CHAPTER 9
Earnings management
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
9.1 evaluate the importance of earnings in assessing the success of an organisation
9.2 explain what earnings management is
9.3 evaluate a number of common methods of earnings management, including
accounting policy choice, accrual accounting, income smoothing, real activities
management and big bath write-offs
9.4 analyse the reasons why entities manage earnings
9.5 evaluate the consequences of earnings management
9.6 assess the role corporate governance plays in controlling earnings management.
The beginning of the twenty-first century saw a series of accounting scandals
worldwide. Following the largest corporate bankruptcy in the United States — Enron in
2001 — evidence surfaced about a number of financial misstatements.1 Further
evidence of substantial irregularities in other companies around the globe followed.
Examples include WorldCom and Xerox in the United States, Parmalat in Italy and HIH,
One.Tel and Harris Scarfe in Australia. Central to all these failures was aggressive
earnings management, in which entities misstated earnings or presented misleading
accounting information.2
This chapter investigates what earnings management means and how it is conducted.
We will start by discussing the importance of earnings as a reporting concept and what
we mean by earnings management. Common methods of earnings management are then
discussed. We then examine why entities might engage in earnings management and
how earnings management relates to the quality of earnings. In doing so, we also
explore corporate distress or failure as a motivation to manage earnings. Finally, the
roles of corporate governance and executive and employee issues in earnings
management are detailed.
9.1 The importance of earnings
LEARNING OBJECTIVE 9.1
Evaluate the importance of earnings in assessing the success of an organisation.
Before the meaning of earnings management is discussed, the importance of earnings
needs to be investigated. Earnings are sometimes called the ‘bottom line’ or ‘net
income’. As a measure of entity performance, they are of great importance to financial
statement users and indicate the extent to which an entity has engaged in activities that
add value to it. The financial press provides many instances of earnings or profit
announcements and a discussion of why earnings might deviate from that which was
forecasted previously. Both financial analysts and managers provide forecasts of
earnings. The theoretical value of an entity’s stock is the present value of its future
earnings.3 Increased earnings signal an increase in entity value, while decreased
earnings represent a decrease in that value.4
Earnings are used by shareholders to both assess managers’ performance — a
stewardship role — and to assist in predicting future cash flows and assessing
risk.5 Francis, Schipper and Vincent found that earnings are more closely associated
with stock prices than are cash flows, sales or other financial statement data.6 Lenders
use earnings as a component in debt covenants to reduce the risk associated with
lending and to monitor performance against covenants. Interest coverage and dividend
constraints are commonly included in both private and public lending agreements.7
Customers may use earnings to evaluate whether products and services are likely to be
supplied into the future, and employees use earnings to assess the entity’s future
prospects and evaluate the level of job security they are likely to hold.8 Correctly
assessing entity performance depends on the level of accounting information quality or
earnings quality. Earnings quality, a concept that will be discussed later, can be affected
by earnings management.
9.2 What is earnings management?
LEARNING OBJECTIVE 9.2
Explain what earnings management is.
There are several definitions of earnings management that are commonly understood
in academic and professional literature. Schipper defines it as ‘a 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)’.9 Healy and
Wahlen argue that ‘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 the contractual outcomes that depend on reported accounting
numbers’.10 McKee meanwhile defines earnings management more conservatively as
‘reasonable and legal management decision-making and reporting intended to achieve
stable and predictable financial results’. He states that earnings management is not to
be confused with activities that do not reflect economic reality — which may be
evidence of fraud.11
The above definitions differ on the basis of whether normal financial decisions are part
of the definition, or whether the purpose of earnings management is to mislead.
Management can take a relative position on accounting issues based on the perspective
of the management team. This can be conservative, with few if any non-recurring or
unusual items or, at the other extreme, a more aggressive or even fraudulent
perspective. This range of earnings management definitions has been classified by
Ronen and Yaari as white, grey or black.12 White, or beneficial earnings management,
enhances the transparency of financial reports; black involves misrepresentation,
reducing transparency or even fraud; while grey defines earnings management as
choosing an accounting method that is either opportunistic — that is, it maximises
wealth of managers — or could be economically efficient for the entity concerned.
Earnings management can therefore range from being beneficial, in that it signals long-
term entity value to stakeholders, harmful because it conceals real entity value in either
the short or long term, or neutral if it documents short-term true performance.13 Giroux
supports this view where he considers that earnings management ‘includes the whole
spectrum, from conservative accounting through fraud’ and provides useful examples of
the range of alternatives, which have been adapted in table 9.1.14
TABLE 9.1Earnings management relating to different entity objectives
CONSERVATIVE
MODERATE
AGGRESSIVE
Revenue
recognition on
services
Services are prepaid and
performed in full
Services are prepaid
and partially
performed
Services are agreed to but not yet
performed
Inventory
Lower of cost and net
realisable value is
consistently applied
Slow to write down
slow-moving
inventory
Obsolete inventory is still recorded as
an asset
Accounts
receivable
Conservative credit
terms and bad debts
allowances used
Liberal credit terms
and bad debts
provision estimates
Liberal use of credit policies to
expand sales; understate bad debts
provisions or reduce bad debts by
ignoring likely defaults
CONSERVATIVE
MODERATE
AGGRESSIVE
Depreciation
Conservative useful life
and residual value
computed
Liberal useful life
and residual value
computed
Restate useful life and residual value
upward
Advertising,
marketing
Expensed as incurred
Expensed based on a
formula; perhaps
sales-based
Marketing costs are capitalised
Source: Adapted from Giroux.15
9.3 Methods of earnings management
LEARNING OBJECTIVE 9.3
Evaluate a number of common methods of earnings management, including accounting
policy choice, accrual accounting, income smoothing, real activities management and big
bath write-offs.
Earnings management encompasses a range of techniques. The most widely used, which
will be discussed in this section, include: accounting policy choice, the use of accruals,
income smoothing, real activity management and an extreme example of loss
recognition known as taking a ‘big bath’.
Accounting policy choice
Choosing between the available acceptable accounting policies is one of the most
commonly used forms of earnings management. Accounting choices are made within
the framework of applicable accounting standards. This decision could relate to a choice
between straight-line and accelerated depreciation, FIFO or weighted average for
inventory valuation, or deciding to be a voluntary early adopter of a new accounting
standard. Earnings management can occur when management have flexibility in making
accounting choices in line with accounting standard requirements. These choices will
lead to different timing and amounts of expense recognition and asset valuation. It is
difficult to determine if these choices are made because they reflect the economic
nature of the underlying transactions, or if management is seeking to delay expense
recognition to a later date.
Entities may even choose to change accounting method in some circumstances. It is
generally thought that once an entity chooses an accounting method, it needs to
maintain this. However, this is not necessarily the case. Provided the entity can put a
case forward to the auditors that the new principle or practice is preferable, it is free to
change this policy. A change in accounting method could relate to a change in
accounting principle (e.g. straight-line or reducing balance depreciation) or a change in
accounting estimate (e.g. extending the useful life of a non-current asset or changing the
estimated salvage value). The auditors will require the entity, if the result is a material
change, to justify this decision.
Accrual accounting
Rather than reporting erratic changes in revenue and earnings year on year, managers
prefer to generate consistent revenues and earnings growth. Shareholders prefer to
invest in an entity that exhibits consistent growth patterns, not one that has uncertain
and changing earnings patterns. For this reason, managers will have incentives to
use accrual accounting techniques to manage earnings over time. The IASB discusses
the importance of using accrual accounting:
Accrual accounting attempts to reflect the effects of transactions and
other events and circumstances that have cash (or other) consequences
for an entity’s resources and the claims to them in the periods in which
they occur or arise. The buying, producing, selling, and other operations
of an entity during a period, as well as other events that affect its
economic resources and the claims to them, often do not coincide with the
cash receipts and payments of the period. The accrual accounting
information in financial reports about an entity’s resources and claims
and changes in resources and claims generally provides a better basis for
assessing cash flow prospects than information solely about the entity’s
current cash receipts and payments. Without accrual accounting,
important economic resources and claims on resources would be
excluded from financial statements.16
Accrual accounting techniques generally have no direct cash flow consequences and can
include: under-provisioning for bad debts expenses, delaying asset impairments,
adjusting inventory valuations, and amending depreciation and amortisation estimates
and adjustments.
Research attempts to measure accruals management by identifying ‘unexpected’
accounting accruals reflected in earnings, where unexpected accruals are used as a
proxy for exercising discretion to manage earnings. One of the most commonly used
methods to determine earnings management was developed by DeAngelo and involves
comparing the accruals component of earnings in one year to accruals the previous year
as an estimate of ‘normal’ accruals, as shown below:
ACt=NPATt−CFOtACt=NPATt-CFOt
where:
ACt
=
the accruals component of earnings in year t
NPATt
=
net operating profit after interest and tax in year t
CFOt
=
cash flows from operations in year t17
To calculate earnings management through accruals accounting, unexpected or
discretionary accruals are calculated as the difference between the change in net
operating profit after interest and tax and the change in cash flow from operations from
year t−1 (the previous year) to year t (the current year).18 This is reflected as:
ΔACt=ACt−ACt−1ΔACt=ACt–ACt-1
Income smoothing
Income smoothing is a variation on accruals accounting, whereby above-normal profits
in good years are artificially reduced by the use of certain provisions and these
provisions are then called on in years where the company is not performing so well to
inflate the reported profit figure. A definition of income smoothing has been provided
by Copeland.19 ‘Smoothing moderates year–to-year fluctuations in income by shifting
earnings from peak years to less successful periods’. The practice can relate to a wide
range of accrual accounting practices including: early recognition of sales revenues,
variations to bad debts or warranty provisions, or delaying asset impairments. Research
has found that some entities will undertake hedging with financial instruments to
encourage income smoothing.20 Anandarajan, Hasan and McCarthy found that Australian
banks used loan loss provisions to manage earnings, with their use being more
pronounced in listed commercial banks and in the post-Basal period.21
Real activities management
Earnings can also be managed through operational decisions, not just accounting
policies or accruals. This is referred to as real activities management.22 Some
examples observed in the research literature include: accelerating sales, offering price
discounts, reducing discretionary expenditures, altering shipment schedules, and
delaying research and development and maintenance expenditures.23 Graham et al., in a
survey of US managers, found:
strong evidence that managers take real economic actions to maintain
accounting appearances. In particular, 80% of survey participants report
that they would decrease discretionary spending on R&D, advertising, and
maintenance to meet an earnings target. More than half (55.3%) state that
they would delay starting a new project to meet an earnings target, even if
such a delay entailed a small sacrifice in value . . .24
Real activities management can affect cash flows and in some cases accruals. Managers
place great importance on meeting earnings targets, such as meeting or beating
earnings targets or prior period’s earnings, and are willing to engage in management of
operational activities, even though it might reduce firm value.25 A reduction in entity
value can occur because actions taken in the current accounting period to increase
earnings can have a negative effect on cash flows in later periods.26 As an example,
aggressive price discounting to increase volume of sales to maximise short-term
earnings can lead customers to expect the same discounts in the future, which will lead
to lower margins on future sales.27 Real activities management is less likely to draw the
attention of auditors than accruals management as auditors are not likely to question
actual pricing and production decisions. Companies tend to use a combination of real
activities manipulation and accrual-based earnings management. Real activities
management takes place during the fiscal year, with the effect of these actions on
