Midterm Earnings Mgt Flashcards
What 3 things would the financial statement analyst want to know pertaining to earnings management?
1 if company analyzed has manipulated/managed financial
Statement numbers
2 numbers on financial statement most likely to be managed
3 magnitude of management
The purpose of this paper is to review earnings management literature from the perspective of…
The financial statement analyst
This review paper reveals that an individual analyst working to understand a single company has little to guide him in assessing probability that firm has… 3 things
1 Managed financial statement numbers
2 which numbers have been managed
3 extent to which they have been managed
What is the main task of the financial statement analyst?
Analyst has the task of estimating a firm’s value by analyzing
financial statements of the company
4 typical tools analyst uses to estimate firm’s value?
1 horizontal analysis
2 vertical analysis
3 ratio analysis
4 industry norms
How does the analyst plan to calculate the present value of the future cash stream?
By using measure of income and a growth factor
2 other ways analyst plans to calculate value of company?
1 using comparable companies
2 price to earnings ratio
According to earnings management research, firm’s have been shown to manipulate earnings in some circumstances for what reasons?
To benefit firms or firm’s managers
Which 3 ratios of comparing comparable companies, would the analyst worry are effected by earnings management materially?
1 return on assets
2 inventory turnover
3 debt-to-equity
3 main questions from earnings management literature focused on in paper?
1 what does the literature say about which firms are likely to have
Managed financial statement numbers?
2 which numbers are likely to have been managed?
3 what amount of earnings management should be expected
For those numbers?
Earnings management literature does not indicate the…
Prevalence of management across firm’s
It has been shown statistically that firms in a given context are more likely to manage earnings in…
A predictable fashion
It has not been shown how many firms in the sample…
Manage earnings
Has research made it possible to predict which companies will or will not manage earnings?
No
This paper notes that earnings management research is…
Of little relevance to the financial statement Analyst
This paper is not a criticism of…
Earnings management literature or earnings management
researchers
Earnings management
Use of accounting discretion, intentional accounting misstatement
Or use of real transactions to alter numbers reported in financial
Statements
To influence outcomes that depend on reported accounting numbers
Example of using accounting discretion to influence outcome that depends on reported numbers
Changing depreciation methods to maintain ratios used in debt
Contracts
Example of using deliberate misstatement
Reporting sales before work is completed in order to meet
Performance goals
Example of altering real transactions to influence numbers reported in financial statements
Deferral of machine maintenance to meet analyst forecasts
Earnings are often managed to…
Meet earnings benchmarks
2 earnings benchmarks earnings management may try to meet?
1 analyst expectations
2 management earnings forecasts
Earnings management, how does it directly benefit the manager?
management compensation plans (stock price and stock option
Values)
Management usually manipulates earnings to…
Increase them slightly rather than decrease them
When do firms manage earnings down?
2) For what purpose?
Prior to management buyouts
2) To lower stock price and thus price of buyout
Firms manage earnings up prior to…
Insider sales to increase proceeds of these sales
Debt covenants: earnings management
Earnings are managed in predictable ways prior to debt covenant
Violations
Debt covenant violations: when do firms make income increasing accounting choices?
To avoid default
Debt covenant violations: when do firms make income decreasing accounting choices? 2
1 if debt is restructured or renegotiated
2 after technical default if they are in debt renegotiation
Earnings are managed in predictable ways by what 3 types of firms?
1 healthy firms
2 firms reporting continuing losses
3 firms that are failing
Even in healthy firms, the closer the firm is to violating debt covenant provisisions, the more likely it is to make…
Income-increasing accounting choices
How are firms with continuing losses often valued?
Valued based on level and growth of revenue
When are firms with continuing losses more likely to overstate revenue?
The longer the past and anticipated string of losses are
In years preceding a bankruptcy firms will…
Manipulate earnings up
3 instances where earnings are managed up in anticipation of major transactions or negotiations
1 share-for-share corporate acquisitions
2 before IPOs
3 before seasoned equity offerings
Earnings are managed down in anticipation of what kind of negotiation?
Labor union negotiations
Smooth earnings
Research suggests earnings are managed to smooth earnings
Stream over time
2 reasons many firms smooth earnings
1 to avoid temporary decrease in earnings
2 in anticipation of future earnings
When and why do oil firms smooth earnings?
To lower income during times of high oil prices
Give an example of a significant event that causes earnings to be managed down?
Earnings are managed down after non routine executive changes,
Especially in firms experiencing financial distress
Give an example of a significant event where earnings are managed before it occurs?
Earnings are managed down by firms in court and subject to large
Punitive damage awards
Earnings management and government regulation 2 things
1 earnings are managed to meet regulatory requirements
2 earnings are managed to circulate regulatory oversight
Not all firms that face incentives to manipulate earnings…
Will do so
If there is an incentive/circumstance that warrants manipulating earnings there is…
An increased likelihood that manipulation of earnings will occur
What 2 factors mitigate the incentive to manage earnings?
Audit committee and board of director characteristics
Accounting choices will vary to the extent of what?
Manager vs. Owner control of the firm
Earnings that have managed earnings up in recent periods have…
Less flexibility to manage earnings up in current period
Beneish (1999) offers a tool for financial analysts to predict if company is managing earnings, what was the sample and function of his study?
Studying a sample of firms that were required to restate earnings
He creates a model to detect which firms manage earnings
What are 5 potential red flags on financial statements that are indicative of earnings management?
1 unusual increases in receivables 2 deteriorating gross margins 3 decreasing asset quality 4 sales growth 5 increasing accruals
Decreasing asset quality, how is it measured?
Measured as Noncurrent asset other than property-plant-and-equipment divided by total assets
Knowing that firms are more likely to manage earnings in a given context does not help the analyst to understand…
The earnings management behavior of the company under review
The items most often used in earnings management models are…
2) how are they measured
Accruals
2) measured as difference between operating income and
Operating cash flows
How are discretionary accruals measured?
Measured as the accruals that can’t be explained by change
In sales and level of fixed assets
What 3 changes will the discretionary accruals measure capture?
1 changes in # of expenses
2 changes in some revenues
3 changes in various working capital accounts
Discretionary accruals, other than demonstrating that income was increased or decreased, it does little to help analyst in indentifying…
Which financial statement numbers were changed
Components of accruals that get manipulated vary by…
Context in predictable ways
How do firms issuing equity manage accruals? 2
By increasing revenue and decreasing depreciation expense
Firms managing accruals to reach an earnings benchmark use…
One time special items to increase income
There is little evidence documenting the kind of special item used
What are 5 other vehicles in the form of assumptions that lead to manipulation of numbers?
1 changes in pension assumptions 2 inventory method 3 depreciation method and estimates 4 LIFO liquidations 5 other one time special items
One time special items for earnings management include: 4 things
1 management of write offs
2 bank loan loss provisions
3 gains from asset sales
4 pension costs
Management of realtime transactions for earnings management 3 things
1 increased sales through discounting or more lenient credit terms
2 decreases in COGS through increased production
3 decreases in discretionary expenses
3 examples of discretionary expenses
1 advertising
2 research and development
3 maintenance
As a result of earnings management research the analyst will understand that some firms… 2 things
1 manipulate accounting numbers to manage earnings
2 vehicles chosen for manipulation vary in predictable ways
Magnitude of earnings manipulation?
Median discretionary accrual for firms with debt covenant violation
And negotiations was 17.3% of total assets
Median of only 1% to meet earnings benchmark
Papers opinion on future direction of earnings management research, 2 things
1 develop models that will predict which Financial statement
numbers are manipulated in given contexts and magnitude of
Manipulation
2 develop model that directly predicts amount of management
In reported earnings
Seasoned equity offering
New equity issue by an already publicly traded company
