Week 10 - Earnings Quality and Earnings Management

Question 1

What are the other ways of saying earnings?

Answer 1

Profit, bottom line, net income

Question 2

What is the importance of earnings?

Answer 2

• Measures entity performance
• Widely reported
• Frequently forecast
• Strongly linked to share value

Question 3

Who are earnings used by?

Answer 3

Shareholders
Creditors
Customers
Employees

Question 4

What do shareholders use earnings for?

Answer 4

To asses stewardship and prospects

Question 5

What do creditors use earnings for?

Answer 5

To asses risk, input to debt covenants

Question 6

What do customers use earnings for?

Answer 6

To assess earnings, long-term survival

Question 7

What do employees use earnings for?

Answer 7

To assess job security.

Question 8

What is the importance of earnings?

Answer 8

*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.

Question 9

What happens if firms miss earnings benchmarks? What do investors infer?

Answer 9

*creates uncertainty about our future prospects
*outsiders think there are previously unknown problems
*increases the possibility of lawsuits
*outsiders think firm lacks flexibility

Question 10

What are features of earnings quality?

Answer 10

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.

Question 11

What is earnings management?

Answer 11

When management uses this discretion to mask the underlying economic performance of a company.

Discretion being using the accounting estimates to mask other performances.

Question 12

Why do firms manage earnings?

Answer 12

1. 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.
2. To meet short-term goals which lead to maximising managerial
   remuneration and bonuses.
   * Enhanced compensation
   * Improved job security
   * Career advancement and reputation

Question 13

What is the difference between earnings management and fraud?

Answer 13

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)

Question 14

What are the methods of earnings management?

Answer 14

Accounting policy choice
Income smoothing
Real activities management
Big Bath write offs

Question 15

What is accounting policy choice referring to in earnings management?

Answer 15

• 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

Question 16

What is income smoothing referring to in earnings management?

Answer 16

• ‘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

Question 17

What is real activities management referring to in earnings management?

Answer 17

■ 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.

Question 18

What is big bath write off referring to in earnings management?

Answer 18

■ 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

Question 19

What is the (principal) agent problem?

Answer 19

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).

Question 20

What is corporate governance?

Answer 20

Corporate governance is the term used to describe the set of rules and mechanisms that define how a company is run.

Question 21

What is corporate governance used for?

Answer 21

Corporate governance can be used to change the rules under which
the agent operates and restore the principal’s interests.

Question 22

What are some examples of corporate governance mechanisms?

Answer 22

Examples of corporate governance mechanisms:
* Audit Committees
* External Auditors
* Internal Auditors
* Managerial remuneration

Question 23

What are the key features of board of directors?

Answer 23

• 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

Question 24

What do shareholders do?

Answer 24

Shareholders appoint directors to serve on the board; the board appoints members of the audit committee.

Question 25

What do the audit committee do?

Answer 25

Audit committee conducts a tendering process and makes recommendations to the board about the appointment of auditors.

Question 26

What do the directors do?

Answer 26

Directors propose the appointment of auditors to shareholders; shareholders vote on whether to approve the appointment.

Directors prepare financial statements; audit committees
monitor the integrity of financial information.

Question 27

What do external auditors do?

Answer 27

External auditors audit the financial statements and report on various matters to the audit committee and
the shareholders

Question 28

What do internal auditors do?

Answer 28

Internal auditors provide additional assurance that the company’s monitoring processes are operating properly

Question 29

What do the remuneration committee do?

Answer 29

Remuneration committee is responsible for all elements of the
remuneration (money paid for a work or service) of the executive directors, senior management and the chair of the board.

Question 30

What do the nomination committee do?

Answer 30

Nomination committee leads the process for appointments, ensures
plans are in place for orderly succession to both the board and senior management positions.

Question 31

What is included in a company’s annual accounts and reports?

Answer 31

■ Directors’ report
■ Strategic report
■ Directors’ remuneration report
■ Auditor’s report
■ Financial statements and Notes to the FSs

Question 32

What is the purpose of a strategic report?

Answer 32

The purpose of the strategic report is to help shareholders “assess how the directors have performed their duty to promote the company’s success”.

Question 33

What are the three areas of the strategic report?

Answer 33

Strategic management - How the entity intends to generate and preserve value.

Business environment - The internal and external environment in which the entity operates.

Business performance - How the entity has developed and performed and its position at the year end.

Question 34

What are the contents of the director’s report?

Answer 34

• Likely future developments
• Research & development activities
• Greenhouse gas (GHG) emissions
• Statement on employee engagement
• Statement on business relationships
• Information on the acquisition of own shares.
• Recommended dividends
• Compliance with UK Corporate Governance Code
• Political donations