Week 10 - Earnings Quality and Earnings Management Flashcards
What are the other ways of saying earnings?
Profit, bottom line, net income
What is the importance of earnings?
- Measures entity performance
- Widely reported
- Frequently forecast
- Strongly linked to share value
Who are earnings used by?
Shareholders
Creditors
Customers
Employees
What do shareholders use earnings for?
To asses stewardship and prospects
What do creditors use earnings for?
To asses risk, input to debt covenants
What do customers use earnings for?
To assess earnings, long-term survival
What do employees use earnings for?
To assess job security.
What is the importance of earnings?
*The theoretical value of an entity’s share price if the present value of its future earnings. Increased earnings signal an increase in entity’s value.
* Earnings are used by shareholders to both assess managers’ performance – a stewardship role – and to assist in predicting future
cash flows and assessing risk.
* Researchers found that earnings are more closely associated with
stock prices than are cash flows, sales or other FS data.
What happens if firms miss earnings benchmarks? What do investors infer?
*creates uncertainty about our future prospects
*outsiders think there are previously unknown problems
*increases the possibility of lawsuits
*outsiders think firm lacks flexibility
What are features of earnings quality?
Repeatability of earnings - relates to how closely current earnings are aligned with future earnings
Believability - the extent to which reported income reflects the underlying economic performance of a company.
What is earnings management?
When management uses this discretion to mask the underlying economic performance of a company.
Discretion being using the accounting estimates to mask other performances.
Why do firms manage earnings?
- For the benefit of the entity, eg:
* to meet analysts’ and shareholder expectations and predictions.
* to maximise share price and company valuation.
* to avoid violating restrictive debt covenants. - To meet short-term goals which lead to maximising managerial
remuneration and bonuses.
* Enhanced compensation
* Improved job security
* Career advancement and reputation
What is the difference between earnings management and fraud?
Fraud has the same objective as earnings management, but differs
from earnings management in that fraud is outside of generally
accepted accounting principles (GAAP), whereas, earnings
management is within GAAP (Erickson, Hanlon and Maydew, 2006)
What are the methods of earnings management?
Accounting policy choice
Income smoothing
Real activities management
Big Bath write offs
What is accounting policy choice referring to in earnings management?
- most common form of earnings management
- strategic choices of accounting policy, eg, a choice between straight-line and accelerated depreciation, FIFO or weighted average for inventory valuation
What is income smoothing referring to in earnings management?
- ‘Smoothing moderates year-to-year fluctuations in income by shifting earnings from peak years to less successful periods.’
■ Premised on the belief that shareholders prefer to invest in an entity that exhibits consistent growth patterns.
■ Rather than one that has uncertain and changing earnings patterns
What is real activities management referring to in earnings management?
■ Managing earnings by managing operational decisions, not just
accounting policies or accruals.
■ Examples include: accelerating sales, reducing discretionary
expenditures, altering shipment schedules and delaying or even
cutting R&D and maintenance expenditures.
What is big bath write off referring to in earnings management?
■ Manipulating income statement to make poor results look even worse in order to make future results appear better.
■ Often used when there is a change in management or significant restructuring.
■ Leads to future reductions in expenses and better performance by presenting a reduced base upon which future valuations and comparisons performance can be assessed
What is the (principal) agent problem?
The agents’ objectives (such as a desire for a high salary, large bonus and status for a director) may differ from the principal’s objectives (wealth maximisation for shareholders).
What is corporate governance?
Corporate governance is the term used to describe the set of rules and mechanisms that define how a company is run.
What is corporate governance used for?
Corporate governance can be used to change the rules under which
the agent operates and restore the principal’s interests.
What are some examples of corporate governance mechanisms?
Examples of corporate governance mechanisms:
* Audit Committees
* External Auditors
* Internal Auditors
* Managerial remuneration
What are the key features of board of directors?
- Executive directors, eg, CFO,
CEO, CIO, etc - Non-executive/ independent
directors (NEDs) - At least 50% of the Board
should be NEDs - Chairman should be
independent on appointment - The roles of Chairman and
CEO should not be occupied
by the same individual
What do shareholders do?
Shareholders appoint directors to serve on the board; the board appoints members of the audit committee.
