Financial Accounting Theory

Eighth Edition

Chapter 11
Earnings Management

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Figure 11.1

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What Is Earnings Management?
• Earnings management is the manipulation by a
manager of accounting policies or real actions, to
achieve some specific reported earnings objective
– Examples of real actions to manage earnings include:
 Cutting or increasing R&D and advertising
 Manufacturing additional goods for inventory
– Examples of accrual-based earnings management
include:
 Managing the allowance for bad debts
 Changing amortization policy

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Accrual-based Earnings Management
• Two types of accruals
– Non-discretionary: management has little discretion to
control amounts
– Discretionary: management has discretion to control
amounts
– To discover role of accruals in earnings management,
accountant needs to separate these two types
 Jones model usually used for this separation

• “Iron law” of accruals reversal: if accruals increase

earnings this period, their reversal lowers earnings
in future periods
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11.2 Patterns of Earnings Management
• Taking a bath
• Income minimization
• Income maximization
• Income smoothing

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11.3 Evidence of Earnings Management
for Bonus Purposes
• Contractual motivation for earnings management
– Healy (1985) predicted that managers would manage
earnings to maximize cash bonus
 Sample contained firms with bonuses based on net income
– Level of bonus affected by bogey and cap
 Evidence of upward earnings management when net income
between bogey and cap
 Measurement of discretionary accruals
– Healy used total accruals as proxy for discretionary
– Now accruals usually measured based on Jones (1991)
model

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11.4 Other Motivations for Earnings
Management
• Competition for manager talent
– Marinovic and Povel (2017)
 Compensation contracts to attract high talent managers
include high proportion of incentive pay
 Managers realize that earnings management needed to meet
incentive targets

• Debt contracts
– Debt contracts include covenants to protect against
actions against the lenders’ best interests
 Earnings management used to reduce probability of covenant
violation

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11.4.2 Meeting Investors’ Earnings
Expectations
• Strong negative share price reaction if
expectations are not met
– Managers have incentive to use earnings management
to meet earnings expectations
 Incentive greater if managers hold ESOs

• Damage to manager reputation if expectations are

not met
– Reputation of management declines when explanation
for poor performance is not plausible

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11.4.3 Stock Offerings
• Incentive for earnings management in order to
increase proceeds when issuing shares
– Cohen & Zarowin (2010) find evidence of use of
income-increasing discretionary accruals in years of
SEOs.
 Report use of real earnings management techniques to
increase reported net income
 Find declining ROA for 3 years following SEO, driven in part by
accrual reversal
– Dechow, Ge, Larson & Sloan (2011) (Section 11.6.2)
 Sample of firms charged by SEC with financial statement
misstatements were actively raising additional capital
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11.5 The Good Side of Earnings
Management (1 of 2)
• Credibly communicate inside information to
investors
– Blocked communication may inhibit direct disclosure of
earnings expectations
– Discretionary accrual management credibly reveals
management’s inside information about earnings
expectations
 Manager foolish to report more earnings than is expected to
persist
 Manager reports earnings to an amount management expects
will persist, thereby revealing inside information about future
profitability

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11.5 The Good Side of Earnings
Management (2 of 2)
• Increase efficiency of managerial compensation
contracts
– Give manager some flexibility in the face of rigid,
incomplete contracts
 Compensation contract based on net income
 Risk-averse manager prefers even compensation over time
 Earnings management reveals information to owner about
income over time

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Earnings Management at General
Electric (1 of 3)
• Theory in Practice 11.2, problems 11.8 & 11.9
• Earnings management devices used by GE 1993–
2007
– Assumed rate of return on pension funds
– Restructuring charges
– Acquisitions, sales of divisions
– Conservative accounting practices
 Sales of leased aircraft
– Allocation of goodwill on purchase of subsidiaries
• Earnings management devices used in harmony
to report steadily increasing earnings
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Earnings Management at General
Electric (2 of 3)
Table 11.3 General Electric Company Reported Net Income 1993–2008, Incl.
Year Reported Net Income Year Reported Net Income
2008 $17,335 2000 $12,735
2007 22,208 1999 10,717
2006 20,829 1998 9,296
2005 16,711 1997 8,203
2004 17,160 1996 7,280
2003 15,002 1995 6,573
2002 14,118 1994 4,726
2001 13,684 1993 4,315

Source: Annual Reports, General Electric Company.

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Earnings Management at General
Electric (3 of 3)
• Argument that even under securities market
efficiency, GE is so large and complex that even
analysts cannot prepare accurate earnings
forecasts
– Management has best inside information about
expected persistent earnings
– Direct communication blocked
– Creates role for earnings management to reveal
management’s expected persistent earnings
• Is this good or bad (i.e., opportunistic) earnings
management?
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11.5.2 Empirical Evidence of Good
Earnings Management
• Tucker & Zarowin (2006)
– Greater use of income smoothing positively associated
with share returns
– Suggests that investors value earnings management
that smooths out non-persistent items
• Other studies
– Bowen, Rajgopal, & Venkatachalam (2008)
– Badertscher, Collins and Lys (2012) (mixed results)
– Cready, Lopez & Sisneros (2012)
– Das, Shroff, & Zhang (2009)
– Jayaraman (2008) (mixed results)
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11.6 The Bad Side of Earnings
Management (1 of 2)
• Examples of bad earnings management
– Groupon Inc. (Theory in Practice 11.1)
 Extreme income maximization
 Capitalize marketing costs
 Emphasize pro-forma income
– Olympus Corp. (Theory in Practice 11.3)
 Elaborate scheme to avoid writedown of investments
 Transfer loss to purchased goodwill

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11.6 The Bad Side of Earnings
Management (2 of 2)
• Standard setters response to bad earnings
management
– IAS 37
 Before recording a provision, payments must be probable and
capable of reliable estimation
 Provision must be valued at fair value
 No excess provision as a result of uncertainty
 Provisions must be used only to absorb costs for which
provision originally set up
– ASC 420-10-25
 No provision until liability incurred

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11.6.2 Empirical Evidence of Bad
Earnings Management
• Healy (1985)
– Reports evidence of management use of accruals to
maximize their cash bonuses
• McInnis & Collins (2011)
– Increase in accrual quality (i.e., less bad earnings
management) following availability of cash flow
forecasts
• Leuz, Nanda & Wysocki (2003)
– Countries with poor investor protection experience
more earnings management

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11.6.3 Do Managers Accept Securities
Market Efficiency?
• Poor disclosure enables earnings management to
affect security prices even if markets are efficient
• Evidence that market efficiency not accepted by
managers
– Pro-forma earnings
 Doyle, Lundholm, & Soliman (2003)
 Brown, Christensen, Elliott & Mergenthaler (2012)
– Managing same-quarter earnings of previous year
 Schrand and Walther (2000)

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11.6.4 Analyzing Managers’ Speech to
Detect Bad Earnings Management
• Cognitive dissonance
– Arises when persons behave contrary to their opinion
of themselves
 An individual will react by trying to reduce his/her dissonance
 Sophisticated computer programs can detect these reactions
– Hobson, Mayhew & Venkatachalam (2012)
 Analyzed managers’ speech during earnings announcements,
obtaining a cognitive dissonance score for each manager
 Found that higher dissonance score associated with future
earnings revisions

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11.6.5 Management Choices Among
Earnings Management Methods
• Choice between methods depends on relative
costs and benefits
– Manager with short-run decision horizon more likely to
use real earnings management than manager with
long-run horizon
– Accruals earnings management difficult to sustain over
many periods
– Real earnings management does not violate GAAP

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11.6.6 Implications for Accountants
• Accountants can reduce bad earnings
management by improving disclosure
– Revenue recognition policies
– Description of low-persistence special items and major
discretionary accruals
 Enables investors to better evaluate earnings persistence

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11.7 Conclusions on Earnings
Management
• Earnings management can be good if used
responsibly
– Gives managers flexibility to react to unexpected
events when contracts are rigid and incomplete
– Provides opportunity for credible communication of
inside information
• Full disclosure helps to control bad earnings
management

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