Earnings Management

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)
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
management’s inside information to
investors
Patterns of Earnings
Management
 Taking a bath
 Income minimization
 Income maximization
 Income smoothing
Measurement
 Total Accruals
 Discretionary Accruals
 Jones (1991)
 Modified Jones model
 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.
Accrual Accounting

 Subjectivity
 Assumptions
 Discretion
 Reporting Discretion
 Why allow reporting discretion?

Rigid rules Flexible rules

trade-off

 Reporting biases  Enables better reporting of larger

number of businesses.
 No discretion  Prone to manipulation
What Motivates Managers’
Choice of Discretionary Accruals?

Victor L. Bernard
Douglas J. Skinner
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
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
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
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
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
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
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
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
Kasanan, Kinnunen, and
Niskanen (1996)
 What do we learn?
 KKn’s results provide strong evidence of
earnings management
 Provides an interesting experiment, but it
may be hard to generalize this conclusion
to other countries
Conclusion
 We need more reliable ways of
measuring earnings management
 A potentially fruitful alternative: may be
to analyze financial statements in
more detail