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Chapter 11
Earnings Management
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Organization of This Chapter
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What Is Earnings Management (EM)?
Earnings management is the choice by a
manager of accounting policies (including
accruals), or real actions, that affect earnings
so as to achieve some specific reported
earnings objective.
Here, we concentrate on role of accruals in
earnings management.
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Patterns of EM
Four common patterns of EM:

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Motivation for EM: Bonus Purposes
A contractual motivation: bonus plan hypothesis
Evidence: Healy (1985)
Confined to bonuses based on net income
Recall concepts of bogey and cap
Findings (see table on next slide):

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Motivation for EM:
Bonus Purposes (cont.)
Healy (1985) (cont.)
Observations with both a Bogey and a Cap









Portfolio Proportion of
Accruals with
Given Sign
No. of
Obs.
Average
Accruals
Positive Negative
LOW 9% 91% 22 - 0.0671
MID 46% 54% 281 +0.0021
UPP 10% 90% 144 - 0.0536
447
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Motivation for EM:
Bonus Purposes (cont.)
Healy (1985) (cont.)
Methodological issues of measuring discretionary
accruals
Healy used total accruals as proxy
Now usually based on Jones (1991) model
Result of downward earnings management when net
income below bogey challenged by Holthausen,
Larcker, and Sloan (1995)
Conclusion: despite methodological challenges, there is
significant evidence that, on average, managers uses
accruals to manage earnings so as to influence their
bonuses



Other Motivations for EM
Other contractual motivations
Debt covenant hypothesis
To avoid violating debt covenants
Implicit contracts
To maintain continuing business relationships with
other stakeholders, such as suppliers and short-term
creditors
Political cost hypothesis: to lower political heat
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Other Motivations for EM (cont.)
Stock market related motivations:
To meet investors earnings expectations and
maintain manager reputation
To increase proceeds from stock issuance,
especially initial public offerings
Teoh, Welch, and Wong (1998)
Fan (2007)
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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 managements inside information about earnings
expectations

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The Good Side of EM (cont.)
Contract-based arguments for good EM
To give firm some flexibility in the face of rigid, incomplete
contracts, thus improving contracting efficiency
Bonus contracts based on net income
New accounting standards may lower net income and/or
increase volatility
Hence may adversely affect evaluation of manager effort
Debt covenant contracts
New accounting standards may increase probability of debt
covenant violation
Contract violation is costly, earnings management may be
low-cost way to work around
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The Good Side of EM (cont.)
Theoretical models supporting good EM
Demski & Sappington (1987a & b)
Chen, Hemmer, & Zhang (2007)
Empirical evidence supporting good EM
Subramanyam (1996)
Barth, Elliott, & Finn (1999)
Tucker & Zarowin (2006)
Francis, LaFond, Olsson, & Schipper (2005)
Etc.



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EM at General Electric
Textbook, problem 9
GEs Steady Increase in Reported Earnings










Year
Reported
Net Income
(Million)
Year
Reported
Net Income
(Million)
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
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EM at General Electric (cont.)
GEs Reported Net Income (Million) from 1993 to 2008
$-
$5,000
$10,000
$15,000
$20,000
$25,000
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
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EM at General Electric (cont.)
EM devices used by GE
Changes to the expected rate of return on pension plan
assets
Sales of divisions
Restructuring charges
Conservative accounting
Allocation of purchased goodwill upon acquisition of
subsidiary companies
EM devices used in harmony to report steadily
increasing earnings
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EM at General Electric (cont.)
Is this good or bad (i.e., opportunistic) EM?
Argument: even assuming securities market
efficiency, GE is so large and complex that even
financial 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
managements expected persistent earnings
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The Bad Side of EM
Contracting Perspective
Healy (1985)
Related to managers bonus plans
Is this good or bad earnings management?
Dechow, Sloan, and Sweeney (1996)
92 sample firms charged by SEC with alleged violation of
GAAP
Related to avoiding debt covenant violation and issuing
stocks
Is this good or bad earnings management?

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The Bad Side of EM (cont.)
Financial Reporting Perspective
Hanna (1999) re. non-recurring charges
Investors and analysts look to core earnings, ignoring
provisions for extraordinary and non-recurring items
But current non-core provisions increase core earnings in
future years, through lower amortization and absorption
of future operating costs
As a result, managers tempted to overdose on non-core
provisions, thereby putting earnings in the bank
(cookie jar accounting)
Decision useful financial information to investors?

The Bad Side of EM (cont.)
Standard setters response to bad EM
IAS 37 on provisions for uncertain future payment
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
Restructuring expense and any reversals thereof must be
shown separately on the income statement
Does this solve problem of abuse of provisions?
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The Bad Side of EM (cont.)
Can accountants reduce bad EM?
Yes, if full disclosure of
Revenue recognition policies
Unusual, non-recurring and extraordinary events
Enables investors to better evaluate earnings
persistence
Effect of previous non-recurring charges on
current core earnings (Hanna,1999)
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Conclusions
Earnings management can be good if used
responsibly
Full disclosure helps to control bad earnings
management