Lecture 11 ACCT 332 – Accounting Thought and Practice ACCT 332 Accounting Thought and Practice Earnings Management - Chapters 11 - Levitt. The Earnings Game - Cheng and Warfield. Equity Incentives and Earnings Management Management - Healy. The Effect of Bonus Schemes on Accounting Decisions
Lecture 11ACCT 332 – Accounting Thought and PracticeACCT 332 Accounting Thought and Practice
Earnings Management
- Chapters 11p- Levitt. The Earnings Game- Cheng and Warfield. Equity Incentives and Earnings
ManagementManagement- Healy. The Effect of Bonus Schemes on Accounting
Decisions
Objectives for Today’s Class
- Tools of Earnings Management
E i M t I ti- Earnings Management Incentives
• Bonus, Debt Covenant, Political Cost
• Healy (1985)
• Beat/Meat Earnings Targets
• Market-based considerations
• Cheng & Warfield (2005)
- Consequences of Earnings Management
• The Blockage Probleme oc age ob e
Definition of Earnings Management
• Scott: Earnings management is the choice (related to accounting policies or accruals) made by a manager that affects earnings sopolicies or accruals) made by a manager that affects earnings so as to achieve some specific reported earnings objective
• Schipper (1989): Earnings management is a purposeful intervention in the external financial reporting process with the intent of obtaining some private gainintent of obtaining some private gain – The importance of exit strategy
Amos Lim
Commonality: 1. Purposeful intervention/choice2. ObjectiveDifference: 1. Schipper asserts that there is an intent for private gain (opportunism)
Amos Lim
If managers have no exit strategy, or do not actually sell their shares in the market, then there may be no grounds to argue that their EM is for private gain.
How to Manage Accounting Earnings?
•Income Statement Management:
Restr ct ring charges-Restructuring charges
-Revenue recognition
-Allowance for doubtful accounts
-Warranty provisions
-Hedge accounting for derivatives
-Pension plan assumptions
-Capitalization of expenses
••Balance Sheet Management:
-Off-balance sheet financing
-Window dressing at reporting datesg p g
•Real Transactions Management:
-Investment policy, R&D spendingy g
-Marketing spending, sales timing
Amos Lim
“Big Bath” - recognising one-time expenses/losses
Amos Lim
Uses estimates
Amos Lim
While the above 2 are accrual EM, these are real EM.
Amos Lim
- Employee expenses
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AEM: 1. Have to eventually reverse2. REM:1. Actual economic effects2. Effects persist into LT
Why Do Firms Manage Earnings?
-Capital market motivations (premium for meeting analysts’ forecasts or reporting increase in earnings)forecasts or reporting increase in earnings)
Attributing successes to oneself, and failures to others
Earnings Management Example (1)- Burgstahler and Dichev (1997): Meeting Earnings Targets
Amos Lim
If we have a large enough sample, a normal distribution should be observed. However, there is a kink. This is attributed to managers knowing that they cannot report zero earnings, or report a loss. They therefore manage their earnings in order to
Amos Lim
0 is the market’s expectation, based on 3 criteria:1. Zero earnings (Is there a Loss / Gain?)2. Analyst Forecast for EPS (Is it less / more than analyst forecasts?)3. Last year’s earnings (Is it less / more than last year’s earnings)If > 0, it exceeds expectations. If < 0, it’s below expectations.The reason the phenomenon is observed at the 0 mark is because it’s less costly to move to 0 or beyond if it’s a marginal difference.Furthermore, Information Asymmetry is present as well. The cost of missing expectations versus the benefit of beating expectations by just a little more greatly differs. Furthermore, many investors use simple heuristics to make investment decisions, one of which may simply be “is there a profit/loss”?
Amos Lim
20 years on, the kink has shifted to the right, given that every one now understands that they need to beat earnings by a larger proportion in order
Earnings Management Example (2)- Bhojraj et al. (2009): Meeting Earnings Targets
Making Sense of Cents: An Examination of Firms that Marginally Miss or Beat Analysts’ Forecasts (Bhojraj, Hribar, Picconi, and McInnis, Journal of Finance 2009)
Amos Lim
Missers did not cut R&D, and did not use AEM. They therefore did not manage earnings, and did not beat forecasts. Beaters cut R&D, or used AEM. They therefore managed earnings, and beat forecasts.Consistent with the hypothesis that AEM incurs cost, it was found that the beaters of analyst forecasts tend to generate lower CARs in the LT.
Amos Lim
Capital market motivation: using the capital market as an incentive for decisions.
Earnings Management Example (3)- Healy (1985): Bonus
• Bonus plan hypothesis: to manage cash bonus • Healy (1985)• Confined to bonuses based on net income• The concepts of bogey and cap
• Evidence of upward earnings managementEvidence of upward earnings management when net income between bogey and cap
• Earnings management measure• Earnings management measure • Healy used total accruals as the proxy
Amos Lim
(He assumed that any accrual is considered EM)
Amos Lim
E.g. Sales of 200, COGS of 100Dr COGS 100, A/R 200Cr Revenue 200, Inventory 100Net income = Accruals + Cash Flows = 100 + 0 (no cash flows)Healy used total accruals (100) as a proxy for EM
Figure 11.2 Typical Bonus Scheme
us
unt�o
f�Bonu
Amou
B ( ) C (U)Bogey (L) Cap (U)
Reported Net Income
Amos Lim
Bogey: The minimum amount of NI managers have to have in order to receive a bonusCap: The maximum amount of NI beyond which no additional bonus is awarded
Amos Lim
Findings: - Most EM occurs at levels just below the Bogey- EM also found between Bogey and Cap, given that managers want to increase their bonus- Downward (negative) EM observed beyond the cap, given that managers want to smooth income and make it easier for them to obtain their bonuses in the following years.
Earnings Management Example (4)- Cheng and Warfield (2005): Equity Incentivesg ( ) y
• Main findings: The incidence of meeting or just beating analysts’ forecasts is positively correlated with equity incentives
Amos Lim
Ability to exit is important, as otherwise managers receive no benefit.
Amos Lim
More likely to have sales of shares in the future, suggesting that there are benefits
Amos Lim
Unlike the previous study, which looked at cash bonuses
Earnings Management Example (5)- Efendi et al. (2007): Equity Incentives
Why do corporate managers misstate financial statements? The role of option compensation and other factors. (Efendi, Srivasta, and Swanson, Journal of Financial Economics 2007Ȍ
( ) y
Amos Lim
Opportunistic View: Managers manage earnings during the period to make options deep in-the-money, which they can then exercise and sell. This was as a lot of them were awarded options as compensation.
Amos Lim
Efficient contracting view: Nothing to do with managers managing earnings to increase the stock price so they can have in-the-money options. These may just be internet companies where the accounting standards are somewhat vague because the standard setters did not know at that point in time how to recognise revenue. at the same time, investors were very exuberant about these companies, resulting in the valuations being very high.
Earnings Management Example (6): Behavioral Biases
The Bad Side of Earnings Management
• Reduces the reliability and information usefulness of accounting reports.reports.
• Can lead to earnings restatements (why is that bad?)• Lower credibility among investorsLower credibility among investors • Higher cost of obtaining capital (equity or debt)
Amos Lim
Earnings restatements can be due to errors or irregularities. Errors imply an unintentional mistake, whereas irregularities imply an intentional bias. Either way, it’s bad, as it indicates either poor controls, or dishonesty, which causes companies to lose credibility
Amos Lim
Due to being perceived as riskier
The Good Side of Earnings Management
• To credibly communicate inside information to investorsinvestors
• Contract violation is costly, earnings management may be low-cost way to work aroundy
Amos Lim
Income smoothing is more believable by investors, who are typically suspicious of sudden, huge gains. It also confers more predictability to earnings.
Amos Lim
E.g. EM as a low-cost way of avoiding violating debt covenants, which would result in higher interest rates or even bankruptcy. Managers are therefore acting in SH benefit.
Earnings Management- Strategic Aspects of Accounting Policy Choice
• Managers may choose policies to achieve certain objectives.
- Efficient Contracting vs Opportunism- Efficient Contracting vs. Opportunism
- These choices may not provide the best information for investor / creditor decisionsinvestor / creditor decisions.
• Thus, managers care about changes in accounting rules Æ may participate in standard-setting debates Æ Chapters 12 / 13.p p g p
Group Questions
• 40 minutes to complete group questions
• A i t f di i l di• Assignment of discussion-leading groups
