Lecture 8 - Earnings Management

Question 1

Define earnings management.

Answer 1

The intentional bias of GAAP through:

1. Accounting choices
   
   1. Discretionary accruals
   2. Accounting policy choice
2. ‘real’ cash flows

With the purpose of misleading stakeholders, in regards to the underlying economic value of the firm.

Or

To influence contractual outcomes.

Question 2

Real Decisions

3 different levels of decisions.

Answer 2

Alter transactions to bias financial reports. Affect real cash flows.

1. Operating Decisions:
   
   • Delay R&D expenditure
     
     1. R&D is expensed (but is often Pos. NPV)
   • Maintenance expenditure (benefit in the long run)
   • Delay or accelerate sales
     
     1. ↑ Credit terms -> ↑bad debt, ↑sales
2. Financing Decisions:
   
   • Premature repaying debt ->↓interest in SR
3. Investment decisions:
   
   • Sales of securities -> report a gain
     
     1. Proceeds>CV
   • Sale of fixed assets to affect gains and losses

Question 3

Accounting Choices

Answer 3

1. Accounting Policies
   
   • No ‘first-order’ cash flow effect, but second-order.
   • Not widely used earnings management: due to disclosure.
   • E.g. type of depreciation, useful life, capitalisation, FV vs HC.
2. Timing and estimation of accruals
   
   • When to recognise accruals
   • E.g. write-offs, write downs, non-performing assets.
3. Recognitions vs disclosures
   
   • Lawsuits – contingent liabilities.
4. Classification decisions
   
   • Operating or non-recurring (underlying earnings)
     
     1. Hide operating expense in ‘restructuring charges’
     2. Move non-operating income to operating.
   • Preference shares à equity not debt.
   • Underlying earnings – bias with non-recurring transactions
   • E.g. Impairment à once off = transoryà ↓deprecation in future
     
     1. ↑NI in future, ↓Equity è ↑ROE in future.

Question 4

4 Incentives or motivations for EM.

Answer 4

1. Contracting Incentives
   
   • Reported earnings are made by agents.
   • Pay aligned with reported earnings
     
     • • Debt covenants à manage debt vs equity

The bonus plan hypothesis:

Good: efficient contracts

Bad: opportunistic

Floor or ceiling for bonus

Theorises that management will move future earnings to this current period à increase bonus, through choice of accounting policy.

1. Change in CEO
   
   • Opportunity for excessive write down à blame prior CEO
   • ‘big bath’
2. Political – avoid industry regulations
   
   • Mining boom tax à incentive to bias downwards revenue.
3. Valuation Method
   
   • Offer shares à IPO, incentive to increase earnings
   • Beat market expectations.

Insider trading.

Question 5

Conservative vs neutral vs aggressive accounting

Answer 5

Conservative – overly aggressive recognition of provisions (e.g. provision for doubtful debt)

• Overvaluation of R&D
• Overstating of restructuring charges and asset write-offs.

Aggressive – understatement of provisions

Drawing down provisions.

Question 6

4 patterns of earnings management

Why might this be the case (reasons)?

Answer 6

Income maximation

Income smoothing

• Look like a low risk firm
• E.g. High operating leverage (ratio changes with)

Earnings bath

• Already writing off, no harm in writing off more (inefficient market).

Income minimisation

• Less extreme than earnings bath

Question 7

7 forces mitigating/limiting earnings management.

Answer 7

1. High quality auditors
2. Contract restrictions
3. Increased regulation à less space for opportunistic discretion.
   
   1. E.g. AASB 138 – intangibles
4. Strong corporate governance (oversight)
   
   1. Ethics, disclosure
5. Reversing effect of accruals
   
   1. Over the life of the firm, accruals will have the opposite effect in following periods.
6. Reputational costs
   
   1. Regulatory scrutiny - ASIC

Question 8

2 reasons why earnings management is beneficial

Answer 8

1. Signalling
   
   1. GAAP bias à overcome bias (more informative)
   2. Esp. firms with high operating leverage, or systemic risk.
   3. ‘Smoothly’ reveal earnings (earnings are “sticky”à creates expectation)
2. ↓ Contracting costs à technical breach (e.g. change in GAAP) à increase cost for firm.
   
   1. Incomplete contracts à new standard impact
      
      1. Compensation
      2. Possible breach of debt covenant

Question 9

4 reasons why earnings management is negative

Answer 9

1. Self interest (transfer of wealth to management – through contracting)
2. Misallocation à share price no longer accurate.
3. Second order à all firms assured EM à increase à lower amount of capital generated.
4. If detected à reputational loss, more regulation