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Earnings management

Relates to positive accounting -> Theories of financial accounting.

About earnings

Earnings are sometimes called the bottom line or net income (Rankin et al, 2012). Earnings indicate the extent to which an entity has engaged in activities that add value to it. The theoretical value of an entity's stock is the present value of its future earnings. As such earnings are used by shareholders to assess the performance of the entity's managers. It also assists in predicting future cash flows and risks.

Francis, Schipper and Vincent found that earnings are more closely associates with stock prices then any other financial statement data. As such, earnings are closely monitored by financial analysts and investors. Customers may use earnings to evaluate whether products and services will be supplied in the future.

What is earnings management

Giroux (2004) describes earnings management in its neutral form as:

operating and discretionary accounting methods to adjust earnings to a desired outcome.

This is a broad statement that covers the conservative and fraudulent use of earnings management. Most problems around earnings management are focussed on aggressive accounting and fraud. Where the deliberate misstatement of financial information for the personal benefit of the managers.

Schipper defines earnings management as a:

purposeful intervention in the external financial reporting proces with the intent of obtaining some private gain

This matches the aggressive accounting and fraud view of Giroux. It shows that earnings management is not free of controverse. Counter views exist as well. McKee sees earnings management as:

reasonable and legal management decision making and reporting to achieve predictable and stable financial results

This view fits the conservative viewpoint of Giroux.

Why earnings management

Earnings management typically concerns relative timing differences. Capitalising on costs to avoid certain expenses or revenues can be increased due to aggressive revenue recognition. Ultimately all these techniques are used to influence the quarter results. These influences are necessary to better match the expectation of analysts or to reach the terms of short-term bonuses of the managers.

As such earnings management typically is in the best interest of the manager and not that of the shareholders and their long-term interest.

Methods of earnings management

  • accounting policy choice

    • Accounting choices are made within the framework or applicable accounting standards.
    • Earnings can be influenced by the choice of measurements as Measurements can be approached subjectively.
    • Extending the useful life of a non-current asset or changing the remaining value can be ways to influence the earnings
    • If the result is a material change, auditors will require a justification
  • accrual accounting

    • This method prefers to record revenue or expenses when the transaction occurs, rather then when payment is made or received
    • typically these methods have no direct cash flow consequences
    • it can include:
      • under-provisioning for bad debts expenses,
      • delaying asset impairments
      • adjusting inventory valuations
    • DeAngelo provided a model to determine earnings management
      • First, compare the accruals component of earsnings in one year to accruals the previous year.
        • $$AC{t}= NPAT{t} - CFO_{t}$$
        • $AC{t}$ = the accruals component of earnings in year _t;
        • $NPAT{t}$ = net operating profit after interest and tax in year _t;
        • $CFO{t}$ = cash flows from operations in year _t.
      • Next, calculate the delta by subtracting the previous year to year t (the current year)
        • $$\Delta AC{t} = AC{t} - AC_{t-1}$$
  • income smoothing

    • Smoothing moderates year-to-year fluctuations in income by shifting earnings from peak years to less successful periods.
    • This can be done via:
      • early recognition of sales revenues
      • variations to bad debts
      • delaying asset impairments
  • Real activities management

    • Manage earnings by managing operational decisions.
    • For example via:
      • Accelerating sales
      • Offering price discounts
      • Altering shipment schedules
      • Reducing discretionary expenditures
    • This method of influencing can have an effect on cash flows. In negative consequence this might lead to a reduction of entity value.
  • Generally accepted accounting principles

  • "Big bath" write-offs

    • Regards large loss reports due to restructures. For example selling subsidiaries or operational units.
    • Can be used when there is a change in management team and write-offs need to be blamed on the outgoing managers.
    • Could be applied when:
      • restructuring of operations
      • troubled debt restructuring
      • asset impairment

Corporate governance and earnings management

The composition of the board highly influences how likely it is that managers are able manipulate or manage earnings. A board made up of internal members is less likely to question a CEO that might want to use aggressive earnings management techniques. This relates to the body of knowledge in described in Governance. Research has shown that earnings management is found more often in organisations where the number of independent members is low.

A way to mitigate this is a) by adding more independent members, but also b) introduce specialist committees. It has been found that an audit committee reduces the practice of aggressive earnings management. Audit committees play an important ole in ensuring financial reports are credible. They control the extent of earnings management.

Academics and earnings management

Academics tend to search for general statements about earnings management. As such, they research large samples, using statistical definitions of earnings management. This often does not align well with practitioners and professionals that review earnings management on case-by-case basis. The particular examples that have been examined by academics have not proven any value to practitioners.

McNichols (2000) identified three type of models:

  1. aggregate accrual models
  2. specific accrual models
  3. frequency distribution models
Earnings management