Chapter 9Earnings 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 EARNINGS MANAGEMENT?

• McKee: ‘reasonable and legal management decision making and reporting intended to achieve stable and predictable financial results’

WHAT IS EARNINGS MANAGEMENT?

• 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 Compensationand 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.

Managerial Compensation

• 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)

Managerial Compensation

• 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 ANDEARNINGS 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.

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