Earnings Management Flashcards
Earnings are also called?
profit,
bottom line,
net income
How does it measure entity’s performance?
By indicating extent entity has engaged in activities that add value.
It is forecasted by?
analyst and managers.
Who is Earnings used by?
- Stakeholders - assess stewardship and prospects
- Creditors - assess risk, input to debt covenants
- Customers - assess earnings, long term survival
- Employees - assess job security
What is earnings management?
‘reasonable and legal management decision making and reporting intended to achieve stable and predictable financial results’
What are the different earnings management styles relating to different entity objectives?
- Conservative - unusual
- Aggressive
- Fraudulent
List the different methods of earnings management.
- Accounting Policy Choice
- Accrual Accounting
- Income Smoothing
- Real Activities Management
- Big Bath Write-Offs
Characteristics of Accounting Policy?
- most common form of earnings management
2. flexibility of choice - leads to different timing and amounts of expense recognition and asset valuation.
Can you change accounting methods?
Yes, provided it can be explained to auditors how the new practice is preferred.
What are some examples of Accounting Policy?
- straight line or accelerated dep?
- FIFO or weighted ave?
- volunteering to be an early adopter of an acct std
Characteristics of Accrual Accounting.
- Managers prefer consistent revenues and earnings growth
2. Allows entity to delay/accelerate recognition - temporarily adjust profit figures
What are some examples of Accrual Accounting?
- Under-provision of bad debts expense
- Delaying asset impairment
- Adjusting inventory valuations
- Amending depreciation
Define income Smoothing.
‘Smoothing moderates year-to-year fluctuations in income by shifting earnings from peak years to less successful periods’
- S/H prefer constant growth patterns
What is Real Activities Management?
- Managing operational decisions.
- affect cash flows and sometime accruals
- could have negative effect on cash flows in later periods
What are some examples of Real Activities Management?
- Accelerating sales; price discounts
- Reducing discretionary expenditures
- Delaying R&D
What is Big Bath Write Offs?
- Refers to selling subsidiaries/operational units resulting in a large loss reported against income
- Often when there is change in management or significant restructuring
Why manage earnings ?
- For the benefit of the entity
2. To meet short-term goals
How does EM benefit the entity?
- meet analysts’ and S/H expectations and predictions
- maximise share price and company valuations
- accurately convey private info
- avoid violating restrictive debt covenants
What are the 3 common methods of Entity Valuation?
- Book value
- Operating Cash Flow
- Net income -> most aligned with this
What is earnings quality?
- Relates to how closely current earnings are aligned with future earnings
- Difficult to observe and measure
- Contradictory views on whether smoothed income indicates high earning quality
What are the potential consequences of EM?
- Aggressive management may lead to poor share performance
- Increase earnings before IPO may lead to overvaluing shares and declines in the following year.
- Negative reaction to fraudulent manipulation.
