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Instructors ManualChapter 11

CHAPTER 11
Earnings Management
11.1

Overview

11.2

Patterns of Earnings Management

11.3

Evidence of Earnings Management for Bonus Purposes

11.4

Other Motivations for Earnings Management


11.4.1 Other Contracting Motivations
11.4.2 To Meet Investors Earnings Expectations and Maintain Reputation
11.4.3 Initial Public Offerings

11.5

The Good Side of Earnings Management


11.5.1 Blocked Communication
11.5.2 Theory and Empirical Evidence of Good Earnings Management

11.6

The Bad Side of Earnings Management


11.6.1 Opportunistic Earnings Management
11.6.2 Do Managers Accept Securities Market Efficiency?
11.6.3 Implications for Accountants

11.7

Conclusions on Earnings Management

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LEARNING OBJECTIVES AND SUGGESTED TEACHING APPROACHES


1.

To Outline Reasons for Earnings Management

I recommend introducing students to the topic of earnings management by discussing


Healys seminal 1985 bonus plan paper. Healys evidence that bonus plans motivate
earnings management helps students to take contracting theory seriously. It opens up a
whole new set of considerations in accounting policy choice beyond the disclosure of useful
information to investors.
While it is somewhat cynical, I sometimes ask the question whether management would
admit to the behaviour documented by Healy, and whether the auditor would assist or
oppose the manager in this type of earnings management. For those interested in research
methodology, Healys paper can be used to point out the desirability in accounting research
areas such as this of using empirical analysis of hard data, with good experimental design
and statistical analysis, in order to more fully understand managements accounting policy
choices.
Having said this, it is important that the Healy results not be oversold, since Healy faced
substantial methodological problems, particularly with respect to separating discretionary and
non-discretionary accruals. The text contains discussions of some of these problems, and the
results of some subsequent papers, in Section 11.3. The Jones (1991) methodology which,
with some variants, is still the state of the art in this area is reviewed in Section 8.5.3. I do not
spend much class time on these methodological issues, other than a brief review of the
Holthausen, Larcker and Sloan (1995) paper. This paper, with better data and different
methodology, supports Healys results for firms with above-cap earnings, even though
Healys below-bogey results seem to disappear in their study.
Since it now appears that meeting earnings expectations drove at least some of the financial
reporting scandals of the early 2000s, such as WorldCom, I also suggest class discussion of
the material in Section 11.4.2. This sets up the point that earnings management relates to
reporting to investors as well as contracting.

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2.

To Appreciate the Good Side of Earnings Management

I begin by asking if the earnings management behaviour documented by Healy is good or


bad. I usually take the role of arguing it is good, from an efficient contracting perspective.
This argument assumes, however, that the earnings management was anticipated by the
principal when the bonus contract was being negotiated, so that it is allowed for in setting the
bonus rate.
While most people probably view earnings management with suspicion, I suggest 2 good
sides. One, as just mentioned, is to lower contracting costs in the face of rigid and incomplete
contracts.
A second, and more controversial, side is that earnings management can reveal inside
information to investors. A provocative discussion question here is to ask if earnings
management can be thought of as an extension of the accrual process. That is, if accruals
smooth out lumpy cash flows to produce a more useful measure of quarterly and annual
performance, why cant earnings management be used to smooth out annual accrual-based
earnings to produce a more useful multi-year measure of persistent earning power? Such a
measure may help investors better predict future firm performance, which is a major goal of
financial reporting.
To pursue the argument that earnings management as a vehicle to release inside information
can be good, the case of General Electric Co. (Problem 9 of this chapter) works well to get
the point across. The steady increase in GEs reported earnings over the years is quite
impressive. I point out the complexity of GE to the point where even financial analysts have
difficulty in understanding the whole company. As a result, it is very difficult to estimate GEs
persistent earning power. I also point out that a simple announcement by GE of its persistent
future earnings is blocked. Such an announcement lacks credibility since, for such a
complex company, the market has little ability to verify it. This sets up the role of good
earnings management as a credible way to reveal this information. An argument that GE
does engage in earnings management for this purpose is supported by both the variety of
earnings management devices available to it and the steadily increasing pattern of its
earnings over time.

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It is interesting to note that GEs earnings management came under suspicion in the market
in the early 2000s, due to the severe apprehension of post-Enron investors about earnings
management in general. According to an article General Electric: Big game hunting in The
Economist (March 14, 2002) investors may have interpreted GEs increased reported
earnings for 2001 as evidence of bad earnings management, since poor economic conditions
during 2001 suggest that earnings should have declined. In addition, GE appointed a new
CEO in late 2001. The Economist suggests that the market may have less trust in the new
CEO than in Jack Welch, the highly regarded former CEO, simply because he is less of a
known quantity. As a result, the market may have felt that there is a higher likelihood that GE
will use its considerable potential for earnings management for bad purposes rather than
good.
GEs response to these market concerns is worth noting. It started to release considerably
more information. Further discussion of how GE worked to overcome investor scepticism is
given in Problem 21 of Chapter 12.
Theoretical and empirical evidence in favour of good earnings management is given in
Section 11.5.2, which I have marked as optional reading for those that wish to pursue good
earnings management in greater depth. Suffice it to say that there is considerable evidence
in this regard.
3.

To Appreciate the Bad Side of Earnings Management

Despite the above arguments, most people would likely regard earnings management with
suspicion, reinforced by revelation of serious abuses of earnings management by Enron and
WorldCom and numerous other corporations in the early 2000s. Consequently, students
should not be left with the impression that it is necessarily good. A useful place to start is
Hannas 1999 article in CA Magazine, which is well worth assigning and discussing. The
important point to get across from this article is that management is tempted to provide
excessive unusual, non-recurring and extraordinary charges, to put future earnings in the
bank. Furthermore, these future earnings are buried in operations. This makes it difficult for
investors to diagnose the reasons for subsequent earnings increases. Nortel Networks
reversals of its excess accruals (see Theory in Practice vignette11.1 in Section 11.6.1)
provide a vivid example of Hannas argument. Also, the effect on future profits of putting
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earnings in the bank has been recognized by an article in The Economist (A world awash
with profits, Business is booming almost everywhere, February 18, 2005, pp. 62-63). This
article states that one reason for the dramatic increase in firm profits during 2002-2004 is that
they are an accounting fiction, which apparently means that they are a consequence of
earlier writeoffs.
I find that to drive home these various considerations, an example of how earnings
management can go too far is instructive. An excellent case in point is the downfall of
Chainsaw Al Dunlap at Sunbeam Corp. Jonathan Laings 1998 article in Forbes is
reproduced in Question 10. Laing demonstrates that Sunbeams 1997 reported earnings
were almost completely manufactured by means of discretionary accruals. The substantial
first quarter, 1998, loss reported by Sunbeam supports Laings analysis, and the iron law of
accrual reversal.
I think that Laings analysis of the effects of the $17.2 million drop in Sunbeams prepaid
expenses for 1997 is backwardssee part a of Question 10. If I am not correct in this,
presumably other instructors will let me know. However, even taking this error into account
does not substantially alter Laings conclusion that 1997 earnings were manufactured.
4.

Do Managers Accept Securities Market Efficiency?

Evidence of good earnings management is consistent with managers beliefs that markets
are reasonably efficient. Why use earnings management to reveal inside information if the
market cannot interpret it? However, evidence of bad earnings management may or may not
be consistent with efficiency.
On the one hand, managers may feel that they can fool the market by managing their
earnings, which seems to have been the case with Sunbeam management. Emphasizing proforma earnings (Section 7.4.2) is another tactic that seems inconsistent with acceptance of
efficiency. It is hard to believe that managers would continue to attempt to manipulate
investors beliefs if an efficient market immediately detected and penalized such behaviour.
On the other hand, bad earnings management may hide behind poor disclosure. If the market
is not aware that reported earnings are being managed, it can hardly be concluded that the
market is inefficient. Rather, the question is whether the market will react once it
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suspects or becomes aware of the earnings management. The markets negative reaction to
the frequency of non-recurring charges as an indicator of possible earnings management, as
documented by Elliott and Hanna (1996) (see Section 5.5) suggests considerable efficiency,
for example. Also, the markets post-Enron suspicion of GEs earnings management,
discussed above, is also consistent with efficiency.
The text concludes that at least some managers do not accept market efficiency. However, it
also concludes that markets are sufficiently close to full efficiency that improved disclosure
will reduce bad earnings management.
5.

To Summarize the Strategic Aspects of Accounting Policy Choice

I end my discussion of earnings management with two main points:


(i)

I emphasize the concept of strategic accounting policy choice, whereby

managers choose accounting policies to achieve certain objectives. These objectives


may include efficient contracting, such as avoiding excess earnings volatility for
compensation and debt covenant reasons, which may conflict with accounting policies
that are most useful to investors. This greatly expands the role of financial reporting,
since we now formally recognize two main roles of financial reporting reporting to
investors and reporting on manager performance. Both roles matter since the quality
of manager effort and the well-working of managerial labour markets is as important to
society as the quality of investor decisions and the well-working of securities markets.
The conflict between these two roles, I hope, validates to the class the time spent on
basic game and agency-theoretic concepts of conflict in Chapter 9.
(ii)

I emphasize that managers have a legitimate interest in accounting policy

choice, since their operating and financing policies, and even their livelihoods, are at
stake. This view is in contrast to many discussions of standard-setting where
management seems to be the bad guys, opposing every new standard that comes
along. The theory provides several legitimate reasons why managers will be
concerned about changes to GAAP.

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SUGGESTED SOLUTIONS TO QUESTIONS AND PROBLEMS


1.

Some reasons why a firms management might both believe in securities market
efficiency and engage in earnings management are:

Income taxation. The firm may be able to postpone payment of taxes if it


can minimize its reported income, for example by managing accruals, or
using LIFO (if allowed by the tax authority).

Managerial bonus plan. As Healy documents, managers have incentives to


maximize their bonuses, consistent with the bonus plan hypothesis of
positive accounting theory. Consequently, they may adopt accounting
policies to increase reported net income, or to reduce reported net income if
it is below the bogey or above the cap of the bonus plan.

Covenants in lending agreements. Managers may adopt policies to increase


reported net income, or other financial statement variables, to avoid
covenant violation or even to avoid being too close to violation. Lending
agreements may also induce income-smoothing behaviour. A smooth
sequence of reported net incomes will reduce the probability of covenant
violation.

A smooth earnings sequence may increase the willingness of lenders and


suppliers to grant short-term credit. This is particularly so if the firm has
implicit contracts with these stakeholders.

Political visibility. By reducing its reported net income the firm may forestall
government intervention which might ensue if the public felt the firm was
earning excessive profits. Question 10 of Chapter 8 illustrates this point.

Earnings management can be a credible way to communicate the firms


inside information about its longer-term expected profitability to the market.

Poor disclosure. The manager may feel he/she can manage earnings
opportunistically but hide behind poor disclosure to prevent the efficient
market from detecting it.
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2.

Taking a bath involves writing off assets against the current years operations and/or
providing currently for future costs. As a result, future years reported earnings are
relieved of amortization, and provisions for future costs can absorb items that would
otherwise be charged against current earnings.
Furthermore, if provisions for future costs are excessive, reversal of the excess will
increase current earnings.
Consequently, future years reported earnings will be higher (or losses lower) than
they would otherwise be, and the probability of the manager receiving a bonus
correspondingly increases.

3.

Next years earnings will be reduced by $1,300 due to the iron law of accruals
reversal. With respect to credit losses, there is a $500 lower cushion to absorb credit
losses in the following year. Consequently, next years credit losses expense will be
$500 higher, other things equal.
With respect to warranty costs, a similar argument applies. The lower the accrued
liability for these costs, the lower the cushion to absorb payments for warranty costs in
the following year. Consequently, next years warranty cost expense will be $800
higher, other things equal.

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4.

a.

You would react negatively to the extent that the charge to record the liabilities

reduced net income for bonus purposes. However, the Compensation Committee may
base the bonus on net income before deducting the charge, particularly if it was
accounted for as an extraordinary item. (See Question 13 of Chapter 10 re BCE Inc.
on this point. See also the evidence of Gaver and Gaver (1998) in Section 10.6, who
report that extraordinary gains tend to be included in the determination of cash
bonuses but not extraordinary losses.)
A counter argument is based on the evidence of Healy (1985). If your net income
before the charge is below the bogey or above the cap of your bonus plan, you may
prefer that the charge be included in net income for bonus purposes.
b.

You would react negatively. A reason is that the increased volatility would

increase the chance that reported net income would fall below the bogey or above the
cap of the bonus plan. If this happens, it would require you to either manipulate
accruals or forego your bonus.
c.

You would react negatively because your expected bonus would be lowered,

with no compensating decrease in bonus volatility.


d.

You would react negatively to a reduction in your ability to choose from different

accounting policies, because your freedom to manipulate discretionary accruals, such


as choice of inventory costing method, for bonus, debt covenant or political reasons
would be reduced.
Also, your ability to communicate inside information about long-term earning power to
the market would be reduced for the same reason. This could adversely affect cost of
capital, hence future earnings.

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5.

The following points should be made:

Generally speaking, fair value accounting for financial instruments


eliminates the ability to manage earnings through gains trading, since the
amounts and timing of the resulting unrealized gains and losses are no
longer under management control.

Some earnings management potential may exist under IAS 39 and SFAS
115 by transferring financial assets between categories, such as from
held-to-maturity to trading or available-for-sale. This triggers an
unrealized gain or loss on the transferred items. However, a sale or
transfer out of the held-to-maturity category is inconsistent with an intent
to hold securities in this category to maturity. Thus, these standards
contain provisions to severely limit such possibilities. For example, if
such a transfer is made, IAS 39 prevents use of the held-to-maturity
category for two years. This eliminates the ability to manage earnings on
future transfers of this nature.

However, under IAS 39 and SFAS 115, unrealized gains and losses on
available-for-sale securities are excluded from net income. Then, there
may be a potential for earnings management by actual sale of financial
instruments, since any realized gains and losses on these instruments
will then be transferred into net income.

Where market values for financial instruments are not available, some
ability to manage unrealized gains and losses remains, since fair values
will then have to be estimated. Management may influence unrealized
and realized earnings by managing the fair value estimates.

We may conclude that while managing earnings for bonus purposes will be reduced
under fair value accounting for financial instruments, some ability to manage earnings
remains.

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6.

a.

The various accruals for JSA Ltd. are as follows:


Add back to
net income
- Depreciation and amortization.

Deduct from
net income

$14

Mainly non-discretionary, since method


of amortization and useful lives fixed
by policy. However, manager has some
discretion to change policy on occasion.
- Reduction of liability for future income tax

$6

Non-discretionary, except to extent that


manager controls depreciation and
amortization policy.
- Provision for reorganization

12

Discretionary, since manager controls


amount and timing.
- Increase in accounts receivable

16

May be driven by increased level of


business activity. However, manager
has considerable discretion over allowance
for doubtful accounts and some discretion
over credit and collection policy.
- Decrease in inventories.

18

May be driven by lower level of business


activity, but seems unlikely since accounts
receivable have increased. Manager has
considerable discretion over valuation of
obsolete, used or damaged items. Also,
under lower of cost or market rule,
manager has discretion over amounts
of writedowns.
- Increase in prepaid expenses.

Considerable discretionary component


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since manager controls capitalization


policy for many of these.
- Decrease in accounts payable.

May be driven by lower level of business


activity. However, manager controls amounts
and timing of purchases and payment policy.
Also, considerable discretion to extent
accounts payable includes accrued liabilities.
- Increase in customer advances.

Largely non-discretionary, although


manager may influence number and
amounts of advances.
- Decrease in current portion of long term debt.

Non-discretionary, since fixed by contract.


-

Increase in current portion of future income


tax liability.

Non-discretionary, since income tax


act specifies.
$50

$31

31
Net income-decreasing accruals

$19

Check:
Net income

$(12)

Net income-decreasing accruals

19

Cash flow from operations

$7

Note: Students often deduct from net income a $1 accrual for the increase in deferred
development costs on the balance sheet. This throws them out of balance. There is
not enough information on the income statement to know if deferred development
costs are being amortized. It appears not. The most likely explanation for the increase

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in this item is that it results from a non-operating transaction, such as cash paid out for
some capitalized development cost.
b.

i)

Pick a specific account for which it is relatively easy to estimate the

discretionary component, such as net accounts receivable. Here, based on past


collection and bad debts history, it is relatively easy to determine what the balance of
the allowance for doubtful accounts should be. The discretionary accrual is then the
difference between what the balance should be and the actual balance.
ii)

Use the Jones model, which is a regression equation to estimate non-

discretionary accruals after allowing for the levels of business activity and capital
investment. Discretionary accruals are then taken as the difference between this
estimate and total accruals.
c.

The manager may take a bath, by writing off investments in capital assets and

setting up provisions for future costs such as reorganization and layoffs. This will
reduce reported net income this year, but the probability of high net income in future
years is increased, since future amortization charges will be lower and future costs
can be charged against the provisions rather than against net income. Furthermore, if
the provisions turn out to be higher than actually needed, the excess amounts can be
reversed into future years operations.
Alternatively, the manager may income maximize, so as to increase net income above
the bogey. However, this tactic is unlikely to be used unless pre-bonus earnings are
only slightly below the bogey.
Obviously, the most suitable accruals are those with the greatest discretion, and
relative invisibility. These include maximization of prepaid expenses, and minimization
of the allowance for doubtful accounts and accrued liabilities. Changes in amortization
policy and useful life estimates of capital assets are possibilities. However, they are
quite visible and could not be used very often.

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7.

a.

Reasons to resort to extreme earnings management tactics:

To meet analysts forecasts. As stated in the question, this was the apparent
reason in BMS case.

Contractual reasons. To increase bonuses and/or to avoid debt covenant


violations.

Implicit contracts. To increase earnings so as to receive better terms from


suppliers. In BMS case, this seems unlikely since wholesalers were pressed
to accept excess inventory.

IPO. The firm may have wanted to increase and/or smooth earnings so as to
increase proceeds from a planned IPO.

b.

From the standpoint of a single year, stuffing the channels seems effective.

This is because it is hard to detect.


Such behaviour may possibly be detected through full disclosure, such as sales by
product, segment, or region. Then, careful analysis may reveal unusual sales patterns.
However, the company has little motivation to provide full disclosure unless required
by GAAP and/or insisted upon by the auditor.
Wholesalers may object if too much inventory is forced upon them. Since wholesalers
are not formally BMS employees, it may be more difficult to keep them from
complaining to regulators or the media. However, in BMS case, paying their carrying
charges may have been a device to avoid such complaints.
Over a series of years, stuffing the channels is likely to be less effective, for the
following reasons:

Accruals reverse. Product stuffed into the channels this year will reduce
sales next year. Ever more stuffing is needed if the strategy is to be
maintained.

Physical limitations. There may be limits on wholesalers storage space.

Cost. It seems that paying the wholesalers carrying costs for their
excess inventory became quite costly for BMS.
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We conclude that while stuffing the channels may be reasonably effective in the short
run, it loses effectiveness to the extent it is used over multiple periods.
c.

Cookie jar accounting seems reasonably effective as an earnings management


device since it can be hard to detect. The firm has some flexibility about the

extent of disclosure of gains and losses from asset disposals (see discussion re
unusual, non-recurring, and extraordinary items in Section 5.5.). Furthermore,
overprovision for losses puts future earnings (i.e., cookies) in the bank (jar), and GAAP
does not require separate disclosure of the effect on operating earnings when these
accruals reverse.
Full disclosure of unusual, non-recurring, and extraordinary items may tip off an
efficient market as to the possibility of cookie jar accounting. This effect was
documented by Elliott and Hanna (1996)see Sections 5.5 and 11.6.1. While even an
efficient market will not really know the actual extent of such accounting without full
disclosure, suspicions may lead to SEC investigation. This seems to have happened to
BMS.
Effectiveness of cookie jar accounting can be increased if it is used responsibly to
reveal managements estimate of persistent earning power (i.e., good earnings
management). It seems unlikely that BMS was using it in this manner, however.
We conclude that while cookie jar accounting can be reasonably effective, and has the
potential to be good, its continuing and excessive misuse may lead to its discovery
and subsequent penalties.
BMS appears to have been using cookie jar accounting to smooth reported earnings.

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8.

a.

In the short-run, capitalizing expenses to manage earnings is of moderate

effectiveness. On the one hand, the reduction in current reported expenses is


considerably greater than the increase in amortization, so that there is scope for a
considerable increase in reported profits. Furthermore, capitalizing expenses does not
reduce current operating cash flows (since they are included in the investing, not the
operating, section of the funds statement). As a result, techniques that attempt to
identify earnings management by estimating discretionary accruals, such as the Jones
model, will not work.
On the other hand, effectiveness is reduced because capitalization of expenses is
contrary to GAAP. As a result, unless the capitalizations can be concealed from the
auditor, they will have to be reversed or the firm will receive a qualified audit report.
The ability to conceal becomes more difficult the larger the amounts capitalized.
In the longer run, the scope for increasing reported profits and the lack of effect on
operating cash flows continues. However, as amounts capitalized continue to
accumulate, it becomes more likely that this earnings management will be discovered.
We conclude that effectiveness is only moderate in the short run and declines over
time.
b.

The importance of meeting earnings targets derives from securities market

efficiency and rational investor behaviour. A firms share price will incorporate the
markets expectations of future firm performance. Earnings targets, for example those
laid down by management forecasts and/ or by analysts, are an important indicator of
future performance. If these targets are not met, investors expectations of future firm
performance will fall and share price will quickly fall with them. This is likely to be the
case even if earnings are just short of target, since the market will suspect that if the
firm could not manage earnings upwards by a small additional amount, its future must
be bleak and/or management is unable to predict the firms future operations.
As a result, managers compensations, including the value of share holdings, ESOs,
and other share price-based compensation will fall. The managers reputation, tenure,
and the firms cost of capital will all be negatively affected.
To avoid these consequences, managers strive to meet earnings targets.
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c.

Large public companies may discontinue earnings forecasts to avoid the

negative consequences of failing to meet them. Forecasts provide an incentive for the
manager to exert effort to attain them. However, if it appears the forecast will not be
met in the normal course of business, the manager may attempt to meet them through
dysfunctional behaviour such as bad earnings management, excessive cost-cutting,
and/or deferral of maintenance. In effect, meeting forecasts encourages short-run
behaviour at the expense of longer-term firm interests.

9.

a.

Restructuring charges are an effective earnings management device. They are

an unusual and non-recurring item, hence of low persistence. As a result, they may be
ignored by investors in evaluating operating earnings, and by compensation
committees for bonus purposes.
However, the reasonableness of the amount of the restructuring charge is difficult for
investors and compensation committees to evaluate. Consequently, as Hanna (1999)
argues, management may overstate the amount, thereby putting earnings in the bank.
These future earnings increases are also difficult to detect, since they become buried
in lower amortization and/or used to absorb costs that would otherwise be charged to
future earnings. Thus management can have it both wayslittle penalty when the
charge is reported, and reward for increased future operating earnings. In effect,
Hannas argument is that restructuring charges are too effective an earnings
management device since they create temptations for opportunistic manager
behaviour.
With respect to GE, it seems that restructuring charges are used in conjunction with
other earnings management devices to manage current reported earnings. GEs goal
seems to be to report steadily increasing earnings. This goal rules out reporting huge
increases in earnings currently, such as earnings from large extraordinary gains, since
it may be hard to top these earnings in future years. Then, restructuring charges serve
a role of reducing current reported earnings to a desired level. Given the variety of
other earnings management devices at its disposal, it seems unnecessary for GE to
overstate restructuring charges. If it did, it is unlikely that it could sustain the pattern of
steadily increasing earnings it has reported. Overall, GEs use of restructuring charges
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seems quite effective as part of an overall earnings management strategy that avoids
reporting large, unsustainable earnings increases.
b.

It seems unlikely that GEs share price always fully reflects all publicly available

information. Costs of fully analyzing all information, and idiosyncratic risk, contribute to
lack of full market efficiency. In GEs case, costs of analysis are particularly high, since
the firms complexity makes it difficult even for analysts to fully interpret GE. Also,
investors who wish to eliminate idiosyncratic risk would find it difficult to find similar
firms to invest in. Thus, any anomalies and resultant mispricing of GE shares are likely
to persist.
However, any mispricing will be reduced, if not eliminated, if GEs management uses
earnings management responsibly to reveal its expected persistent earning power,
since share prices are based to a considerable extent on expected future earnings. If
managements inside information about expected earning power is accurate, GEs
share price should trade at a price similar to its price if the market had fully digested all
publicly available information.
c.

The answer follows from part b. It seems that GE is using earnings

management responsibly to convey inside information about expected earning power.


This stands in for the difficulty analysts and investors face in fully evaluating all
available information themselves. As a result, GEs share price should reasonably
reflect its future performance. We conclude that, in this case, GEs earnings
management is good.
Note: This is an excellent article for class discussion. I begin by discussing the
various earnings management devices that the question refers to, each of which can
be discussed as to its effectiveness. The important point to bring out, however, is that
GE apparently uses these devices in concert, as part of a strategy to generate a
smooth, growing earnings series.
It is also worth reminding the class that the accrual basis of accounting involves
smoothing of annual or quarterly cash flows. Indeed, this is the reason the FASB gives
in SFAC 1 for favouring accrual accounting over cash flow accounting as an indicator
of an enterprises present and continuing ability to generate favorable cash flows....
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See Question 7 of Chapter 3. I then suggest that GEs use of earnings management is
a multi-period version of the same argument.
I also ask the class whether they would go along with GEs use of earnings
management if they were its auditor. Usually, the answer is yes, since nothing GE
does seems inconsistent with GAAP. Then, I point out that, in effect, management can
drive a truck through GAAP, and ask what prevents a firm from reporting just about
any net income it wants. The answer is very importantaccruals reverse. This is what
puts discipline on the earnings management process, and is food for thought for any
budding accountant/auditor/manager. This point is illustrated with a vengeance in
Question 10 re Sunbeam Corp.
Instructors may wish to follow up on GE subsequent to the Enron collapse. GEs
impressive earnings sequence continuing to at least 2006 tends to validate its preEnron earnings management activities. That is, if GE had been excessively pumping
up its reported earnings pre-Enron, it could hardly have continued to report earnings
increases in subsequent yearsthe iron law would have caught up with it sooner or
later.
The decline in investor confidence in financial reporting following Enron led to severe
share price declines for many firms for which there was even a faint suspicion of
reporting irregularities and lack of transparency. As a well-known practitioner of
earnings management, GE was no exception. GEs response is interesting. One
response was to greatly increase its disclosure, including for its GE Capital subsidiary.
See the discussion in point 3 of the Learning Objectives and Suggested Teaching
Approaches above, including problem 21 of Chapter 12. Also, according to an article in
The Globe and Mail by Elizabeth Church (April 1, 2002, p. B6), GE expanded the
number of pages in its 2001 annual report by 30%. See also, GE changing its reports
to provide more details, in The Globe and Mail, February 20, 2002, p. B11 (reprinted
from The Wall Street Journal). The Globe also reported on GEs 1st quarter, 2002
results (GE reports profit up, revenue flat, by Stephen Singer, April 12, 2002, p.B6).
GEs reported net income for the quarter was $3.5 billion (before accounting changes),
compared to $2.57 billion for the same quarter of 2001. However, its revenues were
almost the same as for the 1st quarter, 2001. Its share price fell by 9% on the day it
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released its results. Obviously, the market is suspicious about how its quarterly
earnings increased when revenues were flat.
Another GE response was to amend its manager compensation plan, to reduce the
use of ESOs. See Problem 10 of Chapter 10 for an account of restricted stock units
awarded to its CEO in 2003, in place of ESOs. See also a reference to its policy of not
repricing ESOs in Problem 14.c of Chapter 10.
10.

a.

Laing reports a $23.2 million dollar drop in prepaid expenses in 1997. The

offsetting debit in 1997 was, presumably, to expense (Dr. Expense $23.2, Cr. Prepaid
Expense $23.2). If so, the drop in prepaid expenses has decreased 1997 net income,
not increased it as Laing asserts.
Laing notes that 1996 was a lost year anyway, so the company prepaid everything it
could. He seems to imply that prepaying everything served to decrease 1996 net
income, which, of course, is incorrect since prepaid expenses are assets. He then
states that costs for 1997 were reduced markedly. In fact, 1997 costs would be
increased, as the 1996 prepaid expense accruals were used up in 1997.
Note: An alternative interpretation of what Laing meant is that the company prepaid
everything it could in 1996 but charged the prepayments to expense in 1996. This
would have the effect of decreasing 1996 earnings and increasing those of 1997, as
he asserts. But, if this is what Sunbeam did, the decline in prepaid expense from 1996
to 1997 does not measure the amount by which earnings were affected.

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b.

List of impacts on 1997 net income of the various earnings management

devices described in article. Amounts are estimated net of tax:


Effect on 1997 Net Income
($ million)
(Net of tax)
Increase

Decrease

Inventory written down to zero


in 1996, sold at 50 on the
dollar in 1997

$36.5

Decline in prepaid expense


from $40.4 in 1996 to $ 17.2
in 1997

$15

Decrease in other current


liabilities ($18.1) and other
long-term liabilities ($19),
attributed mainly to reduction in
product warranty provisions

$25

Reduction in 1997 amortization,


due to 1996 writedown of
property, plant and equipment,
and trademarks

$6

Capitalization of product
development, advertising, etc.
into property, plant and
equipment in 1997

$10

Decrease in allowance for


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doubtful accounts from $23.4


to $8.4 during 1997

$10

Manufacturing for stock in 1997,


evidenced by 40% increase in
inventories

$10

Early buy and bill and hold


sales of $50

$8

$105.5
Less total of Decrease column
Net discretionary accruals

___

$15

15
$90.5

Total accruals can be determined as the difference between net income and
operating cash flow:
$109.4 - (-$8.2) = $117.6
We may conclude that $90.5 million of the total accruals of $117.6 million were
discretionary, income-increasing. It thus appears on the basis of Laings analysis that
Sunbeams 1997 reported earnings were largely manufactured.
c.

The article implies that the restructuring charges of $390 million were

excessive. This puts earnings in the bank, which can be drawn down in future years
through reduced amortization and charging of operating costs to the restructuring
reserves.
d.

Sunbeams reported first quarter, 1998 earnings were a loss of $44.6 million,

compared with a profit of $6.9 million for the first quarter of 1997.
Sales were reported as $244.5 million, a decrease of $9 million from the first quarter of
1997. While a decline in actual sales may be at least partly responsible for the first
quarter loss, the reported sales would have been pulled down by the reversal of the

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$50 million of early buy sales accruals recorded in 1997. It appears that the efforts to
pump up first quarter sales (additional buy now, pay later sales, extending quarter
by 3 days) fell short of overcoming the reversal of the sales prematurely recorded in
1997.
With respect to expenses, some of the expense reductions, such as amortization,
noted for 1997 would continue in 1998. However, many others would reverse, such as
warranty expense, allowance for doubtful accounts, and manufacturing for stock
(which would lower 1998 production, hence the amounts of absorbed overhead).
In sum, the early recording of sales in 1997, together with the reversal of discretionary,
income-increasing 1997 accruals, seems to have come home to roost in 1998,
consistent with the iron law of accruals reversal.
Note: Subsequent articles relating to Sunbeams accounting problems include:

Troubled Sunbeam ousts CEO Al Dunlap, The Globe and Mail, June
15, 1998, p. B6 (reprinted from The Wall Street Journal).

Teary-eyed Chainsaw Al defends record at Sunbeam, The Globe and


Mail, July 10, 1998, p. B8 (reprinted from The Wall Street Journal).

Sunbeam audit finds mirage, no turnaround, The Globe and Mail,


October 20, 1998, p. B15 (reprinted from The Wall Street Journal).

Despite Recovery Efforts, Sunbeam Files for Chapter 11, The Wall
Street Journal, February 7, 2001.

S.E.C. Accuses Former Sunbeam Official of Fraud, The Wall Street


Journal, May 16, 2001. Arthur Andersen partner Philip E. Harlow was
also charged.

Sunbeams ex-CEO settles SEC probe, The Globe and Mail,


September 5, 2002, p. B6. The article reports that Mr. Dunlap will pay
$500,000 (U.S.) to settle charges he used inappropriate accounting

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techniques that hid Sunbeams financial problems. Former CFO Russell


Kersh will pay $200,000. Both men were barred from ever serving as
officers or directors of any public company. Mr. Dunlap has also paid $15
million and Mr. Kersh $250,000 to settle a class action lawsuit over
misrepresentation of Sunbeams results of operations.

Morgan Stanley duped financier Perelman in fraudulent deal, Financial


Times, April 7, 2005, page 16. The Laing article mentions Sunbeams
acquisition of Coleman Co., a maker of camping equipment. The
Financial Times article reports that Ronald Perelman, a wealthy financier
and chairman of cosmetics firm Revlon, is suing Morgan Stanley, a large
investment bank. Perelman had owned 82% of Coleman, and accepted
Sunbeam shares as payment. The lawsuit claims that Morgan Stanley
helped Sunbeam dupe Perelman about the value of Sunbeam shares,
which collapsed in value when the earnings management described in
the Laing article was revealed.

11.

a.

Managers may want to smooth earnings for the following reasons:

They may feel that the market rewards share prices of firms that
report steadily increasing earnings, consistent with the findings of
Barth, Elliott, and Finn (1999).

They may want to keep earnings for bonus purposes between the
bogey and cap of their bonus plan.

They may want to reduce the probability of violation of debt


covenants.

They may want to convey inside information about persistent earning


power by smoothing reported earnings to an amount they feel can be
sustained.

They may smooth earnings because of implicit contracts, consistent


with the findings of Bowen, Ducharme, and Shores (1995). The firm
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may be able to secure better terms from suppliers and other


stakeholders with which it has a continuing relationship if it reports
steady earnings.
b.

Costs of smoothing earnings by means of opportunistic discretionary accruals

derive primarily from negative investor reaction should the firms usage of such
discretionary accruals to manipulate earnings be discovered by the market. Investors
may then lose confidence in the integrity and transparency of the firms reporting (i.e.,
their perception of estimation risk increases), leading to a fall in its share price.
Costs of smoothing earnings by means of derivatives include the commissions and
other costs paid in order to acquire and sell the derivative instruments. Also, if the firm
excessively smooths its earnings in this manner, this reduces the managers incentive
to exert effort, since agency theory tells us that if he/she is to work hard, the manager
must bear risk.
Another potential cost is that hedging by derivatives reduces upside risk. The firm will
not benefit if underlying prices move opposite to the direction hedged. Smoothing by
accruals does not have this effect.
Managers will trade off these 2 earnings management devices in order to minimize
costs. Smoothing by means of derivatives involves the use of real variables to manage
earnings, with costs as given in the previous paragraphs. Smoothing by means of
accruals also creates costs, deriving from increased investor estimation risk should
opportunistic earnings management be revealed.
Also, firms may differ in the amounts of discretionary accruals available. For example,
firms that operate in a risky environment, or that are continually buying and selling
other companies and engaging in costly restructurings, have more accruals-based
earnings management potential than a stable firm in a stable industry where, for
example, there may be relatively few large unusual and non-recurring items with
earnings management potential. Stable firms would find it less costly to smooth by
means of derivatives.

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Other firms may already be heavy derivatives users and may be concerned that
further usage could turn into speculation, which could increase, rather than reduce,
volatility of earnings . Alternatively, firms may be in a business for which a derivatives
market does not exist or is very costly. For example, a firm with operations very
subject to the weather may find weather derivatives to be too costly. Other firms may
wish to protect themselves against large credit losses but my find that credit
derivatives are not available or are too costly. Such firms would find it less costly to
smooth earnings by means of discretionary accruals.
c.

Bartons results are more consistent with the efficient contracting version of

positive accounting theory. If managers were not concerned about the costs to the firm
of smoothing activity, they would not trade off the use of discretionary accruals and
derivatives so as to find the lowest-cost way to smooth.
12.

a.

Nortel appeared to be using a policy of big bath in 2001 and 2002, to put

earnings in the bank.


In 2003, the company appeared to be using a policy of income maximization, to enable
bonuses to be paid.
b.

One impact would be to increase manager effort directed towards increasing

sales and profitability. Presumably, this was the intention of the tying of bonuses to a
return to profitability. Nortels compensation committee may have felt that defining
profitability in terms of pro-forma income would contribute to this goal by eliminating
from the profit calculation expenses that were not informative about current sales and
profitability-oriented effort.
However, another impact would be to encourage dysfunctional, short-run manager
behaviour, particularly if it seemed that increasing sales and profitability was more
difficult and lengthy than originally hoped. This behaviour apparently took the form of
reversing previous years excess accruals into current (pro-forma) earnings.
Dysfunctional behaviour could also be encouraged by defining profitability in terms of
pro-forma income. Since there are no rules laid down to define items that can be
excluded from pro-forma income, management may have been tempted to omit loss
items that were informative about effort.
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c.

Nortel went wrong because of poor disclosure. It credited the reversals of

excessive accruals into 2003 operating (and pro-forma) income without disclosing their
source. This created the impression that the increased 2003 earnings were due to
current manager effort (hence persistent) rather than simply a restatement of past
over-provisions.
Matters were made worse by payment of bonuses. These were intended to encourage
current effort but seem to have had the opposite effect of diverting effort into
misleading financial reporting.

13.

a.

The current financial report shows GN. Two points should be mentioned. First,

the persistence of the non-recurring item is low by definition. Thus, it is unlikely to have
much effect on future earnings. This suggests future earnings will be high since the
current non-recurring item will likely reduce future amortization charges and/or provide
a cushion against which future charges that would otherwise be debited to future
earnings can be made.
Second, it appears that CG manages its earnings so as to report a smooth and
growing sequence over time. Thus, the role of the current non-recurring loss seems to
be to reduce reported earnings for the quarter to an amount management expects to
persist. This means that the current increase in earnings will be maintained and likely
increased.
Note: Answers that argue BN on the grounds that the analysts consensus forecast
was only met, not exceeded, are not acceptable. Under the circumstances (increased
earnings, despite a large non-recurring loss) it seems hard to interpret current
earnings as BN.
b.

By Bayes theorem, the posterior probability of the high state, based on GN in

earnings, is:

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P( High / GN ) =

P( High) P(GN / High)


P(GN / High) P( High) + P(GN / Low) P( Low)
0.7 0.9
0.63
63
=
=
0.9 0.7 + 0.2 0.3 0.63 + 0.06 69

= 0.91
P( Low / GN ) = (1 0.91) = 0.09

Then, denoting holding the shares by a1:

EU (a1 ) = 0.91 100 + 0.09 36


= 0.91 10 + 0.09 6
= 9.1 + .54 = 9.64
EU (a 2 ) = 81 = 9
The decision is to hold.
Note: If the answer to a is BN, an answer that correctly evaluates the resulting
decision is acceptable:
P(High/BN) = 0.23
EU(a1) = 6.3
EU(a2) = 9
c.

Yes, your evaluation of the earnings report should now be BN. Managers know

that the market price of their shares will be severely affected if earnings expectations
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are not met. If the manager cannot find enough earnings management to raise
reported earnings by 1 cent per share, the firms earnings outlook must be bleak.

14.

a.

The revenue deferral will decrease relevance, since there is now a greater

recognition lag for contract revenue. This reduces the ability of investors to revise state
probabilities and predict future cash flows of the firm. However, reliability will increase, since
there is now less chance of error or bias in revenue recognition.
b.

Nortel appears to be following a pattern of big bath for 2005. The shareholder

litigation expense item creates a large loss for the year. Nortel may feel that this would
be a good time to defer revenue, since there is a large loss anyway, and, since
accruals reverse, deferral now will increase revenue to be recognized in future
periods.
c.

Abnormal return is the difference between expected and actual share return for

the day. From the market model, the expected return for Nortel for t = March 10/06
was:
Rjt = j + j RMt, where j = Rf(1 j)
= .0001(1 1.96) + 1.96 .0058
= -.0001 + .0114
= .0113
The actual return on Nortel shares for this day was - .0305. Abnormal return was thus
(-.0305 .0113) = - .0418, or - 4.18%.
The abnormal share return likely arose because of the revenue deferral, since the
market would have been aware of the shareholder litigation and would have
incorporated the expected settlement amount into Nortels share price prior to March
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10. The news of the deferral would cause investors to lose confidence in Nortels
accounting, increasing estimation risk.
An opposite answer can also be supported, for either of 2 reasons:

If the amount of the settlement exceeded the markets expectation, the news of
the settlement amount could have caused the negative abnormal return.

If markets are not fully efficient, the market may not have incorporated an
expected settlement amount into Nortels share price prior to the news of March
10.

d. Inclusion in operations seems questionable. Presumably, shareholder litigation


resulting from accounting restatements will not occur frequently over several years.
Also, such lawsuits do not typify the normal business activities of Nortel. In
addition, the amount or timing of the expense does not seem to depend on
decisions or determination by managers or owners. Thus, the 3 requirements for
an extraordinary item are met.
Nortel may have intentionally overestimated its litigation settlement costs charged
to current operations, in order to put earnings in the bank. If so, this is consistent
with the argument of Hanna (1999). To the extent actual litigation costs are less
than $2.474 billion, the difference can be transferred back to earnings from
continuing operations at some future date.

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15.

a.

Revenue recognition is an effective earnings management device because

recognition criteria under GAAP are vague and general. A company can speed up, or
slow down, revenue recognition but disguise the change through vague wording of its
revenue recognition accounting policy disclosure. Also, as in the case of Coca-Cola,
revenue recognition can be speeded up by stuffing the channels to unconsolidated
subsidiaries or customers, without any formal change in revenue recognition policy.
Stuffing the channels can be difficult for investors, or even auditors, to detect.
A superior answer will point out that revenue recognition is an accruals-based earnings
management policy, whereas, stuffing the channels involves real variables.
A disadvantage of revenue recognition as an earnings management device is that
accruals reverse. Consequently, it is difficult to maintain increased reported revenue
over time. Also, stuffing the channels becomes quite costly if it is necessary to
compensate the subsidiary or customer for carrying costs, as Coca-Cola did.
Possible reasons why Coca-Cola managed its reported earnings upwards:

Contractual. To smooth or otherwise manage executive compensation where


this is based on reported earnings, and to reduce the probability of violation of
debt covenants.

To meet analysts earnings projections, thereby avoiding a fall in share price.


This seems to be the most likely reason in Coca-Colas case.

To maintain or increase managements reputation.

Income taxes. To reduce or otherwise manage income taxes payable.

Changes in CEO. CEOs may manage earnings to reduce the probability of


being fired, to reduce the probability of a successful takeover bid, or because
they are approaching retirement.

IPOs. Firms may manage earnings upwards prior to a stock offering so as to


increase the issue price.

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Implicit contracts. To maintain good relations and credit terms from suppliers.

Communicate inside information to investors, providing the upward


management is not to an amount higher than can be sustained.

b.

Since gallons shipped in one quarter correspondingly reduce amounts shipped

in future quarters, an increase in EPS this quarter will create a corresponding


decrease in EPS next quarter. Consequently, even more gallonage must be pushed in
each successive quarter to maintain an EPS increase.
c.

The reason appears to be to avoid a reduction of future core earnings when

bottlers inventories cannot be further increased and reported sales fall off. The
inventory reduction program could be accounted for as an unusual and non-recurring
component of operating income. This would have the appearance of low persistence,
reducing negative investor reaction to the inventory reduction and to lower sales and
earnings in 2000.
16.

a.

Reasons why Deutsche Bank shares rose on October 3:

Reduction of uncertainty. Given the market meltdown of asset-backed


securities, the market had little idea of their fair value, hence little idea of the
losses faced by firms holding these securities. The EUR 2.2 billion writedown
gave investors at least a ballpark figure of Deutsche Banks losses. The result is
to lower estimation risk and/or lower Deutsche Banks beta (since Deutsche
Banks loss provides some information about losses of other bankssee
Section 4.5), both of which raise stock price.

The amount of the writedown may have been less than the market expected.

Cleaning house. The market may have felt that the writedown signals that
Deutsche Bank has put its losses behind it and will now turn its full attention to
increased future profitability.

Optimistic earnings forecast. The market may have felt that the CEOs reaffirmation of Deutsche Banks 2008 profit forecast indicated that he felt that the

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companys asset-backed securities losses were now behind it and that he felt
securities markets will return to normal functioning.
b.

Reasons why the bank may have wanted to take a bath:

Investors feared the worst. Consequently they would not penalize Deutsche
Bank unduly if the writedown was inflated.

Cookie Jar. Since the company reiterated its 2008 profit forecast, it would be
anxious to avoid the consequences of not meeting it. Putting earnings in the
bank by means of a cookie jar increases the likelihood that it will meet its
forecast.

c.

Reasons why the bank may want to understate its writedown:

Investor unease. Investors were concerned about the consequences for the
economy of major losses by financial institutions. If investor concerns led to
recession, this would reduce future bank profits. High reported writedowns
would increase investor concerns.

Regulatory concerns. As a financial institution, Deutsche Bank may have been


concerned about violation of capital adequacy requirements if writedowns were
sufficiemtly high.

Debt covenant hypothesis. Excessive writedowns may lead to violations of debt


covenants.

Management compensation. Managers whose bonuses are tied to earnings or


stock price may fear reduced compensation if high writedowns lead to lower
values of these performance measures.

d.

Reclassification would lead to valuing the reclassified securities at cost, not fair

value. If so, a writedown would be avoided. You would object to this suggestion, for
the following reasons:

Reclassification suggests opportunistic behaviour by management. Accepting


such behaviour violates ethical behaviour and professional responsibility.
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If the reclassification becomes public knowledge, this will adversely affect


managements reputation and market value, and could lead to legal liabilities
and penalties for the firm and its managers.

Once reclassified, the securities could not be sold until maturity. Situations
could arise such that it would be desirable to sell prior to maturity, but, if sold,
the consequences under IAS 39 would be that use of the held-to-maturity
classification is denied for all securities for 2 years.

Ceiling test. Reclassification would be unlikely to avoid writedowns in any case,


since held-to-maturity securities are subject to a ceiling test.

Additional Problems
11A-1. This problem is based on the paper by Elliott, Hanna, and Shaw (EHS), The
Evaluation by the Financial Markets of Changes in Bank Loan Loss Reserve Levels,
The Accounting Review (October, 1991), pp. 847-861. While the main research
interest of this article is information transfer (the impact of a firms financial statements
on the share prices of other firms)a topic not covered in this book, the evidence in the
paper also provides an interesting and persuasive illustration of how earnings
management (in this case, the establishment of loan loss reserves) can reveal inside
information.
During 1987, many United States banks faced severe problems with respect to loans
to lesser developed countries (LDCs). For example, on February 20, 1987, Brazil
declared a moratorium on interest payments on $67 billion of its debt. This led to
problems of how to account for the LDC loans by the banks that were affected.
On May 19, 1987 (4.45 pm), Citicorp (a money-center bank and, at the time, the
largest U.S. bank) announced a $3 billion increase in its loan loss reserve for LDC
loans. This amount equalled 25% of the book value of its LDC loans. In the 2 days
following the announcement, Citicorps share price rose by 10.1%, after falling by
3.1% on the day of the 4.45 pm announcement.
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EHS also examined the share price behaviour of 45 other U.S. banks with foreign
loans in excess of $100,000 and which announced increases in their loan loss
provisions during 1987. Of these banks, 11 (excluding Citicorp) were money-center
banks (with major LDC exposure) and 34 other, regional banks (with lower LDC
exposure). For a 3-day window surrounding the May 19, 1987 Citicorp announcement,
EHS report the following abnormal returns:
11 money-center banks:
34 other banks

1.14%
-.054%

On December 14, 1987 (4.15 pm), the Bank of Boston (not a money-center bank)
announced a $200 million increase in its LDC loan loss reserve, classified $470 million
of LDC loans as non-accrual of interest status, and wrote off $200 million of LDC
loans. In the 3-day window centred on 15 December, 1987, its share price rose by
9.9%. Banks were required to maintain a capital adequacy ratio (see note) of at least
5% for regulatory purposes. The Bank of Bostons capital adequacy ratio remained
strong (8%) after the writeoff.
Note: The capital adequacy ratio is calculated as the ratio of shareholders equity plus
loan loss reserves to total assets. Thus, a provision for loan losses does not affect the
ratio, while a writeoff of loans does.
For a 3-day window centred around 15 December, 1987, EHS report the following
abnormal returns:
12 money-center banks

-7.26%

33 other banks

- 1.14%

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Required
a.

Why did Citicorps share price fall by 3.1% on May 19, 1987 and rebound by

10% over the next two days?


b.

Why did the abnormal 3-day return for 11 money-center banks exceed the

return for the 34 other banks for the same period?


c.

Why did the Bank of Bostons share price rise by 9.9% over a 3-day window

surrounding December 15, 1987?


d.

Why was the average abnormal return of 12 money-center banks significantly

lower (-7.26%) than the abnormal return of 33 other banks (-1.14%) over the 3-day
window surrounding December 15, 1987?

11A-2.Shown below are the income statement and comparative balance sheets of ACR Ltd.,
from its 2008 annual report. The 2008 cash flow statement of ACR Ltd. (not shown)
reports operating cash flow as $2,386.
ACR Ltd.
Income Statement
Year Ended December 31, 2008
Contract income

$11,684

Cost of contracts

9,073

Gross profit

2,611

General and administrative expenses

1,346

Amortization

276

Interest

16
1,638

Operating profit

973

Equity income from affiliates

165

Other income

52
217
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Income before income taxes


and extraordinary items

1,190

Income taxes:
Current

584

Future

59
643

Income before extraordinary items

547

Extraordinary items

Net income for year

$547

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ACR Ltd.
Balance Sheets
As at December 31
2008

2007

Assets
Current assets:
Cash

693

Trade accounts receivable


Income taxes recoverable

2,107

3,464

506

Inventories

810

410

61

99

3,671

4,479

405

203

1,532

1,632

$5,608

$6,314

$1,291

Accounts payable and accrued liabilities

398

497

Income taxes payable

282

34

83

64

763

1,886

62

22

825

1,908

2,268

2,268

80

80

3,895

3,275

1,175

1,307

7,418

6,930

Prepaid expenses
Investments in affiliated companies
Machinery and equipment
Liabilities
Current liabilities:
Bank indebtedness

Liability for future income taxes


Future income tax liability

Shareholders Equity
Share capital
Capital contributed on issue of warrants
Retained earnings
Excess of appraised value of fixed
assets over amortized cost

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Less: Cost of shares purchased

2,635

2,524

4,783

4,406

$5,608

$6,314

Required
a.

What is the amount of net accruals included in ACR Ltd.s year 2008 net
income?

b.

Use the information in the income statement and balance sheets of ACR Ltd. to
calculate the various individual accruals and reconcile to the net total in part a.

c.

Upon comparing operating cash flow and net income, we see that the accruals
have substantially lowered the reported income for the year. Give reasons why
management may want to manage income downwards in this manner.

11A-3.

A way to manage earnings is to manipulate the point in the operating cycle at


which revenue is regarded as earned. An article entitled Bausch & Lomb Posts 4thQuarter Loss, Says SEC Has Begun Accounting Probe appeared in The Wall Street
Journal on January 26, 1995.
The article reports on questions raised by the SEC about Bausch & Lomb Inc.s
premature recording of revenue from products shipped to distributors in 1993. Bausch
& Lomb oversupplied distributors with contact lenses and sunglasses at the end of
1993 through an aggressive marketing plan, and was forced to buy back a large
portion of the inventory [in 1994] when consumer demand didnt meet expectations.
The oversupply amounted to around $10 million, which Bausch & Lomb claimed was
not material.
In addition, the article points out that in the fourth quarter of 1994 Bausch & Lomb had
incurred $20 million in one-time expenses, which included expenses from previously
announced staff cuts of about 2,000. Also, in the fourth quarter Bausch & Lomb took
a $75 million charge in its oral-care division in order to reduce unamortized goodwill

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that it recorded when Bausch & Lomb bought the business in 1988. Many analysts
are saying that Bausch & Lomb are looking to sell the oral-care division, and this
reduction of unamortized goodwill will make the division look better.
Required
a.

What earnings management policy did Bausch & Lomb appear to be following
in 1993?

b.

Evaluate revenue recognition policy as an earnings management device.

c.

The article refers to a $20 million writeoff in 1994 relating to staff cuts, and
another $75 million writeoff in Bausch & Lombs oral-care division. What
earnings management strategy does the firm appear to have followed in 1994?
Why?

d.

Do Bausch & Lombs 1993 and 1994 earnings management strategies suggest
that its management does not accept efficient securities market theory? Explain
why or why not.

11A-4. Note: The 5th edition of this text has removed discussion of push-down accounting.
Earnings management extends into the realm of new share offerings (IPOs), since the
prospectus for a new offering includes current and recent financial statements. An
article entitled RJR Nabiscos Use of Accounting Technique Dealing with Goodwill Is
Getting a Hard Look, which appeared in The Wall Street Journal on April 8, 1993,
describes some earnings management considerations surrounding a $1.5 billion new
share offering of Nabisco, a food subsidiary of RJR Nabisco Holdings.
According to the article, the parent, RJR Nabisco Holdings, has substantial goodwill on
its books arising from its acquisition of Nabisco, which is being amortized at a rate of
$607 million annually (at the time, both the CICA Handbook, and, in the United States,
APB 17 required that goodwill from acquisitions be amortized over a period of up to 40
years). However, this goodwill amortization appears only on the books of the parent
not on those of Nabisco.
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According to the article, What RJR is doing is presenting Nabiscos annual earnings
without the burden of $206 million of 1992 goodwill, leaving this earnings-depressing
item with the parent company instead. This resulted in Nabisco increasing its 1992
after-tax profit from $179 million to $345 million or from 48 cents a share to 93 cents a
share.
The article goes on to state Nabisco executives indicated the food company could
generate 1993 earnings of as much as $1.30 a share. That earnings level might justify
the proposed selling price of $17 to $19 a share for the new Nabisco shares, analysts
say.
The article questions whether RJR is managing the reported net income of its Nabisco
subsidiary by not pushing down goodwill to Nabisco.
Required
a.

What pattern of earnings management is RJR following? Why?

b.

Without considering any strategic issues surrounding the pricing of the new
shares, do you think that goodwill should be pushed down to the subsidiary
company?

c.

Do you think the strategy of not pushing down the goodwill will be successful in
raising the issue price of the new shares? Explain why or why not.

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Suggested Solutions to Additional Problems


11A-1 a.

The 3.1% fall could have been due to a fall in the stock market index (i.e.,

economy-wide risk) on that day. (EHS investigated this possibility, and concluded that
the fall was not the outcome of general macroeconomic events.)
The fall could have been due to investors anticipating the announcement and fearing
the worst. If so, the subsequent rise could have been because the actual loan loss
provision turned out to be less than the market had expected. However, this does not
seem to explain why the subsequent share price increase was so highmuch greater
than the 3.1% drop.
The most likely reason for the initial fall is that the announcement was made quite late
in the day and even rational investors did not have time to analyze the reasons for the
loan loss reserve announcement. They then sold quickly to protect themselves in case
the announcement turned out to be bad news. Over the next 2 days, however, it
became apparent that the loan loss provision was a signal that Citicorp had a strategy
to deal with its LDC loan problems. Consequently, the banks share price rebounded
by more than the initial decline.
b.

The most likely reason follows from part a, namely that Citibanks

announcement was taken by the market to indicate that all exposed banks were
taking steps to deal with the problem. That is, the good news from Citibank
carried over. However, the less exposed a bank was, the less it would be affected
by the good news--it had less to lose in LDC loans in the first place, so information
suggesting that it was taking steps to deal with the problem would have a smaller
effect on its share price. Thus the most-exposed bank (Citibank) enjoyed the
greatest share price increase (10.1% - 3.1% = 7%), followed by the 11 other
exposed money-center banks (1.14%) and the 34 least-exposed other banks (0.54%). The reason the return is negative for these latter banks is likely because
the good news was not good enough to outweigh the losses from writeoffs per se.

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c.

The same reasons as for part a apply here. In addition, the Bank of

Bostons capital adequacy ratio was still well above the regulatory minimum, even
after its $200 million writeoff. This seems to have been interpreted by the market
as an indication of the banks financial strength.
d.

The answer seems to lie in the fact that the Bank of Boston, in addition to

increasing its loan loss provision, actually wrote off $200 million of LDC debt, thereby
taking a hit to its capital adequacy ratio. The market apparently interpreted this as an
indication that actual writeoffs were generally needed, but that other banks were
reluctant to do this, creating fears that these other banks were concerned about their
own capital adequacy ratios, or they would have recorded writeoffs too. This argument
is consistent with the negative returns for all sample banks around December 15. It is
also consistent with the much larger negative abnormal returns for the money-center
banks, which were much more exposed.

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11A2 . a.

Net accruals are the difference between operating cash flows and reported net

income. Here, net accruals for 2005 are $2,386 - 547 = $1,839.
b.

The individual 2008 accruals of ACR Ltd. can be calculated and reconciled as

follows:
Cash flow from operations
Less: Amortization expense
Future income taxes expense
Decrease in net accounts receivable

$2,386
$276
59
1,357

Decrease in income taxes recoverable

506

Increase in income taxes payable

248

Decrease in prepaid expenses

38

Increase in current liability for future


income taxes

19
2,503
(117)

Add: Equity income from affiliates

$165

Increase in inventories

400

Decrease in accounts payable and


accrued liabilities

99

Net income as per income statement

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c.

Reasons why management may want to manage income downwards by means

of accruals:

Political cost hypothesis of positive accounting theory. If ACR is very large, it


is very much in the public eye. It may fear political repercussions if it reports
earnings that are perceived as too high.

Bonus plan hypothesis. If it appears that ACRs earnings for bonus purposes
will be above the cap of the bonus plan, management may wish to lower
reported earnings. Otherwise, bonus will be permanently lost on above-cap
earnings.

Taxation. If firms in the United States use the LIFO inventory method for
income tax purposes, they must also use LIFO in their financial statements.
On a rising market, LIFO reports a lower net income than other methods,
such as FIFO. The firm then reports a lower net income in order to save
taxes. ACR does not indicate which inventory method it uses, however.

Taking a bath. The firm may want to increase the probability of high future
earnings by writing assets down currently and/or providing for future costs,
such as for downsizing or reorganization. This motivation may be present
when a new management takes over, or when earnings are below the bogey
of the bonus plan. In the case of ACR, however, no unusual, non-recurring
or extraordinary items appear on its income statement. Unless these are
buried in larger totals, it seems this motivation does not apply to ACR in
2008.

To communicate inside information to investors. If current years operations


have led to higher earnings than ACRs management thinks will persist, it
may wish to manage reported earnings downwards so as to credibly inform
investors of its best estimate of sustainable earnings.

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11A-3 a.

Bausch & Lomb appears to have followed a policy of income maximization in

1993.
b.

Bausch & Lomb appears to have used revenue recognition policy as a device to

manage annual (1993) earnings. Such a policy is reasonably effective, at least in the
short-run, since revenue recognition criteria under GAAP are vague. This gives the
firm some room to manoeuvre in terms of timing of when it regards revenue as
earned. In particular, current earnings can be increased by recogizing revenue on
excess shipments to distributors.
In the longer run, however, a disadvantage of Bausch & Lombs early revenue
recognition policy is that it involved physical shipment of product to distributors. There
may be limits to distributors storage capacity and ability to carry the additional
inventory, rendering the policy potentially quite costly. Indeed, it was this aspect of
Bausch & Lombs 1993 policy that seemed to come back to haunt it in 1994, namely,
the need for buybacks.
Another longer run disadvantage of early revenue recognition is that accruals reverse.
Thus, higher revenue recognized in 1993 means lower revenue in 1994. Then, even
more shipments to distributors are needed in subsequent years if the policy is to be
maintained.
We conclude that revenue recognition policy is reasonably effective in the short run
but its effectiveness decreases over the longer term.
c.

Bausch & Lomb appears to be taking a bath in 1994. Presumably, this is to

increase earnings in subsequent years by clearing the decks, possibly to make its
oral-care division appear more attractive for a sale, or to bank earnings so as to
increase the probability of substantial earnings increases in future years.
d.

Arguments that Bausch & Lombs management does not accept securities

market efficiency depend on the extent to which its earnings management strategies
are visible to investors. If these strategies are visible, there would be little point in
trying to fool an efficient market. Consequently, visible earnings management
strategies suggest management does not accept efficiency.
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At least some of the firms earnings management strategies are visible. These include
the staff cuts and the $75 million charge in its oral care division.
Visibility of other strategies, such as stuffing the channels in 1993 is less clear. To
the extent that Bausch & Lomb felt the market would not find this strategy out, it is
consistent with acceptance of efficiency. That is, management could both accept
efficiency and feel that it could fool the market through lack of disclosure. However, it
is also consistent with not accepting efficiency. Management may feel that even if
stuffing the channels was visible, the market would still react favourably to higher
reported 1993 earnings.
Additional arguments can be made based on contracting theory. The bath strategy
may be for bonus purposes, consistent with Healys findings for earnings below the
bogey. Management may both accept securities market efficiency and manage
earnings for contractual reasons.
Bausch & Lomb management may feel that with these 1994 writeoffs behind them, the
firms persistent earning power will be revealed, consistent with a desire to convey
inside information to an efficient market.
Yet another possibility may be that management is signalling to the efficient market
that it has its problems in hand and has a well-worked-out strategy to deal with them.
This argument is consistent with the findings of Liu, Ryan, and Whalen (1997) with
respect to banks (see Section 11.5.2).

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11A-4. a.

RJR is following an income maximization policy with respect to Nabisco. A

possible reason is that RJR is planning a new Nabisco share offering. It seems to
believe that higher reported earnings will enhance the offering price. Friedlan (1994)
found evidence that firms use earnings management to increase reported net income
prior to an IPO (Section 11.4.3).
b.

According to the information approach, it should not matter whether goodwill is

pushed down as long as the amount is disclosed, since the efficient securities market
will put the same values on shares of parent and subsidiary regardless. Certainly, the
amounts involved here have been disclosed, since they are reported in the article.
According to the measurement approach, goodwill should be pushed down since this
results in more relevant values on the books of the subsidiary. Furthermore, the value
of goodwill should be reliably determined since it resulted from an arms-length
acquisition transaction.
Note: While it predates SFAS 141 and 142 and Sections 3062 and 1581 of the CICA
Handbook, effective July, 2001, this question can also be discussed in relation to
these standards. They eliminate amortization of purchased goodwill (see discussion in
Section 7.4.2). Then, pushing down goodwill to Nabisco is of less immediate concern
to RJR management since, even if it was pushed down, there would be no goodwill
amortization and resulting lower reported earnings, on Nabiscos books. However,
purchased goodwill is subject to the ceiling test under the above new standards. If
goodwill on Nabiscos books should hit the ceiling, a writedown may be required.
Then, Nabiscos reported earnings would be reduced if the goodwill had been pushed
down. Consequently, RJR management may still wish to avoid this possibility, by not
pushing down.
Of course, if Nabiscos goodwill should hit the ceiling, it would have to be written down
on the parents (RJR Nabisco Holdings) consolidated financial statements, whether or
not it was pushed down.

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c.

The answer depends on the extent of securities market efficiency. Given full

efficiency, and full disclosure, the strategy should not affect the issue price. If markets
are less than fully efficient, the strategy may have an impact. The article seems to
imply less than full efficiency, for example, by implying that share prices are set by
mechanical application of earnings per share ratios. Also, theory and evidence from
behavioural finance (Section 6.2) suggests that investors may not be as adept at
figuring out complex transactions as efficient securities market theory implies. If so,
pushing down the goodwill may help investors evaluate the real value of the shares of
Nabisco.

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