Chapter 11:

Earnings
Management
Matthew Blostein
Michael Choi
Kurtis Holmes
Eric Martin
Trevor Stickl
Earnings Management
Overview
Defined as: The choice by a manager of
accounting policies, or real actions,
affecting earnings so as to achieve
some specific reported earnings
objective
Understanding of Earnings Management
is important as it enables an improved
understanding of the usefulness of net
income, both for reporting to investors
and for contracting
Patterns of Earnings
Management
Takinga Bath
Income Minimization
Income Maximization
Income Smoothing
Taking a Bath
Usually takes place during periods of
organizational stress or restructuring.
The main idea is that if a firm is to
report a loss, managers may feel it
might as well report a large one as it
has little to lose. Large write-offs but
future earnings in the bank.
Income Minimization
Similar to taking a bath but less
extreme. Usually a politically visible firm
chooses this pattern during periods of
high profitability. (Example: United
States vs. AT&T)
Income minimization includes rapid
write-offs of capital assets, and
intangibles, and the expensing of
advertising and R&D expenditures.
Income Maximization
Managers engage in a pattern of
maximization of reported net income for
bonus purposes, so long as it does not
put them above the cap. A firm close to
a debt covenant violation may use this
strategy.
Income Smoothing
First, Risk-adverse managers prefer a less variable
onus stream, other things equal. Consequently,
managers may smooth reported earnings over time
so as to receive relatively constant compensation.
Efficient compensation contracting may exploit this
effect, and condone some income smoothing as a
low-cost way to attain the managers reservation
utility.
Second, when considering covenants in long-term
agreements, the more volatile the stream of reported
net earnings, the higher probability that covenant
violation will occur.
Income Smoothing Cont.
Third, managers may feel as if they will be
fired when earnings are low, income
smoothing reduces the likelihood of
reporting low earnings.
Finally, firms may smooth reported net
income for external reporting purposes. If
used responsibly, smoothing can convey
inside information to the market by enabling
the firm to communicate its expected
persistent earning power.
Evidence of Earnings Management
for Bonus Purposes
The Effects of Bonus Schemes on
Accounting Decisions Healy
Hypothesis:

Managers will find opportunities in which

they could manage net income in an
attempt to maximize their bonuses under
the firms compensation plans.
 Evidence of Earnings
Management
for Bonus Purposes
Only if income is between the bogey and cap will
managers find an incentive to acquire accounting
policies that increase net income
Evidence of Earnings Management
for Bonus Purposes
Sample: 94 firms
Period: 50 years
Between bogey and cap: positive avg.
accruals
Outside bogey and cap: negative avg.
accruals
Consistent with hypothesis of managers
incentive to lower current income when it
does not affect their current year bonus
Evidence of Earnings Management
for Bonus Purposes
Argues that changes in policies are not as
income-influencing as the use of accruals
Changes in policies tend to be implemented
just after the introduction/amendment of
a bonus plan
If income is anticipated to be high in upcoming
years, a manager will choose to implement a
policy that encourages higher reported net
income
 But Wait Theres More!$1,000
Cash flow, as per cash flow statement
Less: Amortization expense
Useful Life (50)
Add: Increase in (net) AR
during year
AFDA 40
Add: Increase in INV during
year
Overhead charge 100
Add: Decrease in AP and
Accruals
Expected WTY claims 30 120
Net Income, as per income
statement $1,120
Other
Motivations
Contractual Motivation
Many companies have covenants in
place to protect lenders
Violating this covenant is dangerous to a
manager
This causes managers to choose
accounting policies to avoid covenant
violation
Contractual Motivation Cont
Sweeny looks at this in a 1994 study
and finds two things:
Firms already violating covenants will
make drastic changes to accounting
policies to boost income
Firms approaching violation will make pre-
mature changes to accounting policies to
boost income
Contractual Motivation Cont
This is a dangerous motivation due to
the significant damage a covenant
violation causes
Managers may be overly aggressive
which may ultimately lead to fraud
Contractual Motivation Cont
Another motivation is implicit contracts
which arises from the relationship of
firm and its stakeholders
This is the idea that a firm will receive
benefits from stakeholders based on
previous contracts
Allows parties to work cooperatively
rather than at the Nash equilibrium
Political Motivations
When a company will make policy
changes to intentionally lower its income
This is done to escape government
scrutiny
For example a company making large
profits in a given year may altar its
amortization policy from straight line to
declining to recognize greater expenses
to match these profits
Meet Earnings
Expectations
This is when estimated earnings for
future periods meet and exceed
expectations of investors
This will ultimately increase share price
due to the strong positive correlation
between expected earnings and share
price
Meet Earnings Expectations
Cont
2010 study looking at 1992-2006 proves
that small earnings surprises actually
leads a decrease in share price
Investors are aware that earnings
surprises are caused by earnings
management
Proves that expectations must be met,
but surprises are not beneficial due to
rational investors
Meet Earnings Expectations
Cont
This creates a case of conflict of interest
as most managers hold stock options
It gives a greater incentive for managers
to meet expectations using earnings
management to avoid share price
decreases
May not be the best option for the firm
Can also lead to fraudulent behaviour
IPO
The issue with an IPO is that there is no
market price for a firms shares
This gives management incentive to
increase estimates of futures earnings
to get a higher price for their shares
IPO Cont
Studies in 1997 and 2007 look at
companies going public and their accruals
The main result found is that companies
boost their accruals prior to the IPO, then
reverse these accruals in later years
causing losses
Shows this type of earnings management
is successful as it works even with
rational investors
Good Side of Earnings
Management
Blocked Communication
Managers have inside information that is
costly to communicate = blocked
information
Managers can use provisions to smooth
earnings to desired levels and unblock
information
It would be foolish to overstate earnings
since the market will react severely when
there is a subsequent reduction
Good Side- Blocked
Communication
Inside Information
New firm strategies
Change in firm characteristics
Market conditions
Allcomplex information, but proven to
be communicated through discretionary
accruals and disclosures.
Good Side- Contracts
EM can be used to maintain investor
expectations and avoid market penalties for
fluctuations
If markets have rational expectations then
both management and investors benefit
from a consistent tracking and flow of
earnings
Upward earning management decreased
contract efficiency, but is a must for
investors
Good Side- Conservative
Accounting
Decreases contract efficiency as higher
manager effort = lower earnings
Also reduces need for upward earnings
management = increased contract
efficiency
Net effect of the two reactions is
positive on firm value
The Bad Side of Earning
Management
Opportunistic EM
Tendency for managers to try to maximize
their bonus
Debt Constraints
Firms that are highly levered need EM to
control if they violate loan covenants
Supported by Dechow, Sloan and
Sweeney study of 92 firms that firms do
practice this technic
Bad Side Contd
Raise new capital
EM can be used to maximize proceeds of
new issues
Discretionary accruals can increase SR
earnings
Techniques:
Speed revenue recognition
Lengthen cap. Asset life
Under reserve for environmental costs
Bad Side Contd
Transitory items
Unusual items so they do not affect
manager bonus
Increase future earnings by reducing
future amortization and absorption of
costs that would normal go through
operating expenses
Standard Setters
Reflect the bad earnings management
view
IAS 37- provision as a liability if timing
of payments is uncertain
Must be probable
Must be reliably estimated
Must be at fair value
Measures of Earning
Management
Variability of operating income
Lower = income smoothing
Correlation between accruals and cash flow
Low correlation =early revenue recognition
Magnitude of total accruals
Higher accruals = higher discretionary
accruals
Small Loss/Gain ratio
Low ratio = EM to avoid small losses
Implications
Ways
to reduce bad earning
management
Dont reject market efficiency
Improve disclosures
Reduces behavioural biases
Lower management incentive to exploit
poor governance and market inefficiencies
Report effects of current earnings on prior
write-offs
Earnings Management
Conclusions
Earnings management is justified through the theory
that true net income does not exist

GAAP does not completely constrain managers

choices of accounting policies
Complex and challenging
Motivated by strategic considerations
Meeting earnings expectations
Specific contracts and their covenants
IPOs or SPOs
Discourage potential competition
Unblock inside information
Earnings Management
Conclusions
Changes in accounting policy are becoming
a game for companies
Managers will react against rule changes that
reduce their flexibility of accounting choice
Need to be aware of legitimate needs of
management, investors, and be aware of
opportunistic strategies

Accompanying earnings management is

reduction in reliability and sensitivity of info
Earnings Management
Conclusions
Earning Management gives managers
flexibility to react to unanticipated
realizations
Earnings Managements can be a vehicle for
the credible communication of inside info to
investors
Both arguments above are consistent with
efficient securities markets and the
efficiency version of positive accounting
theory
Earnings Management
Conclusions
Managers can abuse communication potential of GAAP
Result in failure to accept securities market efficiency or from an
ability to hide bad earnings management behind poor disclosure

Reduce Earnings Management by bringing it to public, out in

the open
Improve disclosure of low persistence items and reporting effect
of previous write offs on current earnings
Assist corporate governance, help better reward good manager
performance and discipline managers who shirk

Improvements in allocation of scarce investment capital and

firm productivity increase social welfare
Taking a Bath and RIM
RIM Stock has plummeted over 70% in the
past year, netting to roughly $8/Share
It recently announced $518 million quarterly
loss
Plans to lay off 5,000 employees

RIM is trying to maximize its losses to

prepare for future reported profitability with
the Launch of Blackberry 10.
Income Minimization and AT&T
United States v. AT&T
Antitrust case that led to the 1984 Bell
Systems divestiture
AT&T accused of using monopoly
profits to subsidize the costs of its own
network
Had they chosen an income
minimization pattern, AT&T may not
have caught the public eye and scrutiny
Enron
This is a perfect example for income
maximization earnings management
Due to the stock option based
compensation managers receive, there
was constant incentive to inflate
earnings
Most of the earnings management was
done using complex accruals and
estimations
Enron Cont
With this type of earnings management
comes risk of government scrutiny
The income was never smoothed out
and governing bodies took interest in
consistently high growth
This ultimately lead to Enrons downfall
and many regulations and accounting
bodies put in place to avoid this in the
future
 Income Smoothing Case
Company overviews (2007)
American International Group (AIG)
Worlds largest insurance and financial services
company
Net Income - $6.2 billion
Premiums written - $59.8 billion
GenRe
One of worlds largest reinsurers
Owned by Berkshire Hathaway
Premiums written - $6.0 billion
Income Smoothing Case
Regulatory Scrutiny
2001 SEC learned AIG assisted client in
manipulating the balance sheet through
bogus insurance transaction

2003 SEC and Justice Department settle

civil case with AIG in amount of $10 million

2004 Federal investigation of AIGs

income smoothing products
Income Smoothing Case
Deal between AIG and GenRe
GenRe was to transfer loss reserves to AIG in
exchange for premium payment
Contracts for loss reserves to total between
$500 and $600 million
GenRe obligated to pay AIG premium of $1
billion
GenRe was to receive $5 million transaction
fee for deal
Contract to last 24 months, at which time it
would be reversed
Income Smoothing Case
Improper Accounting and Public Perception
AIG finally admitted that this deal should have been
accounted for as a deposit

Restatement of AIGs income following this

announcement amounted to a reduction in net income
of $1.32 Billion

Public Perception
Reckless efforts of senior corporate officers that were
designed solely for the unlawful purpose of achieving a
specific and false accounting effect on issuers financial
statements
Thank you
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