Solution Manual

to accompany

Contemporary Issues in
Accounting
Michaela Rankin, Patricia
Stanton, Susan McGowan,
Kimberly Ferlauto & Matt Tilling
PREPARED BY:

Michaela Rankin

John Wiley & Sons Australia, Ltd 2012

 Chapter 9: Earnings management

CHAPTER 9
EARNINGS MANAGEMENT

Contemporary Issue 9.1: Considering earnings quality in investment decisions

1. Explain the three criteria usually considered important in assessing earnings

quality. (K)

The three criteria considered important in assessing earnings quality are:

Trend in profit results: This related to consistency over a significant time period.
Assessing trends requires analysis of how much profits vary from year to year. If
profits are increasingly steadily over time the company is assumed to be a more
attractive investment than a company with volatile earnings.
Operating/non-operating mix: It is important to assess whether profits are generated
from operations or whether they are related to abnormal items. Abnormal items are
generally non-recurring, and a company should be attempting to generate most of its
profits from normal operations.
Earnings base: the more diversified the sources of earnings are, the more attractive an
entity is likely to be. If a company earns profits across a range of geographic regions
and markets it is less likely to be at risk if one of those markets fails.

2. Outline two advantages to a company from having high quality earnings. (J)

High quality earnings provides information to analysts and shareholders about the
quality of management of the company, and meets their expectations and predictions.
As pointed out in the article, the better the quality of earnings, ‘the more consistently
the company should be able to deliver solid results’.
Quality of earnings is likely to lead to a more accurate future earnings forecast. As
such it can affect company share price.

3. Given the information you have already addressed in this chapter, what are
some methods companies could use to ensure they present consistent profits?
(J)

Entities can use a number of methods to present consistent profits. These include:
Accounting policy choice – where managers have flexibility in making accounting
choices, they can chose policies that manage timing differences and the amounts of
expense recognition and asset valuation, for example.

© John Wiley and Sons Australia, Ltd 2012 9.1

Solution manual to accompany: Contemporary Issues in Accounting

Accrual accounting – companies will manage accruals to generate consistent revenue

and earnings growth.
Income smoothing – managing fluctuations in income by shifting earnings from peak
periods to less successful periods. This is also related to accrual management.
Real activities management – managing operational decisions rather than accounting
policies and accruals. This can relate to discretionary spending on research and
development or advertising, offering price discounts to maximize sales towards the
end of an accounting period etc.

© John Wiley and Sons Australia, Ltd 2012 9.2

 Chapter 9: Earnings management

Review questions

1. Define what is meant by ‘earnings’ and outline why it is important to

shareholders.

Earnings is another name for net income or profit. Earnings are important to
shareholders as a measure of entity performance, as they indicate the extent to which
the entity has engaged in activities that add value to it. They are used by shareholders
to assess managers’ performance, and to assist in predicting future cash flows and
assess risk.

2. Explain what is meant by earnings management.

Earnings management has been defined in a number of ways including: to ‘managers

use judgement in financial reporting and in structuring transactions to alter financial
reports to either mislead some stakeholders about the underlying economic
performance of the company, or to influence the contractual outcomes that depend on
reported accounting numbers’ from Healy and Wahlen (1999), or the more
conservative definition by McKee (2005) as ‘reasonable and legal management
decision making and reporting intended to achieve stable and predictable financial
results’. The above definitions differ on whether normal financial decisions are part of
the definition, or whether the purpose of earnings management is to mislead.

3. Is earnings management always bad? Explain your answer.

No, earnings management is not always bad. Ronen and Yaari (2008) classify some
earnings management decisions as ‘white’, referring to beneficial earnings
management that enhances the transparency of financial reports. It can signal long-
term value to stakeholders.

4. How can accounting policy choice be considered earnings management?

Explain your answer.

Accounting policy choices are made within a framework of applicable accounting

standards. Standards provide flexibility to management in making accounting choices.
These can include valuation of inventory, straight-line or accelerated depreciation etc.
A choice between different accounting methods will lead to different timing of
expenses, the amount of expenses that are recognized and recognition of expenses. As
such accounting methods can be used to manage asset values and earnings.

© John Wiley and Sons Australia, Ltd 2012 9.3

Solution manual to accompany: Contemporary Issues in Accounting

5. What is income smoothing and how is it commonly used to manage

earnings?

Income smoothing moderates year-to-year fluctuations in income by shifting earnings

from peak years to less successful periods. It relies on accrual accounting practices
such as early recognition of sales revenues, variations in bad debts and delaying asset
impairments. It is commonly used in earnings management to present consistent firm
value over time and continuous growth – evidence of high quality earnings.

6. Why and in what circumstances would a management team consider

engaging in big bath accounting?

Big bath accounting refers to large losses reported against income. Management
might consider using big bath accounting when there is a change in the management
team, with the need to write-off assets or operational units that were under-performing
under the previous management team. They are also used when restructuring
operations, when there is a need to restructure debt, with significant asset impairment
or disposal of operating units.

7. Provide two reasons why entities might engage in earnings management.

There are two main reasons for engaging in earnings management:

(1) Earnings are managed for the benefit of the entity, including to meet
analysts’ and shareholder expectations and predictions, and to maximize the
value of the entity, to convey private information or to avoid violating
restrictive debt covenants;
(2) To meet short-term goals which lead to maximizing managerial remuneration
and bonuses.

8. How is earnings management related to entity valuation?

A number of methods are used to value an entity including which rely on using
current values to forecast future value. One of the following are commonly used:
book value, operating cash flow and net income. Share prices are more highly aligned
with net income than with operating cash flow, so income, or earnings, is commonly
used to determine entity value. As this is very important to analysts and shareholders
it leads to managers ensuring earnings are smooth, with little volatility. Earnings
volatility can be an indication of the increased chance of insolvency. They want to
send a message to shareholders that the firm is a strong investment.

© John Wiley and Sons Australia, Ltd 2012 9.4

 Chapter 9: Earnings management

9. What is ‘earnings quality’ and how is it related to earnings management?

Earnings quality relates to how closely current earnings are aligned with future
earnings. Current earnings, which are highly correlated to future earnings, are said to
have high earnings quality and lead to a more accurate future earnings forecast. This
leads to more confidence in the entity, and greater demand for shares.
Because of this, managers have incentives to manage earnings to limit volatility –
ensure smooth earnings and to improve earnings quality.

10. Explain why managers who receive a cash bonus as part of their
remuneration might wish to manage earnings.

Managerial bonuses are generally tied to a range of firm performance measures,

including earnings. Agency theory assumes managers are self-interested and wish to
maximize any financial rewards. As such, they will manage earnings, including
income smoothing, accruals management and accounting policy choices to maximize
earnings, and consequently their bonus.

11. Why is corporate governance important for evaluating corporate earnings

management?

The board of directors is responsible for approving plans strategies and investment
decisions made by the management team. How the board functions – corporate
governance – is essential to the overall operation and future of the company. The
constitution of the board, including their expertise and independence are important in
determining how likely it is that managers are able to manage earnings. Strong
governance means a balance between corporate performance and an appropriate level
of monitoring. When the board fails in this role, and is seen to merely ‘rubber stamp’
managerial decisions, it is more likely that inappropriate earnings management can
result.

© John Wiley and Sons Australia, Ltd 2012 9.5

Solution manual to accompany: Contemporary Issues in Accounting

Application questions

9.1 Table 9.1 presents examples of some common accounting decisions, and how
companies following a conservative, moderate, aggressive or fraudulent
strategy might use these to manage earnings. Prepare a similar table and
complete it in relation to the following accounting decisions:
(a) Revenue recognition from services
(b) Intangible assets
(c) Impairment of non-current assets
(d) Revaluation of non-current assets (K, J)

Conservative Moderate Aggressive Fraud

Revenue Services are Services Services are Fraudulent
recognition prepaid and prepaid and agreed to but scheme
from services performed in partially not yet
full performed performed
Intangible Regularly Slow to record Revalue Overstate
assets impair, do not impairment intangibles intangibles
revalue even in losses even when no where non-
an active active market existent
market intangibles are
recognised
Impairment of Conservative Slow to record Non-current Fictitious non-
non-current impairment impairment assets are current assets
assets policy used losses impaired but recorded to
no impairment bolster asset
loss recorded balances
Revaluation of Use cost basis Record Revalue non- Upwardly
non-current of accounting revaluations current assets Revalue
assets annually using when no impaired non-
generous change in fair current assets
valuations value estimates to
meet earnings
targets

9.2 Examine the 2010 annual report of Qantas Airways Ltd, available at
www.qantas.com.au. Review the corporate governance statement and
evaluate how successful you think the board structure is likely to be in
limiting earnings management. In particular, consider the board size,
independence, and committees in place. Prepare a report of your findings.
(K, J, CT)

The corporate governance statement starts on page 20 of the annual report. This
details committees, and how the company meets the ASX good corporate governance
recommendations. Other information that is useful to the completion of a report on

© John Wiley and Sons Australia, Ltd 2012 9.6

 Chapter 9: Earnings management

Qantas governance strategies that are likely to limit earnings management is found on
pages 10-11 of the annual report – details of the board of directors, their experience
and qualifications.
A report should include the following information:
The Qantas board is a large board, with 10 members. Nine of these members are
independent non-executive directors (the only non-independent executive director is
the CEO Alan Joyce). A large, independent board is less likely to merely ‘rubber
stamp’ decisions of the executives and the CEO so is more likely to limit the use of
earnings management.
The committee most relevant to earnings management is the audit committee. The
audit committee of the Qantas board is comprised of four independent directors. The
CEO is not a member of the board. All members are financially literate. A review of
their qualifications on pages 10 and 11 indicate that the chair is a fellow of the
Institute of Chartered Accountants and is a CPA. He previously held the role of
senior partner of Ernst and Young, which is likely to indicate he is well versed in
appropriate accounting methods, use of accruals and income smoothing techniques.
All other members have experience in finance or banking roles, meaning they are also
in a position to be critical of any aggressive earnings management techniques
management use.
Other relevant corporate governance strategies relate to executive remuneration. The
remuneration report is developed by the remuneration committee, and the report is
disclosed in the financial reports of the company. It is important that it includes a
range of both short term and long term performance targets, and they are not all
linked to metrics that executives can ‘manage’ – such as earnings.

9.3 Outline the three methods discussed in this chapter that entities can use to
manage earnings. Discuss the circumstances in which entities are likely to
use each method. (K)

The three methods entities can use to manage earnings include:

Accounting policy choice – where managers have flexibility in making accounting
choices, they can chose policies that manage timing differences and the amounts of
expense recognition and asset valuation, for example. Entities may choose to alter
change accounting policies at a time when they change an accounting estimate (for
example extending the useful life of an asset) or changing the use pattern of an asset
(eg. changing form straight line to reducing balance depreciation). If a company
changes accounting policies they will need to provide the auditor with documentation
to justify the decision. As such, it is more costly than accrual accounting or income
smoothing.
Accrual accounting – Accrual accounting techniques generally have no direct cash
flow consequences. They can include recalculating impairment of accounts
receivables (provisioning for bad debts), delaying asset impairment, adjusting
inventory valuations, amending depreciation and amortization estimates, including
expected useful life and residual values. Companies will manage accruals to generate
consistent revenue and earnings growth.

© John Wiley and Sons Australia, Ltd 2012 9.7

Solution manual to accompany: Contemporary Issues in Accounting

Income smoothing – relates to managing fluctuations in income by shifting earnings

from peak periods to less successful periods. This is also related to accrual
management. It can include such activities as early recognition of sales revenues,
variations in bad debts or warranty provisions, or delaying asset impairments. Income
smoothing is used to present the appearance of constant growth, and limit volatility in
earnings. companies will manage accruals to generate consistent revenue and earnings
growth.

9.4 You have recently been appointed as a researcher for a firm of share
analysts. As one of your first roles you are required to prepare a report for
your manager to outline common techniques used to manage or manipulate
earnings. From your prior accounting knowledge you would have gained an
understanding of techniques you can use to examine entity performance and
profitability, including trend analysis. Document what strategies you might
use as an analyst to detect earnings management using accounting
information. (K, J, CT)

There is a range of techniques analysts can use to examine financial data to detect
earnings management. A number of these are outlined in Contemporary Issue 9.1.
These can include:
Examine trend in profit results – the analyst should be able to determine if profits are
consistent, and growing gradually over time, or if they vary significantly from one
year to the next. Analysts can also access half yearly, and sometimes quarterly data
that can assist in this assessment. Is the company subject to seasonal variations? Are
they meeting forecasts on a half yearly basis?
Operating/non-operating mix – analysts need to determine which part of the business
is generating profits. If earnings are being generated through non-recurring items such
as gain on sale of fixed assets, rather than current operations, it may indicate a
problem with meeting earnings forecasts and continued increases in earnings.
Earnings base – analysts should examine from where the company sources earnings.
If they are spread across a number of operations or sectors there is a higher likelihood
of longer-term success than if the company relies on only one operation, or even one
major customer.
Analysts should also look at the change in debt arrangements in place, and leverage
ratios. This may give an indication of earnings management being used to avoid
breaches of covenants etc. Similarly, executive compensation arrangements and
performance hurdles managers are required to meet to obtain bonuses are going to
provide an indication of the extent to which earnings management is likely, if they are
heavily based on earnings targets.

9.5 Obtain the Remuneration Report for a publicly listed company. Examine the
compensation contract for the Chief Executive Officer (CEO). Document the
range of remuneration components used in the CEO pay arrangements and
what performance targets are used to determine both cash and equity
payments. What earnings management techniques would the management

© John Wiley and Sons Australia, Ltd 2012 9.8

 Chapter 9: Earnings management

team be likely to use in these circumstances to maximise their short-term

and long-term remuneration? Explain your answer. (K, J)

A range of remuneration components and performance targets are used in the

remuneration contract of CEOs. As an example, in the 2011 financial report of David
Jones Ltd:
The remuneration of the CEO consists of fixed pay, short term incentives and long
term incentives. Page 39 of the annual report indicates that fixed pay constitutes 39%,
short term incentives are 19% and long term incentives are 42%.
The table on page 45 indicates the range of performance targets that the CEO and
other executives need to meet to receive short term bonuses. These include: net profit
after tax, capital expenditure, and costs.
Long term incentives are based on: net profit after tax and total shareholder return.
Given both short term and long term incentives are linked to earnings/profits there are
incentives for the executive team to manage earnings to maximize these performance
measures. This can include use of accruals and income smoothing. Real earnings
management through, for instance, managing costs are also likely to be used.

© John Wiley and Sons Australia, Ltd 2012 9.9

Solution manual to accompany: Contemporary Issues in Accounting

Case Study Questions

Case study 9.1: The ethics of earnings management

1. Why would the NZSO wish to smooth income?

The NZSO would wish to smooth income because it needs to assure government
(which provides grants) and sponsors that it is using the funds provided to it on an
annual basis, and does not have a significant surplus over the medium term. This is
important to ensure the continued support of these bodies for the NZSO. It is also
important that the NZSO does not show large deficits in any year, as this can mean
the management of the body will be questioned.

2. Were the earnings management techniques the NZSO used ethical? Explain
your answer.

The earnings management techniques were not used to mislead users, by presenting
financial data that was entirely inaccurate. The difficulty with having the end of the
financial year finishing in the middle of a concert season means the total costs and
income for the entire season are going to be spread over two financial periods. The
NZSO is not using methods to hide costs or overstate profits, they are merely using
methods to smooth out costs and income over the medium term in order to ensure
there are no periods with a large surplus followed by another with a large deficit. As
such it would appear the management techniques are ethical.

3. What factors would you consider when determining whether such a decision
was ethical?

Some of the factors you would consider are:

 Are the decisions designed to mislead stakeholders?
 Is the management of the NZSO using funds for alternative purposes?
 Do costs and income align over the medium term – e.g. over two or three reporting
periods?
 What are the reasons behind the decision to smooth income?

Case study 9.2: Mastering corporate governance: when earnings management

becomes cooking the books

1. What earnings management techniques are outlined in the above article?

The article refers to both legitimate and less than legitimate techniques to manage
earnings. These include: looking for loopholes in generally accepted accounting

© John Wiley and Sons Australia, Ltd 2012 9.10

 Chapter 9: Earnings management

principles, earnings smoothing, accounting estimates and other discretionary

judgments.

2. What role can the audit committee play in detecting and/or limiting earnings
management?

The audit committee needs to overview the policies used in measuring and reporting
transactions, and ensure the methods used reflect a ‘true and fair view’ of the
underlying transactions. They need to, identify and use their judgment to examine
whether earnings management techniques are appropriate given the circumstances,
whether they are legitimate, or whether they in fact obscure the true financial position
of the company.

3. What relationship does the audit committee have with the external auditors
in ensuring earnings management is within acceptable limits?

The audit committee appoints the external auditors and ensures they are independent.
The external auditors will examine the policy and processes the audit committee uses
to assure the truth and fairness of the financial information they are auditing. The
audit committee represents the company in any dealings with the external auditors,
and need to be in a position to answer any of their questions and provide justification
for any earnings management techniques used.

© John Wiley and Sons Australia, Ltd 2012 9.11