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ACTG 4P11 (6)
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Chapter 11

Chapter 11 Notes (Key takeaways from the chapter) - .docx

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Chapter 11 – Earnings Management Earnings Management - Choice by a manager of accounting policies, or real actions, affecting earnings so as to achieve some specific reported earnings objective - Healy and Wahlen (1999): occurs when “manager uses judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of a company or influence contractual outcomes that depend on reported accounting numbers” Patters of Earnings Management - Taking a bath – management may record a larger loss during a loss period so future reported earnings will be enhanced o E.g. during periods of organizational stress or restructuring - Income minimization – less extreme as taking a bath o E.g. to avoid political heat as discussed in Chapter 8 - Income maximization – from PositiveAccounting Theory, maximize reported net income for bonus purposes o Another example is firms close to debt covenant violations - Income smoothing – risk-averse managers prefer a less variable bonus stream o E.g. smooth reported earnings over time so as to receive a relatively constant compensation Evidence of Earnings Management for Bonus Purposes - Healy (1985) study, confined to bonuses based on net income, extends the bonus plan hypothesis, which states that managers of firms with bonus plans will maximize current earnings - If net income is between the bogey and cap, manager is motivated to adopt accounting policies to increase reported net income - Measured discretionary accruals using total accruals as a proxy (but now based on Jones (1991) model discussed in Chapter 9) o Amortization, increase in netA/R (AFDA), increase in inventory, decrease in A/Pand accrued liabilities (warranty liability) Other Contractual Motivations - Debt covenants - Implicit contracts - Political costs - Meet investors’earning expectations o Strong negative share price reaction if expectations not met o Damage to manager reputation if expectations not met - Initial public offerings o To increase proceeds of new share issues The Good Side of Earnings Management - Investor-based arguments to credibly communicate inside information to investors o Blocked communication may inhibit direct disclosure of earnings expectations o Discretionary accrual management as a way to credibly reveal management’s inside information about earnings expectations  Manager foolish to report more earnings that can be maintained  Mana
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