Week 9 - Earnings management & Non-GAAP earnings Flashcards
Earnings management
The choice by a manager of ACCOUNTING POLICIES or REAL ACTIONS, affecting earnings so as to achieve some specific reporting objective
- the more earnings mgmt, the lower EARNINGS/ACCOUNTING QUALITY
» discretion is not always representing economic reality, ie. when used opportunistically; can reduce usefulness of earnings for stakeholders - (Healy and Wahlen, 1999)… to ALTER financial reports to either MISLEAD some stakeholders about the underlying economic performance of the company, or to INFLUENCE CONTRACTUAL OUTCOMES that depend on reported acct. numbers
Important distinction between ACCRUALS and REAL earnings management
- earnings mgmt can also be in the form of accruals (= differences between income and cash flow)
» accruals to represent economic reality and prevent volatile performance - REAL earnings mgmt, eg. choosing straight line depreciation not b/c of the nature of the assets but due to reporting INCENTIVES
Good vs Bad earnings management
Good (NOT MISLEADING stakeholders)
1. meeting analyst forecasts to SIGNAL PERFORMANCE
2. meeting contractual obligations regarding DEBT
» eg. to avoid cost of violating debt covenants; good for both parties (won’t face high interest rates cost & no high risk of lending money)
3. SMOOTHING EARNINGS
» stable earnings are better to predict and helps stakeholders make more informed decisions
Bad (misleading stakeholders)
1. manipulating fin stt.s to boost short-term performance or stock prices
Should we reduce/eliminate discretion in financial reporting standards?
- Not quite possible to eliminate
- Discretion can give stakeholders useful information, eg. suppliers want to know if co. will be a good buyer
- If there is no leeway, regulators have to quickly adapt to standards if there are technological changes
eg. acct. for cryptocurrencies is very difficult to adapt and adjust for stakeholders
6 methods of earnings management patterns/accounting policies
-
Taking a bath
- report large {/all} losses and impairment charges now, getting it done now, to enhance the probability of reporting HIGHER PERFORMANCE in the FUTURE
eg. during Covid/financial crisis (outside firm’s control); before an IPO but not Seasoned Equity Offering (within firm’s control); when new CEO steps in, shifting blame to previous CEO -
Cookie jar
- build up a LARGE RESERVE from high returns in this period, then take impairment charges/ONE-OFF EXPENSES
- so that don’t have to do it when income is lower -
Income minimisation
- less extreme than above; involves taking losses to lower earnings
eg. tax reasons -
Income maximisation
- increase reported earnings for bonuses/contracting reasons -
Income smoothing
eg. to prevent fluctuations in compensation over time -
Materiality
- misusing the concept of materiality to intentionally record errors in a co’s fin. stt.s such that they get improperly labelled as immaterial
eg. if all transactions across the firm are misstated by $5, adding all up becomes material although individually not material to check and correct
What is the percentage of firms committing fraud? Who commits fraud? Who identifies fraud?
(Dyck et al, JF 2010)
Fraud is very common, earnings management even more! (Dyck et al, JF 2010)
- Only 1/3 of accounting scandals come to light
- 40% of companies are committing accounting violations
- 10% of companies are committing securities fraud, destruction of $830bln in equity value per year
- 12% of CFOs had managed earnings at the request of their superiors, an additional 55% of CFOs said they were asked to manage earnings but refused to do so
- 60% of CFOs have felt pressure to manage earnings
- Employees and whistleblowers! {generous whistleblowing incentives & protection by the law}
- But 40% wants to be anonymous (reputation concerns)
- Whistleblowers are sued and fired, hated and harassed by their co-workers
- Most would not do it again!
3 main categories of Incentives for Earnings management
1. Capital market incentives
- Capital market transactions, eg. IPO/SEOs {want to sell equity at as high price as possible to bring in more cash}
- Capital market expectations, eg. analyst forecasts, avoidance of losses
- Managers use (discretionary) accruals to manage earnings
- can be discretion overall, but also in specific accounts (depreciation, revenue, pensions, leases, COGS, investments)
- as mentioned in earlier flashcard, earnings mgmt and discretion used in this context reduces the usefulness of earnings for stakeholders
- evidence is conflicting… {in academia; some anticipation of discretion not used for economic reality(?)}
3 main categories of Incentives for Earnings management
2. Contracting incentives
eg. debt contracts, compensation contracts to optimise bonuses, supplier contracts RELY ON ACCOUNTING NUMBERS
eg. 10% ROA or promise to make particular year-on-year growth to get a lower interest rate
- however, equity ownership reduces accounting irregularities. Lower incentive to commit fraud!
3 main categories of Incentives for Earnings management
3. Regulatory incentives
eg. BANK REGULATIONS - regulators RELY on fin stt.s and ACCT. NUMBERS to decide if bank is close to default, if need to intervene
eg. ANTITRUST REGULATIONS - eg. need to measure excess profits being generated if you think that firms are colluding
- so firms may use (discretionary) ACCRUALS to manage earnings downward to avoid deregulation of regulated markets (collusion argument)
eg. Think about SVB - banks reclassify investments to avoid capital restrictions or regulatory meddling
eg. windfall tax in France as a result of inflation and too high income from firms
» use acct. info to impose tax + also can incentivise firms to report lower earnings
5 main ways to Detect earnings management
Ball (2013): there is always INFORMATION ASYMMETRY. unless we are inside the firm, we won’t know for sure if earnings are managed
- Acct. analysis: Deep dive (what we did in the summative assignment)
- check for asset/liability/equity distortions - Acct. analysis: Quick and dirty {used as 1st screening mechanism}
» using regression analysis to predict bankruptcies (Altman’s Z-score), predict earnings manipulation (Beneish M-score), is your accounting very different from your peers (SEC’s Accounting Quality Model)? - DISCONTINUITY in the earnings distribution {ref. to the “bell curve” graph}
» the firms reporting just below 0 earnings have an incentive to manipulate to be above 0
» b/c cannot keep consistently making losses, hence more profitable firms than loss-making firms - Machine learning
eg. linear regression, NLP techniques to analyse textual disclosures, real time data (eg. if Walmart reports high earnings but parking lots are constantly empty) - Accrual models, ie. Jones model {using regression analysis}
» accruals are not cash so have to estimate, which is difficult
» if estimate is very diff. from industry peers, the firms could be engaging in earnings mgmt
- Problem: different companies have different assets -> incorrectly identifying earnings mgmt / not identifying while it is present
Alternative to earnings management: Non-GAAP earnings
- not required for external reporting/other public disclosures
- firms allowed to exclude certain things but must provide a reconciliation
- Why? INFORMATIVE to STAKEHOLDERS
eg. EBITDA {cash-based, core operation performance metric}, “community-adjusted EBITDA” as reported by WeWork
» commonly non-cash items like stock-based compensation b/c firms argue that not cash-based so not reflecting performance
*non-GAAP earnings also shown for Snapchat and MicroStrategy consulting firm
Not all Non-GAAP reporting is bad! + 2 examples
(Leung and Veenman, JAR 2018)
However, unacceptable use of non-GAAP at WeWork.
» They removed growth and marketing costs in their adjusted EBITDA - impossible to argue that these costs are irrelevant!
- Losses are often uninformative
- Non-GAAP reporting helps stakeholders to disaggregate the loss and its components and are therefore INFORMATIVE
- Non-GAAP reporting is thus USEFUL for stakeholders of LOSS-MAKING FIRMS
{& highly predictive of future performance}
- taking out ONE-OFF EXPENSES helps to SMOOTH EARNINGS, which is desirable and informative to stakeholders
- bottom line earnings’ loss does not necessarily mean that the firm is bad if due to one-off expense
eg. at Pfizer, non-GAAP income is LESS VOLATILE
eg. at PepsiCo, non-GAAP takes out foreign exchange effects which distorts earnings. instead, they report Organic revenue growth <- more informative
> > non-GAAP should be allowed if these set of numbers best capture the co’s core performance in their POV and are more informative to stakeholders
Tesla’s Non-GAAP Accounting Measurements Case
- still no profit in 2014 (GAAP loss of $75mln. in Q3 2014, however non-GAAP profit of $5mln.)
- How reasonable are the non-GAAP adjustments made?
- Does Tesla’s business model require non-GAAP reporting
- can argue that Tesla’s incentive to report profits to maintain INVESTOR CONFIDENCE as a firm still in its START-UP phase
- the UNIQUENESS of the business is not fully captured by GAAP numbers
- stakeholders might not get all relevant information
> > Tesla’s resale value guarantee is a LEASE and should be recognised as deferred revenue under GAAP until buy-back period ends (adding back would result in net increase in liabilities). However, they recognise as Revenue under non-GAAP to show investors their anticipated performance (but not guaranteed will receive the cash in future).
Tesla excluded Stock-based compensation b/c non-cash so they argue that SBC does not reflect economic performance.
Regulatory credits = Benefits received for offsetting emissions, Tesla receives them for free and can sell them at 100% profit (their source of revenue). Reported as revenue under GAAP and they keep it in revenue under non-GAAP. However, can argue that should NOT keep in revenue under non-GAAP because not part of core operations
Tesla’s Non-GAAP Accounting Measurements Case
5 advantages & 2 disadvantages of using GAAP reporting
Pros
1. Prepared by independent professionals
2. Matching of revenue and expenses
3. Standardised and comparable
4. Well-known and understood
5. Audited
Cons
1. Not able to capture Tesla’s UNIQUE BUSINESS MODEL
2. Unable to reflect the CASH FLOWS of the business
Tesla’s Non-GAAP Accounting Measurements Case
2 advantages & 2 disadvantages of using non-GAAP adjustments
Pros
1. Prepared by management to capture ECONOMIC REALITY
2. Emphasis on CURRENT CASH FLOWS as a key measure of economic performance
Cons
1. Makes COMPARABILITY DIFFICULT
2. POTENTIALLY MISLEADING to stakeholders
