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ACCOUNTING THEORY & CONTEMPORARY ISSUES (AT I)

MODULE EIGHT

CONFLICT BETWEEN CONTRACTING PARTIES

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PART 1 - Executive Compensation Plans PART 2 - Executive Compensation Theory PART 3 - Earnings Management PART 4 - Healy’s Study PART 5 - Motivations for Earnings Management PART 6 - Conclusions

Lecture by: Dr. A. L. Dartnell, FCGA

Year 2007 - 2008

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PART I

Executive Compensation Plans Major Points: Handout Objective Executive Compensation Why is a plan necessary A Managerial Compensation Plan Slide 4 Objective First we will look at executive compensation, particularly managerial incentive plans and why they are necessary Describe how an incentive plan can align shareholders and managers’ interests Identify devices to control compensation risk Explain the political ramifications of executive compensation. Explain the various motivations for earnings management. Identify patterns of earnings management. Slide 5 Con’t Distinguish between earnings management that reveals inside information to the market and earnings management that attempts to deceive the market.

Explain the "iron law" of accruals Evaluate whether or not managers accept securities market efficiency Also, we want to look at lending agreements and the covenants contained therein, which control management in that limitations are placed on ratios, etc., beyond which management can go. These aspects of business represent conflict between the parties. It is important for the accountant to understand the nature and sources of these conflicts.

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Slide 6 Executive Compensation Executive compensation plans are very important in the work-a-day world as they set the parameters for compensation for executive remuneration. A definition is: “An executive compensation plan is an agency contract between the firm and its manager that attempts to align the interests of owners and manager by basing the manager’s compensation on one or more measures of the manager’s effort in operating the firm.” Note the various aspects of the definition. Slide 7 Many compensation plans are based on two measures net income and share price, others are based only on net income. Compensation can take a variety of forms: salary, bonus, shares, options and perks. You can see that net income becomes a very important aspect of financial accounting. Slide 8 Why is a plan necessary Human beings generally need incentives to encourage them to seek and attain goals. Incentives for people can cover a wide range of objectives. You might say promotion or recognition in a firm should be sufficient to encourage managers not to shirk. While this is a popular notion, often it does not achieve what is thought it would achieve. As shown in Module 7, a payoff is a very good method to have the manager onside and doing his/her very best . It directly rewards particular effort expended to reach a particular goal. Slide 9 In your particular case the effort you expend depends on your individual ability to pass the examination and obtain a CGA designation. You are rewarded for your effort.

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Slide 10 A Managerial Compensation Plan Let’s look briefly at a managerial Compensation plan First a word about the plans. Slide 11 A Typical Plan Your module notes and text deal with the BCE, inc., (Bell Corporate Enterprises) plan. The compensation philosophy is to offer total compensation based on a comparative group of 26 major Canadian and U.S. Corporations, with revenues in excess of $1 billion dollars: Slide 12 A substantial portion of the cash compensation is contingent upon corporate performance; in addition, there are long-term incentive programs designed to motivate the attainment of longer-term objectives, to align executive and shareholders’ interests and to ensure opportunities for capital accumulation as share prices increase. Slide 13 There are three main components and other perks of the BCE plan Salary – Short-term incentive awards Long-term incentive awards Other perks could be considered as a fourth.

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Slide 14 Salary is determined by the mid-point of a salary range for an executive officer which is equal to the median levels in the comparative groups of similar positions in the selected companies, using either a direct comparison of responsibilities, or a widely-accepted job evaluation system. Base salaries are then determined by the Management Resources and Nominating Committee of the Board. Slide 15 Short-term incentive awards, which would include a bonus provision, are based on corporate performance and individual contribution, with greater emphasis on the corporate performance. If an officer participates in the share unit plan of the long-term incentives, they will not participate in the short-term awards. Slide 16 Long-term Compensation – under this plan options to purchase common shares of the corporation are available. There are various provisions attached to the options. To increase the alignment of executive and shareholder interests, BCE established the Share Unit plan for senior executives. Shares can be awarded to senior employees and others so designated. Slide 17 You will note there is no bogey or cap but this is implied to some extent. A bogey is a minimum level for bonus and a cap the maximum level. It will also be noted that the plan is very sophisticated and it includes aspects which deal with incentives, decision horizon, and risk. Slide 18 The important points to notice are: • there is the base salary to take care of risk; • the short-term incentive, which depends on net income; • and the longer-term aspect which depends on share performance. • other perks which could include club memberships, including sports clubs, car and chauffeur, generous terms for expenses, etc., general loyalty.

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Slide 19 PART 2

Executive Compensation Theory

Major Points: The Theory of Executive Compensation Risk in Management Compensation Empirical Compensation Research The Politics of Management Compensation Slide 20 The Theory of Executive Compensation It was established that compensation plans contain a mix of accounting-based, market-based and individual performance measures. However, the proportion of each was not determined. The proportion of accounting-based measures in the plan is of particular interest. Slide 21 If one can identify which financial statement characteristics increase the correlation of reported net income with manager effort it will enable accountants to improve the ability of their product to motivate executive performance. Slide 22 It was mentioned that historical-cost based net income tends to motivate a relatively short-run decision horizon for managers. Why? Money spent today for r and d, advertising, etc., which brings increased net income, may take a number of periods to appear. Thus, if a manager’s compensation is tied to net income, management may tend to eliminate those good items which do not show good results for a longer period of time. Slide 23 In Module 7 we spoke about two terms which can be applied to performance measures. They are sensitivity and precision, both of which increase the correlation between the performance measure and management effort.

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Slide 24 Sensitivity Sensitivity is the rate at which the performance measure increases as the manager’s efforts increase and, of course, the reverse is the case. Slide 25 There is some discussion on how sensitive is net income to performance. For example there can be core earnings, unusual types of earnings, non-recurring earnings and extraordinary earnings. How these are disclosed is important. If there is full disclosure then the investor and compensation committee can get the full picture of earnings. Slide 26 For example if one can see the core earnings they can see the persistence of earnings. This is a good gauge of what the manager is doing. Even here core earnings may not be telling the true story as there may be some lag in the earnings which will eventually be achieved, example r & d, inventory on hold for a special purpose, etc. Slide 27 The text points out that low sensitivity of net income is an argument to use share performance as the measure rather than net income. For example if the market sees a cut in advertising or r & d, it may or will penalize the firm for not looking to the longer term. Thus, maybe share income is a more sensitive measure than net income. Slide 28 Precision But a lower sensitivity of net income does not mean it should be dropped in favour of share performance. Why? The precision. The precision is measured by the variance. A precise measure is one where the influence of the manager is high and the random state of the economy, for example, is low.

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Slide 29 What is meant is that if there is little influence from outside then the likelihood is that the manager’s efforts are affecting the net income. A high share price is less likely to result from manager effort, then the share price is less precise, since it may be driven by outside factors such as interest rate changes. As you realize share price is affected by a host of items external to the firm - such as, trade agreements, interest rates, exchange rates, etc., not to mention noise traders. So this would seem to impose an excessive risk on managers. Slide 30 The real question then is not using accounting-based and market-based measures of performance solely, but proportions of each that are appropriate for measuring purposes. For a control of the decision-horizon one may want to vary the proportion of accounting-based versus market-based measures. For example, if the net income measure shortens that decision horizon, then use a greater proportion of net income. Slide 31 Refer to Handout Short-Run and Long-Run Effects On pages 320-322 there is a section on the short-run and long-run effect of management effort. The text writer talks about a single period for managerial effort and a second period. To better understand executive compensation he talks about a first and second period, the short-run and long-run effect. Short-run is giving attention to such things as cost control, maintenance, employee morale, advertising, short-run supply, customer complaints, and other things. Long-run would be such as long-range financing and planning, research and development and purchase and acquisitions. Then return is derived from efforts for both periods. There are now two sensitivities to net income rather than one. He points out that random factors are zero and that assumes that manipulation or bias are not present in net income. He assumes that the manager exerts effort in the first period and net income is reported at the end of the first period. But part of the results of the payoff are not fully observable until the second period. The manager’s “full effort” is not fully realized until the second period.

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The manager is compensated in the first period and the owner receives the full net income portion which would be generated in the second period. This is because the performance formula is only based on the first period and omits the second period residual payoff in its calculations. He then deals with congruency of income and he says if the hard work effects of the short-run period produce a similar (same) proportion of return in both periods, even though the long-run is a lower amount, then the net income is said to be congruent. If the income is congruent then the owner can design a contract for the first period without concern for how the manager allocates efforts between short-run and long-run activities. Each type of effort generates equal effect to the payoff. He states: “…the manager will choose an effort intensity and allocation to maximize his/her expected utility of compensation, net of disutility.” However, it is not likely that congruency of income will take place and short-run and long-run will most likely be different. He gives an illustration of R &D for long-run payoff, which may be much higher than short-run payoff, such as cost cutting, which may be good in the first period but very poor in the second period due to employee layoffs, etc. However, the manager will tend to the first period as it will tend to produce higher net income and compensation. But the compensation contract must not only consider the intensity of the manager effort in the first period but the intensity of allocation across the two periods, across the total activities. What does the owner do? To see what is happening the owner may use two congruent performance measures, such as net income and share price, the latter of which is less subject to lag than net income. While share price may be sensitive to R&D and encourage a long-run horizon, the preciseness may not be that congruent and share-price based compensation may not increase contracting efficiency. However, the second possibility is that, as stated earlier by Holstrom, two performance measures are good and compensation will depend on both net income and share price, which is consistent with what we observe in real compensation contracts. Slide 32 Risk in Management Compensation Regardless of the payoff measures, managers do bear risk with respect to their compensation (remuneration). As would be expected, the higher the risk they have the greater will be the expected compensation.

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Slide 33 However, the amount of risk imposed by the incentive plan is important because managers cannot diversify. They work only with the firm, they are limited on stock option action often, so it may be well that they try to control risk. Slide 34 Some methods are: • In oligopolies managers can be competitive and retain the demand for their products, thus, in

a sense soften the competition. • Having more than one performance measure • Controlling downside risk. The bogey does this. If there is income less than the bogey, then managers do not have to return pay. If downside risk is limited, then upside gains should no doubt be limited Slide 35 • Making stock options available • Filtering manager's incentive pay through the compensation committee of the board - all factors can be taken into consideration Slide 36 • More of a general nature is Relative Performance Evaluation RPE, will reduce downside risk. This is the setting of bonuses based on the average performance of other firms in the industry. This method filters out the systematic risk and common industry risk. There is no strong evidence to support this but it is a factor. It is thought that net income and price shield against systematic risk and negates the need for RPE. It has merit nevertheless Slide 37 Although I think it is more extensively followed than people admit. The theory of executive compensation explains why managers dislike accounting policies that increase volatility of net income. One reason is the more volatile is income the lower the utility concerning the cash flows expected.

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And of course, out of volatility often comes concern for violating debt covenants and reduced bonuses. So there is a risk in management’s eyes. Slide 38 Empirical Compensation Research We can question whether real compensation plans are designed as theory suggests. This was studied by Lambert and Larckner. Using a sample of 370 U.S. firms from 1970 to 1984, they investigated the relative ability of return on shares and return on equity to explain managers’ cash compensation (salary plus bonus). Slide 39 If, for example, compensation plans and committees primarily use share return as a manager performance measure, the share return should be significantly related to cash compensation. Alternatively if they use net income then net income should be related to cash compensation. Slide 40 They found that return on equity was more highly related to cash compensation than was return on shares. Other studies have shown the same. This would support the risk-reduction and decision horizon controlling roles for net income. Slide 41 They also found that the relationship of these two measure to cash compensation varied in systematic ways. For example, they showed that the relationship between return on equity and cash compensation strengthened when net income was less noisy relative to return on shares. Slide 42 Another discovery was that executive compensation for growth firms tended to have a lower relationship to return on equity than the average firm. Slide 43 One interesting finding was that for firms where the correlation between share return and return on equity was low, there tended to be a higher weight on return on equity in compensation plans, and vice versa.

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Slide 44 Put in another way it was that when net income is relatively uninformative to investors (that is a low correlation between share return and return on equity), that same net income is relatively informative about manager effort (higher weight on return on equity in the compensation plan.) This gives evidence that in accounting theory the informing of investors and the monitoring of management performance must be traded off. Slide 45 It was found in another study by Bushman, et al, that growth firms and firms with long-product development lines, such as pharmaceutical companies, derived a greater proportion of their compensation from individual performance measures relative to net income and stock price-based measures. For example, such items as what would be driving up the price and reducing the price, would be of value to the committee. Slide 46 It was concluded that persistence of earnings is important to compensation committees. The transitory earnings did not mean nearly as much as the core, continuing earnings. Also, compensation committees on average are sophisticated and they do use accounting information, which indicates a necessity for full, reliable Information which would increase the value of net income for compensation purposes. Slide 47 The Politics of Management Compensation Are managers overpaid? This has been a long-standing discussion. Slide 48 One study in 1990 argued they were not overpaid but compensation should be more related to performance, which is happening more frequently. It has its downside, however. Often it is beyond the manager’s control because of outside factors.

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Slide 49 Another finding was that variability of the CEO's income was almost the same as regular workers. They concluded that CEO's did not bear enough risk to motivate good performance and they recommended larger stock holdings for managers. It is probably who you talk to whether they think management is overpaid. Slide 50 Some counter-arguments are: • We would expect the relationship between pay and performance to be lower for large firms, than small ones, because of size alone. • It is difficult for a corporation to put much more downside risk on an executive whose

pay is highly related to performance. Such an executive would have a great deal to lose even with a small decline in the firm value. It could lead to dysfunctional performance, for example, short-term planning horizons - "I'm going to get all I can out of it now because there may be no tomorrow."

Slide 51 Other mechanisms There are other mechanisms, apart from incentive contracts, to bring in line the shareholders’ and managers’ interests. We will come to these in Module 9. Slide 52 The Managerial Labour Market - which continually evaluates managers. The Takeover Market - the poor performing manager may find his/her firm the object of a takeover bid. There have been a number of takeovers in recent years. The Securities Market - investors are constantly looking at share price.

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Slide 53 Concerns about Executive Salaries There are concerns about executives salaries. Disclosure of executives salaries has been required by the Securities and Exchange Commission in the U.S. and more recently by the Ontario Securities Commission in Ontario. Slide 54 In 1996 BCE had its best income. Due to writedowns required in 1997 there was a considerable loss, yet management compensation increased. The writedowns were ignored. Should such be considered in determining management compensation or should compensation be based on core income? Slide 55 Large writedowns, if ignored, benefit management. They miss the impact in the current year and get the benefit in future years as amortization takes effect. Thus, it is important that accountants ensure full disclosure of non-recurring charges. Further, if such non-recurring charges are excessive, accountants and auditors should object and have reassessment.

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Slide 56 PART 3

EARNINGS MANAGEMENT

Major Points: What is earnings management What will the manager likely to do How does a manager control net income Controlling Accruals Slide 57 What is earnings management Earnings Management is the choice by a manager of accounting policies to achieve some specific objective. This is the selection of accounting policies and disclosures in order to affect net income in a desired manner. How does management behave in regard to earnings when the managers are under Incentive Plans? Slide 58 In Module 7 we saw why owners offer incentive plans to managers. Primarily because owners cannot observe the actions of managers; thus, letting them share in the rewards it is hoped they will do the best work possible. Your module uses Healy's study, page 346 of the text, to examine the subject. Slide 59 We want to deal with the theory of why managers may be urged to manipulate their reported net income for bonus purposes, (the bonus plan hypothesis) how they can manipulate, and the results of Healy's study. Healy comes up with some suggestions as to how and under what circumstances managers will engage in earnings management. Healy's findings are based on net income plans only.

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Slide 60 First, frequently the payoff measure is net income. There are, however, other payoff measures such as stock ownership, insurance plans (such as pensions, group life, medical and disability, etc.), deferred salary and bonus plans, etc. Bogeys and caps. They are bonus limits. Not all have caps but all have bogeys. It is unlikely that there would be any reduction in pay if a loss is made. Slide 61 Your module notes show a diagram as follows, for a typical bonus scheme: No Cap Bonus - Cap Amount of Bonus Bonus Bogey(L) Cap(U) Net Income You will note on the x axis there is shown net income. Also, is shown the bogey and the cap. On the y axis is the amount of bonus. Once the net income exceeds the point of where the bogey cuts the x axis then bonus starts increases say at a constant rate of 5% of net income between the bogey and the cap. Below the bogey level the bonus is zero and above the cap it is constant. If there were no cap then it would continue on up above the cap point. Slide 62 What will the manager likely to do Assume net income is below the bogey. He/she is liable to lower it further. This is referred to as "taking a bath", because if no bonus is going to be received, accounting policies and other accrual action would further reduce income, making it more probable for a bonus or better bonus in the next year.

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Slide 63 From time to time articles will appear in the press that companies are “taking a bath”. As a matter of fact, about three years ago such articles appeared regarding two large Canadian Banks “taking a bath.” With the subprime mortgage situation some financial institutions could be considered as taking a bath. Slide 64 On the other hand, if net income is above the cap, there is a motivation for management to reduce income so that any lost bonus will not be permanently lost - and may be carried over to the next year by having lower income this year. - The conclusion is then that only if income is between the bogey and the cap will management adopt policies to increase income. Slide 65 Patterns of earnings management

In summary, the text describes four patterns of earnings management, as follows:

Taking a bath — If the reported net income is expected to be below the bogey, add as much as you can so that future cost may be lower and higher net income may be reported in the following year, with a brighter future for bonus prospects.

Income minimization — This is a reduction of income but not as severe as taking a bath. Management may choose this pattern if it expects net income to exceed the cap of the bonus plan.

Income maximization — This may be chosen if the firm is between the bogey and the cap. It may also be chosen to avoid violation of debt covenants.

Income smoothing — This is the use of earnings management to smooth income in order to avoid excessive volatility in reported net income.

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Slide 66 How does a manager control net income By accruals – as shown in Healy’s study Slide 67 Controlling various accruals, which are revenues and expenses on the income statement not represented by cash flows. The concept of accruals is: Net income = operating cash flow + or – total non-discretionary accruals + or – total discretionary accruals. Slide 68 Controlling Accruals Your module materials show a number of items which do not affect cash flow and they do affect the net income - amortization expense, receivables, inventory, accounts payable and other liabilities. Slide 69 To indicate the situation there is a short statement below showing the difference between cash flow and net income and the reversed situation. Note carefully that a question given could ask for a statement going in either direction. Cash flow - as per cash flow statement $1,000 Net income $1,120 Less: amortization expense -50 Plus 50 Add: Increase in net accounts receivable +40 Less - 40 Add: Increase in inventory during the year +100 Less -100 Add: Decrease in accounts payable and accrued liabilities during the year +30 120 Less - 30 Net Income $1,120 Cash Flow $1,000 Amortization expense - This is a non-discretionary item generally as it is laid down by the firm's policies. However, it can be discretionary under certain conditions. For instance depletion of oil and gas reserves could be subject to some management discretion; also for capital assets.

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Net accounts receivable - The allowance for doubtful accounts is a discretionary item as management can control this to some extent, exercising a more generous credit policy and keeping the books open beyond the end of the year or cutting off earlier than normal. One could not detect these types of changes by just comparing statements. Inventory - Discretionary - this could come from the firm manufacturing for inventory during a period of excess capacity. The result is to include fixed overhead costs in inventory rather than charging them off to expense as unfavourable volume variances. Other possibilities exist. Changes in accounts payable and accrual of liabilities - One source would be to be more or less optimistic about warranty claims than in previous years. Borderline contingencies could be included or excluded - see Section 3290.l5 of CICA. Discretion is allowed here. These examples, illustrate that management does have some leeway under GAAP to manage net income.

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Slide 70 Part 4

Healy’s Study

Major Topics: Earnings Management and Accruals Study with only Bogey Involved Frequency of Change A Typical Examination Question re Accruals: Slide 71 Earnings Management and Accruals We will consider Healy’s study on accruals. He did not have access to the books and records, thus he was unable to determine specific discretionary accruals. However, he made estimates and presumably this was sufficient to justify his contention that there was discretionary action taken to control accruals. Slide 72 He took 94 of the largest companies in the U.S. industrial group and observed the changes from 1930 to 1980. He classified his observations into three categories. These companies had bogeys and caps. His categories were Low - where net income was below the bogey, Mid - between the bogey and the cap and Upp - net income was above the cap. Slide 73 The theory is then that total accruals should be greater for the Mid group than for the Low and Up groups. To increase net income the accruals would have a positive sign. For example, an increase in inventory would increase net income, as shown above. The following table is shown on page 350 of the text.

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Slide 74 Observations with Both a Bogey and a Cap Proportion of Accruals Number of Average with Given Sign Observations Accruals Positive Negative LOW 0.09 0.91 22 -0.0671 MID 0.46 0.54 281 +0.0021 UPP 0.10 0.90 144 -0.0536 447 Slide 75 It will be noted that in the Low and Upp ranges there are shown negative accruals of 91 and 90%, respectively, and only 9 and 10%, respectively, for positive accruals. This indicates a dampening of net income. Slide 76 However, it will be noted that of the Mid group 46% of the 281 observations were positive total accruals, i.e., income increasing, and 54% were negative. This makes a good deal of sense. Where firms would be near the bogey they would increase but as they approach the cap they may well decrease to keep net income from going beyond the cap. The average accrual of the 281 observations was +0.0021 of total assets. Slide 77 This bore out Healy's arguments that the firm managers with net income below the bogey and above the cap will tend to adopt income-decreasing accruals and only managers with net income between the bogey and the cap will adopt income-increasing accruals. Slide 78 Study with only Bogey Involved There is another table showing the observations of bogey only. There is no cap. The module materials state that the size of the Mid accruals on average is larger than the Low supporting Healy's arguments.

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Slide 79 Summary In summary then, it was found accruals were used to decrease income which was outside the bogey and the cap and they were used to increase net income inside the bogey and the cap and some decrease as the net income came nearer the cap. These effects are difficult for financial statement users, even auditors, to detect. . Slide 80 A Typical Examination Question re Accruals: Question: Balance sheet and income statements were given. The 1991 statement of changes of financial position showed operating cash flow of $2,386. a) Calculate the various accruals for 1991. Answer Cash flow from operations $2,386 Less:Depreciation expense $176 Deferred income taxes 59 Decrease in net account receivable 1,357 Dec. in income taxes recoverable 506 Inc. in income taxes payable 248 Dec. in prepaid expenses 38 Inc. in current def. income taxes. 19 2,403 (17) Add: Equity income from affiliates 165 Inc. in inventories 400 Dec. in accts. payable and acc. liabilities 99 664 Net income as per statement $ 647 b) Indicate for each accrual the extent to which the accrual may contain a discretionary or non-discretionary component, and why. Answer: Depreciation expense - non-discretionary. (My view is that it could have some discretionary component. Depends how closely the board is involved in the setting of depreciation.)

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Deferred (now Future) income taxes – non-discretionary as it is determined by income tax regulation. Decrease in net accounts receivable. Likely to contain a discretionary component. Decrease in income taxes recoverable. Probably non-discretionary as they are determined by income tax regulations and closely regulated by the CICA Handbook regulations. Increase in income taxes payable - may contain a discretionary component to the extent that the firm can be more or less optimistic in claiming deductions, allowing for contingencies, etc. Decrease in prepaid expenses - largely discretionary since management controls capitalization policy for many of these items, e.g., office supplies may be capitalized. Increase in current deferred income taxes - current balances for deferred income taxes arise when, say, the firm records revenue on its books earlier than it need be for tax purposes. Equity income from affiliates - discretionary to the extent the firm controls the operating and accounting policies of the affiliates. Increase in inventories - likely to contain a discretionary component. Decrease in accounts payable and accrued liabilities. Accounts payable are unlikely to contain a discretionary component and the accounts payable are fairly well set as is. Accrued liabilities are likely to contain a large component of discretion as they can be recorded in different ways. c) Give the reasons why a manager, whose remuneration includes a bonus based on net income, may wish to reduce reported net income by accruals. Answer: - If earnings are greater than the cap on a bonus plan, then no bonus will be received on the earnings above the cap. Thus, the manager will want to reduce earnings to the cap so that the excess earnings will be included in future years when earnings may be less than the cap at which time bonus money will be received. - If earnings are less than the bogey in the plan then no bonus will be earned. Thus it is likely the manager will take a bath and include as many losses as possible so that in future years earnings will be higher than the bogey and management earnings will be paid thereon. Either way manipulation of discretionary accruals is an easy and convenient way to adjust reported net income. Other ways such as using accounting policy changes are more visible and may draw auditor comment.

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d) Given that accruals are subject to manipulation, why would a firm not offer a bonus based on share price or market value of the shares, rather than net income. Answer: A firm’s share price is not controllable by the manager and thus a share-price-based bonus would increase the risk for the manager’s remuneration. Thus the manager would require higher remuneration to compensate. The firm could well feel that accrual manipulation of net income would be a lesser penalty to pay than higher average remuneration for the share-price-based plan.

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Slide 81 PART 5

Motivations for Earnings Management

Major Points: Contractual motivations Meeting Investor’s Expectations Debt Contract Violation Firms with Initial Public Offerings Slide 82 Contractual motivations As shown, Healy suggests, earnings management do exist. One such source of earnings management would be contractual motivations, or motivation from the contract involved. Also because of covenants in lending agreements, one can consider these as contractual motivations on the part of long-term lending arrangements. The covenants are for the protection of the lender in such situations. Because of the possible costs of covenant violation, managers will endeavour at all costs to avoid breaching them. Contracts can be rigid and they can have economic consequences because of the problem of covenant violation. So earnings management can have some room to manoeuvre to prevent the firm from having violations. Also earnings management may benefit investors as such management may convey information to capital markets - efficient contracting and efficient information flow. Slide 83 As can be easily understood, management will be concerned about standard-setting situations where it will affect net income or the volatility of net income. These can threaten bonus contracts and/or lending contracts. Earnings management may protect against changes in accounting policy but in the total effect earnings management cannot completely offset accounting changes, which have major effects on net income or volatility.

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Slide 84 Meeting Investor’s Expectations When investors are expecting favourable earnings they will buy shares and raise share price. But if a firm fails to meet expected increased earnings in a a forecast this can have a significant effect on earnings. The market tends to penalize firms that fall short of forecast. This is an important motivation for managers to manage earnings upward. The market would be expecting such. If such fails then investors will react negatively. Slide 85 Debt Contract Violation Debt contracts generally contain covenants, as mentioned earlier, As can be understood that the result of covenant violation can be very far reaching Managers try at all costs to avoid violating such covenants. Some of the findings have been:

• Greater use of income accounting changes, such as, early adoption of new accounting standards.

• Use of discretionary accruals to increase reported net income. • Some firms cut dividends with large negative accruals at the same time. • Earnings management for implicit contracting purposes which really

depend on the good reputation of the mangers to keep confidence of the shareholders – see page 354.

Slide 86 Firms with Initial Public Offerings Another aspect of earnings management is where firms want a steady, smooth flow of earnings so that when they are raising capital it will impress the investors giving the view that it is a strong, stable company Slide 87 Question Assume a firm's incentive contract stated that no bonus would be paid to the manager if income before bonus was less than zero. Should net income be less than zero, what type of an earnings plan would management engage in? Why?

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Answer: The manager is likely to engage in taking the big bath. The reason is that future bonuses are likely to be increased. Question: Assume the manager is risk averse. A new accounting standard is proposed that will not change future expected net income but it will greatly increase the volatility of net income. Explain why the manager would object to the proposed new standard. What pattern of earnings management would such a manager be expected to engage in? Answer: He/she will likely object because the future stream of net income will likely be volatile and thus the future bonus stream will be more volatile. As the volatility increases so will the bonus scheme be volatile. As the volatility of the bonus scheme increases, the utility of the risk averse manager will be less. Such a manager would engage in income smoothing to reduce volatility.

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Slide 88 PART 6

CONCLUSIONS

Major Points: Is Earnings Management Good or Bad? Stock Market Reaction to Earnings Management Do Managers Accept Market Efficiency? Summary Questions Slide 89 Is Earnings Management Good or Bad? Most would probably think earnings management is "bad." It is difficult to believe that rational investors would think otherwise. They want "reliable" income. Certainly earnings management introduces biases in income. It works against reliability as we perceive it. Slide 90 The Good Side of Earnings Management Why do earnings management exist? Blocked Information. What is this? Often management has information is what you might say is blocked and cannot be released. To use an example given, say, a manager has inside information that would indicate an additional $2,000,000 of persistent earnings over the long haul. What would happen if the manager just blandly announced it? Many would not believe it. If there were large discretionary accruals this could give credibility to the situation as it is according to the financial statements, which are prepared according to GAAP. Further the manager has responsibility for the statements. A number of studies indicate that good earnings management can be a credible channel for conveying information, provided management wishes to do so. See pages 356 -359 of the text. However, care has to be taken that the accruals are within reasonable bounds. To quote “If opportunistic earnings management overwhenlmed the information content of accruals, an efficient market would not react positively to them.

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Slide 91 The Bad Side There can be bad earnings management. For example, when firms are close to debt violation, warding it off by earnings management may or may not be good for the firm. It may be misleading to the investors or it may give some leeway for a better year(s) ahead. Another one mentioned above, is increasing reported net income for IPOs. How it is done is important. For example, early recognition of revenue may be harmful to the firm, or non-inclusion of legitimate expenses. Also excess charges for non-recurring items, which do not take away from managers’ bonuses and do not take away from meeting forecasts, as they are not core income. Yet, they do increase future earnings because of the current increased amortization and costs which would normally be charged to expense when they were incurred. It should be noted the upward effect on core earnings is difficult to detect as deduction of amortization and other charges become buried in larger totals. Slide 92 Investors may not be able to fully determine the accruals that management has made but they may get a sense of the future from the signals being given. It is important for accountants to understand earnings management as it helps them understand management's position and reasons for accruals and accounting policy choice and its reaction to changes. Slide 93 Stock Market Reaction to Earnings Management There is some room for earnings management. However, it is complex and difficult to determine whether the stock market views earnings management as good or bad. There is some evidence that the stock market reacts favourably to some earnings management the question needs more study. At the moment if reasonable action is taken it could be positive but large accruals or unwarranted policy changes could receive an unfavourable reaction.

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Slide 94 Do Managers Accept Market Efficiency? A number of studies are shown in the text pp 361-363. There is not a clear answer. You can read them. The last reference indicates that if the market is efficient management policies do not make a lot of sense as the market can see through them. It would seem that managers who engage in earnings management activities would not appear to accept them. As shown policies which do or do not affect cash flows are felt by manager to mean something. Do they believe the market can see through them? Slide 95 Summary Management may or may not believe in market efficiency. However, we have shown that activities to encourage earnings management do take place. Accountants need to be aware of the various stances of standard setters and ramifications of standard releases, a good case can be made for earnings management in communication, while excessive earnings by management can be a problem to the firm, the investor, the community and employees. Then how earnings management is used can determine whether it is good or bad. Where bad earnings management takes place, accountants can help by bringing the information out for public consumption. Slide 96 Questions Question: Why was Healy’s study of managers’ choices of accruals consistent with positive accounting theory? Give three reasons. Answer: 1. He found statistically significant evidence that managers manipulate accruals for bonus purposes. 2. It helps explain how managers choose accounting policies, including accruals.

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3. It implies that managers are rational, utility maximizing individuals. Question RE: the pros and cons of stock options What are two reasons why stock options are an important component of the total compensation package of senior managers of many firms? How would you think this would relate to earnings management? Answer: They may be one way of conveying benefits to managers at lower personal tax costs. An award of stock options gives managers a long-term perspective in operating a firm. Managers benefit if stock prices increase and stock prices increase if investors perceive future cash flows to be high. In an efficient securities market share prices reflect all information about prospective payoffs from managers’ current actions. Stock options compensate managers for actions, such as research and development, which negatively affect current income but which benefit future periods. If earnings are up, prices of shares will no doubt be up. Question: Firms are required to value their stock options and treat that amount as an expense on the income statement. What would be the resulting relevance and reliability of reported net income? Answer: If a company awards stock options to its managers, it has borne some additional cost. This cost should be considered when measuring the net income of the firm. Thus, relevance of earnings is enhanced. On the other hand it would be very difficult to estimate the value of the stock options and FASB allows companies to evaluate their own stock options. Thus, there could be some bias on management’s part and reliability could be reduced.