LECTURE NINE

EARNINGS MANAGEMENT

INTRODUCTION

In the previous lesson, we discussed shareholders, their activism and how

their interests could be protected.

This lesson extends the discussion on shareholder protection by looking at

one weapon used by insiders of the company to conceal their private benefits

which ultimately undermines the interests of outsiders.

This weapon is earnings management.

OBJECTIVES

At the end of the discussion, the student should be able to:

Define and identify types of earnings management

Identify types of earnings management

Identify the factors that motivate earnings management behavior

Provide arguments for and against earnings management

Prescribe ways for dealing with earnings management

DEFINITION OF EARNINGS MANAGEMENT

Earnings sometimes called bottom line or net income are the outcome of a

firm’s value-added activities.

They serve as a signal that helps direct resource allocation in capital markets.

Earnings are used to determine the theoretical value of a firm.

The stock of a publicly traded company is valued by determining the present

value of its future earnings.

Many phrases have been used to describe

earnings management. These include:

• income smoothing,

• accounting hocus-pocus,

• financial statement management,

• the numbers game, aggressive accounting,

EARNINGS MANAGEMENT CONT’D

• re-engineering the income statement,

• juggling the books, creative accounting,

• financial statement manipulation,

• accounting magic,

• borrowing income from the future,

• banking income for the future,

• financial shenanigans, window dressing, and

• accounting alchemy.

EARNINGS MANAGEMENT CONT’D

•The simple definition of earnings

management is that it is the orchestrated

timing of gains and losses to smooth out

bumps and especially avoid a decline.

Techniques for managing earnings include;

• Insiders using financial reporting discretion to overstate earnings and

conceal unfavorable earnings realizations (i.e., losses) that would trigger

outsider interference and

• Insiders using their accounting discretion to create reserves for future

periods by understating earnings in years of good performance,

effectively making reported earnings less variable than the firm’s true

economic performance.

The literature recognizes two types of earnings management:

• Acceptable earnings management and

• unacceptable earnings management.

• Acceptable earnings management refers to reasonable and lawful

management decisions and financial reporting intended to accomplish

stable and predictable financial results.

TYPES OF EARNINGS MANAGEMENT CONT’D

• Thus, this definition recognizes earnings management as a tool for

achieving stable and predictable financial results of the firm.

• The definition recognizes two channels of earnings management:

• management decision making and

• financial reporting.

Thus, we have

• earnings management by (Generally Accepted Accounting Principles

(GAAP) accounting choice also called accounting earnings management

and

• earnings management by management operating decisions also called

economic earnings management.

ACCOUTING EARNINGS MANAGEMENT CONT’D

• Examples of accounting earnings management are

• choice of method of asset depreciation (straight line or reducing balance

method?);

• treating of expenditure (what expenditure should be capitalized?); and

• adoption of new accounting standard (should the firm be a voluntary adopter of

a new accounting standard? or should it wait until it becomes compulsory for

companies to adopt this new standard?).

Examples of earnings management via management decisions (economic

earnings management) are:

introducing special discount or incentive to boost sales near the period when

it is anticipated that revenue targets for the period are not likely to be met;

management refusing to invest in new equipment in order to maintain some

level of cash flows;

management refusing to employ the needed additional employees in a

particular period so as to achieve some earnings targets;

management refusing to undertake routine maintenance in a particular period

because doing so will undermine meeting earnings targets for the period; and

Leasing some critical equipment instead buying in order to achieve some

level of cash flows.

Capitalization of expenses that do not generate future cash flows(i.e.

expenses that are reasonably not expected to generate future cash flows

are recorded in the books of the company as investment expenditures and

thus appear in the assets side of the balance sheet instead of charging them

against income for the period.

Unacceptable earnings management practices (cooking the books)

Earnings management via management decision that has the objective of

manipulating financial statements in order to distort the economic reality of the

firm’s performance is called “cooking the books”.

• It is a deliberate misrepresentation of financial results.

• Illegal earnings management is an intentional practice in corporate financial

reporting in which corporate managers and directors manipulate or

misrepresent financial performance of the firm orchestrated to achieve two

main objectives:

misinformation of the stakeholders of the firm and exacting of favorable

contractual outcomes which has the overall consequence of erosion of trust

between shareholders and the firm.

(Unacceptable)Earnings management occurs when managers employ

judgment in financial reporting and in configuration of transactions to alter

financial reports to either misinform some stake holders or to influence

contractual outcomes that rely on accounting numbers (Healy and Wahlen,

1999).

UNACCEPTABLE EARNINGS MANAGEMENT CONT’D

Following Healy and Wahlen (1999), Leuz, Nanda & Wysocki (2003)

define unacceptable earnings management “as the alteration of firms’

reported economic performance by insiders to either mislead some

stakeholders or to influence contractual outcomes”.

These definitions see unacceptable earnings management as a deliberate

modification of the true economic performance of a firm that is perpetrated by

insiders of the firm with two objectives: to throw dust into the eyes of

stakeholders about the performance of the firm or to use it as bait to obtain

favorable contractual outcomes.

The following activities represent fraud and are, therefore, examples of illegal

earnings management:

Recording fictitious sales

Recording sales when there is right of return and return of the goods is

expected

Recording sales and shipping unfinished products

Failing to properly record expenses

Backdating sales invoices

Engaging in barter transactions when goods exchanged are substantially

overvalued or undervalued

Improper capitalization of expenses

Overvaluing assets

As can be observed, both earnings management via accounting choices and

economic earnings management involve real economic costs for

shareholders.

For example, adopting a new accounting standard early may boost the

earnings in the period of adoption but may come with real economic costs of

paying higher bonuses and compensation in the subsequent years.

Similarly, avoiding maintenance costs in one period may mean paying

higher maintenance costs in the subsequent years.

Due to the real economic costs involved in earnings management and the fact

that earnings management obscures the true economic performance of the

firm, financial economics literature consider it unacceptable.

We must state that from the agency theory perspective because earnings

management reduces transparency and obscures the “true” earnings, earnings

management however its channel is unacceptable.

FACTORS THAT MOTIVATE EARNINGS MANAGEMENT BEHAVIOR

Factors that motivate earnings management are in two categories: internal

factors and external factors.

Internal factors include the desire to meet performance expectation so as to

obtain managerial incentives such as bonus and share option.

EXTERNAL FACTORS

External factors that compel managers to manage earnings include:

the desire to meet the expectations of financial analysts;

the desire to increase the share value of the firm and

the desire to mask private benefits from outside shareholders

(outsiders).

Regarding the latter incentive for earnings management, it has been

observed that controlling owners or managers have incentives to hide

their private control benefits from outsiders because, if the benefits are

noticed, outsiders will likely take disciplinary action against them.

ARGUMENT IN FAVOUR OF EARNINGS MANAGEMENT

Those who consider earnings management as an acceptable practice cite three

reasons:

• Flexibility in accounting choices and estimations permitted by GAAP:

This has been cited as one reason for earnings management. In many

accounting choices, there is no clear limit beyond which a choice becomes

illegal; much depends on the ability to offer a reasonable basis for opting for

a particular choice. Matching concept requires that expenses in a fiscal year

must be matched with related revenue.

For instance, GAAP requires that in product warranty cost should be estimated

and matched with the revenue from the product in the fiscal year in which the

transaction takes place. Thus, selling a mobile phone for GH¢ 100 and offering

a free refund or replacement warranty if the mobile phone breaks down within

one year requires that you estimate the warranty cost and record it as an

expense in the same year as GH¢ 100 revenue is generated.

However, since GAAP is not clear as to the limit of the warranty cost, its

estimation is subject to arbitrariness.

Similarly, in depreciation of a fixed asset some discretion is given as to how

this should be done which gives room for earnings management.

Managers intending to maximize future reported earnings can decide to opt

for the depreciable life of the asset that is at the high end of industry norms

(i.e. if the depreciable life of the asset in the industry ranges between 5 and

10 years) management can decide to opt for 10 years) in order to minimize

expenses.

Many parties benefit from active earnings management: For instance,

earnings management that increases the value of the firm is in the best

interest of shareholders since they are likely to realize capital gains.

Deepening of the company’s image: Active earnings management may

deepen the image of the company as a performing company which may

attract investors and customers as well decrease its cost of capital since its

good performance will be perceived by the financial markets as

representing a lower risk.

ARGUMENT AGAINST EARNINGS MANAGEMENT

It aggravates the agency problem: Earnings management is perceived as tool

for obscuring the real economic performance of the firm which means that

shareholders are denied access to information about the true economic

performance of the firm.

Undeserved rewards to company executives: Earnings management can be

used by corporate executives to extract undeserved rent/compensation from

shareholders. For instance, capitalization of non-future cash flowing generating

expenditure will result in shareholders paying subsequent bonuses to corporate

executive for meeting profit targets which in reality should not be so.

Loss of investor confidence in the firm: Manipulation of financial

information if detected will lead to loss of investor confidence in the firm

resulting in the value of the firm going down

Earnings management is unethical: Management decisions and

discretion in financial reporting that result in telling half-truth about the

economic performance is deemed to be unethical.

Earnings management can be used to marginalize the interest of

minority shareholders: Earnings management can be used by inside

shareholders to obscure their private control benefits (Examples include

perquisite consumption and transfer of firm assets to other firms owned by

insiders or their families) which marginalizes the interest of outside

shareholders. Evidence exists that earnings management is positively

associated with the level of private control benefits enjoyed by insiders

(Leuz, Nanda &Wysocki, 2003)

DEALING WITH EARNINGS MANAGEMENT

The following measures can be used to minimize the incidence of earnings

management:

Limited use of performance-based incentives as well as value-of-

stock-based executive compensation: Bergstresser &Philippon (2006)

provide evidence that the use of discretionary accruals to manipulate

reported earnings is more pronounced at firms where the CEO’s potential

total compensation is more closely linked to the value of stock and option

holdings.

Strengthening and enforcing investor protection laws: Legal systems

that effectively protect outside investors reduce insiders’ need to conceal

their activities. Therefore, earnings management is more pervasive in

countries where the legal protection of outside investors is weak, because

in such countries insiders enjoy greater private control benefits and hence

has stronger incentives to disguise firm performance (Bergstresser

&Philippon, 2006).

Clear-cut financial reporting policy: Having a clear-cut financial

reporting policy that limits managerial discretion in financial reporting

could help reduce the incidence of earnings management.