Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 11
CHAPTER 11
EARNINGS MANAGEMENT
11.1 Overview
11.2 Patterns of Earnings Management
11.3 Evidence of Earnings Management for Bonus Purposes
11.4 Other Motivations for Earnings Management
11.4.1 Other Contracting Motivations
11.4.2 To Meet Investors’ Earnings Expectations and Maintain Reputation
11.4.3 Initial Public Offerings
11.5 The Good Side of Earnings Management
11.5.1 Blocked Communicaton
11.5.2 Empirical Evidence of Good Earnings Management
11.6 The Bad Side of Earnings Management
11.6.1 Opportunistic Earnings Management
11.6.2 Do Managers Accept Securities Market Efficiency?
11.6.3 Analyzing Managers’ Speech to Detect Earnings Management
11.6.4 Implications for Accountants
11.7 Conclusions on Earnings Management
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LEARNING OBJECTIVES AND SUGGESTED TEACHING APPROACHES
1. To Outline Reasons for Earnings Management
I recommend introducing students to the topic of earnings management by discussing
Healy’s seminal 1985 bonus plan paper. Healy’s evidence that bonus plans motivate
earnings management helps students to take contracting theory seriously. It opens up a
whole new set of considerations in accounting policy choice beyond the disclosure of useful
information to investors.
I sometimes ask the question whether management would admit to the behaviour
documented by Healy, and whether the auditor would assist or oppose the manager in this
type of earnings management. For those interested in research methodology, Healy’s paper
can be used to point out the desirability in accounting research areas such as this of using
empirical analysis of hard data, with good experimental design and statistical analysis, in
order to more fully understand management’s accounting policy choices.
Having said this, it is important that the Healy results not be “oversold,” since Healy faced
substantial methodological problems, particularly with respect to separating discretionary and
non–discretionary accruals. The text contains discussions of some of these problems, and
the results of some subsequent papers, in Section 11.3. The Jones’ (1991) methodology
which, with some variants, is still the state of the art in estimating discretionary accruals is
reviewed in Section 11.3. I do not spend much class time on these methodological issues,
other than a brief review of the Holthausen, Larcker and Sloan (1995) paper. This paper, with
better data and different methodology, supports Healy’s results for firms with above–cap
earnings, even though Healy’s below–bogey results seem to disappear in their study.
Since it now appears that meeting earnings expectations drove at least some of the financial
reporting scandals of the early 2000s, such as WorldCom, I also suggest class discussion of
the material in Section 11.4.2. This sets up the interrelation between investor–oriented and
contracting rationales for earnings management.
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of earnings management devices available to it and the steadily increasing pattern of its
earnings over time.
It is interesting to note that GE’s earnings management came under suspicion in the market
in the early 2000s, due to the severe apprehension of post–Enron investors about earnings
management in general. According to an article “General Electric: Big game hunting” in The
Economist (March 14, 2002) investors may have interpreted GE’s increased reported
earnings for 2001 as evidence of bad earnings management, since poor economic
conditions during 2001 suggest that earnings should have declined. In addition, GE
appointed a new CEO in late 2001. The Economist suggests that the market may have less
trust in the new CEO than in Jack Welch, the highly regarded former CEO, simply because
he is less of a known quantity. As a result, the market may have felt that there is a higher
likelihood that GE will use its considerable potential for earnings management for bad
purposes rather than good.
GE’s response to these market concerns is worth noting. It started to release considerably
more information. Discussion of how GE worked to overcome investor scepticism is given in
Theory in Practice 12.1 Problem 19 of Chapter 12. Discussion of market reaction to GE’s
lower reported earnings during the 2007–2008 market meltdowns is given in Problem 9 of this
chapter.
3. To Appreciate the Bad Side of Earnings Management
Despite the above arguments, most people would likely regard earnings management with
suspicion, reinforced by revelation of serious abuses of earnings management by Enron and
WorldCom and numerous other corporations in the early 2000s. Consequently, students
should not be left with the impression that it is necessarily good. A useful place to start is
Hanna’s 1999 article in CA Magazine, which is still well worth assigning and discussing, even
though the rules surrounding reporting of unusual items have changed since the article was
written. The important point to get across from this article is that management is tempted to
provide excessive unusual, non–recurring and extraordinary charges, to put future earnings in
the bank. Furthermore, these future earnings are buried in operations. This makes it difficult
for investors to diagnose the reasons for subsequent earnings increases. Nortel Networks’
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reversals of its excess accruals (see Problem 11.12) provide a vivid example of Hanna’s
argument. Also, the effect on future profits of putting earnings in the bank has been
recognized by an article in The Economist (“A world awash with profits, Business is booming
almost everywhere,” February 18, 2005, pp. 62–63). This article states that one reason for
the dramatic increase in firm profits during 2002–2004 is that they are an “accounting fiction,”
which apparently means that they are a consequence of earlier writeoffs.
I find that to drive home these various considerations, an example of how earnings
management can go too far is instructive. An excellent case in point is the downfall of
“Chainsaw Al” Dunlap at Sunbeam Corp. Jonathan Laing’s 1998 article in Forbes is the
subject of Problem 10. Laing demonstrated that Sunbeam’s 1997 reported earnings were
almost completely manufactured by means of discretionary accruals. The substantial first
quarter, 1998, loss reported by Sunbeam supports Laing’s analysis, and the “iron law” of
accrual reversal.
I think that Laing’s analysis of the effects of the $17.2 million drop in Sunbeam’s prepaid
expenses for 1997 is backwards, and have shown it as a decrease in its effect on net
income. Regardless, taking this error into account does not substantially alter Laing’s
conclusion that 1997 earnings were manufactured.
4. Do Managers Accept Securities Market Efficiency?
Evidence of good earnings management is consistent with managers’ beliefs that markets
are reasonably efficient. Why use earnings management to reveal inside information if the
market cannot interpret it? However, evidence of bad earnings management may or may not
be consistent with efficiency.
On the one hand, managers may feel that they can fool the market by managing their
earnings, which seems to have been the case with Sunbeam management. Emphasizing
pro–forma income (Section 7.11.2 is another tactic that seems inconsistent with acceptance
of efficiency. It is hard to believe that managers would continue to attempt to manipulate
investors’ beliefs if an efficient market immediately detected and penalized such behaviour.
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On the other hand, bad earnings management may hide behind poor disclosure. If the
market is not aware that reported earnings are being managed, it can hardly be concluded
that the market is inefficient. Rather, the question is whether the market will react once it
suspects or becomes aware of the earnings management. The market’s negative reaction to
the frequency of non–recurring charges as an indicator of possible earnings management, as
documented by Elliott and Hanna (1996) (see Section 11.6.1) suggests considerable
efficiency, for example. Also, the market’s post–Enron suspicion of GE’s earnings
management, discussed above, is also consistent with efficiency.
The text concludes that at least some managers do not accept market efficiency. However, it
also concludes that markets are sufficiently close to full efficiency that improved disclosure
will reduce bad earnings management.
5. To Summarize the Strategic Aspects of Accounting Policy Choice
I end my discussion of earnings management with two main points:
(i) I emphasize the concept of strategic accounting policy choice, whereby
managers choose accounting policies to achieve certain objectives. These objectives
may include efficient contracting, such as avoiding excess earnings volatility for
compensation and debt covenant reasons, which may conflict with accounting policies
that are most useful to investors. This greatly expands the role of financial reporting,
since we now formally recognize two main roles of financial reporting– reporting to
investors and reporting on manager performance. Both roles matter since the quality
of manager effort and the well–working of managerial labour markets is as important to
society as the quality of investor decisions and the well–working of securities markets.
The conflict between these two roles, I hope, validates to the class the time spent on
basic game and agency–theoretic concepts of conflict in Chapter 9.
(ii) I emphasize that managers have a legitimate interest in accounting policy
choice, since their operating and financing policies, and even their livelihoods, are at
stake. This view is in contrast to many discussions of standard–setting where
management seems to be the “bad guys,” opposing every new standard that comes
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along. The theory provides several legitimate reasons why managers will be
concerned about changes to GAAP.
SUGGESTED SOLUTIONS TO QUESTIONS AND PROBLEMS
1. Some reasons why a firm’s management might both believe in securities market
efficiency and engage in earnings management are:
1. Income taxation. The firm may be able to postpone payment of taxes if it
can minimize its reported income, for example by managing accruals, or
using LIFO (if allowed by the tax authority).
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5. It is difficult to make general statements about the impact of fair value accounting for
financial instruments on opportunistic earnings management, since some aspects of
fair value measurement restrict earnings management, and others increase it. The
following points can be made:
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comprehensive income to net income. This assumes that, for bonus purposes,
net income is the performance measure rather than comprehensive income.
• The fair value option can be used to manage earnings. However, under IFRS 9,
use for this purpose is restricted, since the option can only be used to reduce a
mismatch. The FASB fair value option is more flexible, since its use is not
restricted to mismatch situations. It thus offers greater earnings management
potential.
A reasonable conclusion is that fair value accounting standards try to prevent
opportunistic earnings management. However, it is likely that managers will figure out
ways to work around the protections built into these standards.
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– Increase in prepaid expenses. 1
Considerable discretionary component
since manager controls capitalization
policy for many of these.
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Note: Students often deduct from net income a $1 accrual for the increase in deferred
development costs on the balance sheet. This throws them out of balance. There is
not enough information on the income statement to know if deferred development
Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 11
7. a. Reasons to resort to extreme earnings management tactics:
• To meet analysts’ forecasts. As stated in the question, this was the apparent
reason in BMS’ case.
b. From the standpoint of a single year, stuffing the channels seems effective.
This is because it is hard to detect.
Such behaviour may possibly be detected through full disclosure, such as sales by
product, segment, or region. Then, careful analysis may reveal unusual sales patterns.
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complaining to regulators or the media. However, in BMS’ case, paying their carrying
charges may have been a device to avoid such complaints.
Over a series of years, stuffing the channels is likely to be less effective, for the
following reasons:
We conclude that while stuffing the channels may be reasonably effective in the short
run, it loses effectiveness to the extent it is used over multiple periods.
c. BMS appears to have been using cookie jar accounting to smooth reported
earnings. Cookie jar accounting seems reasonably effective as an earnings
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