Chapter 11

Earnings Management

11 - 1
Organization of This Chapter

11 - 2
 What Is Earnings Management (EM)?

 Earnings management is the choice by a

manager of accounting policies (including
accruals), or real actions, that affect earnings
so as to achieve some specific reported
earnings objective.
 Here, we concentrate on role of accruals in
earnings management.

11 - 3
 Patterns of EM

Four common patterns of EM:

11 - 4
 Motivation for EM: Bonus Purposes

 A contractual motivation: bonus plan hypothesis

 Evidence: Healy (1985)
 Confined to bonuses based on net income
 Recall concepts of bogey and cap
 Findings (see table on next slide):

11 - 5
Motivation for EM:
Bonus Purposes (cont.)
 Healy (1985) (cont.)
Observations with both a Bogey and a Cap
Portfolio Proportion of No. of Average
Accruals with Obs. Accruals
Given Sign
Positive Negative
LOW 9% 91% 22 - 0.0671
MID 46% 54% 281 +0.0021
UPP 10% 90% 144 - 0.0536
447

11 - 6
 Motivation for EM:
Bonus Purposes (cont.)
 Healy (1985) (cont.)
 Methodological issues of measuring discretionary accruals
 Healy used total accruals as proxy

 Now usually based on Jones (1991) model

 Result of downward earnings management when net

income below bogey challenged by Holthausen,

Larcker, and Sloan (1995)
 Conclusion: despite methodological challenges, there is
significant evidence that, on average, managers uses
accruals to manage earnings so as to influence their
bonuses

11 - 7
 Other Motivations for EM

 Other contractual motivations

 Debt covenant hypothesis
To avoid violating debt covenants
 Implicit contracts
To maintain continuing business relationships with
other stakeholders, such as suppliers and short-term
creditors
 Political cost hypothesis: to lower political “heat”

11 - 8
 Other Motivations for EM (cont.)

Stock market related motivations:

 To meet investors’ earnings expectations and
maintain manager reputation
 To increase proceeds from stock issuance,
especially initial public offerings
 Teoh, Welch, and Wong (1998)
 Fan (2007)

11 - 9
 The Good Side of EM
 Investor-based arguments for good EM
 To credibly communicate inside information to
investors
 Blocked communication may inhibit direct disclosure of
earnings expectations
 Discretionary accrual management as a way to credibly
reveal management’s inside information about earnings
expectations

11 - 10
 The Good Side of EM (cont.)
 Contract-based arguments for good EM
 To give firm some flexibility in the face of rigid, incomplete
contracts, thus improving contracting efficiency
 Bonus contracts based on net income

 New accounting standards may lower net income and/or increase

volatility
 Hence may adversely affect evaluation of manager effort
 Debt covenant contracts
 New accounting standards may increase probability of debt
covenant violation
 Contract violation is costly, earnings management may be low-cost
way to work around

11 - 11
 The Good Side of EM (cont.)

 Theoretical models supporting good EM

 Demski & Sappington (1987a & b)
 Chen, Hemmer, & Zhang (2007)
 Empirical evidence supporting good EM
 Subramanyam (1996)
 Barth, Elliott, & Finn (1999)
 Tucker & Zarowin (2006)
 Francis, LaFond, Olsson, & Schipper (2005)
 Etc.
11 - 12
 EM at General Electric
Textbook, problem 9
GE’s Steady Increase in Reported Earnings
Year Reported Year Reported
Net Income Net Income
(Million) (Million)
2008 $17,335 2000 $12,735
2007 22,208 1999 10,717
2006 20,829 1998 9,296
2005 16,711 1997 8,203
2004 17,160 1996 7,280
2003 15,002 1995 6,573
2002 14,118 1994 4,726
2001 13,684 1993 4,315
11 - 13
EM at General Electric (cont.)
GE’s Reported Net Income (Million) from 1993 to 2008

11 - 14
 EM at General Electric (cont.)
 EM devices used by GE
 Changes to the expected rate of return on pension plan
assets
 Sales of divisions
 Restructuring charges
 Conservative accounting
 Allocation of purchased goodwill upon acquisition of
subsidiary companies
 EM devices used in harmony to report steadily
increasing earnings

11 - 15
 EM at General Electric (cont.)
 Is this good or bad (i.e., opportunistic) EM?
 Argument: even assuming securities market
efficiency, GE is so large and complex that even
financial analysts cannot prepare accurate
earnings forecasts
 Management has best inside information about
expected persistent earnings
 Direct communication blocked
 Creates role for earnings management to reveal
management’s expected persistent earnings
11 - 16
 The Bad Side of EM

 Contracting Perspective
 Healy (1985)
 Related to manager’s bonus plans
 Is this good or bad earnings management?
 Dechow, Sloan, and Sweeney (1996)
 92 sample firms charged by SEC with alleged violation of
GAAP
 Related to avoiding debt covenant violation and issuing
stocks
 Is this good or bad earnings management?

11 - 17
 The Bad Side of EM (cont.)
 Financial Reporting Perspective
 Hanna (1999) re. non-recurring charges
 Investors and analysts look to core earnings, ignoring
provisions for extraordinary and non-recurring items
 But current non-core provisions increase core earnings in
future years, through lower amortization and absorption
of future operating costs
 As a result, managers tempted to “overdose” on non-
core provisions, thereby putting earnings “in the bank”
(“cookie jar accounting”)
 Decision useful financial information to investors?

11 - 18
 The Bad Side of EM (cont.)
 Standard setters response to bad EM
 IAS 37 on provisions for uncertain future payment
 Before recording a provision, payments must be
probable and capable of reliable estimation
 Provision must be valued at fair value
 No excess provision as a result of uncertainty
 Provisions must be used only to absorb costs for which
provision originally set up
 Restructuring expense and any reversals thereof must be
shown separately on the income statement
 Does this solve problem of abuse of provisions?

11 - 19
 The Bad Side of EM (cont.)

 Can accountants reduce bad EM?

 Yes, if full disclosure of
 Revenue recognition policies
 Unusual, non-recurring and extraordinary events
 Enables investors to better evaluate earnings
persistence
 Effect of previous non-recurring charges on
current core earnings (Hanna,1999)

11 - 20
 Conclusions

 Earnings management can be good if used

responsibly
 Full disclosure helps to control bad earnings
management

11 - 21