PAT and Earnings Mgmt

Question 1

What is earnings mgmt?

Answer 1

• Managers using discretion over accounting choices / how they report earnings / real economic decisions to influence how economic events are reported in produced financial decisions
• Contractual (PAT)
• Capital market reasons

Question 2

What is the debt covenant hypothesis?

Answer 2

• The closer a firm is to violating a debt covenant (breaching certain level of debt-to-equity / interest cover) the more likely they are to move future earnings into the current period
• Breaching these leads to technical default (bad for firm)

Question 3

What is the study conducted for the debt covenant hypothesis?

Answer 3

• DS
• Examined private loans to corporations that needed certain current ratio or net worth and calculated the slack they needed
• Predicted they would want slack at a level higher than 0
• They found the distribution of slack to be consistent with manipulation because there were more cases with 0 or positive slack and fewer than expected quarters with negative slack

Question 4

What is the bonus hypothesis?

Answer 4

• Comes from agency problem which is managers and owners being separate entities
• Managers want a higher income
• Managers can either get a fixed salary or one that is tied to the performance of the corporation
• When they get it tied to the company, they are more likely to move future earnings into the current period so that they receive better rewards (if tied to performance they are more likely to take risks)

Question 5

What is the study for the bonus hypothesis?

Answer 5

• Healy
• 447 firm years across 94 industrial corporations in the USA back this

Question 6

What is the political costs hypothesis?

Answer 6

• Certain firms have greater scrutiny from third parties due to size, industry or being previously state-owned (or they suddenly report higher earnings)
• These firms are more likely to choose more conservative accounting policies

Question 7

What is the study for political costs hypothesis?

Answer 7

• Jones model
• Found firms employed accounting tactics to reduce income during periods when they had to show profit detriment
• Separated discretionary and non-discretionary accruals and found that discretionary accruals were found to be significantly negative over this period, leading to reduced income and increased chances of relief

Question 8

What are the overvalued companies capital market reasons?

Answer 8

• Jensen’s theory
• Markets can be less than fully rational
• Managers can earning manage to trick the market
• The more a company is overvalued in equity, the more earnings management has taken place

Question 9

What is the IPOs capital market reasoning for earnings managment?

Answer 9

• Fan
• Firms use IPOs to signal information
• Rational for IPO firms to manage firms upward so that they signal confidence
• Firms do manage earnings but it is interpreted correctly by the market
• Due to managers having greater information than the market, they are able to correctly convey the future via earnings management upwardly

Question 10

What is the Earnings Game capital market motives?

Answer 10

• Gore
• Firms persuade the market that they will meet or beat their financial forecast
• Can be done by forward looking statements or lowering the forecast to a number they are more likely to reach
• If they were to suffer bad news, they are less likely to meet the forecast, which is bad for the firm
• Reasoning for meeting or beating the forecast in the US is because they gain a stock premium
• They can avoid loss, meet, or beat the forecast

Question 11

What are the predictions of how managers will act in the bonus hypothesis?

Answer 11

• Choose less conservative and less volatile accounting policies
• Object to volatility increasing accounting standards (like fair value)

Question 12

What is the relevance of PAT for standard setters?

Answer 12

• Design standards which are in accordance with accounting concepts
• Need transparency
• Management lobby for policies that work for them
• Makes it hard

Question 13

What do flexible standards allow?

Answer 13

• Discretion
• Firms to adapt
• Endorsement by capital markets

Question 14

What do unflexible standards allow?

Answer 14

• Opportunistic behaviour
• Management assumed to be self-interested and against shareholders

Question 15

What are the roles of contracts in accounting?

Answer 15

• Use information to reduce agency costs
• Monitoring and bonding to control self-interested agents
• Agency explains why certain methods may matter

Question 16

What are the problems with contracts?

Answer 16

• Costly to write complete contacts
• Once contracts have been negotiated managers will use accounting choices to serve their own interests anyway
• There is a tradeoff between being unflexible and exposing the firm to managerial exploitation

Question 17

What are the predicitions of the political cost hypothesis?

Answer 17

• Choose more conservative accounting policies
• Be less opposed to income reducing accounting policies

Question 18

What are the predictions of the debt covenant hypothesis?

Answer 18

• Managers with higher d-e ratios will choose less conservative accounting policies and oppose new standard which restrict their ability to do this

Question 19

Origins of PAT?

Answer 19

• EMH (public, private, public and private)