Originally prepared by:Professor Farshid Navissi (Monash University)

Semester 2, 2005Updated by:

Gatot Soepriyanto (Binus University)Semester 2, 2008

A Review of Earnings Management

Accounting Seminar

Week 3

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Agenda

A Review of Earning Management (EM) Method of EM Incentives for EM Detecting EM

Jones Model Step by Step guidance

Modification of EM studies

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“Numbers in the abstract are just that -- numbers. But relying on the numbers in a financial report are livelihoods, interests and ultimately, stories of American Investors”.(The “Numbers Game”: Arthur Levitt – former SEC Chairman)

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Earnings Management (EM) Defined

Use of judgment in financial reporting and in structuring transactions to alter financial reports to influence the perceptions of stakeholders about the underlying economic performance of the company and / or influence outcomes that depend of the reported accounting numbers

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EM and Corporate Fraud Virtually all managerial activities affect earnings

constitute EM EM covers a wide variety of legitimate and

illegitimate managerial actions that affect earnings EM may manifest in terms of the extremities of

either conservatism or optimism Fraud typically comes into existence when firms try

to paint an extremely optimistic picture of their operations through aggressive use of illegitimate practices

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EM: Example Behaviours“Conservative”

Accounting“Neutral”

Accounting“Aggressive”

Accounting

“Fraudulent” Accounting

WITHIN

GAAP

VIOLATES

GAAP

Tendency to understate Tendency to overstate

earnings and to overstate liabilities earnings and to understate liabilities

Overly aggressive recognition of provisions

Unbiased or neutral representation of the firm’s financial operations

Understatement of provisions

Recording fictitious transactions e.g. Sales

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Patterns of EM

Income Maximisation Income Minimisation

Extreme case known as “taking a bath”

Income Smoothing Keeping earnings consistent over a long

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Methods of EM

1. Accounting Method Choice Choice of accounting method affects the timing

of when revenues and expenses are recognised in income

For example the “percentage of completion” method permits the recognition of revenue on an ongoing basis, while the “completed-contract method” recognises revenue only at the completion of projects

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Methods of EM

2. Application of Discretionary Estimates Even after the selection of accounting methods there

remains the discretion of how the method is applied For example when depreciating assets using the

straight-line method there still remains the issue of estimating the useful lives and the residual value using a longer useful life and larger residual value estimate will increase revenue in current accounting period

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Methods of EM

3. Accounting Method Timing Exercising discretion over when and how to carry out

activities that affect financial statements For example when to write-off impaired assets or

recognise a liability as a contingent liability

4. Control of Major Expenses / Revenues For example how much to invest in R&D, advertising

and maintenance expenses. Also firms can delay or accelerate the delivery shipments of goods to customers

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Incentives for EM

1. Behavioral Incentives Lending Contracts Accounting-Based Bonus Plans Political Costs Management Transition

2. Market Based Incentives Dividend Payout Rates Management Buyouts Equity Offerings Analyst Expectations Share Repurchases Management Share Option Plans

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Behavioural Incentives Lending Contracts

Many debt arrangements contain restrictions relating to interest coverage, debt-to-equity, etc

The desire to prevent the violation of these restrictions presents an incentive for the firm to manage earnings upwards in periods where the firm is close to breaching those restrictions

Accounting-Based Bonus Plans Firms often reward managers on the basis of reported earnings or

other accounting-based performance measures The desire to receive higher bonuses presents an incentive for the

manager to manage earnings upwards in some periods

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Behavioural Incentives

Political Costs Large firms are often under scrutiny for their large profits The desire to circumvent increased regulatory intervention presents

an incentive for the firm to manage earnings downwards Management Transition

Poor performing managers often replaced with new management The possibility of “taking a bath” and attributing the poor performance

to its predecessors presents an incentive for the manager to manage earnings downwards in the period immediately after appointment

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Market-Based Incentives

Dividend Payout Rates Shareholders may expect steady stream of dividends The desire to maintain its historical dividend payout rates presents an

incentive for the firm to manage earnings smoothly Management Buyouts

In an attempt to acquire more control managers may purchase a substantial equity stake in the company they manage

The desire to purchase as many shares as possible presents an incentive for the manager to manage earnings downwards in the period prior to the buyouts

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Market-Based Incentives Equity Offerings

Earnings commonly used to value a firm going to public for the first time

The desire to acquire more funds (via a high offering price) presents an incentive for the firm to manage earnings upwards in the periods prior to the offerings

Analysts Expectations Financial Analysts (and/or management) often provide public

forecasts of earnings The desire to meet or better those forecasts presents an incentive for

the manager to manage earnings upwards in periods where it is anticipated that actual “unmanaged” earnings will fall short of the forecasted earnings

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Market-Based Incentives Share Repurchases

Firms with excess cash sometimes purchase their own shares for a variety of reasons

The desire purchase these shares at a lower price presents an incentive for the firm to manage earnings downwards in the period prior to the repurchase

Management Share Option Plans Firms often issue managers with share options as part of

their remuneration package The desire to maximise their “profits” from these options

presents an incentive for the manager to manage earnings downwards in the period prior to the award of the options and to manage earnings upwards in the period prior to the exercise of the options

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Detecting EM

It is impossible to detect every accounting choice that is made by every firm and to evaluate whether the choice has been made for opportunistic reasons

Researchers have tended to focus on measures that provide an aggregate measure of earnings management

Earnings is composed of two components1. Cash Flow from Operations2. Accruals

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Detecting EM

Operating cash flows are very difficult to exercise discretion over

Researchers typically focus on the levels of total accruals made by firms

Accruals are typically used by firms to recognise the consequences of transactions in the periods in which they occur

Since accruals commonly involve discretion, accruals are more susceptible to manipulation

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Detecting EM

Many models exist to detect levels of abnormal accruals (discretionary accruals)

Healy (1985), DeAngelo (1988), Jones (1991), Dechow, Sloan and Sweeney (1995) and Kothari, Leone and Wasley (2005).

Basic idea is to use past firm accruals and financial information to estimate normal levels of accruals (non-discretionary accruals) in the period of investigation. The non-discretionary accruals in the period of investigation are then subtracted from the actual accruals to derive a measure of discretionary accruals

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Jones (1991) Model Step 1: Calculate total accruals in time t

TACt = [(∆CA - ∆Cash)/ TAt-1]–[(∆CL - ∆STD)/ TAt-1]–(Dep/ TAt-1) (1)

Where ∆CA = change in current assets, ∆Cash = change in cash/cash equivalent, ∆CL = change in current liability, ∆STD = change in short-term debt included in current liabilities, ∆TP = change in income taxes payable, Dep = depreciation and amortization expense, and TA = total assets. Short-term debt is excluded from current liabilities because it relates

to financing activities, as opposed to operating activities.

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Jones (1991) Model

Step 2: Estimate the coefficient of normal accruals in estimation period. Jones assumes that normal accruals are related to changes in revenue (sales) and by the level of plant, property and equipment (PPE):

TACt/At-1= α0 + α1 (ΔREVt/At-1) + α2 (PPEt/At-1) + υt (2)

Where: TAct is the total accruals of firm i in period t Ait-1 is the total assets of firm i at the end of period t-1 REVit is the change in revenue of firm i in period t

Period t revenue for firm i - Period t-1 revenue for firm i PPEit is the balance of plant, property and equipment of firm i at the

end of period t

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Jones (1991) Model

Step 3:The coefficients estimates from model (2) are then applied to the event years to predict the normal accruals

NAt= ά0 + ά 1 ((ΔREVt /TAt-1) + ά 2 (PPEt/TAt-1) (3)

Step 4: Finally, the magnitude of abnormal accruals (AN) is then obtained as the difference between total accruals computed in model (2) and the estimated (equation 3), that is:

ANt = TACt – NAt (4)

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Example?

Lets assume that we would like to investigate whether a sample of 24 firms manipulated earnings upwards in 2004

20031993

10 Year Estimation Period

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So what next?

For each of the 24 firms we have to collect historical data (used in model 1) which will enable us to estimate the expected level of normal accruals in 2004. Lets assume we decide to gather 10 years of data for estimation purposes

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Putting it all together

For each firm we run regression (1) in the estimation period and obtain the parameter estimates of 1, 2, and 3

200420031993

10 Year Estimation Period

itititititititit APPEAREVAATA )/.(ˆ)/.(ˆ)/1.(ˆ/ 1312111

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Putting it all together

The parameter estimates are then applied to the event year to provide an estimate of expected normal accruals.

Using discretionary accruals of the 50 sample firms, the mean and the statistical significance of the discretionary accruals is calculated

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Evidence on Specific Accruals

Models such as Jones (1991) use abnormal accruals as a proxy for earnings management

But standard setters are more interested in which specific accruals are used in earnings management Depreciation estimates Bad debt provisions Deferred tax valuations

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Modification of EM Research

EM as the measure of financial reporting quality

EM as the dependent variables is tested with others independent variables (e.g. GCG proxies and audit quality proxies)

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Review Questions

Using Jones (1991) model, please: Design the research methodology to investigate

whether firm manage their earnings before a significant share repurchases.

Design the research methodology to examine whether firm manage their earnings after management transition.

Design the research methodology to test whether Big 4 CPA firms provide higher audit quality (lower EM) than non Big 4 CPA firms.

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Assignments