Accounting Theory 9.

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11
Chapter

Accounting Theory
Chapter 11 Notes
What is Earnings Management
Earnings management is the selection of accounting policies to achieve a specific
objective. You can do this in two ways:
1) Choice of accounting policy
2) Discretionary use of accruals
3) Classification
4) Engaging in or avoiding transactions (ex. Reducing spending)

Evidence of Earnings Management for Bonus Purposes

Despite challenges in methodology, Healys study certainly provides evidence that
managers maximize their bonuses by using accruals to manage earnings. His findings
were also consistent with the bonus plan hypothesis of positive accounting theory.
Other Motivations for Earnings Management

Contractual Motivations 2 types of contracts provide incentive for earnings

management. The first is the contract between the firm and its managers. This
contract sets out the bonus scheme, which is usually tied to net income. This
provides an incentive to manage earnings in such a way that maximizes the bonus.
The second is earnings management for debt covenant purposes. To the extent that
firm managers have an incentive to avoid the costs of violating their long-term debt
covenants they will manage earnings.

Political Motivations Jones and Cahan found that firms under investigation for
monopolistic practices used earnings management to revise reported net income
downward. Their studies showed that this type of earnings management happened
more frequently in years that these politically visible firms were under investigation
than in other years.

Taxation Motivations Generally, tax avoidance is not a large motivator for earnings
management because taxation authorities have created policies that restrict
manipulation in this area. However, evidence evidence suggests that tax savings are
the primary motivator when deciding between LIFO and FIFO for inventory valuation

CEO changes There is no evidence that CEOs approaching retirement used

earnings management to maximize income

Initial Public Offering Firms that are going public are interested in signaling a positive
value of their firm to the market. Evidence to support this was found by Friedlan. He
noted that that managers used income-increasing accruals to boost firm value in the
period before the IPO. No other comparable period other than the one just before the
IPO showed the same level of accrual usage.

Communicating information to investors Earnings management, if used properly

brings information from inside the corporation to outside and in so doing makes the
market more efficient.

Patterns of Earnings Management

Here are some examples of what a manager using each of these types of earnings
management might say:
Taking a bath
If were going to have a bad number, lets make it a really bad one. We have nothing
more to lose.
This practice enhances the probability of profits in the future.
Income Minimization
We need help from the government, but they think were making too much money. If we
can revise these numbers downward, they may be more sympathetic.
This practice may be used by high profile, politically visible firms during periods of high
profitability..
Income Maximization
Were in trouble Ken, we need to report a high net income to get the lenders off our trail
There is evidence that Enron attempted to inflate earnings as it came closer to violating its
debt covenants.
Income Smoothing
We dont want growth of 30% this year and 3 % next year. Investors like firms that
demonstrate persistent earnings power. Lets save some of this growth for next year
Healys research showed that this practice is used to keep income between the bogey and
the cap (P. 353)

If Earnings Management is so bad.

Why dont boards of directors, regulatory agencies, lenders, government and
investors band together and get rid of it?

The cost of correcting earnings management far outweighs the benefit

Amounts of discretionary accruals are very difficult to determine.

It is difficult for outsiders to decipher legitimate business decisions from self motivated
business decisions. How can one know if an accounting policy changes resulted from
business necessity or opportunistic earnings management.

In some ways earnings management is efficient because it counteracts the blocked

communication problem. (p.367)

Stock Market Reaction to Earnings Management

Subramanyam found that the market responded positively to discretionary accruals that
appeared to come from responsible earnings management. However, his research is
subject to different interpretations since it is inconclusive as to whether the model
separates accruals into discretionary and non-discretionary components in the same way
that the market does.

Chapter 11 Quiz
1) What is earnings management?

Earnings management is the selection of accounting policies to achieve a specific

objective
2) In what 2 ways can earnings management be positive?

Earnings management can be a vehicle for communicating inside information to investors

and it gives managers the flexibility to protect themselves and the firm in the face of
unexpected events.
3) How can earnings management be negative?

It can reduce the reliability of the financial statements by distorting the true earnings of the
firm.
4) What is the iron law of earnings management? What implication does it have for the

earnings manager?
All accruals eventually reverse themselves is the iron law. The implication is that
earnings management cannot indefinitely postpone the day of reckoning. Just as
earnings were high due to the accruals they will be pushed downward as the accruals
reverse.
5) Why do some firms forego tax savings in favour of higher reported earnings under

FIFO?
Because their bonuses are tied to profits and they may get more utility from a higher
bonus or a reduced probability of debt covenant violation than they do from reduced taxes.
6) Earnings management is not illegal and its not immoral as it complies with GAAP so

what if any is the problem with earnings management?

The financial statements are not transparent and not reliable.
Discussion Questions
7) Read the attached article on GE.

GE has reported 101 quarters of consecutive

revenue growth. Is the author correct in saying we have been lied to? Would you
recommend GE stock to someone? Why or why not?

8) Should firms be required to show EBS? Earnings before Smoothing?