Earnings Management

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Earnings Management
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Definition

• Earnings management
• Purposeful intervention in the external financial
  reporting process, with the intent of obtaining
  some private gain (as opposed to, say, merely
  facilitating the neutral operation of the
  process) (Schipper, 1989)
• Is the choice by a manager of accounting policies
  so as to achieve some specific objective (Scott,
  2009)

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Two Ways to Think about Earnings Management

• Opportunistic behaviour
• To maximize management utility in the face of
  compensation and debt contracts and political
  costs
• Efficient contracting perspective
• A vehicle for the communication of managements
  inside information to investors

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Patterns of Earnings Management

• Taking a bath
• Income minimization
• Income maximization
• Income smoothing

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Measurement

• Total Accruals
• Discretionary Accruals
• Jones (1991)
• Modified Jones model

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Accrual Accounting

• Recognizes the financial benefits and obligations
  accruing to an enterprise over the reporting
  period - regardless of cash inflows and outflows.
• Objective Better indication of performance than
  current cash receipts and payments.

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Accrual Accounting

• Subjectivity
• Assumptions
• Discretion

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Reporting Discretion

• Why allow reporting discretion?

Rigid rules
Flexible rules
trade-off

• Enables better reporting of larger number of
  businesses.
• Prone to manipulation

• Reporting biases
• No discretion

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What Motivates Managers Choice of Discretionary
Accruals?

• Victor L. Bernard
• Douglas J. Skinner

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Introduction

• Subramanyam (1996) and Kasanen, Kinnunen, and
  Niskanen (1996) both considers why managers
  choose to manipulate accounting accruals
• Subramanyam concludes hat managers choose
  accruals to enhance the informativeness of
  accounting earnings
• KKN find strong support that Finnish managers set
  earnings to satisfy the demand for dividends by
  their keiretsu-like institutional investors

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Subramanyam (1996)

• Central research question
• Whether managers choose discretionary accruals to
  convey information or whether their choices are
  opportunistic
• He concludes that discretionary accruals are used
  by managers to increase the informativeness of
  accounting earnings
• Alternative explanation for this findings is that
  the Jones model systematically misclassifies
  nondiscretionary accruals as discretionary

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Subramanyam (1996)

• How well does the Jones model work?
• Dechow et al (1995) indicate none of Jones model
  (or their modified Jones model) works very well
  in detecting earnings management
• The estimated discretionary accruals will likely
  contain some nondiscretionary items

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Subramanyam (1996)

• How does misclassification of discretionary
  accruals affect the interpretation?
• At best lower the power of the research to detect
  earnings management
• At worst cause the researcher to conclude that
  there is earnings management when none actually
  exist

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Subramanyam (1996)

• Some conclusions and suggestions
• The only way to resolve the problem is to develop
  better specified models of the accruals process
• Focus on narrower settings (particular industry)
  or particular components of accruals)
• Try and use tools from financial statement
  analysis to better model accruals
• Separately analyze the informativeness of
  different categories of accruals

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Kasanan, Kinnunen, and Niskanen (1996)

• In Finland, the demand for dividends by
  institutional investors is so strong that
  dividend policy is effectively set outside the
  firm, so that earnings have to be managed to
  justify the requisite dividend payout

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Kasanan, Kinnunen, and Niskanen (1996)

• Institutional features and evidence of earnings
  management
• Important features
• Stock ownership is dominated by large
  institutional holders and cross-holdings are
  common. Finnish regulations are such that only
  realized income (i.e. dividend) may be included
  as part of the capital base of these
  institutional stockholders
• Institutions demand relatively large dividend
  payments
• Managers of Finnish firms are restricted by law
  to paying dividends out of earnings, including
  retained earnings
• Provides managers with incentive to report
  earnings that are sufficiently high to justify
  the required dividend
• Managers of Finnish firms have an unusual amount
  of flexibility in the reporting process

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Kasanan, Kinnunen, and Niskanen (1996)

• Institutional features and evidence of earnings
  management
• Reported earnings and dividends track each other
  so closely
• Provide strong evidence of earnings management

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Kasanan, Kinnunen, and Niskanen (1996)

• What do we learn?
• KKns results provide strong evidence of earnings
  management
• Provides an interesting experiment, but it may be
  hard to generalize this conclusion to other
  countries

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Conclusion

• We need more reliable ways of measuring earnings
  management
• A potentially fruitful alternative may be to
  analyze financial statements in more detail