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BU457 Study Guide - Midterm Guide: Earnings Management, Credit Risk, Accounts Payable

Course Code
Bixia Xu
Study Guide

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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
o Accounting policy choices (ex. straight-line vs declining
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
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
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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
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
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