Financial Accounting Theory

Feb./Mar. 2011 week 5

Final questions week 4

`

What do you expect a manager to prefer: pre-tax or after-tax income as performance measure What are plusses and minuses for motivating on stock price?

Jacco Wielhouwer - financial accounting theory - 2011

Today
`

Earnings management
` ` `

What it is Good/bad earnings management Implications for accounting

Standard setting: Economic Issues (part I)

` `

Information production Disclosure principle

Jacco Wielhouwer - financial accounting theory - 2011

Earnings management
`

A definition:
`

Choose accounting policies or actions to achieve some specific earnings objective

Last week: how?

` ` ` ` ` `

Changing accounting policies Timing of adoption of new standards Changing real variables (decisions): R&D, advertising etc Create Special Purpose Vehicles (Enron) Capitalize operating expenses (WorldCom) Discretionary Accruals
` ` `

Provisions for reorganization, layoffs etc Allowance for doubtful accounts Warranty provisions
Jacco Wielhouwer - financial accounting theory - 2011

Real variables versus Accruals

`

Real variables (R&D e.g.):

` ` ` `

change cash flows and thus shareholder value directly Typically: impact on result now and in the long run Conflicting interests between shareholder and manager Example: bank adjusting savings rate

Accruals
` `

Generally a timing issue of income recognition IRON LAW: ACCRUALS REVERSE !!

Jacco Wielhouwer - financial accounting theory - 2011

Patterns of earnings management

`

Taking a bath
`

Reason: accruals reverse!

Income minimization
`

Reasons: political, potential entrants, taxes

Income maximization
`

Reasons: bonuses, covenants

Income smoothing
`

Reasons: risk aversion, covenants, bonus caps, signalling persistence

Jacco Wielhouwer - financial accounting theory - 2011

Bonus plan hypothesis

Typical bonus scheme (Scott fig. 11.2)

Amount of bonus

bogey

cap

Reported net income

7 Jacco Wielhouwer - financial accounting theory - 2011

Empirical evidence: avoid losses Burgstahler and Dichev (1997)

Burgstahler & Dichev, Earnings Management to Avoid Earnings Decreases and Losses, Journal of Accounting and Economics, 24/1 (1997), 99-126.

Jacco Wielhouwer - financial accounting theory - 2011

Empirical evidence: bonus plan hypothesis Healy (1985)

Proportion of accruals with given sign Positive LOW MID UPP 0.09 0.46 0.10 Negative 0.91 0.54 0.90 22 281 144 447
P.M. Healy, Journal of Accounting & Economics, 1985 p.96

# obs

Average accruals

-0.0671 +0.0021 -0.0536

Jacco Wielhouwer - financial accounting theory - 2011

Empirical evidence: bonus plan hypothesis Holthausen, Larcker, Sloan (1995)

`

Contrary to Healy, later studies find evidence of income smoothing (not taking a bath), when looking at discr instead of total accruals

10

Jacco Wielhouwer - financial accounting theory - 2011

Earnings management: good or bad?

`

Do you think earnings management is good or bad? Good Efficient contracting Flexibility (debt cov.) Unblocking ins. information Showing earnings persist. Signalling Bad Opportunistic behaviour Breaking GAAP rules Raising more capital (IPO) Misleading investors Fooling the market

11

Jacco Wielhouwer - financial accounting theory - 2011

Earnings management and market efficiency

` `

Meet (and beat) expectations: positive abn. return Fall short on expectations: more negative abn. return Does this conflict with market efficiency?
`

No for example:
` ` `

Prospect theory (6.2.2 p.181 5th ed. Scott) Limited attention, so lower degree (longer time to adjust) Efficient: market is aware of EM possibilities: falling short implies even when applying EM Managers do not accept market efficiency (there are anomalies) Expect the market not to fully see through
Jacco Wielhouwer - financial accounting theory - 2011

Yes for example:

` `

12

Manager interests
`

Option compensation: asymmetric reaction for losses and gains more EM? If managers assume some degree of inefficiency more EM? Relation of EM with contracts:
` `

Some flexibility is good (contracts rigid, efficient risk sharing) Too much makes contracts worthless (tells nothing, no motivation to high effort)
Jacco Wielhouwer - financial accounting theory - 2011

13

EM: the role of accounting

` 1. 2. 3.

So what is the role of accounting with respect to EM? Disclose choices made to facilitate see through Maybe increase comparability (limited attention)? Finding out real persistence
In order to

4. 5.

Detect (and prevent) bad earnings management, but Allow good side (signalling) Objective: assist investors in determining firm value
` `

Information perspective (Decision usefulness) (1.) Measurement perspective (2.)

Jacco Wielhouwer - financial accounting theory - 2011

14

Today
`

Earnings management
` ` `

What it is Good/bad earnings management Implications for accounting

Standard setting: Economic Issues (part I)

` `

Information production Disclosure principle

Jacco Wielhouwer - financial accounting theory - 2011

Economic view on information production

`

Crucial economic issue:

`

What is socially optimal role of accounting (amount of information production) and is regulation necessary to obtain this?

To discuss this:
`

Focus on regulation w.r.t. standard setting ` minimum information production (disclosure) ` with reliability (audits) So first: ` Types of information ` Types of information production ` Incentives for information production

Jacco Wielhouwer - financial accounting theory - 2011

Proprietary vs. Non-proprietary inform.

`

Two types of information:

`

Proprietary
` `

Disclosure will affect firm cash flows Examples?

Technical details on valuable patent, Strategic initiatives, Takeover/merger plans, Demand information in duopoly

Non-proprietary
` `

Disclosure will not directly affect firm cash flows Examples?

Financing details, earnings forecasts, financial statement, audit

Jacco Wielhouwer - financial accounting theory - 2011

Types of information production

`

Finer
` `

More detail Increase relevance New information Possibly relevant info E.g. better audits (switch to big 4?) Increase reliability

Additional
` `

More credible
` `

Information production Y/N: cost/benefit analysis

`

Note: often made error: no marginal approach

Jacco Wielhouwer - financial accounting theory - 2011

Do market forces lead to the optimal amount of information? Incentives

`

Firm incentives to provide information are? To be able to enter contracts

` ` ` `
` `

1.

Offer an audited statement Offer an audited statement Offer an audited ratio Note problems:

investors pay more base remuneration on performance less interest required by banks

Too many parties, too many different needs not one contract Contract must be enforced (otherwise no Nash equilibrium): cancel audit

2.
` `

Market forces
Managerial labor market (reputation) Capital market: reduce estimation risk higher share price

Jacco Wielhouwer - financial accounting theory - 2011

Do market forces lead to the optimal amount of information? Desincentives

`

Firm desincentives to provide information are? Costs

` `

1.

Direct (producing the info) Indirect (e.g. competitor learns valuable info)

Note: managers and firms interest may not be aligned

Jacco Wielhouwer - financial accounting theory - 2011

Market forces leading to disclosure

`

Sales disclosure increased over time But: slowly

Alternative explanation: deter regulation

Sales disclosure by dynamic panel of 75-100 listed Dutch companies, 1945-1983; no mandatory disclosure until 1984; index figure is required minimum disclosure starting 1971; Camfferman (1997) Jacco Wielhouwer - financial accounting theory - 2011

The disclosure principle

`

Suppose all firms have information on future profitability

` `

Market expectation: Alternatives: Will you disclose?

on average 10 between -10 and +30

Your firm has information:

`

+15 0

Your firm has information:

`

Will you disclose?

The disclosure principle: ` All firms with > 10 disclose; ` new market expectation of non-disclosers: 0, so ` All firms with > 0 disclose; so ` So all firms disclose: otherwise the market assumes the worst case ` Nondisclosure implies that the worst case is expected!
Jacco Wielhouwer - financial accounting theory - 2011

Reasons for the disclosure principle not too hold

`

When does this reasoning not hold?

` `

If there are costs of disclosure (direct, indirect, proprietary) If the market is unsure whether the firm has the information
`

The market cannot punish non-disclosers since they may not have info

` ` ` `

If the objective of the manager is not optimizing firm value If disclosure policy has to be committed to before the information is available If disclosure may not be fully thruthful If contracting purposes and investor needs conflict
` `

E.g. manager may want to delay share price increases Disclosure may decrease discretion and make contract more risky (inefficient)
Jacco Wielhouwer - financial accounting theory - 2011

Alternative way of disclosure: signalling

`

It may be desirable to reveal the fact that there is good news, without disclosing details (e.g. because of proprietary costs) SIGNALLING
` `

Taking an action that reveals good news (without disclosing details), that would be irrational for someone without the favourable info. Examples?
` ` ` `

Audit quality (more expensive and higher quality audits) Earnings forecasts (high penalties if not met) Buying own shares (by management) Smooth earnings (lower bonus) to reveal earnings persistence

Note: tighter reporting standards may lower signalling possibilities!

Jacco Wielhouwer - financial accounting theory - 2011