Mangers undertake economic transactions Accounting system measures these economic transactions Aggregates of transactions are reported according

ng to accounting standards In this model management does not change its decisions about how and which economic transactions to enter into. Role of managers Managers are self interested parties. The reporting of economic transactions impacts their self interest So management changes the choice of economic transactions to enter into Reporting now impacts managements operating behavior and not only reflect the consequences of operating behavior Economic consequences of reporting not trivial Regardless of the EMH or whether they affect FCF Examples of economic consequences Example 1: SFAS 123 (employee/executive stock options) Example 2: SFAS 106 (other post-employment benefits)

Chapter 8: Economic consequences and positive accounting theory

History of employee stock options Example 1: Financial accounting for employee (mostly executive) stock options In 1972, APB 25 no need to expense In 1995, SFAS 123 can expense if want (but nobody wants) In 2006, SFAS 123R (and IFRS 2) must expense The path (APB 25 to SFAS 123R) is very interesting Managers with large proportion of options: If expense, NI will go down, managers will go away, then no good managers already Early employee stock options a/c treatment APB 25 (1972) and the intrinsic value method: Compare stocks FMV with OEP on date of grant If the FMV is greater than OEP then take the difference as an expense Usually options issued at current market value Executive compensation >> Company expense (e.g., Michael Eisners tenure as Disney CEO) Managers want to max compensation (Salary, bonus, stock options) If get option at higher exercise price: already gain, hence Dr Cash 1000 managers less incentive to give their best as already get Cr Share Cap 100 the profit Cr additional paid up cap 900 Manipulation of a stock whose price has been rising To issue stock option via option backdating Zero expense, gains for CEO When issue share, no impact on IS Old rule: as long as exercise price and market price are the same, thereis Then: no expense In 1991, US Senate threatened to get involved; so, in But managers are getting compensation as they exercise 1992, FASB resumed reconsideration of APB 25 Now have to find out the expense for the options that are granted to FASB met consultants, held board / task-force meetings recognize compensation as expense April 8, 1993 FASB voted for expense / equity recognition Compensation expense now is the fair market value of the option June 30, 1993 FASB issued an Exposure Draft Hence stock option increase tremendously for the more high tech firms Criticism (!!!) business, auditors, VCs, industry groups As a result, NI was overstated by a lot December 15, 1994 FASB issued SFAS 123 compromise Old rule: no compensation expense (i.e., JE or FN option pricing model estimate of expense) New rule: there is some compensation expense Later steps in ESO accounting Management to change transaction to minimize impact Over the next decade or more: One is stock option expense Dramatic increase in (fixed) employee stock options If co give mgmt compensation, it should be in form of expense Option pricing models (Black & Scholes JPE But if compensation is expensed, the NI will increase den will look into it, 1973) Very sharp criticism of APB 25 (e.g., then will realize why paying them so much compensation but they not inconsistency) doing well During 1984-1988 FASB reconsidered APB 25 Share: if there is no outflow of resources, why should it be an expense? FASB was unanimous about the debit, but not the In stock option expense there is no expense that is being used up credit (this led to a broader study of RHS of Since there is no asset used up, no cash given, then why is that an Balance Sheet) expense FASB researched various option pricing models Cause there is an opportunity cost to company cos they can sell the (big issue of reliably estimating compensation options outside and profit from it expense) ESO incentives If do not give option then will give some kind of bonus (cash) hence will While stock-based compensation solves one agency problem, it arguably creates another o While it incents managers to care about stock price o It may incent them to care too much Now restricted stock is taking over as the compensation choice

be an expense Hence they want t treat it as an expense in the IS Management option to the treatment change the most as they are affected the most Economic is no option on IS managers will want more stock option If there consequence If it is on the IS thenSloan will not want stock option as much as will focus Dechow, Hutton, they (JAR 1996) onMany compensation their companies submitted criticism letters. Why? No evidence of increase in cost-of-capital from lowernot care But no cash flow implications so managers should NI (inconsistent with threat as the way the reporting happens affect their own But managers will care to competitiveness argument) No association with company leverage or size incentives (inconsistent: debt covenant and political coststhe compensation So they will want to change the way they do hypotheses) Strong association with options to compensate executives (consistent: bonus plan hypothesis), opposition to expensing stock options arose because of top executives concerns with public scrutiny of their compensation.

Valuing options Standard Black Scholes overstates cost Employees exercise early Why not use expected time to exercise This varies over time and across firms This also depends on in the moneyness of the option and risk aversion of CEO Options need to vest vesting uncertain Difficult to value option expense unreliable

If exercise early, then BS no applicable IS not reliable, If exercise early, BS overstate value, option expense is too high, income is low But can put the expected time for exercise Not so indicative of future How to know expected time: look at previous years ( the average exercise time0 Then take the number and put into BS formula Put an estimated period where employees exercise their option for a more accurate BS value 3 Hypothesis of positive theory accounting Get a distribution of when employees exercise 1. The bonus plan hypothesis (e.g., Dechow et al. If there is too much variation, the expected exercise time will be a bad JAR 1996) measure 2. The debt covenant hypothesis (e.g., Mittelstaedt Need to be constant over time for the same firm for it to be a good measure et al. TAR 1995) If company is reasonably new, and too short period to find out when will they 3. The political cost hypothesis (e.g., Jones JAR exercise 1991 p. 291-293) - Do not have much history to predict If can get bonus, will manipulate upwards - = look at similar firms, whether is it constant If no change, will not manipulate - But found out that it varies for different firms If can save for future then will manipulate - = difficult to figure out a good estimate of exercise downwards - = decrease reliability of the value calculated from BS 2. Debt covenant hypothesis Expected time to exercise depends on Will try to manipulate leverage downwards How deep in the money (how much money they make) Debt/equity or debt/total assets And the risk aversion of the managers (if risk neutral or risk adverse) Can reduce debt payback or move some debt off Hence difficult to figure out the value of option books and into off BS items (capital lease) Economic conseq - restatements Increase the assets revaluation, increase SH equity, Efendi, Srivastava, Swanson (JFE 2007) - associations w restatements create some fake assets, 1. Debt covant violation. Interest coverage : how much NI can cover the If firm close to violating, it will manipulate the interest. Want to show higher interest coverage ratio so can continue number so violations will not happen borrowing and dnt hav to incur loss for renegotiation 3. Political cost hypothesis 2. Raise capital: reduce cost of capital, show is profitable firm, can get Firm does not want political cost (people in the govt, lower interest rate and sell capital at higher price regulators, some agencies) 3. If CG is not very good: CEO and his friends on the board, directors are Do not want anything bad happen if not people will not independent; scrutinize Or when CEO is chariman of the board duality (one person holds 2 Eg. SMRT will not want to show high profits as do not position), if do both, very powerful as know the company very well, can want to draw attention to yourself and incur high control and can manipulate the Board and firm for their own benefit political cost 4. When CEO have a lot of in the money option (market value higher than Money lenders incur a lot of political cost as they exercise price): incentive of manager to manipulate is less if it is deep in have a lot of money the money. Manager manipulate so value goes up Companies will manipulate their numbers such that Economic conseq - OPEB they will not have high political cost Accounting change: from cash basis to current value (discounted PV) liability If have high liability in BS: debt covenant may be violated, high leverage ration: hence want to cut healthcare to make benefit smaller Economic conseq: cut the benefit for retiring employee If the employees were productive assets Retired employees no longer productive for the company hence can reduce their healthcare Why dont cut benefits to current employees? They will leave But retired employees cannot do anything, cannot quit so easy target Mittelstaedt, Nichols, Regier (TAR 1995) Many companies reduced / terminated OPEB. Why? Weak association with financial weakness Weak association with rising health care costs Strong association with the impact of (new) SFAS 106 liability in terms of how it increases pre-SFAS 106 liabilities (consistent: debt covenant hypothesis)

Positive accounting theory Is concerned with predicting such actions as the choice of accounting policies by firm managers and how these managers will respond to proposed new accounting standards. If you view firms as nexus of contracts, this emphasizes importance of contracting costs Trying to design the most efficient contracts Costs of moral hazard / opportunistic behavior stemming from rational, selfinterested managers

Chapter 9: Game theory Mathematical models of conflict Cooperative games vs. Non Cooperative games Cooperative games Cartels Non Cooperative games Oligopolies. For example: Between shareholders and managers (the agency problem) Between debt-holders and shareholders (the agency problem) Between standard-setters and other parties Between auditors and clients Equilibriums Nash Equilibrium: A box from which neither party wants to move. Coordination: Using a some device to coordinate actions Pure strategies: Where there is a preferred corner solution Mixed strategies: One can go with any of the strategies with some probability Repeated games: Play the same game with the same player multiple times

The agency problem Principal (owner) is risk-neutral, manager (agent) is risk-averse (square root utility). Managers reservation utility is 3. Managers fixed pay is $25 in all states Manager works hard: Owner gets (100*0.6)+(55*0.4)-25 = 57 Manager shirks: Owner gets (100*0.4)+(55*0.6)-25 = 48 Owner is risk neutral so U = X If costless monitoring is possible, pay the manager only if the manager doesnt shirk. (First-best = 57 owners pay off) Owner prefers manager to work hard Problem: owner cannot monitor the manager Costless monitoring: if the manager can be costlessly monitored by the owner st 1 best solution: owner gets the max payoff No agency problem: if owner can monitor the manager very closely - When owner is the manager - Family owned businesses have much better monitoring - Why do you need monitoring and not give a contract giving them bar for net income - Managers will have incentive to manipulate the numbers - Managers giving their own grades by making the books - Can use auditors to control but still is the managers that hire the auditors Rent the firm to the manager for a fixed rent that leaves the manager with an expected utility of 3 if the manager works hard. Rent that manager will pay the owner is say 51 Manager gets: 0.6**(100-51)+ + 0.4**(55-51)] 2 = 3 (work hard) 0.4**(100-51)+ + 0.6**(55-51)] 1.71 = 2.29 (shrink) Manager chooses to work hard Owner is worse off in renting than monitoring (lesser payoff, was once 57)

Auditors payoff = [-3*p*q] + [-5*q*(1-p)] + (1-q)(-3p) = -3pq -5q + 5pq 3p + 3pq = -5q + 5pq 3p Slope over p = 5q 3 (differentiate wrt p) Equating to zero, q= 3/5 = 0.60 Clerk is committing more fraud and the auditor is committing less fieldwork Clerk commit fraud 60% of the time and auditor verify 50% of the time there is no one cell that dominates the other cell. Then have to put some weight in each of the cell Putting some weight in every of the cell. Dont follow one particular strategy but follow a mixed strategy Now nobody is buying, now all the money flow to risk free = no capital investment, Hence is not a good equilibrium to have To get away from this equilibrium, distort to honest eqm - Through regulation, - If manager is getting the money out front, need to give them punishment - Clawback: if find out that they have lied - So as to induce them to be more honest - If there is any distortion, investors will sue the managers and get their money back - Have to make the threat credible (make people believe that they will carry out the threat) - Through enforcement

Fixed salary = 25: utility = 25 = 5 Disutility at high effort = -2 Net utility for manager = 5 2 = 3 Disutility at low effort = -1.71 Net utility for manager = 5 1.71 = 3.29 Reservation utility is 3 Manager wants to shirk (net utility for shrinking is higher) Moral hazard Manager knows effort expended owner does not Manager will not want to work hard as utility from not working hard is grater Hence fixed salary is not good as no incentive for managers to work hard There is noise in net income. Assume the following: If the payoff is $100, net profit is $115 with probability 80% and $40 with 20% probability. If the payoff is $55, net profit is $115 with probability 20% and $40 with probability 80%. Calculate bonus as 0.3237 of net income. This gives the manager her reservation utility of 3 if she works hard (less if she doesnt). The owners expected payoff is 55.46. This is the second-best contract. It has an agency cost of 57-55.46 = 1.54.

Caculations of bonus and payoffs to owner Bonus calculation 0.6*0.8(115x) + 0.2 (40x)+ + 0.4*0.2(115x) + 0.8 (40x)+ 2 = 3 *0.48 (115x) + 0.12 (40x) + 0.08 (115x) + 0.32 (40x)+ = 5 *0.56 (115x) + 0.44 (40x)+ = 5 *0.56*10.72381 (x) + 0.44*6.32455 (x)+ = 5 6.005331 (x) + 2.782804 (x)+ = 5 (x)*8.788135 = 5 Square both sides 77.23x = 25 X = 0.3237 Payoff to owner (1-0.3237)*100*0.6 + (1-0.3237)*55*0.4 = 55.46 If profits are more relevant Suppose accounting standards can improve net profits, so that the probability of high net profit increases when the payoff is 100, and The probability of low net profit increases when the payoff is 55 Required bonus to make the manager work hard always goes down to 0.3185 Owners expected payoff goes up to 55.8829 Calculations of bonus and payoff to owner Bonus calculation 0.6(100x) + 0.2 (55x)+ 2 = 3 *0.6*10(x) + 0.4*7.7162 (x) = 5 6 (x) + 2.96648 (x)+ = 5 (x)*8.96648 = 5 Square both sides 80.3978x = 25 X = 0.31095 Payoff to owner (1-0.31095)*100*0.6 + (1-0.31095)*55*0.4 = 56.50 role of accounting is to reduce the noise Provide more reliable FS as noise is related to reliability Owner is interested in co having high reliability FS If give more bonus to manager, owner get less If have less noise, owner will get more money Hence they want more reliable FS Get big 4 to audit (ppl with the expertise) Or with standard setters to give them reliable accounting standards If there is no regulation of accounting at all then The manager will always report 115. The manager will always shirk. The bonus plan will fail. This problem can be reduced through standards. Cost: low flexibility, Cannot distinguish from other company no private info Force managers to run biz in particular way = become accounting driven business Rigid contracts Contracts cant be changed once signed. (e.g., AIG bonuses) Incomplete Contracts Contracts cannot anticipate every possible action and state (unlike the toy games we looked at).

Is it better to add another variable in the contract? (for example, both net profit and share price) Yes, provided: The second measure is observed by the principal and agent, and The second measure adds information (the information system based on both measures is better than that based on only one) Risk neutral lender can lend 100 to firm or invest in risk free bonds with 10% return Firm offers 12% interest There is credit risk, firm can go bankrupt Lender looses everything due to bankruptcy Manager can pay no dividend or high dividend Bankruptcy probability = 0.01; 0.1 ND/HD Manager gets salary plus bonus. Dividend does not affect the managers pay. Manager can pay dividend with p = 0.5 Problem: firm can go bankrupt Risk free no problem as no bankruptcy Have to think how to get about incorporating risk of bankruptcy Can give SH as dividends instead of putting in projects, or put into very risky projects = manager moral hazard problem Dividend come out of SHE, does not affect management pay

Expected Return = 0.5 x [12 x 0.99 -100 x 0.01] + 0.5 x [12 x 0.9 100 x 0.1] = 5.84 Payoff on risk-free debt is 10%. Minimum nominal rate to induce lending 0.5 x [R x 0.99 -100 x 0.01] + 0.5 x [R x 0.9 100 x 0.1] = 10 = 16.40%

To attract lenders Offer a higher interest rate to compensate for the agency costs Agree to debt covenants to reduce the probability of paying a dividend Same framework for putting in more risky project Instead of dividend or no, change to agreed upon risk and high risk If company give dividend to SH, investors require higher returns for their investment Bring r closer to 21% by including debt covenant Have debt covenant t ensure doesnt pay dividend Managers to report why using this debt - How they use the money - Why they use money - Will have some penalty

Chapter 10: Executive compensation Limits to withdrawals of bonus 1. Want to give them a long term horizon But capital lands incentive scheme is based on NI for current year, then there will not be incentives to take LT transactions 2. Can use to retain managerial talent so can keep the good managers If there is high value, bonus is large, they dont want to lose a portion of it, hence they will stay Can give deferred compensation to future years So that they will have incentive to work hard for the future Important whether is it pretax or post tax By doing pretax: not giving the person incentive to min taxes for the company = not giving manager much leeway to reduce the taxes Government is controlling the tax, has nothing to do with the effort the CEO put in - Dont want to add compensation risk by putting In the variable that will affect the effort he put in Extraordinary items to include Want to put extra ord loss into operating item: show a higher profit than otherwise If there is extra ord gains, want to put it into operating gain: this is called income shifting Accounting changes Accruals do a good job in bringing forward the future Make it more comparable to past year performance May not have anything to do with the efforts of the CEO hence remove Management may opportunistically change the accounting policy so better to remove Bonus hypothesis: If will affect the bonus of managers, they will make it for it, or fighting the regulators so they dont have to put it on the IS and make IS look bad If there is no ceiling, managers has a lot of incentive with the pretax income: increase thru better operations, or manipulate by post-phoning exp and bring forward revenue Reduces incentive of managers to take projects that decrease NI - High risk projects To go on with the ceiling: Even as NI increase, % of bonus paid is lesser Net benefit of bonus decrease Decrease managers incentive to manipulate as the benefit goes on decreasing (decreasing marginal return) Formulas: Want managers to work towards certain goals so that they know what to work towards Dont want them to manipulate the plan at the end. Dont want them to be shifting the weights after seeing their results Compensation consultant: External auditors Give a report that says the best plan you can come up with Arms length, independent, objective, reliable, reputation, expertise Expertise know all the varies techniques Have value add. Are experts in the biz, know what the pther players are doing, hence can bring in the expertise in Dont want the board to be doing what the management wants, but what the SH wants If the consultant were doing other services, they will not want to lose that service, hence they recommend higher pay to the management report So lack of objectivity, arms length transaction Adv of benchmarking: To make the pay more competitive. Want them to compete with other managers - Aligns how investors is making the decision and the way how management is being given the compensation - Investors have to benchmark to see which co to invest in. so managers have to be benchmarked too, so that they will compete with each other - If do relative, take out effect of the economy. Whatever is the risk impacting the whole economy, take out. - Want them to manage the firm specific risk - Hence reduces compensation risk: risk that managers cannot control - Reward for taking firm specific risk and not market risk (cos cannot control market risk) - So remove market risk Small economy: hard to get peer group: have comparison/benchmarking difficulty Advantage of letting CEO and committee decide on bonus together - Can leverage on insider knowledge of CEO if they are forthcoming (disclose the thing properly) - Less disputes - Some efficiency if let them pick the rates: less disputes. Can get more information on how they do their job - Each of the components have different risks if CEO sit down together, CEO can portray how much risk they are willing to take (CEO are generally risk adverse) so good to know how much risk they willing to take so can align risk Disadvantage - If CEO has a lot of power, then they can take it to their advantage and benefit themselves Lehman bro compensation phy Performance-based compensation linked to Annual and long-term goals of the company Aligning manager and shareholder interests Emphasize share-based compensation to: Align manager and shareholder interests Encourage prudent long-term decisions and risk management Ensure that compensation is similar to rival companies Companies that hire compensation consultant paid more than the medium company in the industry (as the CEO can bargin about the compensation, it will go higher and higher than the previous one) The more risk free compensation you give to managers, the less they will do
Is incentive-based compensation needed? Fama (1980) NO! theres an efficient market for managers A manager who shirks will not be able to get another job if booted (bad reputation) Wolfson (1985) - Test of Fama Oil and gas limited partnerships General partner (agent) runs the business; limited partners (principal) supply outside capital Completion cost paid by general partner (tax rule) So complete only if her share of R > completion cost otherwise shirk

Fixed salary reduce risk, but managers can slack Annual incentive bonus Adv: easy to measure Disadv: managers have full control over NI Only allow for SR effort, but not LR LT incentive plan Adv: allow manager to take LT effort Reliability decrease, noise increase Share based compensation Adv: managers cannot control stock price directly, can only manipulate the disclosure to affect stock price But semi strong form (use other sources) then can manipulate nd 2 adv: allow managers to take LT effort like R&D stock price will capitalize but accounting expenses Disadv: noise is too high as so many things affect stock price If mkt is inefficient, managers get compensated for the inefficiency rather than for ther effort Perks (corporate jets) Adv: save time, not like cash can anyhow use. Increase efficiency of managers Disadv: managers can misuse it They spend more on corporate jet: but spend too much, never spend time doing co work so firm is hurt Exploratory well: dunno how mush oil, then to go new places, tend to have high rewards and high risk If reward is high, more likely that the share they get will be higher than completion cost High reputation: if they work hard, complete the project and earn more profit for their owners Vice versa Investor willing to put in more capital to high rep managers Development: not fully exploited, low risk Managers willing to contribute less to such well Reputation doesnt have any relation to development wells Contribution is not related to reputation Manager effect horizons Bushman and Indjejikian (1993) Two different types of effort Short-run effort and long-run effort How to design the compensation contract such that manager engages in both types of effort Short run: increase sales, cut costs Long run: invest in growth opportunities e.g. R&D As R&D grows, share price increases because market recognizes these as assets. Relation btwn risk and manager compensation Cash compensation: little or no risk, wont put in effort If compensation contract too much risk: managers take less risky projects to min risk (risk adverse) Under invest in risky projects Manager compensation and risk taking Too little risk and manager will not put in any effort Too much risk and manager will under-invest in risky projects ESO one way to compensate manager for risk taking Works well for upside risk but not for downside risk so promotes excessive risk taking Manager in more competitive industry will get compensated less Given 2 managers of the same caliber Negative relationship btwn compensation and performance of industry But may not seem to work that bad

Banker and Datar (1989) Linear combination of two measures of performance Depends on the product of their sensitivity and precision Sensitivity: how much the value of the measure changes with managers effort Precision: inverse of the noise in the measure How to increase sensitivity: use current values or increase disclosure Problem with current values: precision decreases Precision Less noise, more precision, more reliability, High sensi, low precision vs low sensi, high precision Have to compare the product of the two To increase sensitivity by using current value Problem: reliability decrease, precision decrease, noise increase

Risk in CEO pay: if a lot of variation in CEO pay, means they taking risk CEO have more risk, but middle managers get stable as they take less risk Lambert and Larcker (1987) Relationship between ROE and managers cash compensation Stronger when variation in ROE / variation in share price is less (precision) Variance of ROE / Variance of share price Low ROE and share price are moving together Weaker (Low) for high-growth firms (sensitivity) Bebchuk, Fried and Walker (2002) Contracts are not efficient Managers use their power to take whatever they can Their power is limited by public outrage Controlling outragecamouflage Compensation consultant Adjust compensation to peer companies Contracts not efficient, board not independent, managers use their power to take as much compensation as they can. And also perks. The trade off between compensation and perks is not very clear. If no disclosure, rather take compensation as can hide Perks can be hidden Public outrage: stakeholders, investors, regulators, media, lenders
Compensations not marked down. Gains not due to the manager: can be due to economy doing well To adjust the gains not due the manager: compare with other companies that are very similar in the same industries and compare the difference: which is the effort Stop managers from trying to pick their own peer company: can take away the impact of the economy Reduce the impact of systematic risk: impact all the firms, taking away the effect of the performance on the effect of firm Management has power over the board, the best peer group to pick: all the firms in that particular industry. Then wouldnt have a fight that why choose one over the other. Just chose all as difficult to argue against using the average

Chapter 11: Earnings management accounting choice that will help them Usually take 2 forms Most do toerh accrual management (book entry) Or real earnings management there is cash flow implication - expenses that are under control of the management 2 types of costs firm face: fixed and variable (have control) Variable costs they have control over: advertising, R&D Revenue may go up a lot but impact may not be that much R&D may not affect this year but in future years The best time to do accrual earnings management: at the end of the accounting period As can manipulate at the end and try to hide Can be done at all the way at the end of year Real earnings management cannot do/hard to do at the end. Already fixed. Happen more during the year than at the end of the year Manager to do more accrual incentive to Highest incentive to manipulate: planning to resign or retire As they are resigning they want to show the new company how well they can do, and the changes will also be relfected later, they wil not bear the cost, it will only happen in the future To put I the compensation contract: Claw back Have some LT compensation contract The next year profit will unravel Options. ___ Incentive of new CEO: blame the old CEO. Take below the line charges. Say is due to the old CEO. Restructuring Below the line does not affect bonus as not inclusive. Then blame the old CEO If accrue the earnings now, if reduce allowance this period, next period will have to cover the balance by increasing the debt expense. Next period will have to increase accrual. Accrual reversal Constraints the management from manipulating the numbers as accruals will reverse and next year the profits will be lower. If the firm is going to do very well next year: will not mind accrual reversal, just let it wash out They dont mind manipulating now if there is some chance of getting bonus and get it swwp later as the next year dunno if the economy will be helpful or not

Bonus hypothesis very impt when below the lower bound and above the upper bound But in between is not that important as there are other reasons behind the manipulation. Bonus hypothesis very impt when below the lower bound and above the upper bound But in between is not that important as there are other reasons behind the manipulation. Eg new ED come out and will make the firm NI higher. Give 2-3 years fro firms to adjust the accounting system Early adopters; vol adopt the new rule even before it was come into play - Can be due to NI higher or they are closer to violating the debt covenants - Late adopters: vice versa. Will not want to have an impact on their debt covenants - Point to management try to manipulate number to avoid breaching debt covenants; before going to the capital market - To get better valuation, lower cost of capital, - When go into the debt market: easier covenants, pay less collateral, lower interest

Todays CF converts to tomorrows accrual: prepaid Todays CF converts to todays accrual: AR Todays accrual could be due to today, tml cash How diff to predict the cash coming out from accrual = variance

Upper bound: cap If go beyond this much, compensation will not increase Lower bound If fall below, CEO get no bonus at all Let the bonus be 10% of NI Let the CAP be $100 implies that bonus cannot exceed $10 Let the bogey be $60 Let the max earnings management be $15 up or down

Strong from: both public and private: disclosure no diff Semi-strong from: market will take note of disclosure as it makes a diff - Hence they feed the market so stock price will increase (if is semi strong form efficient) - Not semi strong form efficient: E (2000) E(1999) E (1999)-NI E(1999) Operating items E(1999) extraord items Surprise OI Surprise NI Firm A $2/share $1.5/share 1.5=0.5 2-1.8=0.2 Firm B $2/share $2.1/share 2.1=-0.1 2-1.8=0.2 $1.8/share $1.5/share Gain $0.3 $1.8/share $1.8/share Loss $0.3

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Earnings announcement for year 2000 earnings: what strategy should firm A and B follow? Firm A: Tell: Non operating gain of 0.3, made profit of 1.5 Strategy in year 1999: tell this year we made a profit of $1.8, dont tell we made an extra ordinary gain of $0.30 Firm B: - No need to tell anything; tell we made a profit we made $1.8 for NI last year Strategy in year 1999: tell this year we made a profit of $2.1, tell we made an extra ordinary loss of $0.3 If market is semi strong form efficient, so when dont tell them in 2000 that never tell them about the loss in 1999 they will know already (can remember) But managers behave as though the market is not efficient, so they dont remind the market about the loss in 1999, but not the loss in 1999 Pro-forma: not audited (what the management thinks the firms earnings are) Usually the management will talk about core and non-core items Want to call non profiting biz non core So can say are making profits in the core biz New biz: non core biz - losing money Will think the co is doing well as the main biz is doing well, if non core dont do well is cos they are experimenting Classify as non core as giving them a persistent of one But were not one time times as they did not do well in the future If market is semi strong from efficient, should be able to tell persistence and non persistence But they Dont understand managers are playing a game by separating biz into core and non core

Bad sides of earnings management Contractive perspective to accruals - Why does accruals have a harmful effect on contracts (due to management compensation, debts) - = they can lie - Good part to this: unanticipated events: management can smooth the earnings and get some compensation - Dont want to punish the manager for outside risks - Debt contract: profit if < 40 bucks will have to renegotiate - Managers can manipulate the profit to >40, contract is not complete, some states are left out, hence managers can manipulate to overcome some states in the contract Managers report number to the market One of the big players in the market: analysts Usually compensated or ranked as they do a good job at forecasting Normally forecast operating income (sustainable, more persistent, stable, easier to forecast) Wont fluctuate a lot due to one time items, unlike net income Managers know analysts are focusing on operating income If it is non operating it should have nothing to do with future expense Today non op expense impact tml op expense Impairment charge reduced the operating expense every year (depreciation charge) Can say impairment is a one time item In a way can reduce operating expense as depreciation lower with impairment Bonuses is based on net income - If take impairment, bonus will go down Wont affect bonus 1. If bonus is calculated on NI before one time charges : non core charges are excluded 2. If below the bogey, then dont mind taking a one time charge and write profits down this period and future periods will have benefit (from lower depreciation) 3. If far above the cap, dont mind taking the impairment. Cookie jar when you want then use - Write back your reserves - More non core items: lower ERC - Market is skeptical - Non core items have low persistence: estimation risk - Big bath: - Political cost: dont want public to look at you; attract attention - Want to keep potential entrants out - Smooth earnings: - They are risk adverse, dont want variance in earnings - Investors also dont want uncertainty, but smooth earnings; investors are happy and stock price are stable - Should be able to meet predicted earnings