: managers alter earnings to mask poor managerial

performance & safeguard themselves from possibledismissals or managing earnings to maximize

remunerations or increase personal wealth


9/18

Reduce Political Visibility

Political process imposes costs on firms believed to be takingadvantage of the public & making excessive profits

Political cost hypothesis predicts that managers of larger firms have

greater incentives to reduce reported profits and hence reduce their

perceived ability to bear political costs

Political costs refers to wealth transfer away from a firm due to its

political exposure. The amount of transfer depends on size &/or

visibility of the firm. For example, employees may see an unusually

high profits reported as an exploitation of their labor & hence theylobby for higher pay

In other words, Managers of these firms have incentive to reduce

reported earnings and lower their political risk.

5/31/20149


10/18


11/18

Taxation Motivations

Most obvious motivation

Previous studies by Guenther et al., (1997) & Maydew (1997)

suggested that firms choose accounting accruals to save tax costs

Guenther et al., 1997 found that firms forces to switch from cash

method to accrual method

Maydew, 1997 found that firms with tax based incentives shifted

income in order to maximize current net operating losses

Nevertheless, firms opportunity to manipulate economic result

reduced because taxation authorities tend to impose their own

accounting rules for calculation of taxable income

5/31/201411


12/18

Changes of CEO

Variety of income management motivations among CEOs

exists such as

Bonus plan hypothesis predicts that CEOs approaching retirement

would maximize income to increase their bonuses

CEOs of poorly performing firms may maximize income to prevent

or postpone from being fired

DeAngelo, DeAngelo & Skinner (1994) found that CEOs

may take a bath so as to increase the probability of future

earnings

5/31/201412


13/18

Communicate Blocked Inside

Information to Investors

Managers might undertake income smoothing to convey

inside information about the firms long run earnings

potential.

A simple announcement about the firms long run earnings

potential maybe costly for investors to verify. EM (through

income smoothing) would convey the information in acredible fashion.

5/31/201413


14/18

Describes the patterns of earnings

management (EM)

5/31/201414


15/185/31/201415

Patterns of

Earnings

Management

Taking a bath

write off assets show large losses

Enhance probability

of future reported

profits

Income

Minimization used by politically visible

firm during period of

high probability

e.gs., rapid writeoff of

assets, expensing R&D,

advertising

IncomeSmoothing

Income

Maximization


16/18

The Advantages of EM

EM provides room for managers to take steps to avoid technicalviolations of debt covenant.

EM can be used as a device to convey blocked, inside information

to the market. This enable share price to better reflect the firms

future prospects.

EM reveals goodwill component of firm value which provide

better knowledge to investors of the value of goodwill & hence

enable better estimates of firm value to investors.

Market responds efficiently to discretionary accruals (proxy for

EM).

5/31/201416


17/18

The Disadvantages of EM

Resulted from opportunistic manager behaviour.

Opportunistic EM is bad as it reduces the reliability of FS

information.

Opportunistic EM involves manager selecting accounting

policies to maximize his/her own self interest rather than the

interest of the owners (e.g. bonus purposes).

Opportunistic EM is aimed to hide real operating performance

by creating artificial accounting entries or strecthing estimatesbeyond reasonableness.

Only if the EM practices violated GAAP (Dechow, Sloan &

Sweeney, 1996)

5/31/201417


18/18

Summary

EM is possible because GAAP provides managers choices of

accounting policies and procedures.

Managers accounting policy choices are motivated by strategic

considerations such as

Bonus purposes Reduce political visibility

CEO motivations

Maximize proceeds from IPOs

Taxation motivations Unblock inside information

18

Documents

TOPIC 7(Earnings Mgt)_Mac 2013