Kwame Nkrumah University of
Science & Technology, Kumasi, Ghana
ACC 559/ACF 655
ACCOUNTING THEORY
Lesson 4: Earnings Management
Department of Accounting and Finance
Dr Abukari Salifu Atchulo
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Learning Outcomes
By the end of the Lecture, students are expected to demonstrate
an understanding of;
Definitions of Earnings Management
Factors that enhance Earnings Management
Accounting Theories and Schemes
Merits and Demerits of Earnings Management
Implications of Earnings Management on Financial Reporting
Ethicality of Earnings Management
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What is Earnings Management
Earnings Management occurs when managers use judgement in financial
reporting and in structuring transactions to alter financial reports to either
mislead some stakeholders about the underlying economic performance of
the company or to influence contractual outcomes that depend on reported
accounting numbers (Healy & Whalen ,1999,p.368)
• Levit (1998), “Earnings Management is a gray area where accounting is being
perverted, where managers are cutting corners; and, where earnings reports
reflect the desires of management rather than the underlying financial
performance of the company”.
•
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What is Earnings Management
WHITE GRAY BLACK
Earnings Management is Earnings management is Earnings Management is
taking advantage of the choosing an accounting the practice of using
flexibility in the choice of treatment that is either tricks to misrepresent or
accounting treatment to opportunistic (Maximizing reduce transparency of
signal the manager’s utility of management the financial reports
private information on only ) or economically (Schipper 1989,Levitt
future cash flows efficient 1998,Healy & Wahlen
(Ronen & Sadan (Fields, Lys & Vincent 1999,Tzur and Yaari 1999)
1981,Demski,Patell and 2001,Scott 2003).
Wolfson 1984,Suh 1990)
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Tentative Definition
Earnings Management is the intentional manipulation of
reported earnings by either altering economic transactions or
choosing accounting estimates that do not accurately reflect the
firm's underlying fundamentals.
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Some Terminologies associated to EM
• Creative Accounting : This is the manipulation of financial
numbers, usually within the letter of the law and accounting
standards, but certainly deviating from the spirit of those rules.
• Cosmetic Accounting :It is the process whereby accountants
use their knowledge of accounting rules to manipulate the
figures reported in the accounts of a business.
• Income Smoothing :This is the shifting of revenue and
expenses among different reporting period in order to present
the false impression that a business has steady earnings.
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Accounting theories explaining EM
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Agency Theory
• Agency Theory:
• Divorce of management from ownership (neoclassical economic theory)
• Agents are rational human beings
• Agents must account to their principals by meeting certain performance
indicators
• The primary feature of agency theory that has made it attractive to
accounting researchers is that it allows us to explicitly incorporate
conflicts of interest, incentive problems, and mechanisms for controlling
incentive problems into our models.
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Positive Accounting theory
• Initiated by Watts & Zimmerman (1978 and 1986), the positive accounting
theory consists of different accounting practices used to affect the result of
the company.
• Watts & Zimmerman (1986) suggested three explanatory factors that can
explain the use of earnings management:
• compensation,
• debt and
• the size. Watts & Zimmerman (1978 and 1986) and Healy & Whalen (1999)
• According to Healy (1985) the compensation criterion is not automatic
once the payment of managers is capped.
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Signaling Theory
• Ross (1977), examined the relationship between managers
and investors in a context of asymmetric information.
• By having information about the expectations and future
prospects of the firm, managers can use earnings
management by increasing reported earnings and thus report
the correct performance of the company.
• Projecting good outlook to entice prospective investors
• Reducing earnings to signal small size to avoid public scrutiny.
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Factors that enhance Earnings Management
Internal Factors
• Meeting earning targets set by supervisors (Sun et al., 2013),
• Compensations and bonus plan (Mc Nichols & Wilson, 1988, Jeanjean, 2001
and Mard, 2004).
• Avoid violating lending contracts
External Factors
• Capital market ;meeting targets set by analysts and stock prices.
• Political motivation
• Taxation motivation
• Industry regulations
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Case Study
The corporation of Enron is a company that deals with electricity and
natural gas that is based in Houston, Texas.
Enron had 21000 people working for them and was rated the seventh
largest company in America.
Enron conned the public into investing trillions of dollars into their
company stocks based on their earnings.
When Enron faced major drop in stock prices, trillions of dollars of
investors vanished.
During 2001, shares worth $85 were trading at $0.30.
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Case Study
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Accounting Schemes Used In Earnings
Management
Big bath charges : This is applied when a company places large
amounts of money into charges associated with company
restructuring in order to alleviate finances.
Creative Acquisition accounting : This is the allocation to
expense of a large portion of the acquisition price in an effort to
reduce acquisition year earnings.
Cookie-jar Reserves : This application is achieved when
companies portray unrealistic assumptions when calculating
estimates for sales returns, loan losses or warranty costs. These
accruals are then reserved and used during bad times. www.knust.edu.gh
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Accounting Schemes Used In Earnings
Management
Materiality :This occurs when a company knowingly misstate
earnings by amounts that fall below the materiality threshold
by not correcting known errors or other misstatements.
Revenue Recognition : This method is applied when companies
increase their earnings by recognizing a sale prior to
completion of that sale or before the product is delivered to
the customer.
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Perspectives of Earnings Management
• The review of the literature has revealed that earnings
management is defined from two perspectives;
• An informational perspective; According to this perspective,
earnings management can be defined as any decision of
reasonable, legal and appropriate management that provides
value to stakeholders
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Perspectives of Earnings Management
Opportunistic Perspective
• Asset pricing implications :Empirical studies have shown that,
distorted information flow can cause adverse capital market
reactions. 9% decline in stock prices of firms in the 2years
following the announcement of SEC investigation (Dechow et
al.1996)
• The overall consequence of earnings management is that, it
leads to the erosion of trust between shareholders and
companies.
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Implications of Earnings Management on Financial
Reporting
• This behaviour can result from a failure to accept securities market efficiency or
from an ability to hide bad earnings management behind poor disclosure, or
both.
• Accountants can reduce the extent of bad earnings management by bringing it
out into the open. This can be accomplished by improved disclosure of low-
persistence items and reporting the effect of previous write offs on current
earnings.
• In addition to assisting share prices to more closely reflect fundamental firm
value, improved disclosure assists corporate governance, since compensation
committees and the managerial labour market can better reward good
manager performance and discipline managers who shirk
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Is Earnings Management Ethical
• Earnings management behaviour is unacceptable, regardless of
materiality (Grant et al.,2000)
• According to Loomis (1999),earnings management obscures facts
investors ought to know, leaving them in the dark about the true value
of a the business.
• Current shareholders have a positive demand for earnings
management in order to maximize the value of the stock at the
expense of future shareholders(Dye 1988)
• According to Schipper(1989),earnings management is inherent in the
financial reporting system and does not eliminate the usefulness of
accounting earnings.
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Why does Earnings Management Persist
Accruals( Schipper 1989)
It arises when there is discrepancy between the timing of cash flows
and the timing of accounting recognition of the transactions.
• Types
• Non - discretionary: They are accruals that arise from transactions made
in the current period that are normal for the firm given it performance.
• Discretionary: They arise from transactions made or accounting
treatment chosen in order to manage earnings. Discretionary accruals
are accruals over which the manager can exercise some control.
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Why does Earnings Management Persist
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Security and Exchange Commission View On
Earnings Management
• Securities Industry Act, 2016, Act 929 section 149
• False or misleading statements
• A person shall not make a statement or disseminate
information that is false or misleading in a material particular,
that is likely to induce the sale or purchase of securities by any
other person or is likely to have the effect of raising, lowering,
maintaining or stabilising the market price of securities.
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Regulations On Earnings Management
• Penalties
• A person who contravenes a provision of section 147 to section
153 commits an offence and is liable on summary conviction to
a fine of not less than one thousand penalty units and not
more than two thousand five hundred penalty units or to a
term of imprisonment of not less than four years and not
more than five years or to both (Securities Industry Act, 2016,
Act 929 section 154)
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Try this……..
• Checklist for students to understand reason for Earnings
Management:
You are required to explain the likely motivation a company's
directors might have to manipulate its reported profit
(a) upwards; or
(b) downwards; or
(c) it is not possible to tell as it depends upon the particular
circumstances, in the following situations.
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Try this…..
1. A company that faces a high (and difficult to meet) security
analysts' (consensus) profit forecast.
2. A listed company which prepares interim financial statements.
3. A recently taken-over company.
4. A company whose directors are considering changing the
status of the company from private to publicly listed. That is
they are planning an Initial Public Offering (IPO).
5. A large regulated utility company
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Try this…..
6. A company operating in an economy that is moving into
recession.
7. A company whose trade unions are about to submit a large
wage demand.
8. A company which is rumored to be subjected to a hostile
takeover bid in the next few weeks.
9. A company that is performing below its industry average.
10.A company whose directors are on a profit related bonus
scheme.
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Try this…..
11. A company that is in fairly permanent decline.
12. A company that has borrowed heavily and is highly geared.
13. A company that operates in an industry known for highly
volatile profits.
14. A company that is faced with severe foreign competition.
15. A divisional company whose director's are planning a 'buy-
out’.
16. A company that is looking to reduce its tax bill.
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Summary
• Earnings management occurs when reported earnings differ
from the true value.
• Earnings management can be an increase (decrease) of
revenue or profits through aggressive accounting tactics.
• Manipulation of earnings is more likely in firms with a weak
Board structure (Peasnell et al. 2001)
• Aggressive earnings management becomes more probable
when a company is affected by a downturn in business.
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