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Chapter 6 - FAR 5 - Note Earnings Management

Earnings management occurs when company managers use their judgment in financial reporting and structuring transactions to alter reported profits or other financial metrics in order to mislead stakeholders or influence contractual outcomes. It can involve artificially increasing revenues, profits, or earnings through aggressive accounting methods. Management may seek loopholes in standards to adjust numbers to achieve desired earnings targets or analyst projections. Common earnings management strategies include income smoothing, maximizing or minimizing reported income to influence bonuses, avoiding debt covenant violations, or managing taxes and political costs. Motivations to engage in earnings management include bonuses, contracts, taxes, changes in leadership, IPOs, and meeting capital market expectations.

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83 views5 pages

Chapter 6 - FAR 5 - Note Earnings Management

Earnings management occurs when company managers use their judgment in financial reporting and structuring transactions to alter reported profits or other financial metrics in order to mislead stakeholders or influence contractual outcomes. It can involve artificially increasing revenues, profits, or earnings through aggressive accounting methods. Management may seek loopholes in standards to adjust numbers to achieve desired earnings targets or analyst projections. Common earnings management strategies include income smoothing, maximizing or minimizing reported income to influence bonuses, avoiding debt covenant violations, or managing taxes and political costs. Motivations to engage in earnings management include bonuses, contracts, taxes, changes in leadership, IPOs, and meeting capital market expectations.

Uploaded by

Sofia Arissa
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© © All Rights Reserved
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Meaning of Earnings Management

 According to Healy and Wahlen (1999), "Earnings Management" occurs when


managers use judgment in financial reporting and in structuring transactions to alter
financial reports to either mislead some stakeholders about the underlying economic
performance of a company or to influence contractual outcomes that depend on
reported accounting numbers.
 Earnings management/”Cook the Book” usually involves the artificial increase (or
decrease) of revenues, profits, or earnings per share figures through aggressive
accounting tactics. Aggressive earnings management is a form of fraud and differs
from reporting error.
 Management wishing to show earnings at certain level or following a certain pattern
seek loopholes in financial reporting standards that allow them to adjust the numbers
as far as is practicable to achieve their desired aim or to satisfy projections by
financial analysts.
 These adjustments amount to fraudulent financial reporting when they fall 'outside the
bounds of acceptable accounting practice'.
 Aggressive earnings management becomes more probable when a company is
affected by a downturn in business.
 Earnings management is seen as a pressing issue in current accounting practice. It is
relatively easy for an auditor to detect error but earnings management can involve
sophisticated fraud that is covert.

Several ways that management of company can exercise judgment in financial


reporting to manage earnings:

 Estimating numerous future economic events


These include identifying expected useful lives and salvage values of fixed assets,
obligations for pension benefits and other post employment benefits, deferred taxes,
bad debts allowance and asset impairments. On intangibles assets manager can
determine the amortization period.

 Choosing among acceptable accounting methods for reporting the same


economic transactions
These include method of depreciating fixed assets such as straight-line method,
composite method, the sum of year digit method and others. Besides that, manager
can choose inventory valuation method such as LIFO, FIFO or weighted-average.

 Managing working capital


These include inventory level, the timing or inventory shipments or purchases and
receivable policies which affects cost allocations and net revenues.

 To make or defer expenditure


These include the treatment of research and development expense, advertising
expense and maintenance expense.

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Types/patterns/strategies/techniques of Earnings Management

Taking a bath/ big bath

 Takes place during organizational stress or reorganization, when hiring a new


management/CEO or if net income less than bogey.
 It is sometimes termed as “clear the deck”.
 If company must report a loss, report a large one
 The manager may take a bath, by writing off investments in capital assets and setting
up provisions for future costs such as reorganization and layoffs.
 This will reduce reported net income this year, but the probability of high net income
in future years is increased, since future amortization charges will be lower and future
costs can be charged against the provisions rather than against net income.
 Furthermore, if the provisions turn out to be higher than actually needed, the excess
amounts can be reversed into future years’ operations.
 Consequently, future years’ reported earnings will be higher (or losses lower) than
they would otherwise be, and the probability of the manager receiving a bonus
correspondingly increases.

Income minimization

 Similar to taking a bath but less extreme.


 It involves rapid write off of capital assets and intangibles, expensing advertising and
R&D and successful efforts accounting for oil and gas exploration costs.
 Use for politically visible firms during period of high profitability or if net income
above the cap.

Income maximization

 For bonus purposes and to violate debt covenants


 When the net income is between bogey and cap
 Use the accounting policies and procedures that can increase an income
 Alternatively, the manager may income maximize, so as to increase net income above
the bogey.
 However, this tactic is unlikely to be used unless pre-bonus earnings are only slightly
below the bogey.

Income smoothing

 Similar to income maximization but try to sustain income between bogey and cap.
 Reduce volatility of reported net income thus it shows a good signaling to the whole
market.
 To maintain the good reputation of management / CEO.

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Cookie jar (Normally use for income smoothing)

 Cookie jar accounting seems reasonably effective as an earnings management device


since it can be hard to detect.
 The firm has some flexibility about the extent of disclosure of gains and losses from
asset disposals (unusual, nonrecurring, and extraordinary items).
 While cookie jar accounting can be reasonably effective, and has the potential to be
good, its continuing and excessive misuse may lead to its discovery and subsequent
penalties.
 Some companies appear to have been using cookie jar accounting to smooth reported
earnings.

Motivation to Manage Earnings

Bonus Motivation

 Managers have incentives to maximize their bonuses, consistent with the bonus plan
hypothesis of positive accounting theory.
 Consequently, they may adopt accounting policies to increase reported net income if
net income between bogey and cap (income maximization), or to reduce reported net
income if it is below the bogey (taking a bath) or above the cap of the bonus plan
(income minimization).
 Please refer to typical bonus scheme figure as suggested by Healy 1985.

Contractual motivation

 Managers may adopt policies to increase reported net income, or other financial
statement variables, to avoid covenant violation or even to avoid being too close to
violation.
 It consistent with the debt covenant hypothesis of positive accounting theory.
 Lending agreements may also induce income-smoothing behavior.
 A smooth sequence of reported net incomes will reduce the probability of covenant
violation.
 Also, higher reported profits will reduce the probability of technical default on debt
covenants.
 For example, a smooth earnings sequence may increase the willingness of lenders and
suppliers to grant short-term credit.
 This is particularly so if the firm has implicit contracts with these stakeholders.

Political motivation

 By reducing its reported net income the firm may reduce government intervention
which might emerge if the public felt the firm was earning excessive profits.

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 According to the political cost hypothesis, the largest/utilities oil companies would be
most concerned because big companies are more in the public eye and because of
their size and economic power, they tend to attract media and political attention.
 Also, they may be under greater pressure to behave responsibly than smaller firms
that attract little or no public attention.
 Thus, big oil/utilities companies are the ones most likely to suffer adverse
consequences such as higher taxes if they take advantage of the rising price of crude
oil/increase tariff to earn high profits.

Taxation motivation

 The firm may be able to postpone payment of taxes if it can minimize its reported
income, for example by managing accruals like depreciation, or using LIFO (if
allowed by the tax authority).
 However, IRB have it own rules for calculating taxable income
 Example: Choice of valuation of inventory between LIFO @ FIFO
 In Malaysia, LIFO is not allowed for tax purposes by IRB

Change of CEO motivation

 Motivation to manage earnings usually occurs around the time of changes of CEO.
 CEO approaching retirement would likely try to maximize net income so as to
increase their bonuses.
 New CEO usually motivated to take a bath to increase profitability of future earnings

Initial public offerings (IPO) motivation

 Firms making IPOs do not have an established market price.


 Thus, it is difficult to value the shares of IPO firms in this situation
 Financial accounting information in prospectus is useful sources in helping to make
economic decisions.
 The firm may have wanted to increase and/or smooth earnings so as to increase
proceeds from a planned IPO.
 High net income may be a good signal and manager may manage reported earning
hoping to receive higher price for their shares

To meet investors’ earning expectations (capital market) motivation

 Firms that report earnings greater than expected typically enjoy a significant share
price increase, as investors revise upwards their probabilities of good future
performance.
 In contrast, firms that fail to meet expectations suffer a significant share price
decrease.

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 Previous studies showed that the market penalizes firms that fall short of expectations
by more than it rewards firms that exceed them.
 As a result, managers have a strong motivation or incentive to ensure that earnings
expectations are met, particularly if they hold ESOs and other share related
compensations.
 In this context, managers will employ earnings maximization.
 It is suggested that meeting investors’ expectations is a powerful earnings
management incentive.

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