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)
Earnings Management as a Tool for conveying Information to Investors
Investors tend to seek information about a firm that helps to predict future
firm performance. If reported earnings are managed to a number that represents
managements best estimate of persistent earning power, and the market
realizes this, share price will quickly reflect this inside information.
The major patterns of earnings management include taking a bath, income
minimization, income maximization, and income smoothing. It is important to
note that managers can be motivated by a variety of earnings management
patterns but that these patterns may often come into conflict. For instance, a
firm may wish to smooth income for borrowing purposes but at the same time
reduce income for political rationales.
Is Earnings Management Good or Bad?
Earnings management is bad", in the sense that it reduces the reliability
of financial statement information. Managers tweak reported earnings for
reasons that are not obvious. There is, however, a dependence on earnings
management to translate inside information into public information, as the costs
of uncovering inside information are often very high.
Earnings management does have a good side, fortunately. This relates to
efficient contracting. When a contract imposes strict or incomplete terms on a
manger, earnings management can provide an option of flexibility, so long as it
excludes a managers opportunistic (self-interested) motivations.
Additionally, earnings management can serve as a way to unblock
communication to outsiders. Blocked communication exists when it is very
difficult and costly to translate a mangers skilful expertise about a firm to the
board of directors and/or investors. By using the financial statements to
communicate the financial health of the firm, earnings management can be used
to inform outsiders of managements inside information as per their exercised
expertise.

Good Side of Earnings Management

Contract-based arguments(Scot 2009)
1.
Earnings management gives firm some flexibility in the face of rigid,
incomplete contracts.
2.
Contract violation is costly, earnings management may be low-cost way to
work around.
Investor-based arguments(Scot 2009)

To communicate inside information to investors

1.
Blocked communication may inhibit direct disclosure of earnings
expectations.
2.
Discretionary accrual management as a way to credibly reveal
managements inside information about earnings expectations.
3.

Manager foolish to report more earnings than can be maintained.

4.

Manage reported earnings to an amount management expects will persist.

The Bad Side of Earnings Manegement

Financial Reporting Perspective(Hanna 1999)

1.
Investors and analysts look to core earnings, ignoring extraordinary and
non-recurring items.
2.
Implies manager not penalized for non-core charges, such as writedowns,
provisions for restructuring.
3.
But current non-core charges increase core earnings in future years,
through lower amortization and absorption of future costs.

Recommendation

To the Auditing Standards Board:

I.
It is recommended that the ASB develop stronger and more decisive
auditing standards to effect a considerable change in auditors performance and
improve the possibility that auditors will detect fraudulent financial reporting.
II.
Discussion by supervisory engagement personnel (including the auditor
with final authority, usually the engagement partner) with other engagement
team members about the vulnerability of the entity to fraud. This discussion
should cover what is expected of team members in dealing with a potential for
fraud in the specific areas of the audit assigned to them. An important objective
of these discussions would be to identify the appropriate engagement team
members to address the potential for fraud (e.g., the engagement team
members who should interview company personnel) and how their work is to be
supervised and reviewed.

To audit firms:
It is recommended that audit firms:
I.
Begin working immediately with the notions in the recommendations to
the ASB to increase the auditors ability to identify and detect financial
statement fraud. The results of those attempts should be shared with the ASB for
consideration in developing its standards, with the purpose of speeding the
standard-setting process up.
II.
Develop or expand training programs for auditors at all levels oriented
toward responsibilities and procedures for fraud detection. These programs
should emphasize interviewing skills and the exercise of professional skepticism,
as well as testing techniques. They also should emphasize (especially to staff
and in-charge personnel) that misappropriation of assets is a significant risk and
that being alert to its possibility at any level in an entity is necessary. Training
programs should include case examples of how defalcations might be effected,
the types of controls over the safeguarding of assets that are effective in
preventing and detecting defalcations, and how defalcations are concealed.
Special emphasis should be given to how information technology might be used
to misappropriate assets and disguise the results.

To audit committees:
It is recomended that audit committees:
I.
Request management to report on the control environment within the
entity and how that environment and the entitys policies and procedures
(including managements monitoring activities) serve to prevent and detect
financial statement fraud. Such reporting should acknowledge, in explicit terms,
that fraud prevention and detection are primarily the responsibility of

management. It also should help audit committees assess the strength of

managements commitment to a culture of intolerance for improper conduct.
Furthermore, audit committees should seek the views of auditors on their
assessment of the risks of financial statement fraud and their understanding of
the controls designed to mitigate such risks.
II.
Accept responsibility for confirm that the auditors receive the necessary
cooperation from management to carry out their duties in accordance with the
strengthened auditing standards to be developed by the ASB.
And the last one is to "make sure investors' expectations are based on
reasonable assumptions. If they are not, you need to do a better job of
communicating the underlying realities of your business. If their expectations are
reasonable and you miss the target, that's just a fact of life that you have to
explain and you should have to explain it, not cover it over."
Conclusion
In the literature review we had many definitions of earnings management.
Generally, it can be defined as misrepresentation of finanacial reports in order to
either mislead shareholders or affect contractual outcomes depended on reports.
Moreover, motives for managers to manage earnings were mentioned in this
paper like explicit contract such as bonus plans, and debt covenants, implicit
contract, capital markets and need for external financing, the political and
regulatory process, and some specific circumstances such as earnings decreases
or losses. Earnings management is a managers choice of accounting policies
that achieves some specific objective. Even under GAAP, managers still retain
some flexibility in accounting policy selection that may be able to positively
impact their personal satisfaction and/or the market value of their firm.

Is Earnings Management Good or Bad?

Earnings management is bad", in the sense that it reduces the reliability of
financial statement reports. Managers change reported earnings for reasons that
are not clear. Howeves, there is a dependence on earnings management to
translate inside information into public information, as the costs of uncovering
inside information are often very high.
Earnings management does have a good side, fortunately. This relates to
efficient contracting. When a contract imposes strict or incomplete terms on a
manger, earnings management can provide an option of flexibility, so long as it
excludes a managers opportunistic (self-interested) motivations.
Additionally, earnings management can serve as a way to unblock
communication to outsiders. Blocked communication exists when it is very
difficult and costly to translate a mangers skilful expertise about a firm to the
board of directors and/or investors. By using the financial statements to
communicate the financial health of the firm, earnings management can be used

to inform outsiders of managements inside information as per their exercised

expertise. Earnings management that makes the company look better than it
really is may result in disappointing for the single investor and potentially leads
to a welfare loss in society when the resource allocation is distorted. A more
specific knowledge of occurrence of earnings management supposedly increases
the awareness of the investor and thus leads to better investments and
increased welfare. Therefore, earnings management can entail both bad and
good consequences for both external and internal side of a company depending
on how they use and implement it.

is the process where publicly traded corporations write-off or

write-down certain assets from their balance sheets in a single year. The write-off
will
help removes or reduces the asset from the financial books and results in lower
net
income for that year.