EARNINGS MANAGEMENT

Guided By Prof. Dr. V.K Vasal

Submitted By Group V
Goriparthi Rama krishna (3171)
B S B Vamsi krishna (3173)
Harshit Aggarwal (3172)
Neeraj Acharya (3169)
Dharmesh Chaudary (3067)
Vineeta singh (3078)
Acknowledgement
We express our sincere gratitude to our Professor, Dr. V.K. Vasal for his guidance,
continuous support and cooperation throughout the project, without which the present
work would not have been possible.
Table of Contents

Earning management definition

Accounting principles VS policies
Earnings quality
Accruals
Discretionary&non-discretionary
Measuring accruals
Motivations to do Earnings Management
Earnings Management Good or Bad
Environment of Earnings Management
Earnings Management Techniques
Cookie jar reserve
Big bath technique
Big bet on the future - techniques
Flushing - the investment portfolio
Throw out - a problem child
Amortization, depreciation, and depletion
Sale/leaseback and asset exchange techniques
Operating versus non-operating income
Early retirement of debt
Use of derivatives
Shrink the ship
Detecting earning management (research paper)
Earnings Management Definitions:

Earnings management is the use of accounting techniques to produce financial reports that present
an overly positive view of a company's business activities and financial position. Many accounting rules
and principles require company management to make judgments. Earnings management takes
advantage of how accounting rules are applied and creates financial statements that inflate earnings,
revenue or total assets. Companies use earnings management to smooth out fluctuations in earnings
and present more consistent profits each month or year. Large fluctuations in income and expenses
may be a normal part of a company's operations, but the changes may alarm investors who prefer to
see stability and growth.

Accounting Principles Vs Accounting Policies:

Accounting policies are the specific principles, rules and procedures implemented by a company's
management team and are used to prepare its financial statements. These include any methods,
measurement systems and procedures for presenting disclosures. Accounting policies differ from
accounting principles in that the principles are the accounting rules and the policies are a company's
way of adhering to those rules. These policies may differ from company to company, but all accounting
policies are required to conform to IND-AS. Accounting changes require full disclosure in the footnotes
of the financial statements.

EARNINGS QUALITY :

Earnings quality, in accounting, refers to the ability of reported earnings to predict a company's
future earnings. It is an assessment criterion for how "repeatable, controllable and bankable" a
firm's earnings are, amongst other factors, and has variously been defined as the degree to which
earnings reflect underlying economic effects, are better estimates of cash flows, are conservative, or
are predictable Earnings management is predominantly a function of manipulating accruals, so it is
intuitive to use the magnitude of accruals as a proxy for earnings quality: the higher the total
accruals as a percentage of assets, the greater the likelihood that earnings quality is low. The
objective of accounting information is to explain financial and economic reality, including both
performance and the financial position of company. The chief financial officer (CFO) develops a
perspective on what this economic reality is and how it should be reported Earnings management
includes the whole spectrum, from conservative accounting through fraud, a huge range for
accounting judgment, given the incentives of management.

Is Earnings Management Good or Bad ?

Contracting Perspective:
Good earnings management
Under ”efficient contracting”, it is desirable to give managers some ability to manage earnings in the
face of incomplete and rigid contracts like bonus, debt covenant, & political. Thus, we would expect
some earnings management to persist for efficient contract. In financial reporting context, earnings
management can be a device to convey inside information to the market, enabling share price to
better reflect the firm’s future prospects.
Bad earnings management
From contracting perspective, this can result from opportunistic manager behavior. Example, the
tendency of managers to use earnings management to maximize their bonuses , debt covenant
violations. In a financial reporting context, earnings management can be used to increase reported
net income in the short run for raising new share capital. Example: speeding up revenue recognition,
lengthening the useful life of assets, etc.

CEO Perspective
Good earnings management
As reasonable and proper practices that are part of operating a well-managed business and
delivering value to shareholders
Bad earnings management
That is, improper earnings management, is intervening to hide real operating performance by
creating artificial accounting entries or stretching estimates beyond a point of reasonableness.

Abusive earnings management

Abuses such as earnings management occur when people exploit flexibility in accounting. Trickery is
employed to obscure actual financial volatility. This, in turn, mask the true consequences of
management’s decisions.

Earnings Management Environment

Corporate Governance
The governance structure includes the board of directors, the functions of the committees, the
interaction of the board with management, and auditing.
Auditing
The external auditors must have the ability to discover significant discrepancies with IND-AS and
willingness to report the discrepancies to the audit committee or other relevant bodies.

Accounting regulation and Standard Setting

Securities and Exchange Commission (SEC) is responsible for regulating the entire equity
capital market structure.

Motivations For Earnings Management

Capital Market Motivations

The widespread use of accounting information by investors and financial analysts to help value
stocks can create an incentive for managers to manipulate earnings in attempt to influence stock
price performance
Contracting Motivations
Accounting data are used to help monitor and regulate the contracts between the firm and its many
stakeholders
Regulatory Motivations
The effects of two forms of regulation : industry specific regulation and anti trust regulation.
Accounting standard setters have demonstrated an interest in earnings management to circumvent
industry regulation. Standard setters may also be interested in earnings management for anti-trust
purposes.
Taxation Motivations
Income taxation is perhaps the most obvious motivation for earnings management. However,
taxation authorities tend to impose their own accounting rules for calculation of taxation income,
thereby reducing firms’ room to maneuvers.
Changes of CEO
CEOs of poorly performing firms may income-maximize to prevent or postpone being fired.
Alternatively, CEOs may take a bath so as to increase the probability of positive future earnings. This
motivation also applies to new CEOs, especially if large write-offs can be blamed on the previous
CEO.

Earnings restatement
An earnings restatement is the revision of public financial information that was previously reported.
It represents real evidence of past earnings manipulation.

Earnings management techniques :

The most successful and widely used earnings management techniques can be classified into Eleven
categories.

“COOKIE JAR RESERVE” TECHNIQUES:

This form of accounting practice involves creation of reserves during periods of good
financial results to shore up profits in lean periods. The management has to estimate and
record obligations that will be paid in the future as a result of events or transactions in the
current fiscal year based on accrual basis. There is always uncertainty surrounding the
estimation process because future is not always certain. Under the cookie-jar technique, the
corporation will try to overestimate expenses during the current period to manage earnings.
If and when actual expenses turn out lower than estimates, the difference can be put into
the "cookie jar" to be used later when the company needs a boost in earnings to meet
predictions. “Cookie jar accounting” is used by a company to smooth out volatility in its
financial results, thus giving investors the misleading impression that it is consistently
meeting earnings targets. Common areas where cookie jar reserves are created are in:

Common areas where cookie jar reserves are created are in:

• Recognize a liability when the company in fact has not incurred a liability

• Estimating bad debt write-offs

• Terminating pension plans

• Estimating sales

Examples of Cookie Jar Accounting

• Microsoft was investigated for cookie jar accounting by the SEC, in October 1999, for
its alleged misconduct in recognizing revenue. At the center, was whether it was
using financial reserves to shore up its financial earnings.
• Fannie Mae, a company created to promote home ownership by purchasing
mortgages from banks that issue them to decrease interest rates, was caught in
 violation of accounting regulations that involve the recording of loans in 2004.
• WorldCom Inc., the carrier of about half of all Internet traffic in 2002, used the
cookie jar accounting methods by using reserves to boost their earnings. It increased
provision for projected expenses and used these to increase the earnings amount.
The company had hidden $3.9 billion in expenses since 2001.
• The computer giant Dell in July 2010 agreed to pay a $100 million penalty to the
SEC to settle SEC allegations that it used cookie jar reserves.
“BIG BATH” TECHNIQUES:

A big bath is an accounting term defined as a management strategy of manipulating a

company's income statement to make poor results look even worse to make future results better. It
effectively accelerate expenses and losses into a single year with already poor results so that future
income looks better. It can be done through
1) Recognizing losses on assets that have a fair market value below the current book carrying value
2) Doing a restructuring that a company may not otherwise have done

When is Big Bath technique used

“Big bath” technique is used in the belief that if bad news has to be reported like a loss, it is
better to report it all at once and get it out of the way. It is used:

• When an organization is already reporting poor results in a year, so that an even larger
loss will not bother investors excessively.

• When management wants to write off assets that have over-inflated or fraudulent
values. For example, managers could have created false sales, which require that
corresponding accounts receivable also be stated on the books. A big bath can be
employed to write off these receivables.

• When management wants to earn bonuses in future periods. They take a big bath in a
losing year, when they will not be earning bonuses anyways, thereby improving the odds
that they can earn bonuses in later years, when profits are more likely

BIG BET ON THE FUTURE” TECHNIQUES:

A company that acquires another company may be said to have made a “big bet on the future”. This
technique is commonly used after acquiring another company. This technique can be used for
earnings management by: Integrating the earnings of the acquired company into corporate
consolidated earnings. Current earnings of an acquired company may be consolidated with parent
company earnings—providing an automatic earnings boost if the subsidiary is purchased on
favourable terms.

“THROW OUT” A PROBLEM CHILD:

“The problem child” here refers to the subsidiary that is not performing well. To increase the the
earnings of future periods, the company can sell the subsidiary which is not performing well i.e. “the
problem child” may be “thrown out”. Earnings can be managed through selling the subsidiary,
exchanging the stock in an equity method subsidiary and spinning of the subsidiary. A gain or loss is
reported in the current period statement when a subsidiary is sold.
• Sell the subsidiary
• When a subsidiary is sold, a gain or loss is reported in the current period income statement
• Create an SPE for financial assets
• Transfer financial assets to a Special Purpose Entity
• Spin off the subsidiary
• In a spin-off, shares in the subsidiary are distributed to or exchanged with current
shareholders, thus making them, not the company but the owners of the problem child. No
gain or loss is normally reported on a spin-off
Change Accounting Standards:

Once a company chooses the accounting principles it will use, they are rarely changed. Companies
that adopt changes take care that stock market does not view the changes as lowering the quality of
earnings as they undermine stock prices. Earnings can be managed by this technique through:

 Volunteering for a new accounting standard – Periodically new accounting standards are
introduced with an adoption window of 2-3 years. Voluntary early adoption may provide
room for earnings management.

 Improved revenue recognition rules – Many industries have several alternative revenue
recognition rules. Timely adoption of “better” revenue rule provides an opportunity of
earnings management.

 Improved expense recognition rule - For companies that record certain expenses on cash
basis, a timely change to accrual based rule provides an opportunity of earnings
management.

AMORTIZATION, DEPRECIATION, AND DEPLETION:

The cost of long-term operating assets used or consumed is normally written off as an expense over
the periods expected to be benefited. It can be expensed in three ways:
 Amortization expense, for intangible assets such as goodwill, patents, copyrights, and
trademarks.
 Depreciation expense, for tangible assets such as buildings, machinery, and equipment.
 Depletion expense, for natural resources that are being harvested or extracted, such as
timber, coal, oil, natural gas.
Writing off long-term assets requires a variety of judgments, which offer an opportunity to
manage earnings:

• Selecting the write-off method

• Management has to decide what method to use to write-off newly acquired long-
term operating assets. Some methods result in greater expense in the current period
than others
• Selecting the write-off period
 • Management must often estimate the “useful” life of a long-term asset, which can
be substantially shorter than its actual physical life
• Estimating salvage value
• Some long-term assets retain substantial value at the end of their estimated useful
lives. This value must be estimated in order to record the correct annual expense
amount. The value may be realized 10, 15, or even 30 years in the future, so there
can be a range of reasonable estimates.
• Change to non operating use
• If a long term asset is changed from operating to non-operating use, it will no longer
be necessary to record depreciation or amortization expense. It’s permissible when
a company ceases to use an asset for operating purposes

SALE/LEASEBACK AND ASSET EXCHANGE TECHNIQUES:

Timely disposition of long-term productive assets carried at historical cost in the balance sheet so a
company can enhance the earnings of the financial statement by selling a long term asset that has
unrealized gain or losses. By recording a gain or loss a company can manage its earnings.
Methods to accomplish this are:

• Outright sale

• A company can sell a long-term asset that has unrealized gains or losses in a year
when the sale will best enhance the financial statement.

• Sale/Leaseback

• It is not unusual for one company to sell an asset to another and immediately lease
it back. The lease can be an operating lease or a capital lease.

According to IAS 17, losses occurring in a sale/leaseback transactions are recognized on the seller’s
book immediately and gain are amortized over the period if it is capital lease or proportion of the
payment is operating lease. A sale/leaseback transaction offers an opportunity for managing
earnings by recording gain/loss. It also offers an opportunity to manage earnings by transforming a
non depreciable asset like land into a lease expense deduction. It is also possible to dispose of long
term productive assets without recording any gain/loss. This can be done by Exchange of similar
productive assets.

OPERATING VERSUS NON-OPERATING INCOME:

Earnings are two types: operating and non-operating. Non operating earnings will not affect future
earnings whereas operating earnings are expected to continue in the near future. Non operating
income includes: discontinued operations, extraordinary gains or losses, cumulative effect of change
in accounting principles. Earnings can be managed by categorizing items which fall into grey areas.
Possible income statement categories for reporting unusual items that are not considered part of
normal operating income include:

1. Special or unusual charges.

2. Discontinued operations
3. Extraordinary gains and losses.
Special or unusual charges are reported under income from continuing operations but the rest three
are not. There are grey areas in classification so it is possible to manage earnings when making
decisions about items in grey areas. To illustrate, a disposition of a major manufacturing plant could
possibly be classified as either a special or unusual charges or as discontinued operations. Accuracy
of classification depends upon management’s prudence.

EARLY RETIREMENT OF DEBT:

Management can manage the earnings by selecting the fiscal period of early retirement of debt. A
gain or loss is occurred when the company makes the early payment of debt which is different from
the book value of long term debt such as bonds. This gain or loss is recorded as an extraordinary
item at the bottom of the income statement which boost the earnings of that period. Long-term
corporate debts, such as bonds, are typically recorded at amortized book value. When they are
retired early, the cash payment required may be substantially different from book value, generating
an accounting gain or loss. This gain or loss to be reported as an extraordinary item at the bottom of
the income statement even though it may not meet the normal criteria for such a classification.
Debt-for-equity swaps are used to both smooth income and to relax potentially binding sinking-fund
constraints in the cheapest feasible manner.

USE OF DERIVATIVES:

Derivatives offer a lot of opportunities for manager to manage earnings. Derivatives can be used to
protect against some types of business risk such as:
 Interest rate changes
 Commodity price change
 Oil price changes
 Changes in foreign currency exchange rates
Some of the varied types of derivatives are:
 Forwards
 Options
Derivatives are reported according to IAS 39 as assets and liabilities in the balance sheet and
measured at fair value. Historical cost or other specific accounting treatment in many circumstances
is also allowed.
For instance:
Suppose a company had a large issue of bonds outstanding at a fixed interest rate. The company
could enter into an interest rate swap that would effectively convert the fixed rate bonds into
variable rate bonds. When the interest rate increases, the company would then record an increase
in interest expense for the bonds and a decrease if the rate has decreased. Since, when the company
enters into the swap is up to the company, the timing option provides an opportunity to manage the
earnings.

SHRINK THE SHIP:

Companies do not have to report any gain or loss for repurchase of their own shares on the income
statement because no income is recognized on the transaction. Income is only earned through
equity transactions outside the firm, not with those involving the firm’s owners. A stock buy does
not affect earnings but it is used to affect earnings per share. So, these are the common & popular
earnings management techniques. Management uses this technique as and when required to
manage earnings.

Detecting Earning Management (Research Paper)

Author(s): Patricia M. Dechow, Richard G. Sloan, Amy P. Sweeney

This paper evaluates alternative accrual-based models for detecting earnings management. The
evaluation compares the specification and power of commonly used test statistics across the
measures of discretionary accruals generated by the models

INTRODUCTION

Analysis of earnings management often focuses on management's use of discretionary accruals. Such
research requires a model that estimates the discretionary component(s) of report.

i. The specification of the test statistics is evaluated by examining the frequency with which they
generate type I errors. Type I errors arise when the null hypothesis that earnings are not
systematically managed in response to the stimulus identified by the researcher is rejected
when the null is true.

ii. The power of the test statistics is evaluated by examining the frequency with which they
generate type II errors. Type II errors arise when the null hypothesis that earnings are not
systematically managed in response to the stimulus identified by the researcher is not
rejected when it is false.

MEASURING DISCRETIONARY ACCRUALS

It’s an usual starting point for the measurement of discretionary accruals is total accruals.
It’s help in enabling total accruals to be decomposed into a discretionary and a nondiscretionary
component. Models used in this paper require at least one parameter to be estimated, and this is
typically implemented through the use of an "estimation period," during which no systematic earnings
management is predicted. We have cast all models in the same general framework to facilitate
comparability.
THE HEALY MODEL

It tests for earnings management and compares mean total accruals (scaled by lagged total assets)
across the earnings management partitioning variable and also predicts the systematic earnings
management occurs in every period. Inferences are then made through pair wise comparisons of the
mean total accruals in the group where earnings is predicted to be managed upwards to the mean
total accruals for each of the groups where earnings is predicted to be managed downwards.

DEANGELO MODELS

A common feature of the Healy and DeAngelo Models is that they both use total accruals from the
estimation period to proxy for expected nondiscretionary accruals. If nondiscretionary accruals are
constant over time and discretionary accruals have a mean of zero in the estimation period, then both
the Healy and DeAngelo Models will measure nondiscretionary accruals without error. Which one of
the two models is more appropriate then depends on the nature of the time-series process generating
non discretionary accruals.

JONES MODEL

It assumes that revenues are non discretionary and non discretionary accruals are not constant. This
model controls the effect of changes in a firm's economic circumstances on nondiscretionary accruals.
Limitation of this model equates total accruals with respect to revenues and will therefore extract this
discretionary component of accruals, causing the estimate of earnings management to be biased
toward zero.

THE MODIFIED JONES MODEL

It designed to eliminate the conjectured tendency to measure discretionary accruals with error when
discretion is exercised over revenues with non discretionary accruals are estimated during the event
period. There is change in revenues is adjusted for the change in receivables in the event period.
Assumes that all changes in credit sales in the event period result from earnings management

THE INDUSTRY MODEL

This model relaxes the assumption that nondiscretionary accruals are constant over time. It Assumes
that variation in the determinants of nondiscretionary accruals are common across firms in the same
industry. To mitigate measurement error in discretionary accruals hinges critically on two factors, one
is It removes variation in nondiscretionary accruals that is common across firms in the same industry
and other one is it removes variation in discretionary accruals that is correlated across firms in the
same industry.
EXPERIMENTAL DESIGN

Sample (i) used for the earnings management partitioning variable is selected at random; it is expected
to be uncorrelated with any omitted variables. Note that this is simply a test of whether the Gaussian
assumptions underlying the regression are satisfied.

Sample (ii) is used to examine the impact of firm performance on model misspecification. The earnings
management stimulus investigated in many existing studies are correlated with firm performance.

Sample (iii) made three different sets of assumptions regarding the components of accruals that are
managed:

1) Expense Manipulation - delayed recognition of expenses. This approach is implemented by

adding the assumed amount of expense manipulation to total accruals in the earnings
management year, and subtracting the same amount in the following year. Since none of the
models use expenses to estimate non discretionary accruals, none of the other variables used
in the study need to be adjusted.

2) Revenue Manipulation - premature recognition of revenue (assuming all costs are fixed). This
approach is implemented by adding the assumed amount of revenue manipulation to total
accruals, revenue and accounts receivable. The same amount is subtracted from total
accruals, revenue and accounts receivable in the following year.

3) Margin Manipulation - premature recognition of revenue (assuming all costs are variable).
This approach is implemented by adding the assumed amount of margin manipulation to total
accruals and by adding the following to revenue and accounts receivable.

IMPLEMENTATION

1) Subtle cases of earnings management in the order of, say, one percent of total assets
require sample sizes of several hundred firms to provide a reasonable chance of detection.
Our analysis has focused primarily on documenting the properties of existing models.
Further research to develop models that generate better specified and more powerful
tests will further enhance our ability to detect earnings management.

2) Pertinent measures of firm performance include earnings performance and cash from
operations performance. For example, the nature of the performance-related bias may be
such that the coefficient on the earnings management partitioning variable is negatively
biased, while the researcher's hypothesis predicts a positive coefficient. Thus, if the
researcher finds a significant positive coefficient, it would be reasonable to conclude that
the hypothesis is supported, since the misspecification works against finding the result.

3) If the Jones Model is used in a research context where discretion is exercised over
revenues, then it is likely to extract the discretionary component of total accruals.
Similarly, if the Industry Model is used in a research context where intra-industry
 correlation in discretionary accruals is expected, then it is likely to extract the
discretionary.

CONCLUSIONS

This research paper evaluates the ability of alternative models to detect earnings management. All
models produce reasonably well specified tests for a random sample of event-years. Power of the tests
is low for earnings management of economically plausible magnitudes. Modified version of the model
developed by Jones (1991) provides the most powerful tests of earnings management.