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BU457 Midterm: Earnings Management REVIEW

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Bixia Xu

Earnings Management REVIEW • Managers may use earnings management to meet analysts’ earnings forecasts, thereby avoiding reputation damage and strong negative share price reaction that quickly follows a failure to meet investor expectations • Management may use it to report a stream of smooth and growing earnings over time • Given securities market efficiency, this requires management to draw on its inside information • Earnings management can be used as a way to protect the firm from the consequences of unforeseen events when contracts are rigid and incomplete • Too much earnings management, however, may reduce the usefulness of financial statement reports for investors • This is particularly so if opportunistic earnings management is not fully disclosed • Managers can use earnings management to smooth their compensation over time, thereby reducing compensation risk • Earnings management is the choice by a manager of accounting policies, or real actions, affecting earnings so as to achieve some specific reported earnings objective • It is convenient to divide accounting policy choices into two categories o Accounting policy choices (ex. straight-line vs declining balance) o Discretionary accruals and provisions for restructuring • Iron law: accruals reverse • In effect, if a firm is performing poorly, earnings management cannot indefinitely postpone the day of reckoning • Another way to manage earnings is by means of real variables, such as advertising, R&D, maintenance, timing of purchases and disposals of capital assets, stuffing the channels, overproduction etc. • Firms use both accrual-based and real earnings management strategies, and real earnings management does indeed compromise longer-term performance Patterns of Earnings Management • Taking a bath o If a firm must report a loss, management may feel it might as well report a large one – it has little to lose at this point o Because of accrual reversal, this enhances the probability of future reported profits • Income minimization o May be chosen by a politically visible firm during periods of high profitability • Income maximization o Managers may engage in a pattern of maximization of reported net income for bonus purposes, providing that this does not put them above the cap o Firms that are close to debt covenant violations may also maximize income • Income smoothing o Managers may smooth reported earnings over time so as to receive relatively constant compensation o More volatile the stream of reported net income, the higher the probability that covenant violation will occur o Income smoothing may reduce the likelihood of reporting low earnings, so managers have less chance of getting fired o Firms may smooth net income for external reporting purposes, enabling the firm to communicate its expected persistent earning power Evidence of Earnings Management for Bonus Purposes • Bonus schemes have bogeys and caps • If bonus plans have the rules set as the following, it is called piecewise linear o Below the bogey, bonus is 0 o If there is no cap, bonus would increase along the dotted line o Otherwise, the bonus becomes a constant for net income greater than the cap • If net income is low (below the bogey), the manager has an incentive to lower it even further (take a bath) to increase the chance of receiving a bonus next year since writeoffs will reduce future charges • If net income is high (above the cap), there is motivation to adopt income minimization policies, because bonus is permanently lost on reported net income greater than the cap • Discretionary accruals: accruals over which the manager can exercise some control o Amortization expense: non-discretionary o Increase in net accounts receivable: discretionary o Increase in inventory: discretionary o Decrease in accounts payable and accrual liabilities: discretionary (ex. warranty) • From opportunistic point of view, managers will exploit their power by maximizing their utility at the expense of the firm’s shareholders and other investors who may find it costly to unravel discretionary accruals • From efficient contracting perspective, firms will rationally anticipate managers’ incentives to manage earnings and allow for this in the amount of compensation they offer • Whether we view them from opportunistic or efficient contracting perspective, compensation contracts do create earnings management incentives Other Motivations for Earnings Management Other Contracting Motivations • Earnings management can rise as a device to reduce probability of covenant violation in their debt contracts • When its troubles are profound, the firm’s behaviour transcends that which is predicted by the debt covenant hypothesis and, instead, earnings management becomes part of the firm’s (and its manager’s) overall strategy for survival • Earnings management incentives also derive from implicit contracts, also called relational contracts o They arise from continuing relationships between the firm and its stakeholders and represent expected behaviour based on past business dealings To Meet Investors’ Earnings Expectations and Maintain Reputation • Market penalizes firms that fall short of expectations by more than it rewards firms that exceed them • As a result, managers have a strong incentive to ensure that earnings expectations are met, particularly if they hold ESOs or other share-related compensation • One way to do this is to manage earnings upwards • Failure to meet investors’ earnings expectations thus has seriou
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