9 Earnings Management.2
9 Earnings Management.2
9 Earnings Management.2
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1 describe the importance of earnings in assessing the success of an
organisation
2 explain what earnings management is
3 describe a number of common methods of earnings management,
including accounting policy choice, accrual accounting, income
smoothing, real activities management and big bath write-offs
4 explain why entities manage earnings 5 identify the consequences of
earnings management 6 assess the role corporate governance plays in
controlling earnings management.
Conservative
Moderate
Aggressive
Fraud
Revenue
recognitio
n on
services
Services are
prepaid and
performed in
full
Services
prepaid and
partially
performed
Services are
agreed to but
not yet
performed
Fraudule
nt
scheme
Inventory
Lower of cost
and net
realisable value
is consistently
applied
Slow to write
down slowmoving
inventory
Obsolete
inventory is still
recorded as an
asset
Overstat
e
inventor
y where
nonexistent
inventor
y is
recognis
ed
Accounts
Conservative
receivable credit terms
and bad debts
allowances
used
Liberal credit
terms and
bad debts
provision
estimates
Liberal use of
credit policies to
expand sales;
understate bad
debts provisions
or reduce bad
debts by
ignoring likely
defaults
Fictitious
receivabl
es
establish
ed to
support
nonexistent
sales or
services
Depreciati
on
Conservative
useful life and
residual value
computed
Change
useful
life and
residual
value
estimate
s to
meet
earnings
targets
Advertisin
g,
marketing
Expensed as
incurred
Expensed
based on a
formula;
perhaps
Costs
are
capitalis
ed and
Marketing costs
are capitalised
sales-based
manipul
ated to
meet
earnings
targets
short-term earnings can lead cus- tomers to expect the same discounts
in the future, which will lead to lower margins on future sales.25 Real
activities management is less likely to draw the attention of auditors
than accruals management as auditors are not likely to question actual
pricing and pro- duction decisions.
quality. These will be addressed in the next two sections. This will then
be followed by a discussion of managerial remuner- ation motives to
manage earnings.
Entity valuation
To understand why managers might manage earnings to maximise
share price it is important to consider how a company is valued. There
are a number of different methods commonly used to determine the
value of a company. They generally rely on determining current value
by forecasting the future value of one of the following measures:
book value of the company (reflected in the balance sheet)
operating cash flow net income.35
Research by Dechow indicates that share prices are more highly
aligned with net income than operating cash flows.36 As such, net
income, or earnings, is commonly used to determine entity value. An
entitys value is effectively the present value of future income
discounted at a riskadjusted discount rate, which is usually the cost of
capital. In doing so, analysts generally forecast earnings for a five-year
period.37 Because deter- mining entity value relies on some measure
of risk, entities with more volatile patterns of earnings are likely to
have a higher risk measure and therefore are likely to have a lower
entity value. Earnings volatility could be an indication of an increased
chance of insolvency.
As a result of this, managers are more likely to engage in income
smoothing to reduce volatility and therefore risk of investment. This is
anticipated to send a stronger message to shareholders and lead to an
increase in entity value.
Earnings quality
Quality of earnings can also affect a companys share price. The last
section shows that current earnings are commonly used to forecast
future earnings. Earnings quality relates to how closely current
earnings are aligned with future earnings. Current earnings which are
highly correlated to future earnings are said to have high earnings
quality and lead to a more accurate future earnings forecast. On the
other hand, if current earnings have a low correlation with future
earnings, low earnings quality is said to be present.
Contemporary Issue 9.1 considers earnings quality from a practical
investment perspective.
Many companies will detail this mix in their annual report under
segment reporting. (Of course, companies can fall into disfavour
because they have too much of a spread and are unable to harness
scale or synergies, so a balance needs to be struck.)
An analysis of these three factors, and if the company performs well
against each bench- mark, should mean your purchase has less
downside risk.
And, as you know, protecting the downside is just as important as
benefiting from the upside.
Source: Earnings quality, Herald Sun.38 Questions
1. Explain the three criteria usually considered important in assessing
earnings quality. K 2. Outline two advantages to a company from
having high quality earnings. J 3. Given the information you have
already addressed in this chapter, what are some methods companies
could use to ensure they present consistent profits? J
The above article reflects earnings quality from an accounting
perspective. Earnings quality as a concept is difficult to observe and
measure. Research has not determined a consensus view on what
characterises high quality earnings.39 This is, in part, due to the fact
that different parties are looking for different outcomes from
accounting earnings. For example, standard setters might be
interested in how objective entities have been in applying accounting
regulations, while analysts and shareholders might be more interested in earnings as a good predictor of future earnings or cash flows.
Much of the research in earnings quality has focused on the role of
accruals in finan- cial reporting.40 Current earnings have been found to
be a better predictor of future cash
flows than current period cash flows.41 Dechow found that earnings
explain a larger proportion of share returns than do cash flows.42
Given the difference between earnings and cash flows are accounting
accruals, the greater explanatory power of earnings can therefore be
attributed to accounting accruals. Ultimately, over the life of an asset
or a business, cash flows will equal accruals; however, accruals are
used in such a way as to smooth earnings over time and to predict
future cash flows.
As we discussed previously, accounting accruals can be classified as
either discretionary or non-discretionary. Non-discretionary accruals are
the normal part of earnings that result from applying accounting rules
in a neutral way. Discretionary accruals are those that result from
of the upwards earnings management and share price does not react
negatively following earnings management associated with an IPO.61
Researchers have also examined the share price reaction to evidence
of fraudulent reporting. Dechow, Sloan, and Sweeny; Palmrose,
Richardson, and Scholz; and Beneish all find that the market reacts
negatively to the disclosure that there has been fraudulent
manipulation, implying that investors were surprised and interpret the
information as negative news.62
Chapman, in an examination of real activities management by
supermarkets, observed stock discounting in the last fiscal quarter. He
also finds evidence that entities engage in persistent, longer-term price
reduction to meet analysts forecast targets. The author also notes that
earnings management incentives at one entity are related to
competitor price discounting.63
LO 6. CORPORATE GOVERNANCE AND EARNINGS MANAGEMENT
While the management team is responsible for the day-to-day
operations of the organ- isation and for developing plans, strategies
and investment decisions, the board of direc- tors is responsible for
approving these and ensuring they are in the long-term interests of
shareholders. How the board functions is essential to the overall
operation and future of the company, as well as the earnings
management environment of the entity.64
The composition of the board, including the number of members, their
expertise and independence are important in determining how likely it
is that managers are able to manipulate or manage earnings. A board
made up of internal rather than independent directors is less likely to
question a CEO who may want to use aggressive earnings management strategies. Strong governance means a balance between
corporate performance and an appropriate level of monitoring.65 It is
important that the board exhibits an optimal mix of monitoring and
expertise, and is not just seen as providing a rubber stamp to
decisions of the CEO. If this is the case, it is more likely that
inappropriate earnings management can result.
Research has found that there is likely to be greater levels of earnings
management when the proportion of independent directors on the
board is low.66 Beasley also found that the presence of independent
directors reduces the likelihood of fraudulent earnings management.67
Boards often delegate certain responsibilities to separate specialist
committees. The audit committee plays an important role in ensuring
financial reports are credible and controls the extent of earnings
equally risky, because it shows that the management has not used all
the resources available to it. Contributors may then decide that some
of their money is no longer needed, and may direct their funds
elsewhere. For most such organisations, then, the ideal result is a
surplus which is so small as to be immaterial.
The NZSO shows how this works. It has three major streams of
revenue: concert sales, sponsorship and government funding. For the
year ended 30 June 1998, these revenues were about $2.7, $1.4 and
$8.9 million respectively. Like many other similar organisations, the
NZSOs expenses are largely fixed, even before the start of the season.
The concert pro- grammes, the required orchestral forces, conductors
and soloists and the associated costs are all set in advance. The main
uncertainties about the success of a season concern the subscription
and door sales revenue from its concerts.
The financial year starts half-way through the concert season. By that
time, the result for the first half of the financial year is nearly
unalterable, and that for the second half depends largely on the
attractiveness of the next season to subscribers and sponsors.
For this reason, the NZSO has little opportunity to manage earnings,
either by making discretionary accruals or by structuring real
transactions in the short term. However, in the medium term, an
unexpected cash surplus in one year (perhaps from a particularly successful concert) can be used up by providing extra services in later
years, thus incurring an offsetting deficit. Not-for-profit organisations
are expected not to amass large surpluses, except to be used in future
operations. By smoothing out reported short-term surpluses and
deficits, management may show that it has credible ways of using its
resources in full, to break even over the medium term. As we
suggested above, allowing a large surplus to be reported without
smoothing may put the organisations future revenue at risk.
Source: Excerpts from James Gaa & Paul Dunmore, The ethics of
earnings management, Chartered Accountants Journal.70
Questions
1. Why would the NZSO wish to smooth income?
3. What relationship does the audit committee have with the external
auditors inensuring earnings management is within acceptable limits?
J
K
Additional readings
Dechow, P 1994, Accounting earnings and cash flows as measures of
firm performance: the role of accounting accruals, Journal of
Accounting and Economics, vol. 18, no. 1, pp. 342.
Dechow, PR & Dichev, I 2002, The quality of accruals and earnings:
the role of accruals estimation error, The Accounting Review, vol. 77,
supplement, pp. 3559.
Dunmore, P 2008, Earnings management: good, bad or downright
ugly?, Chartered Accountants Journal, vol. 87, no. 3, pp. 327.
Godfrey, J, Mather, P & Ramsay, A 2003, Earnings and impression
management in financial reports: The case of CEO changes, Abacus,
vol. 39, no. 1, pp. 95123.
Godfrey, JM & Jones, KL 1999, Political cost influences on income
smoothing via extraordinary item classification, Accounting and
Finance, vol. 39, no. 3, pp. 22954.
Sloan, R 1996, Do stock prices fully reflect information in accruals and
cash flows about future earnings? The Accounting Review, vol. 71, no.
3, pp. 289315.
End notes
1. Goncharov, I 2005, Earnings management and its determinants:
closing gaps in empirical accounting research, Frankfurt, Germany:
Peter Lang.
2. Giroux, G 2004, Detecting earnings management, Hoboken, N.J.:
John Wiley and Sons Inc.
3. McKee, TE 2005, Earnings management: an executive perspective,
Mason, O.H.: Texere, Thomson Higher Education.
4. Lev, B 1989, On the usefulness of earnings and earnings research:
lessons and directions from two decades of empirical research, Journal
of Accounting Research, vol. 27, supplement, pp. 153201.
Review of Quantitative Finance and Accounting, vol. 18, no. 2, pp. 161
83.
54. Bushman, RM & Smith, AJ 2001 Financial accounting information
and corporate governance, Journal of Accounting and Economics, vol.
32, no. 13, pp. 237333; Murphy, KJ 1999, Executive compensation,
Handbook of Labor Economics,
vol. 3, Ashenfelter, O & Card, D eds, Amsterdam: North Holland, pp.
2485563; Rankin, M 2010, Structure and level of remuneration across
the top executive team, Australian Accounting Review, vol. 20, no. 3,
pp. 24155.
55. Ronen, J & Yaari, V 2008, Earnings Management: emerging insights
in theory, practice, and research, New York, N.Y.: Springer.
56. Reitenga, AL & Tearney, MG 2003 Mandatory CEO retirements,
discretionary accruals, and corporate governance mechanisms, Journal
of Accounting, Auditing and Finance, vol. 18, no. 2, pp. 25580.
57. Pourciau, S 1993, Earnings management and nonroutine executive
changes, Journal of Accounting and Economics, vol. 16, no. 13, pp.
31736.
58. ibid; Strong, J & Meyer, J 1987, Asset writedowns: managerial
incentives and security returns, Journal of Finance, vol. 42, no. 3, pp.
64362.
59. Godfrey, J, Mather, P & Ramsay, A 2003, Earnings and impression
management in financial reports: the case of CEO changes, Abacus,
vol. 39, no. 1, pp. 95123.
60. Teoh, SH, Wong, TJ & Rao, G 1998, Are Accruals During Initial
Public Offerings Opportunistic?, Review of Accounting Studies, vol. 3,
nos. 12, pp. 175208.
61. Brav, A, Geczy, C & Gompers, P 2000, Is the abnormal return
following equity issuances anomalous?, Journal of Financial Economics,
vol. 56, iss. 2, pp. 20949.
62. Dechow, PM, Sloan, RG & Sweeney, AP 1996, Causes and
consequences of earnings manipulation: an analysis of firms subject to
actions by the SEC, Contemporary Accounting Research, vol. 13, iss. 1,
pp. 136; Palmrose, Z, Richardson, V & Scholz, S 2004, Determinants
of