earnings management Flashcards
what is earnings mgmt
process of manipulating FS numbers through accounting adjustments, real activities or both
what are some accounting adjustments that managers use to manipulate earnings
changes in accounting policy and adjustments to accruals (these methods have no effect on cash flows)
what are some examples of changes in accounting policy
changing the depreciation method or useful life of assets
why is changing accounting policy less common
it is hard to justify, hard to keep changing the useful life/method of depreciation every year, also too costly to extend useful life (capitalisation of maintenance cost)
how will adjustments to accruals lead to earnings mgmt
net income = CF from ops + (or -) total accruals
different types of accruals:
depreciation and amortisation
increase/decrease in receivables/payables, inventories
prepayments/unearned ervenue
provisions and write-offs
what are some real activities that lead to earnings mgmt
operating activities, financing activities and investing activities (these methods will have real effects on cash flows)
what are some examples of operating activities
cutting r&d and maintenance cost,
boosting sales through excessive sales discount
what is an example of financing activities
pre-paying debt -> pay more of principal so that interest expense decreases
what is an example of investing activities
boosting income through asset or security sales
what are some patterns of earnings mgmt
big bath: make poor results look worse -> implemented in bad year to enhance next year’s earnings
income minimisation -> less extreme of income minimisation
income maximisation -> maximise present period earnings
income smoothing -> level net income fluctuations (reduce estimation risk, investors predict)
what are some motives for earnings management
contractual, regulatory, capital mkt
contractual motives for earnings mgmt
compensation -> max cash bonus
debt covenants -> financial tripwires which will shift control rights to lenders, covenants are designed around attributes of firm’s financial reports
regulatory motives for earnings mgmt
avoid regulation,
reduce political exposure,
take advantage of govt grants/benefits
capital markets
e.g. for IPO
