What is earnings management and is it good or bad?

Can positive accounting

theory and signalling theory helps use to understand earnings management?

Definition of earnings management

Earnings management is the process by which management can potentially

manipulate the financial statements to represent what they wish to have
happened during the period rather than what actually happened (Scott
2009).

Factors that motivate earnings management (internal targets,

income smoothing, external expectations and window dressing)

Management wants to manage earnings because of internal and external

pressures.

The main internal reason is to meet targets. The targets may be there for a
number of reasons. Some may just be budgeted numbers, which if they are not
met will look unfavorable on the person, department, or company that “blew the
budget.” Others may be “required” numbers, which if not met will mean that a
person doesn’t get his or her bonus.

The external factors are a bit more diverse. The company may have previously
projected numbers that external parties are now expecting the company to
meet or exceed. External analysts may have made their own predictions public,
which the company would now like to achieve.

Investors, and potential investors, like to see continual upward income growth. It
looks really positive and looks as if the company is doing well in the charts found in
annual reports. Hence, income smoothing is the second external factor potentially
contributing to earnings management.

Finally, if a company is looking for new financing, they will have an easier time
obtaining it (or obtain better terms if it is debt financing) if they have good looking
financial statements. Therefore, window dressing is the final factor listed.

Techniques of earnings management

The big bath – This form of income manipulation can be thought of as part of
income smoothing. What it usually does is effectively accelerate expenses and
losses into a single year with already poor results so that future income looks
better and smoother. Even though the FASB has issued fairly recent statements
to reduce the magnitude for taking a big bath, companies can, and do, still use
this technique. Examples may include recognizing losses on assets that have a
fair market value below the current book, or carrying, value, cookie jar reserves
(to be discussed in 3. below); and doing a restructuring (taking the expenses
allowed under SFAS No. 146) that a company may not otherwise have done.

Creative acquisition accounting – As the number of acquisitions has decreased

(since the late 1990s) and with the advent of SFAS Nos. 141 and 142, this
doesn’t seem to be as much of a problem as it once was. Still, when a company
has made an acquisition or acquisitions during the year, the transactions should
be looked at closely to see exactly how they were accounted for and what effect
the treatment has on current, and will have on future, earnings.

Cookie jar reserves – These can go along with the big bath and are a form of
income smoothing. Earnings are managed under this method by selecting the
period in which a revenue or expense item is taken. This is usually done for
expenses that are based on estimates. If a company is having a particularly good
year and next year’s results are uncertain, they can over-accrue some reserves
in the current year and then have the ability to under-accrue them in the next
year if needed. By doing so, they effectively inflate the following year’s income
at the expense of this year’s.

Income, thus, appears smoother, and the company may be able to publicly
forecast higher profits for the following year even if their business isn’t actually
going to do any better in the following year. This may temporarily be good for
the stock price, but it isn’t good for those wanting to know how the company is
actually performing.

Materiality – This topic may not be a big deal to small companies since nearly
everything is material and, hence, should be accounted for. But for large,
publicly traded companies with revenues and assets in the billions of dollars,
they can potentially get away with millions of dollars worth of misstatements and
merely write them off as being “nonmaterial” in nature. Auditors are primarily
concerned with material misstatements. Materiality has the potential to allow
companies to slightly fudge their numbers, just enough to get them to where the
analysts forecasted.

Revenue recognition – Sort of the flip-side of cookie jar reserves, improper

revenue (or expense) recognition can lead to inflated financial statements now at
the expense of future earnings. Some companies that have dabbled with this
earnings management technique then have to inflate revenue in the next period
even more to make up for the shortfall caused by the prior period’s accelaration
of revenue. It becomes a never-ending game of covering up for the previously
improperly recorded revenue and can fairly easily lead to outright fraud. Several
of the bigger scandals of the past few years have been the result of companies
improperly, and/or prematurely, recording revenues in order to meet or exceed
forecasts, only to have the house of cards eventually come tumbling down,
resulting in massive restatements to the prior financial statements, new
management, new auditors, and very low stock prices (if not bankruptcy).

Pros (Goods) of earnings management

It is good, from an efficient contracting perspective. This argument

assumes, however, that the earnings management was anticipated by the
principal when the bonus contract was being negotiated, so that it is
allowed for in setting the bonus rate.
Is to lower contracting costs in the face of rigid and incomplete contracts.
A second, and more controversial, side is that earnings management can
reveal inside information to investors. A provocative discussion question
here is to ask if earnings management can be thought of as an extension
of the accrual process. That is, if accruals
smooth out lumpy cash flows to produce a more useful measure of
quarterly and annual performance, why can’t earnings management be
used to smooth out annual accrual-based earnings to produce a more
useful multi-year measure of persistent earning power? Such a measure
may help investors better predict future firm performance, which is a
major goal of financial reporting.
To pursue the argument that earnings management as a vehicle to
release inside information can be “good,” the case of General Electric Co.
(Problem 9 of this chapter) works well to get the point across. The steady
increase in GE’s reported earnings over the years is quite impressive. I
point out the complexity of GE to the point where even financial analysts
have difficulty in understanding the whole company. As a result, it is very
difficult to estimate GE’s persistent earning power. I also point out that a
simple announcement by GE of its persistent future earnings is ‘blocked.”
Such announcement lacks credibility since, for such a complex company,
the market has little ability to verify it. This sets up the role of “good”
earnings management as a credible way to reveal this information. An
argument that GE does engage in earnings management for this purpose
is supported by both the variety of earnings management devices
available to it and the steadily increasing pattern of its earnings over
time.

It is interesting to note that GE’s earnings management came under

suspicion in the market in the early 2000s, due to the severe
apprehension of post-Enron investors about earnings management in
general. According to an article “General Electric: Big game hunting” in
The Economist (March 14, 2002) investors may have interpreted GE’s
increased reported earnings for 2001 as evidence of bad earnings
management, since poor economic conditions during 2001 suggest that
earnings should have declined. In addition, GE appointed a new CEO in
late 2001. The Economist suggests that the market may have less trust in
the new CEO than in Jack Welch, the highly regarded former CEO, simply
because he is less of a known quantity. As a result, the market may have
felt that there is a higher likelihood that GE will use its considerable
potential for earnings management for bad purposes rather than good.
GE’s response to these market concerns is worth noting. It started to
release considerably more information. Further discussion of how GE
worked to overcome investor scepticism is given in Problem 21 of Chapter
12.
Theoretical and empirical evidence in favour of good earnings
management is given in
Section 11.5.2, which I have marked as optional reading for those that
wish to pursue good
earnings management in greater depth. Suffice it to say that there is
considerable evidence
in this regard.

Cons (Bads) of earnings management

Despite the above arguments, most people would likely regard earnings
management with
suspicion, reinforced by revelation of serious abuses of earnings
management by Enron and
WorldCom and numerous other corporations in the early 2000s.
Consequently, students
should not be left with the impression that it is necessarily good. A useful
place to start is
Hanna’s 1999 article in CA Magazine, which is well worth assigning and
discussing. The
important point to get across from this article is that management is
tempted to provide
excessive unusual, non-recurring and extraordinary charges, to put future
earnings in the
bank. Furthermore, these future earnings are buried in operations. This
makes it difficult for
investors to diagnose the reasons for subsequent earnings increases.
Nortel Networks’
reversals of its excess accruals (see Theory in Practice vignette11.1 in
Section 11.6.1)
provide a vivid example of Hanna’s argument. Also, the effect on future
profits of putting earnings in the bank has been recognized by an article in
The Economist (“A world awash
with profits, Business is booming almost everywhere,” February 18, 2005,
pp. 62-63). This
article states that one reason for the dramatic increase in firm profits
during 2002-2004 is that
they are an “accounting fiction,” which apparently means that they are a
consequence of
earlier writeoffs.
I find that to drive home these various considerations, an example of how
earnings management can go too far is instructive. An excellent case in
point is the downfall of “Chainsaw Al” Dunlap at Sunbeam Corp. Jonathan
Laing’s 1998 article in Forbes is reproduced in Question 10. Laing
demonstrates that Sunbeam’s 1997 reported earnings were almost
completely manufactured by means of discretionary accruals. The
substantial first quarter, 1998, loss reported by Sunbeam supports Laing’s
analysis, and the “iron law” of accrual reversal.
I think that Laing’s analysis of the effects of the $17.2 million drop in
Sunbeam’s prepaid expenses for 1997 is backwards–see part a of
Question 10. If I am not correct in this, presumably other instructors will
let me know. However, even taking this error into account does not
substantially alter Laing’s conclusion that 1997 earnings were
manufactured.

Techniques of earnings management

Revenue recognition. revenue recognition is an accruals-based

earnings
management policy Is effective because recognition criteria under
GAAP are vague and general. A company can speed up, or slow down,
revenue recognition but disguise the change through vague wording of its
revenue recognition accounting policy disclosure. Also, as in the case of
Coca-Cola, revenue recognition can be speeded up by stuffing the
channels to unconsolidated subsidiaries or customers, without any formal
change in revenue recognition policy.
Stuffing the channels can be difficult for investors, or even auditors, to
detect.

A disadvantage of revenue recognition as an earnings management

device is that accruals reverse. Consequently, it is difficult to maintain
increased reported revenue over time. Also, stuffing the channels
becomes quite costly if it is necessary to compensate the subsidiary or
customer for carrying costs, as Coca-Cola did.

Reasons for income smoothing

They may feel that the market rewards share prices of firms that report
steadily increasing earnings, consistent with the findings of Barth, Elliott,
and Finn (1999).
They may want to keep earnings for bonus purposes between the bogey
and cap of their bonus plan.

They may want to reduce the probability of violation of debt covenants.

They may want to convey inside information about persistent earning

power by smoothing reported earnings to an amount they feel can be
sustained.

They may smooth earnings because of implicit contracts, consistent with

the findings of Bowen, Ducharme, and Shores (1995). The firm may be
able to secure better terms from suppliers and other stakeholders with
which it has a continuing relationship if it reports steady earnings.

Do managers accept securities market efficiency?

Evidence of good earnings management is consistent with managers’

beliefs that markets
are reasonably efficient. Why use earnings management to reveal inside
information if the
market cannot interpret it? However, evidence of bad earnings
management may or may not
be consistent with efficiency.
On the one hand, managers may feel that they can fool the market by
managing their
earnings, which seems to have been the case with Sunbeam
management. Emphasizing proforma
earnings (Section 7.4.2) is another tactic that seems inconsistent with
acceptance of
efficiency. It is hard to believe that managers would continue to attempt
to manipulate
investors’ beliefs if an efficient market immediately detected and
penalized such behaviour.
On the other hand, bad earnings management may hide behind poor
disclosure. If the market
is not aware that reported earnings are being managed, it can hardly be
concluded that the
market is inefficient. Rather, the question is whether the market will react
once it suspects or becomes aware of the earnings management. The
market’s negative reaction to
the frequency of non-recurring charges as an indicator of possible
earnings management, as
documented by Elliott and Hanna (1996) (see Section 5.5) suggests
considerable efficiency,
for example. Also, the market’s post-Enron suspicion of GE’s earnings
management,
discussed above, is also consistent with efficiency.
The text concludes that at least some managers do not accept market
efficiency. However, it
also concludes that markets are sufficiently close to full efficiency that
improved disclosure
will reduce bad earnings management.

To Summarize the Strategic Aspects of Accounting Policy Choice

I end my discussion of earnings management with two main points:
(i) I emphasize the concept of strategic accounting policy choice, whereby
managers choose accounting policies to achieve certain objectives. These
objectives
may include efficient contracting, such as avoiding excess earnings
volatility for
compensation and debt covenant reasons, which may conflict with
accounting policies
that are most useful to investors. This greatly expands the role of financial
reporting,
since we now formally recognize two main roles of financial reporting–
reporting to
investors and reporting on manager performance. Both roles matter since
the quality
of manager effort and the well-working of managerial labour markets is as
important to
society as the quality of investor decisions and the well-working of
securities markets.
The conflict between these two roles, I hope, validates to the class the
time spent on
basic game and agency-theoretic concepts of conflict in Chapter 9.
(ii) I emphasize that managers have a legitimate interest in accounting
policy
choice, since their operating and financing policies, and even their
livelihoods, are at
stake. This view is in contrast to many discussions of standard-setting
where
management seems to be the “bad guys,” opposing every new standard
that comes
along. The theory provides several legitimate reasons why managers will
be
concerned about changes to GAAP.