Chapter 11 - Earnings Management

Question 1

4 patterns of earnings management

Answer 1

1. taking a bath
2. income minimization
3. income maximization
4. income smoothing

Question 2

what is taking a bath

Answer 2

• during organizational stress and restructuring times
• might as well report a large loss if going to report a loss (write offs)
• accrual reversals enhance probability of future profits

Question 3

what is income minimization

Answer 3

• less extreme than taking a bath
• rapid write off of assets and intangibles
• expensing R&D expenditures

Question 4

what is income maximization

Answer 4

• PAT –> maximizing reported net income for bonus purposes

- firms close to debt covenants do this

Question 5

what is income smoothing

Answer 5

• from contracting perspective, risk-averse managers prefer a less variable bonus system
• more volatile a stream of reported income, the higher probability that covenant violation will occur
• can also convey inside information to the market

Question 6

characteristics of the bonus spectrum

Answer 6

• if net income is low (below bogey) –> incentive to lower further
• if net income is high (above cap) –> motivation to income minimize
• between bogey and cap –> motivation to increase net income

Question 7

what is a bonus bogey?

Answer 7

the minimum net income that needs to be met before bonuses kick in

Question 8

accruals management strategies/trends

Answer 8

• net income below bogey or above gap –> adopt income decreasing accruals
• net income between bogey and gap –> adopt income increasing accruals
• income between two extremes –> discretionary accruals were much lower (income increasing)

Question 9

evidence that earnings management consistent with PAT’s bonus hypothesis

Answer 9

• opportunistic behaviour to exploit power by achieving maximum utility at the expense of shareholders
• efficient contracting perspective –> firms anticipate earnings management and allow to this in the compensation offer

Question 10

why do contracts allow for some earnings management?

Answer 10

less costly than eliminating completely

Question 11

other contracting motivations for earnings management

Answer 11

• device to reduce the probability of covenant violation in debt covenants –> income increasing tactics
• implicit contracts (relationship contracts)
• meet investors’ earnings expectation and maintain reputation
• initial public offering

Question 12

why is it so important to meet investor’s earnings expectations?

Answer 12

• market penalizes firms that fall short of expectations by more than it rewards firms that exceed them
• investors are aware of this, which makes meeting expectations more important
• market reacts negatively to small earnings surprises (probably due to earnings management)

Question 13

good side of earnings management

Answer 13

1. blocked communication
   - management’s inside info can be conveyed by means of earnings management
2. empirical evidence of good earnings management