Part 9: Earnings Management

Question 1

Are managers likely to manipulate earnings?

Answer 1

“If they have strong corporate governance, then the risk that someone
manipulates earnings is very low.”
(Sell-side analyst, Denmark)

“Well you have a bonus related to NI in this case so that you always have
to remind.”
(Fund manager, Sweden)

“I mean, in some cases it could be that they want to show weak figures if
they are undergoing some sort of inquiry for competitive practices. In
other instances they could be interested in showing strong figures, for
instance in a merger process or… because of the bonuses or… because
the amount of capitalisation of the company also will change…”

Question 2

What is earnings management?

Answer 2

• Whenever a manager strategically influences the earnings recording process, he engages in earnings management.

Earnings management refers to discretionary accounting decisions that affect earnings (net income, bottom line in the income statement). Since almost any decision in accounting is to some extent discretionary, most accounting decisions can qualify as earnings management.

• As the earnings recording process requires human judgment and
• as humans behave strategically by definition,
• there are no unmanaged earnings.
• Earnings are opinion, cash is fact.

Question 3

Types of earnings management?

Answer 3

• Accounting earnings management

- real earnings management

Question 4

Examples of accounting earnings management

Answer 4

• Explicit, rule based options
– Cost model or revaluation model of IAS 16/38
– Valuation model (cost/fair value) for investment property
– Classification options for FI under IFRS 9
– Consolidation of special purpose entities (SPEs) under old FIN 46 (US-GAAP
pre-Enron)

• Implicit, principal based options
– Asset recognition of development costs
– Provision recognition
– Deciding upon an (a goodwill) impairment
– Revenue recognition
– Consolidation of SPEs under SIC-12 (IFRS)

Question 5

Examples of real earnings management

Answer 5

• Why wait for revenues tomorrow if you can have them today?
– Barter transactions
– Bill and hold
– Servicing contracts

• The needs of man are few: Get food, find shelter and keep debt off the balance
sheet.
– Window dressing (repay Monday, borrow on Tuesday)
– Leasing
– Factoring
– Asset backed securities
– SPEs

• Cut expenses which won’t pay back until long.
– R&D
– Marketing

Question 6

Measurement of earnings management

Answer 6

• Remember: Earnings management is an unavoidable part of the accounting
process and, in itself, neither good nor bad.
• To measure earnings management, we need some idea about what “normal”,
“true” or “good” earnings are.
• Unfortunately, we do not have a real understanding of the “true” or “good” part.
– Thus, most researchers focus on the concept of “normal” earnings,
– interpreting abnormal earnings as indicator for out-of-equilibrium earnings
management (induced by the manager).

Question 7

Earnings quality

Answer 7

– We define earnings quality as the portion of accounting earnings not
susceptible to management discretion.

– We define earnings quality as the proportion of true economic earnings in total reported earnings.

– We define earnings quality as an earnings stream more closely associated with future cash flows from operations.

Question 8

Measurement of earnings quality: The accrual concept

Answer 8

• Central assumption or idea:

– Earnings management manifests itself in accruals (and not in cash flows!).

– Earnings quality is high if accruals are “normal”.

Question 9

What does “normal” mean in accruals ?

Answer 9

1) Regress accruals (ACC) on gross property, plant and equipment (GPPE)
and changes in revenues (REV) [adjusted for receivables, REC]; the
residual of the regression equals abnormal accruals:

Jones (1991) model: ACC = f(REV, GPPE) or

Modified Jones model (Dechow et al., 1995): ACC = f(REV - REC, GPPE)

2) Regress working capital accruals(WC) on last period, current period and
next period cash flow from operations (CFO); the residual equals accruals
unrelated to cash flows and its standard deviation is a measure for quality:
Dechow and Dichev

Question 10

Earnings management is good or bad?

Answer 10

– from the manager’s viewpoint: A rational manager would only engage in
earnings management if it is optimal for him.

– from investors’ viewpoint: This depends on whether the incentives between
managers and investors are aligned (we know this already).

– from other stakeholders’ viewpoints: Again a question of incentive alignment.
Remember: What’s good for one stakeholder might be bad for another.

– from a social welfare perspective: This is close to non-addressable as long as we don’t assume that all but very few factor markets are highly
competitive.

Question 11

Models of earnings management

Answer 11

1. Rational accrual choice by the manager
   – exogenous bonus plan and
   – no strategic interaction.
2. Rational expectations model
   – Two players: investors and manager.
   – Investors form rational expectations about earnings management.
   – The manager receives bonus payments based on stock price.
3. Incentive alignment through contracts
   – Assumption: The manager faces a limited capital market.
   – Implication: Consumption induced shifting of earnings over time.

Question 12

What are incentives for earnings management?

Answer 12

Some examples:
• To provide information.

• To increase compensation.

• To beat benchmarks (external, such as analyst forecasts or market
expectations in more general terms, or internal, such as earnings from the
previous year).

• To decrease taxes (precondition: earnings are related to the taxable profit).

• To influence M&A negotiations.
• To facilitate the raising of new capital (IPO, SEO).

• To influence the outcome of regulatory assessment (such as the material injury assessment in dumping cases).