ACCT3013 Lec 3 Earnings Management Flashcards
What does TRUE AND FAIR VIEW mean?
- True means prepared according to GAAP, no material misstatement that would mislead users.
- Fair means faithfully represented business reality without bias.
T and F subjective view, there is no single ‘truth’.
What is the MANAGEMENT MYOPIA THEORY state?
Managers will interfere with the normal course of earnings in order to meet ST targets, forgoing profitable LT investment opportunities so that current profits meet market consensus expectations. (i.e. shift of focus from permanent earnings to transient earnings.)
What are myopic managerial INCENTIVES? (5)
- Influence market opinion to minimize cost of EQUITY financing!!!
- Avoid violation of loan covenants.
- Income smoothing / reduce volatility of earnings to reduce PERCEIVED risk, increase CREDIT RATING for cheaper DEBT financing.
- Reduce tax and gov / regulatory intervention.
- Private gains: maximize bonuses, return from stock options.
What are the 3 EARNINGS BENCHMARKS that myopic managers are tunnelled on meeting / beating? and why?
- Analysts forecasts consensus (i.e. beat mean / median). Most important benchmark given the far-reaching capital market implications.
- Zero earnings (i.e. report positive profit) Zero is a psychological boundary of net value in the perception of value creation.
- Prior earnings (i.e. report positive earnings growth). Otherwise indicates that that competitors are outgrowing / company becoming less competitive.
How do companies manage earnings in face of a small loss vs. medium loss?
Small: manage earnings to push it into the positive side bc they know small losses are heavily penalised in the market.
Medium: manage earnings to create “big bath” so next periods earnings will be more positive.
What are the 2 ways earnings can be managed?
(1) Disclosure management: exploiting the flexibility inherent in accrual accounting, e.g. choices in accounting policies, and adjustments for allocating values across time.
(2) Transaction management: altering timing of REAL operating activities. E.g. delay capital investments, R&D expenditure, inventory production. Preferred method!
What is the Q1 - Q4 pattern of earnings management?
Q1 - Q3: Accrual management - unaudited, integral accounting approach forgives estimation errors in the interim.
Q4: Transaction management - external audit.
Why does LT earning management aways REVERSE?
Accruals always reverse to their cash-equivalent.
If performance was measured over the life of the business:
∑Cash Earnings = ∑Accrual Earnings
Describe some disclosure management examples?
e. g. Allowance for DD
e. g. Depreciation
e. g. Recognise less DD’s so that current earnings look better, but real bad debts will still be realised and reduce future earnings.
e. g. Revise useful life upwards, recognise less depreciation expense, higher earnings, but will need to be impaired in the future.
What is the earnings management DETECTION method?
Statistical approach
Assumption: If earnings management reverses then it should revolve around its mean (i.e. mean-reverting).
The unexplained portion of the model (e) gives the unexplained variability in accruals. One could then rank accruals and investigate the extreme positive errors and the extreme negative errors:
When is the statistical approach successful? What is wrong with the lecture example?
If the model is correct, the econometric assumptions are met, and the industry classification makes sense.
Lec Example: Focuses on current accruals but for Light Manufacturing it is non-current accruals that matter the most. Industry classification is very broad.
Step 1: Identify Identify KEY ACCOUNTING POLICIES important to the industry.
Retailers: receivables, inventory, payables.
Technology firms: R&D.
Lease-dependent firms: operating leases.
Labour-intensive firms: employee benefits, stock options.
Fixed asset-intensive firms: depreciation, capitalised expenses, impairments.
Step 2: Assess accounting FLEXIBILITY allowed by GAAP
Retailers: book revenue in advance before earned, can lower their allowance for DD’s.
Technology firms: can change amortization rates, and charging all sorts of expenses on research.
Lease-dependent firms: operating leases.
Labour-intensive firms: employee benefits, stock options
Fixed asset-intensive firms: change depreciation rates, excessive impairments charges in big bath years.
Step 3: Identify suspicious events
*Renegotiation of borrowing
o
*Change in auditor
Share issues or share buybacks
Management rewards are tied to earnings per share
*Weak governance structure (weak audit committee, few independent directors)
*Firm is a takeover target
*Unexpected voluntary disclosure, i.e. unregulated information released at the discretion of the management.
Step 4: Identify narrow-escapes from trouble
- Barely meeting analysts forecasts of earnings
- Barely reporting zero earnings
- Barely meeting last year’s earnings
- Debt covenants are close to be violated
- Regulatory requirements are close to be violated (e.g. minimum capital requirements for banks)
