topic 7(earnings mgt)_mac 2013
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Accounting
Theory & PracticeFAR 600
EARNINGS MANAGEMENT (EM)
By:
Dr Suhaily Hasnan
Faculty of Accountancy
UiTM
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Learning Objectives
At the end of this lesson, students should beable to understand :
Discuss the motivations for earnings management
(EM)
Describes the patterns of earnings management (EM)
Discuss the advantages & disadvantages of earnings
management (EM)
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Earnings Management
EMIs the choice by a manager of accounting policies, oractions affecting earnings, so as to achieve some specificobjective. (Scott, 2003, p.369)
GAAP are not a set of rigid rules and procedures. They are
standards and guidelines that are applied through the use ofprofessional judgment.
Since not all firms are required to have the same accountingpolicies, each firm can manage its earnings through theaccounting policies that it chooses; i.e. straight-line vs. reducing
balance amortization.
Another way to manage earnings is by means of realvariables;i.e. R&D, maintenance, timing of purchases and disposal ofcapital assets. These devices maybe costly since such actions may
compromise long term objectives.
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Fraudulent Financial Reporting (FFR)
as an Extension of EM
Although legal, the practice of EM can make the financialstatements difficult for investors and analysts to interpret.
Management of earnings suggests tinkering with earnings toachieve a more favorable reporting outlook, but with apresumption that the financial results are not fraudulentlymisrepresented. However, tinkering may lead to cooking.
Over time, this constraints within-GAAP EM options, and furtherEM crosses into non-GAAP reporting.
FFR starts out small with no intent to deceive, but grows overtime as the pressures build until it is full-blown cooking thebooks.
Accruals are comparatively high in most fraud cases in the years
preceding fraud discovery.(Lee, Ingram & Howard, 1999)
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Discuss the motivations for
earnings management (EM)
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Motivations for earnings management?
1. Profit-based incentive compensation bonus
purposes
2. Avoid debt covenant violations
3. Reduce political visibility4. Maximize proceeds from IPOs
5. Taxation motivations
6. Changes of CEO
7. Communicate blocked inside information to
investors
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Profit-based incentive Compensation-
Bonus Purposes
Managers have incentive to select accounting methods
and exercise discretions over accounting estimates to
improve their compensation
Studies by Dechow & Sloan (1991) showed that CEOs
increase their compensation in their final years in
office by cutting research & development (R&D)
expenditures
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Avoid Debt Covenant Violations
Managements incentive to opportunistically manage
earnings is driven by contractual agreements and/or
change in economic environments
Contractual agreements are in the form of management
compensation or debt covenants
Example: managers alter earnings to mask poor managerial
performance & safeguard themselves from possibledismissals or managing earnings to maximize
remunerations or increase personal wealth
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Reduce Political Visibility
Political process imposes costs on firms believed to be takingadvantage of the public & making excessive profits
Political cost hypothesis predicts that managers of larger firms have
greater incentives to reduce reported profits and hence reduce their
perceived ability to bear political costs
Political costs refers to wealth transfer away from a firm due to its
political exposure. The amount of transfer depends on size &/or
visibility of the firm. For example, employees may see an unusually
high profits reported as an exploitation of their labor & hence theylobby for higher pay
In other words, Managers of these firms have incentive to reduce
reported earnings and lower their political risk.
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Taxation Motivations
Most obvious motivation
Previous studies by Guenther et al., (1997) & Maydew (1997)
suggested that firms choose accounting accruals to save tax costs
Guenther et al., 1997 found that firms forces to switch from cash
method to accrual method
Maydew, 1997 found that firms with tax based incentives shifted
income in order to maximize current net operating losses
Nevertheless, firms opportunity to manipulate economic result
reduced because taxation authorities tend to impose their own
accounting rules for calculation of taxable income
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Changes of CEO
Variety of income management motivations among CEOs
exists such as
Bonus plan hypothesis predicts that CEOs approaching retirement
would maximize income to increase their bonuses
CEOs of poorly performing firms may maximize income to prevent
or postpone from being fired
DeAngelo, DeAngelo & Skinner (1994) found that CEOs
may take a bath so as to increase the probability of future
earnings
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Communicate Blocked Inside
Information to Investors
Managers might undertake income smoothing to convey
inside information about the firms long run earnings
potential.
A simple announcement about the firms long run earnings
potential maybe costly for investors to verify. EM (through
income smoothing) would convey the information in acredible fashion.
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Describes the patterns of earnings
management (EM)
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Patterns of
Earnings
Management
Taking a bath
write off assets show large losses
Enhance probability
of future reported
profits
Income
Minimization used by politically visible
firm during period of
high probability
e.gs., rapid writeoff of
assets, expensing R&D,
advertising
IncomeSmoothing
Income
Maximization
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The Advantages of EM
EM provides room for managers to take steps to avoid technicalviolations of debt covenant.
EM can be used as a device to convey blocked, inside information
to the market. This enable share price to better reflect the firms
future prospects.
EM reveals goodwill component of firm value which provide
better knowledge to investors of the value of goodwill & hence
enable better estimates of firm value to investors.
Market responds efficiently to discretionary accruals (proxy for
EM).
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The Disadvantages of EM
Resulted from opportunistic manager behaviour.
Opportunistic EM is bad as it reduces the reliability of FS
information.
Opportunistic EM involves manager selecting accounting
policies to maximize his/her own self interest rather than the
interest of the owners (e.g. bonus purposes).
Opportunistic EM is aimed to hide real operating performance
by creating artificial accounting entries or strecthing estimatesbeyond reasonableness.
Only if the EM practices violated GAAP (Dechow, Sloan &
Sweeney, 1996)
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Summary
EM is possible because GAAP provides managers choices of
accounting policies and procedures.
Managers accounting policy choices are motivated by strategic
considerations such as
Bonus purposes Reduce political visibility
CEO motivations
Maximize proceeds from IPOs
Taxation motivations Unblock inside information
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