Earnings Management

The importance of earnings

Earnings sometimes are called the 'bottom line' or 'net income'. As measure of entity
performance, they are of great importance to financial statement users and indicate the extent
to which entity has engaged in activities that add value to it. Earnings are used by shareholder
to both assess managers' performance a stewardship role and to assist in predicting future cash
flows and assessing risk.

What is earning management

earning management occurs when 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 Earning management can also be defined as more
conservatively as 'reasonable and legal management decision making and reporting intended
to achieve stable and predictable financial results. earnings managements are not to be confused
with activities that do not reflect economic reality which may be evidence of fraud'

5 methods of earnings management

• accounting policy choice is choosing between the available acceptable accounting
policies is one of the most used forms of earning management. This decision can relate
to choose between straight line and accelerated depreciation, FIFO, or weighted average
for inventory valuation, or deciding to be a voluntary early adopter of new accounting
standard. Earning managements can occur when management have flexibility in
making accounting choices in line with accounting standards requirements. These
choices will lead to different timing and amounts of expense recognition and asset
valuation. It is difficult to determine if these choices are made because they reflect the
economic nature of the underlying transactions, or if management is seeking to delay
expense recognition to a later date.
• Accrual accounting is managers prefer to generate consistent revenues and earnings
growth. shareholders prefer to invest in an entity exhibits consistent growth patterns,
not one that has uncertain and earnings changing patterns. For this reason, managers
will have incentive to use accrual accounting techniques to manage earnings over time.
Accrual accounting attempts to reflect the effects of transactions and other events and
circumstances that have cash (or other) consequences for an entity's resources and the
claims in them in the periods in which they occur or rise. Accrual accounting techniques
generally have no direct cash flow consequences and can include under-provisioning
for bad debt expenses, delaying asset impairments, adjusting inventory valuations, and
amending depreciation and amortisation estimates and adjustments
• income smoothing is defined as smoothing moderates’ year-to-year fluctuations in
income by shifting earnings from peak years to less successful years. this practice can
relate to a wide range of accrual accounting practices including early recognition of
sales revenue, variations to bad debts or warranty provisions, or delaying asset
impairments
• real activities management is management can also manage earning by managing
operational decisions, not just by accounting policies or accruals. real activities
management can have effect on the cash flows and in some cases accruals. Real
activities management is less likely to draw attention of auditors than accruals
management as auditors are not likely to question actual pricing and production
decisions
 • big bath write-offs are when management are required to significantly restructure, he
organisation, which might mean selling off subsidiaries or operational units. This will
result in a large loss reported against income. big bath accounting is often used when
there is a change on the management team, with the need to write off assets or
operational units being blamed on the outgoing managers' poor management of
resources. This will lead to future reduction in expenses and benefits the new
management team by presenting a reduced base upon which future valuations and
comparisons of the management team's performance can be assessed.

Why do entities manage earning?

There are two main motivation for engaging in earnings management
1. Earnings are managed for the benefits of the entity for several reasons including: to
meet analysts' and shareholder expectations and predictions; to maximise share price
and company valuation; to accurately convey private information; or to avoid violating
restrictive debt covenants
2. Earnings are managed to meet short-term goals which lead to maximising managerial
remuneration and bonuses

Entity valuation
To understand why managers might manage earnings to maximise share price it is important
to consider how company is valued. There are several different methods commonly used value
by forecasting the future value of one the following measures:
• book value of the company (reflected in the balance sheet)
• operating cash flow
• net income
Managers are more likely to engage in income smoothing to reduce volatility and therefore risk
of investment.

Earnings quality
Quality of earnings can also affect a company's share price. Earning 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 forecast. On the hand, if current earnings have a low correlation with future earnings,
low earnings quality is said to be present.

Managerial compensation and earnings management

Senior managers, including the chief executive officer (CEO) and the chief financial officer
(CFO), play an integral role in generating and reporting earnings. While the board of directors
approves key decisions, it is the management team that makes those key decisions about
strategy, investments, budgets, operations and acquisitions. While managers are appointed to
operate the business for the benefit of shareholders, their objectives do not necessarily always
align. Agency theory literature identifies a number of problems that can exist between
managers and owners in an agency relationship. These problems include: the horizon problem,
risk aversion and dividend retention. The remuneration package for senior managers, therefore
relates payment of cash, shares and options to various performance measures, where
performance could include a combination of share returns and earnings, as well as a number of
non-financial performance targets. Some common performance measures that directly relate to
earnings include, but are not restricted to:
 • accounting returns
• sales revenue
• net interest income
• a balanced scorecard index of multiple indicators
• economic value added (EVA).
Share-based compensation has increasingly been used in recent years and comes in a range of
forms, including: share grants, restricted share grants where managers are restricted from
selling their shares until a certain time elapses or the entity reaches specific performance goals,
and share performance rights, which offer the right to receive shares when specific performance
goals are reached. Research examining equity-based compensation generally supports the
existence of earnings management that is intended to inflate earnings.

Change in CEO and earnings management

Research has found that earnings management is particularly evident around the time a CEO
changes. This research has looked at two distinct issues: (1) whether the departing CEO used
earnings management to mask poor performance, which can lead to a higher bonus upon
leaving; and (2) whether the incoming CEO used earnings management in the form of a big
bath write-off to blame poor performance on his or her predecessor and in turn increase
earnings the following year. Research has found that incoming CEOs are more likely to take
an earnings bath in the first year and then the following year show large earnings increases.
Godfrey, Mather and Ramsay, in a study of earnings and impression management surrounding
Australian CEO changes, found evidence that in the year of a CEO change, earnings are
managed downwards, with upwards earnings management in the year after a CEO change. The
authors note that the results were strongest where the CEO change was prompted by a
resignation rather than a retirement.

Consequences of earnings management

The consequences of earnings management decisions will depend on the nature and extent of
earnings management that has taken place. A number of studies explore the consequences of
earnings management for an entity’s value by examining share price reactions surrounding a
significant event such as an initial public offering (IPO) or a management buyout. Researchers
have also examined the share price reaction to evidence of fraudulent reporting. Dechow, Sloan
and Sweeny; Palmrose, Richardson and Scholz; and Beneish all found that the market reacts
negatively to the disclosure that there has been fraudulent manipulation, implying that investors
were surprised and interpreted the information as negative news.

Corporate governance and earnings management

The composition of the board, including the number of members, their expertise and
independence, are important in determining how likely it is that managers are able to
manipulate or manage earnings. A board made up of internal, rather than independent, directors
is less likely to question a CEO who may want to use aggressive earnings management
strategies. Strong governance means a balance between corporate performance and an
appropriate level of monitoring. It is important that the board exhibits an optimal mix of
monitoring and expertise, and is not just seen as providing a ‘rubber stamp’ to decisions of the
CEO. If this is the case, it is more likely that inappropriate earnings management can result.
Research has found that there is likely to be greater levels of earnings management when the
proportion of independent directors on the board is low. Beasley also found that the presence
of independent directors reduces the likelihood of fraudulent earnings management.