Chapter 11

Earnings Management

11 - 1
Copyright © 2009 by Pearson Education Canada
 Chapter 11
Earnings Management

11 - 2
Copyright © 2009 by Pearson Education Canada
 What is Earnings Management?

• Earnings management is the choice by a manager

of accounting policies, or real actions that affect
earnings, so as to achieve some specific reported
earnings objective

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 11.2 Patterns of Earnings
Management

• Bath
• Income minimization
• Income maximization
• Income smooth

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 11.3, 4 Motivations for Earnings
Management
• Contractual motivations
– Bonus plan hypothesis: to manage cash bonus
• Evidence: [Healy (1985)]
– Debt covenant hypothesis: to manage debt covenants
• Evidence: Dichev & Skinner (2002), text Section 8.5.3
• Political cost hypothesis
– To lower political “heat”
• Evidence: Jones (1991), text Section 8.5.3

» Continued

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 11.3, 4 Motivations for Earnings
Management (continued)

• To meet earnings expectations

– Significant negative effects on share price and manager
reputation if expectations not met

• Other motivations
– Initial public offerings

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 11.5 The Good Side of Earnings
Management
• Contract-based arguments
– To give firm some flexibility in the face of rigid,
incomplete contracts
• Bonus contracts based on net income
– New accounting standards may lower net income and/or
increase volatility. May adversely affect manager effort
• Debt covenant contracts
– New accounting standards may increase probability of debt
covenant violation
• Contract violation is costly, earnings management may be
low-cost way to work around

» Continued

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 11.5 The Good Side of Earnings
Management (continued)
• Investor-based arguments
– To credibly communicate inside information to investors
• Blocked communication may inhibit direct disclosure of
earnings expectations
• Discretionary accrual management as a way to credibly
reveal management’s inside information about earnings
expectations
– Manager foolish to report more earnings than can be
maintained
– Manage reported earnings to an amount management
expects will persist

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 11.5.2 Theory & Evidence of Good
Earnings Management
• Theoretical models supporting good earnings
management
– Demski & Sappington (1987)
– Stocken & Verrecchia (2004)
– Evans & Sridhar (1996)
– Dye (1988)
– Chen, Hemmer, & Zhang (2007)

» Continued

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 11.5.2 Theory & Evidence of Good
Earnings Management (continued)
• Empirical studies supporting good earnings
management
– Subramanyam (1996)
• Xie (2001) questions
– Tucker & Zarowin (2006)
– Liu, Ryan, & Whalen (1997)
– Barth, Elliott, & Finn (1999)
– Callen & Segal (2004)
– Francis, LaFond, Olsson, & Schipper (2005)

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 Problem 11.9 Earnings Management
at General Electric
• Earnings management devices used by GE
– Assumed rate of return on pension funds
– Restructuring charges
– Acquisitions, sales of divisions
– Conservative accounting practices
• Sales of leased aircraft
– Allocation of goodwill on purchase of subsidiaries
• Earnings management devices used in harmony to report
steadily increasing earnings

» Continued

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 Problem 11.9 Earnings Management
at General Electric (continued)
• GE Reported Net
Income (Millions)
– 2007 $22,208 – 1999 $10,717
– 2006 20,700 – 1998 9,296
– 2005 16,353 – 1997 8,203
– 2004 16,593 – 1996 7,280
– 2003 15,002 – 1995 6,573
– 2002 14,118 – 1994 4,726
– 2001 13,684 – 1993 4,315
– 2000 12,735 – 1992 4,725
» Continued

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 Problem 11.9 Earnings Management
at General Electric (continued)
• Note argument that even under securities market
efficiency, GE is so large and complex that even
analysts cannot prepare accurate earnings
forecasts
– Management has best inside information about
expected persistent earnings
– Direct communication blocked
– Creates role for earnings management to reveal
management’s expected persistent earnings
• Is this good or bad (i.e., opportunistic) earnings
management?

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 11.6 The Bad Side of Earnings
Management
• Contracting Perspective
– Healy (1985)
• Is this good or bad earnings management?
– Dechow, Sloan, and Sweeney (1996)
• Is this good or bad earnings management?

» Continued

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 11.6 The Bad Side of Earnings
Management (continued)
• Financial Reporting Perspective
– Hanna (1999)
• Investors and analysts look to core earnings, ignoring
extraordinary and non-recurring items
• Implies manager not penalized for non-core charges, such
as writedowns, provisions for restructuring
• But current non-core charges increase core earnings in
future years, through lower amortization and absorption of
future costs

» Continued

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 11.6 The Bad Side of Earnings
Management (continued)
– Hanna, cont’d.
• As a result, managers tempted to “overdose” on non-core
charges, thereby putting earnings “in the bank”
– also called cookie jar accounting
– Note securities market reaction
• Hanna found evidence that market uses frequency of such
charges as proxy for their misuse--lower ERC when greater
frequency
– Example: Nortel (Theory in Practice 11.1)

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 Problem 11.10 Earnings
Management at Sunbeam Corp.
• See Liang (1998) article
• Devices used by Sunbeam to manage earnings
upwards
– See next slide
• Note loss reported earnings 1st Q. 1998
– Illustrates “iron law” of accrual reversal
• Where was auditor?

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 Problem 11.10 Earnings
Management at Sunbeam Corp.

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 11.6.2 Do Managers Accept
Securities Market Efficiency?
• Perhaps
– Poor disclosure enables earnings management even if
markets efficient
• Perhaps Not
– Theory and evidence that securities markets may not be
fully efficient supports a “no” answer
– Evidence that efficiency not accepted
• Pro-forma earnings
– Doyle, Lundholm, & Soliman (2003)
• Managing same-quarter earnings of previous year
– Schrand and Walther (2000)

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 11.6.3 Can Accountants Control Bad
Earnings Management?
• Full disclosure
– Revenue recognition policies
– Unusual, non-recurring and extraordinary events
• Enables investors to better evaluate earnings persistence
– Effect of previous writeoffs on current core earnings
• Hanna ( 1999)

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 11.7 Conclusions

• Earnings management can be good if used

responsibly
• Full disclosure helps to control bad earnings
management

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