Earnings Management: Powerpoint Presentation by Matthew Tilling ©2012 John Wiley & Sons Australia LTD

Chapter 9
Earnings Management
PowerPoint Presentation
by Matthew Tilling
©2012 John Wiley & Sons Australia Ltd
THE IMPORTANCE OF EARNINGS
• Also known as profit, bottom line, net income

• Measures entity performance
• Widely reported
• Frequently forecast
• Strongly linked to share value
THE IMPORTANCE OF EARNINGS
• For example, used by

– Shareholders
• Assess stewardship and prospects
– Creditors
• Assess risk, input to debt covenants
– Customers
• Assess earnings, long term survival
– Employees
• Assess job security
WHAT IS
EARNINGS MANAGEMENT?
• Healy and Wahlen:
‘earnings management occurs when managers use
judgement in financial reporting and in structuring
transactions to alter financial reports to either
mislead some stakeholders about the underlying
economic performance of the company, or to
influence the contractual outcomes that depend on
reported accounting numbers’
WHAT IS
• McKee:
‘reasonable and legal management decision making
and reporting intended to achieve stable and
predictable financial results’
WHAT IS
• In reality there are different definitions of
what is earnings management.
– White
• Beneficial for all, enhances transparency
– Grey
• Biased to benefit organisation or management
– Black
• Misrepresents reality, fraudulent
Earnings Management Relating to
Different Entity Objectives
METHODS OF
EARNINGS MANAGEMENT
• Accounting policy choice
– Most common form of earning
– Strategic choices of accounting policy
• Accrual accounting
– Allows entities to delay or accelerate recognition
of income and expense
– Enables entity to temporarily adjust profit figures
Income Smoothing
‘Smoothing moderates year-to-year fluctuations in
income by shifting earnings from peak years to less
successful periods’
– Premised on the belief that shareholders prefer to

invest in an entity that exhibits consistent growth
patterns.
– Rather than one that has uncertain and changing
earnings patterns.
Real Activities Management
• Managing earnings by managing operational
decisions, not just accounting policies or accruals.
• Examples Include:
– Accelerating sales
– Reducing discretionary expenditures
• Can reduce entity value because actions taken in
the current period to increase earnings can have
negative effects on cash flows in later periods.
Big Bath Write-Offs
• When management realises that larger than normal
write-offs can be justified, they may attempt to bring
forward or even overstate expenses in the same
period.
• Often when there is a change in management or
significant restructuring.
• Leads to future reductions in expenses and better
performance by presenting a reduced base upon
which future valuations and comparisons
performance can be assessed.
WHY MANAGE EARNINGS?
• Earnings are managed:
1. For the benefit of the entity
• To meet analysts’ and shareholder expectations and
predictions;
• To maximise share price and company valuation;
• To accurately convey private information;
• To avoid violating restrictive debt covenants.
2. To meet short-term goals which lead to
maximising managerial remuneration and
bonuses.
Entity Valuation
• Share prices are highly aligned with net income.
• An entity’s value is effectively the present value
of future income discounted at a risk adjusted
discount rate.
• 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.
• Income smoothing reduces volatility and
therefore risk of investment.
Earnings Quality
• Relates to how closely current earnings are
aligned with future earnings.
• Earnings quality as a concept is difficult to
observe and measure.
• There are contradictory views on whether
smoothed income indicates high earnings
quality.
Managerial Compensation
and Change in CEO
• Management makes the key decisions about strategy,
investments, budgets, operations, business strategy
and acquisitions.
• Managers are appointed to operate the business for
the benefit of shareholders.
• However, their objectives do not necessarily always
align.
• Agency theory is often used to understand that
managers, as agents, are likely to act in their own
interest.
• The remuneration package for senior managers
relates payment to various performance measures.
• Some common performance measures that directly
relate to earnings include:
– Accounting returns
– Sales revenue
– Net interest income
– A balanced scorecard index of multiple indicators
– Economic Value Added (EVA)
• It has been observed that:
– Managers will manage earnings in such a way that
they maximise their bonus.
• If earnings are so low that they are unlikely to meet their
targets, they are likely to engage in big bath write-offs
• Entities that adopt a long-term bonus plan in
addition to a short-term plan mitigate earnings
management and have higher annual returns.
Change in CEO
• Earnings management is particularly evident
around the time a CEO changes.
• Outgoing CEOs are likely to manage earnings
up in final year to increase opportunities or
reduce appearance of poor performance.
• Incoming CEOs are more likely to take an
earnings bath in the first year and then the
following year show large earnings increases.
CONSEQUENCES OF
EARNINGS MANAGEMENT
• The consequences of earnings management
decisions will depend upon the nature and
extent of earnings management that has taken
place.
– It appears that aggressive earnings management
often leads to subsequent poor share
performance
CORPORATE GOVERNANCE AND
EARNINGS MANAGEMENT
• 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.
– 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.
21

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What are some of the methods used for earnings management?

What are some of the reasons why earnings management is important?

Chapter 9

• Also known as profit, bottom line, net income

• For example, used by

– Premised on the belief that shareholders prefer to

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