CIA3003:

 Accounting  Theory  and  Practice  

Special   Issues   in   Financial   Accounting   &  
Reporting:  Creative  Accounting  and  Ethics  
Semester  1,  20192020  
 
 
Outline
•  Defini&on  of  earnings  management  
•  Common  methods  of  earnings  management  
•  Reasons  why  en&&es  manage  earnings  
•  Role  of  Corporate  Governance  in  controlling  earnings  
management  

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The  importance  of  earnings  
Earnings  
•  Also  known  as  profit,  boAom  line,  net  income.  
•  Measures  en&ty  performance  /extent  to  which  an  en&ty  has  
engaged  in  ac&vi&es  that  add  value  
•  widely  reported,  frequently  forecast.  
•  Strongly  linked  to  share  value.  

Earnings  are  used  by:  

•  Shareholders:  
•  assess  stewardship  and  prospects  
•  Creditors:  
•  assess  risk,  input  to  debt  covenants  
•  Customers:  
•  assess  earnings  to  gauge  long  term  survival  of  company.   3  
What  is  earnings  management?  
•  Healy  and  Wahlen(1999):    
•  ‘earnings  management  occurs  when  managers  use  judgement  in  
financial  repor&ng  and  in  structuring  transac&ons  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  
accoun&ng  numbers’.  
•  McKee  (2005):  
•  ‘reasonable  and  legal  management  decision  making  and  
repor&ng  intended  to  achieve  stable  and  predictable  financial  
results’.  
•  The  defini&ons  above  differ  on  whether  normal  financial  
decisions  are  part  of  the  defini&on  or  the  purpose  of  earnings   4  
management  is  to  mislead    
What  is  earnings  management?  
•  There  are  different  defini&ons  of  what  earnings  management  
is.  

White   Grey   Black  

•  Beneficial  for   •  Biased  to   •  Misrepresents  

all,  enhances   benefit   reality,  
transparency.   organisa&on   fraudulent.  
or  
management  
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What  is  earnings  management?  
•  Earnings  management  rela&ng  to  different  en&ty  
objec&ves:  
Methods  of  earnings  management  
 
•  Accoun7ng  policy  choice:  
•  most  common  form  of  earnings  management  
•  strategic  choices  of  acceptable  accoun&ng  policy  
•  Eg:  deciding  to  be  an  early  adopter  of  a  new  accoun&ng  standard,  
FIFO  or  weighted  average  for  inventory  valua&on  
•  These  choices  will  lead  to  different  &ming  of  amounts  of  expense  
recogni&on  and  asset  valua&on  
•  Difficult  to  determine  if  these  are  made  because  they  reflect  the  
underlying  nature  of  underlying  transac&ons  or  management  is  
seeking  to  delay  expense  recogni&on  
 

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Methods  of  earnings  management  
 
•  Accrual  accoun7ng  
•  Rather  than  repor&ng  erra&c  changes  in  revenue  and  earnings,  
managers  prefer  to  generate  consistent  revenues  and  earnings  
growth  
•  Accrual  accoun&ng  techniques  allows  en&&es  to  delay  or  
accelerate  recogni&on  of  income  and  expense  and  generally  have  
no  direct  cash  flow  consequences  
•  enables  en&ty  to  temporarily  adjust  profit  figures.  
•  Eg:  under  provisioning  of  bad  debt  expenses,  delaying  asset  
impairments,  amending  deprecia&on  es&mates  

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Methods  of  earnings  
management  
•  Income  smoothing  
•  Copeland  (1968)  ‘Smoothing  moderates  year-­‐to-­‐year  fluctua&ons  
in  income  by  shieing  earnings  from  peak  years  to  less  successful  
periods.’  
•  Premised  on  the  belief  that  shareholders  prefer  to  invest  in  an  
en&ty  that  exhibits  consistent  growth  paAerns  rather  than  one  
that  has  uncertain  and  changing  earnings  paAerns.  
•  Managers  will  have  incen&ves  to  to  smooth  earnings  over  &me  
•  Relate  to  wide  range  of  accrual  accoun&ng  prac&ses  such  as  
warranty  provisions,  early  recogni&on  of  sales  revenues  

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Methods  of  earnings  
management  
•  Classifica7on  shi<ing  
•  Misclassifica&on  of  items  within  the  income  statement  
without  altering  net  income  
•  McVay  (2006)  –  first  to  find  empirical  evidence  that  firms  in  
the  US  manipulate  core  earnings  by  shieing  core  expenses  
from  cost  of  goods  sold  to  income  decreasing  special  items  
•  Based  on  strand  of  literature  that  the  ability  of  an  income  
statement  line  to  predict  future  earnings  depends  on  its  posi&on  
in  the  income  statement  
•  Line  items  closer  to  sales  revenue  are  more  likely  to  predict  
future  earnings  
•  Managers  have  incen&ves  to  disclose  core  earnings  without  
excluding  non  opera&ng  revenues   10  
Methods  of  earnings  management  
•  Real  ac7vi7es  management:  
•  Managing  earnings  by  managing  opera&onal  decisions,  not  just  
accoun&ng  policies  or  accruals.  
•  Examples  include:    
•  accelera&ng  sales  
•  altering  shipment  schedules  and  delaying  research  and  development  
and  maintenance  expenditures.  
•  Can  reduce  en&ty  value  because  ac&ons  taken  in  the  current  period  
to  increase  earnings  can  have  nega&ve  effects  on  cash  flows  in  later  
periods.  

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Methods  of  earnings  management  
•  Big  bath  write-­‐offs:  
•  Big  bath  accoun&ng  occurs  when  large  losses  are  reported  
against  income  as  a  result  of  significant  restructure  of  opera&ons/
change  in  management.  
•  Management  realises  that  larger  than  normal  write-­‐offs  can  be  
jus&fied,  they  may  aAempt  to  bring  forward  or  even  overstate  
expenses  in  the  same  period.  
•  Leads  to  future  reduc&ons  in  expenses  and  beAer  performance    
by  presen&ng  a  reduced  base  upon  which  future  valua&ons  and  
comparisons  performance  can  be  assessed.  

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Why  do  entities  manage  earnings?  
•  Main  mo7va7ons  to  manage  earnings    
For  the  benefit  of  the  en&ty:  
•  To  meet  analysts’  and  shareholder  expecta&ons  and  predic&ons.    
•  To  maximise  share  price  and  company  valua&on  
•  To  accurately  convey  private  informa&on    
eg:  different  deprecia&on  rate  for  computer  technology  may  be  because  en&ty  is  signalling  
that  an&cipated  technological  advances  may  make  equipment  obsolete  faster  than  industry  
norms  
•  To  avoid  viola&ng  restric&ve  debt  covenants  
 
To  meet  short-­‐term  goals  which  lead  to  maximising  managerial  
remunera&on  and  bonuses.  
 
•  McKee  (2005)  points  out  that  these  mo&va&ons  may  not  be  in  
conflict  as  managers  can  be  mo&vated  by  both  mo&va&ons  at  the  
same  &me  
•  If  the  en&ty  performs  well  financially,  this  will  lead  to  managers  
maximising  their  own  remunera&on  
Why  do  entities  manage  earnings?  
•  En7ty  valua7on  
•  Research  by  Dechow  (1994)  indicates  that  share  prices  are  more  
aligned  with  net  income  than  with  opera&ng  cash  flows  
•  Net  income/earnings  is  commonly  used  to  determine  en&ty  value  
•  An  en&ty’s  value  is  effec&vely  the  present  value  of  future  income  
discounted  at  a  risk  adjusted  discount  rate  
•  Companies  with  more  vola7le  paFerns  of  earnings  are  likely  to  
have  a  higher  risk  measure,  therefore  likely  to  have  lower  en&ty  
value  
•  Managers  are  more  likely  to  engage  in  income  smoothing  to  reduce  
vola&lity  and  therefore  risk  of  investment.  
•  However,  many  managers  may  also  take  a  short-­‐term  
perspec&ve  and  focus  on  delivering  earnings  and  mee&ng  
targets.  
•  Long-­‐term  value  maximising  decisions  may  not  be  considered.  
Why  do  entities  manage  earnings?  
•  Managerial  compensa7on  and  earnings  management  
•  Management  makes  the  key  decisions  about  strategy,  
investments,  budgets,  opera&ons,  business  strategy  and  
acquisi&ons.    
•  Although  managers  are  appointed  to  operate  the  business  for  the  
benefit  of  shareholders,  agency  theory  argues    their  objec&ves  do  
not  necessarily  always  align.  
•  The  remunera&on  package  for  senior  managers  relates  payment    
to  various  performance  measures.  
•  Some  common  performance  measures  that  directly  relate  to  
earnings  include:  
•  accoun&ng  returns  
•  sales  revenue  
•  net  interest  income   15  
 
Why  do  entities  manage  earnings?  
•  Managerial  compensa7on  and  earnings  management,cont  
•  Prior  research  suggest  that  managers  will  manage  earnings  in  
such  a  way  that  they  maximise  their  bonus.  
•  If  earnings  are  so  low  that  they  are  unlikely  to  meet  their  targets,  they  are  
likely  to  engage  in  big  bath  write-­‐offs.  
•  En&&es    that  adopt  a  long-­‐term  bonus  plan  in  addi&on  to  a  short-­‐
term  plan  are  able  mi&gate  earnings  management  

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Why  do  entities  manage  earnings?  
•  Changes  in  CEO  and  earnings  management:  
•  Earnings  management  is  par&cularly  evident  around  the  &me  a  
CEO  changes.    
•  Outgoing  CEOs  are  likely  to  manage  earnings  up  in  final  year  to  
increase  opportuni&es  or  reduce  appearance  of  poor  
performance.  
•  Incoming  CEOs  are  more  likely  to  take  an  earnings  bath  in  the  
first  year  and  then  the  following  year  show  large  earnings  
increases.  

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Why  do  entities  manage  earnings?  
•  To  avoid  viola7ng  restric7ve  debt  covenants/  corporate  distress  
•  Default  on  a  debt  agreement  can  be  associated  with  corporate  
distress.  
•  En&&es  that  are  financially  distressed  and  facing  debt  covenant  
viola&ons  are  likely  to  use  earnings  management  to  avoid  the  
costly  breach  of  debt  covenants.  

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Consequences  of  earnings  management  
•  The  consequences  of  earnings  management  decisions  will  
depend  upon  the  nature  and  extent  of  earnings  management  
that  has  taken  place.  
•  In  ini&al  public  offerings  (IPOs)  –aggressive  earnings  management  
oeen  leads  to  subsequent  poor  share  performance  when  
earnings  decline.  
•  Earnings  management  leads  to  market  temporarily  overvaluing  the  
en&ty  
•  Share  market  reacts  nega&vely  to  disclosure  that  there  has  
been  fraudulent  manipula&on  of  earnings  

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Corporate  governance  and  earnings  
management  
•  The  composi7on  of  the  board,  including  the  number  of  
members,  their  exper&se  and  independence  are  important  in  
determining  how  likely  it  is  that  managers  are  able  to  
manipulate  or  manage  earnings.  
•  Research  has  found  that  there  is  likely  to  be  greater  levels  of  
earnings  management  when  the  propor7on  of  independent  
directors  on  the  board  is  low.  

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Summary  
•  The  importance  of  earnings  in  assessing  the  success  of  an  
organisa&on.  
•  What  earnings  management  is.  
•  A  number  of  common  methods  of  earnings  management.  
•  Accoun&ng  policy  choice,  accrual  accoun&ng,  income  smoothing,  
real  ac&vi&es  management  and  big  bath  write-­‐offs.  
•  The  reasons  why  en&&es  manage  earnings.  
•  The  consequences  of  earnings  management.  
•  The  role  corporate  governance  plays  in  controlling  earnings  
management.  

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Discussion  
1.  Discuss  methods  that  en&&es  use  to  manage  earnings.  Why  
might  en&&es  engage  in  earnings  management.  Refer  to  
Mohanram  (2003)  Group  5  
2.  Discuss  the  use  of  classifica&on  shieing  as  an  earnings  
management  tool.  Refer  to  Malikov  et  al  (2018)  Group  6  
3.  Discuss  whether  CEO  compensa&on  is  related  to  earnings  
management.  Refer  to  Tahir  et  al  (2019)  Group  7  
4.  Discuss  the  role  of  corporate  governance  in  preven&ng  
earnings  management.  Refer  to  Xie  et  al  (2003)  Group  8  
 

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