Session 5 - Earnings Management and Earnings Quality (Essay)

Question 1

High Earnings Quality

Answer 1

Fair representations of the Economic / Financial performance of the firm

Question 2

Low Earnings Quality

Answer 2

Overstate true earnings

NOT Fair representations of the Economic / Financial performance of the firm

Question 3

Earnings Management (EM)

Answer 3

• Managers use Judgment in Financial Reporting and in structuring transactions to alter financial reports
• To either mislead some stakeholders about the underlying economic performance or to influence contractual outcomes that depend on reported accounting numbers.

Question 4

Types of Earnings Management

Answer 4

• Accruals-based Earnings management
• Classification shifting
  (ex. recurring loss as non-recurring loss)
• Recognition vs. disclosure

Question 5

Relationship between Earnings Management & Earnings Quality

Answer 5

• Inversely related

- Higher Earnings Management –> Lower Earnings Quality

Question 6

5 Attributes of Earnings Quality (PAP CVS)

Answer 6

1. ) Predictability
2. ) Accrual Quality
3. ) Persistence
4. ) Smoothness
5. ) Value Relevance

Question 7

Predictability

Answer 7

PREDICTABILITY
Using current earnings/cash flows to predict future earnings/cash flows

An element of relevance
Highly valued by analysts

Question 8

Accrual Quality

Answer 8

ACCRUAL QUALITY
When earnings map more closely into cash flow
earnings are high quality

Question 9

Persistence

Answer 9

PERSISTENCE

• Permanence or Sustainability of earnings
• Inclusion of non-recurring components makes earnings less permanent

Question 10

Smoothness

Answer 10

SMOOTHNESS
Controversial
- Makes earnings more predictable and hence desired by investors
- The SEC would argue this distorts true earnings so not desirable

Question 11

Value Relevance

Answer 11

VALUE RELEVANCE

The relation between Market Value of equity and Earnings and book value of equity

Question 12

Conservatism

Answer 12

CONSERVATISM

Asymmetric property of earnings – bad news is recognized quicker than good news

Question 13

Consequences of Earnings Restatements

Answer 13

• Increases in Cost of Equity Capital
• Lower the perceived Earnings Quality of the firm –> increase investors’ required rates of return
• Corporate boards and the external labor market impose significant private penalties on managers for violating GAAP

Question 14

Detect Earnings Management

Answer 14

1. Use of red flags (one issue at a time)
   Look at overall (aggregate) attributes of earnings quality
2. Beneish model (focus on Red Flags)

Question 15

How to Identify EM?: Red Flags

Answer 15

• Unexplained changes in accounting
• Unusual increases in accounts receivable in relation to sales increases
• An increasing gap between a firm’s reported income and its cash flow from operating activities – accruals are rising
• An increasing gap between a firm’s reported income and its tax income (spread).
• Delays in writing down current assets

Question 16

More Red Flags

Answer 16

• Unexpected large asset write-offs
• Qualified audit opinions or changes in independent auditors that are not well justified. Is the management “opinion shopping”?

Question 17

EM Studies

Answer 17

• EM is lowest in the US relative to other countries

Question 18

Beneish Model

Answer 18

Eight Variables capture the Probability of Manipulation of financial statements

ex. used to detect Enron years before