Chapter 11

Earnings Management

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Overview• Earnings management (EM)

– Concept (11.1)– Patterns (11.2)– Why EM? (11.3; 11.4)– Is EM good or bad? (11.5; 11.6)– Conclusion (11.7)

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Earnings Management – Concept (11.1)

• Earnings management (EM) is the choice by a manager of accounting policies (accruals) or real actions, that affect earnings so as to achieve some specific reported earnings objectives– What? Who? How? Why?

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EM at GE (Q9, p.476) – GE’s Reported Net Income

– 2008 $17,235– 2007 22,208– 2006 20,700 – 2005 16,353– 2004 16,593– 2003 15,002– 2002 14,118– 2001 13,684

– 2000 $12,735– 1999 10,717– 1998 9,296– 1997 8,203– 1996 7,280– 1995 6,573– 1994 4,726– 1993 4,315

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In-Class Discussion1) From what you observe, do you believe GE has been

managing earnings or not?2) Assume the actual net income in 1996, 1997, and

1998 is $8,203, give two techniques (one through accruals and the other through real actions) that help managers to a) Reduce net income from $8203 to $7280 in 1996b) Boost net income from $8203 to $9,296 in 1998

3) Is earnings management good or bad for GE? For investors?

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EM at GE (Q8, p.476)• Techniques used by GE to smooth earnings

1. Change expected rate of return on pension plan assetsPension costs = pension services costs – return on plan assets

2. Sale of divisions•Generally lead to large non-recurring gains

3. Restructuring charges•Used to offset non-recurring gains•The timing and amount of 2&3 are tactically managed

4. Buying profitable businesses5. Conservative accounting

•Use DDB instead of SLM, then•Manage the timing of the sale of PP&E and leased assets

6. Allocation of goodwill on purchase of subsidiaries•e.g. 1986 acquisition of RCA (NBC vs. non-NBC units) – next slide 6

One of GE's most intriguing moves to boost its net income was in its accounting for its $6.4 billion acquisition of RCA Corp. in 1986. One former GE executive recalls that GE allocated a disproportionate amount of this price to NBC, increasing the TV network's book value while reducing that of other RCA assets. The higher book value for NBC and the resulting lower value for other RCA assets raised GE's profits on sales of some of RCA's non-NBC assets.

Among the RCA units sold, GE recorded a $110 million gain on the disposition in 1991 of NBC's interest in an RCA-Columbia home-video joint venture. And the aerospace business was sold in 1993 at a pretax profit of $1.43 billion. That leaves NBC as the last major piece of RCA still on GE's books.

(Source: Wall Street Journal, Nov 3, 1994, “Managing profits: how General Electric damps fluctuations in its annual earnings”)

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Two Types of Accruals• Non-discretionary accruals

• Management has little discretion to control amounts• e.g. utility expenses

• Discretionary accruals• Management has discretion to control amounts

• e.g. the GE case: note GE uses both accruals and real actions to manage earnings

• Slide #6: What are EM through accruals?

• The “iron law” of accruals reversal: if accruals increase earnings this period, their reversal lowers earnings in future periods

• e.g. Decrease in GE 2008 net income8

Patterns of Earnings Management (11.2)

• Big bath• Income minimization• Income maximization• Income smoothing• etc.

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Why EM? (11.3; 11.4)1. To meet contractual goals

a) Bonus incentives (slide #11)

b) Debt covenants (Slide #12)

2. To lower political costs (Slide #12)

3. To meet investors’ earnings expectations (Slide #13)

4. To earn abnormal return at IPO or SEO (Slide #13)

5. To maintain managers’ reputation and job security

6. To maintain continuing business relationships

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11.3 Evidence of EM for Bonus Purposes

1. To meet contractual goals– (a) Bonus incentives

• Evidence: Healy (1985)– Examines firms in which manager bonuses based on net

income– Concepts of bogey and cap (Figure 11.2, p.448)– Evidence of upward earnings management when net

income between bogey and cap

• Measuring earnings management– Net income = CFO + Non-DA + DA (Equation 11.1, p.449)DA = Net Income – CFO – Non-DA

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11.4 Other EM Motivations 1. To meet contractual goals

– (b) Debt covenants incentives• Dichev & Skinner (2002, text Section 8.5, p.321)

– Covenant slack = actual current ratio – contracted current ratio

– Quarters with zero or slightly positive slack are significantly greater than expected

– Quarters with negative slack is significantly less than expected.

2. To lower political costs• Jones (1991, text Section 11.3)

– Reports firms used income-reducing discretionary accruals to bolster their case for tariff protection 12

11.4 Other EM Motivations (Cont’d)3. To meet investors’ earnings expectations

– If expectations not met• Strong negative share price reaction• Damage to manager reputation

– Jackson & Liu (2010) find evidence of management of bad debt allowances to avoid missing market’s earnings expectations

4. To increase proceeds from new share issues• Cohen & Zarowin (2010) find evidence of use of income-increasing

discretionary accruals in years of SEOs (i.e. Second Equity Offering).

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11.5 The Good Side of EM• Investor-based arguments for good EM

– To credibly communicate inside information to investors

• Blocked communication may inhibit direct disclosure of earnings expectations

• Discretionary accrual management as a way to credibly reveal management’s inside information about earnings expectations

– Manager foolish to report more earnings than can be maintained. Why? -> iron law

– Manage reported earnings to an amount management expects will persist

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The Good Side of EM• Contract-based arguments

– To give firm some flexibility in the face of rigid, incomplete contracts

– Contract violation is costly, earnings management may be low-cost way to work around

• There exist empirical evidence supporting good EM– Demski & Sappington (1987a & b), Chen,

Hemmer, & Zhang (2007), etc.15

11.6 The Bad Side of EM• Contracting perspective

– Opportunistic manager behavior• e.g. to maximize bonuses (Healy 1985, Figure 11.2)

• Financial Reporting Perspective– Hanna (1999) found

• Investors and analysts look to core earnings, ignoring provisions for extraordinary and non-recurring items

– Implies manager not penalized for non-core provisions

• Managers engaged in cookie jar accounting• Lower ERC when greater frequency of EM use

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11.6.2 EM and Market Efficiency

• EM is not necessarily inconsistent with EMH– Poor disclosure keeps manager’s opportunistic behavior

as inside information• Managers may not accept EMH

– That is, managers may believe market is inefficient– e.g. Schrand and Walther (2000)

• Investigate firms with G/L on disposal of PP&E in prior quarter, but none in current quarter

• Find that when compare current quarter performance with previous quarter performance,

– managers is more likely to remind investors when there is a one-time gain in prior quarter than when there is a one-time loss in prior quarter 17

11.6.3 Dealing with EM• Role of GAAP and auditor

– Manager can observe real (unmanaged) net income, but owner can’t

– Reported net income is jointly observable by owners and managers

• Standard setter and auditor help ensure the quality of reported net income

• Controlling length of manager decision horizon (short vs. long horizon) – e.g. Bonus vs. stock options

• Increase quality of net income– Fair value accounting (but decrease precision)– Full disclosure

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11.7 Conclusions• Some earnings management can be

“good” if not abused• However, managers may abuse or

opportunistically use such flexibility• It’s hard to differentiate “good” and “bad”

motivations underlying earnings management

• Full disclosure helps to control bad earnings management

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