Chapter 11

Earnings Management

Summary and Quiz

9.403 Accounting Theory

L02

March 5, 2002

Chapter 11Earnings Management

Summary
Defining Earnings Management
Earnings management is the choice by a manger of accounting policies so as to
achieve some specific objective. By nature, the accounting policies set out in GAAP do
not stipulate specific accounting policies for managers to follow. For example, GAAP
allows a company to choose the amortization policy that best reflects the use of an asset;
this flexibility allows managers to accurately reflect the earning potential of the asset.
Therefore, while the results of earnings management may not represent the actual cash
flows for the period, it should reflect the periods revenues and expenses. Provided that
management stays within the regulations of GAAP, this type of earnings management is
allowed. Because managers have the discretion to choose those accounting policies that
best reflect the business of the firm, it can be assumed that managers will choose those
accounting policies that can put themselves and their companies in the best possible light.
That is, mangers can use earnings management for personal reasons (for example,
increasing current period earnings to receive a bonus) and managers can use earnings
management to influence the market value of the company (for example, claiming less
amortization expense in order to increase net income for that period).
Earnings management can help firms communicate insider information to the
public, but financial statement users need to understand earnings management in order to
make good use of management prepared financial statements. A firms choice of
accounting policies signals to the public whatever future expectations the firm may have.
For example, a firm changing from straight-line to double declining amortization signals
to the public that the earning potential of the asset lies more in its earlier years of use.

3
There are two key types of earnings management: adjusting individual accounting
policies and using different accrual methods. In turn, these two methods can be used to
either increase or decrease a firms current earnings. First, managers can adjust any
number of accounting policies to affect the value of a firm. Common accounting policy
changes can include adjusting amortization expense or revenue recognition methods.
Second, mangers can set up different accruals to spread revenue and expense recognition
over several periods. For example, a construction company receiving revenue up front for
a 10-year project can accrue revenue over the period to match expenses.
There is a limit to the benefits of earnings management. While responsible
earnings management allows a firm to communicate insider information to financial
statement users, abusing earnings management can reduce the long-term reliability of the
financial statements. Earnings management should help financial statement users
understand the earnings of the company. Managers must remember that earnings
management has no cash flow effect; all accruals will eventually have to be reversed.

Motivations for Earnings Management

There can be a strong motivation for managers to play with earnings figures since
bonuses are often based on the bottom line. Managers may be tempted to increase the
earnings figure since their bonuses may be a direct result of this amount. On the other
hand, a manager may be willing to take a bath in a year where net income is expected
to be low since they will not reach the earnings figure required to receive a bonus. Healy
(1985) noted that a cap and bogey is often applied when bonuses are determined. The
bogey is the minimum net income figure required for the manager to receive a bonus; the

4
cap is the maximum net income figure for which a bonus will be paid out. Therefore,
managers realizing that they will not be able to reach the targeted minimum net income
figure may be enticed to take a bath. Likewise, if income were considerably higher
than the cap, the manager would be willing to absorb additional losses since the amount
of their bonus will not be affected. Ultimately, managers who take losses in the current
year to reduce net income below the cap will place the firm in a better position to perform
well in future years.
As discussed by Sweeney (1994), managers may use earnings management when
involved in contractual agreements. Many contractual agreements within the corporation
revolve around the debt covenant hypothesis. This hypothesis implies that lenders to the
corporation may include requirements in the debt contracts that net income, the current
ratio, the debt to equity ratio, and dividend policies must not change or fall below a
certain level. Since the costs of violating a debt covenant can be extremely high, a
managers interests lie in keeping the corporation at a level that does not jeopardize the
contractual agreement. In order to do so, the manager could use earnings management to
create the illusion that the company has not violated the debt covenant.
A third reason for earnings management stems from political motivations. Many
industries in the economy operate under a monopoly or an oligopoly. Firms in these
industries may be tempted to use earnings management to decrease net income because
profits that are too high may prompt a public outcry for government intervention in the
industry. Minimizing net income allows the industries to continue operations without
government interference. Joness study in 1991 found evidence of income smoothing,
especially in years where firms are under government investigation.

5
The fourth reason for earnings management is to take advantage of taxation
policies. The manager of a corporation may be willing to manage earnings to decrease
net income, which will in turn decrease taxes payable. The decision to use LIFO or FIFO
provides US firms with the biggest opportunity for tax savings. Dopuch and Pincus
(1988) noted that it is common for US companies to use LIFO instead of FIFO because
they can report lower net income in periods of increasing prices. While all Canadian
firms must use FIFO, the use of earnings management to decrease or defer taxes must not
be overlooked in Canadian firms.
A fifth reason why corporations may wish to practise earnings management
occurs when there is a change in CEOs. As discussed by DeAngelo et al. (1994), new
CEOs may be tempted to take a bath on earnings in the first year and blame the results
on the prior CEO. Also, CEOs nearing retirement will be more willing to increase
earnings now so that their bonus will be higher at the time of retirement.
A sixth reason for earnings management occurs when a firm is considering an
IPO. Firm will be tempted to report higher income in the years preceding the offering so
that they will receive a higher bid for their IPO. Clarkson, Dontoh, Richardson, and
Shefix (1992) noted that the market responds positively to earnings forecasts and this
can be a measure of the firms value.
As previously mentioned, managers can also participate in earnings management
to communicate insider information to investors. This theory implies that a firms
accounting policies may reveal insider information to investors, in turn helping investors
evaluate the firm and make useful decisions regarding the firms profitability.

6
Conclusions
As soon as managers have the ability to alter accounting numbers, there is a
decrease in the reliability of the financial statements. However, despite its effects on
reliability, earnings management can still be beneficial. Earnings management is a valueadded practice as long as managers act in the best interest of financial statement users
(i.e. mangers do not abuse earnings management for personal gain). Demski and
Sappington (1987) noted that expensive communication channels could block
communication. Earnings management can try to reduce these communication barriers
but only to a certain extent. If extracting insider information from financial statements is
too difficult or costly, then financial statement users do not derive any benefits from
earnings management practices. Ultimately, the benefits of earnings management depend
on the motivation behind its use; research by Subramanyam (1996) indicates that markets
do react positively to financial statements meant to provide insider information about
future income potential.

Chapter 11
Earnings Management Quiz
Part One Multiple Choice (5 points, 3 minutes)
Select the best alternative for each question.
1. What tools do managers have at their disposal to manage net income?
a)
b)
c)
d)
e)

Accruals and discretionary accruals

Fraud and under-the-table transactions
Discretionary accruals and accounting policy
Inventory sell-offs and accounts receivable write-downs
Discretionary accruals and corporate bonuses tied to net income

2. Which of the following is not a reason that management would use earnings
management to decrease net income?
a)
b)
c)
d)

Net income has exceeded managements bonus cap.

Net income is significantly lower that managements bonus bogey.
A firm under investigation for monopolistic practices.
Net income is slightly below managements bonus bogey.

3. Which of the following is an example of an earnings management pattern?

a)
b)
c)
d)
e)

Taking a bath
Taking a shower
Income manipulation
Juggling the books
Income balancing

4. Earnings management is:

a) The decision to pay dividends or not.
b) Marketing during slow periods to try and increase sales.
c) A financial ratio used to better understand the relationship between earnings and
sales.
d) The choice by a manager of accounting policies so as to achieve some specific
objective.
e) Predicting the effects of new accounting standards on earnings.

8
5. Why does earnings management still persist if it allows managers to manipulate
earnings?
a)
b)
c)
d)
e)

It is not cost effective to eliminate.

It provides investors with insider information.
It allows investors to choose between honest and dishonest companies.
Both a) and b)
All of the above

Part Two True and False (5 points, 3 minutes)

1. Research has found that stock markets do not react to earnings management.
True False
2. One would expect that the changes to GAAP regarding extraordinary items (Jan
1990) would increase the use of earnings management.
True False
3. Earnings management is irrelevant for taxation purposes because taxation authorities
impose their own accounting rules for calculation of taxable net income.
True False
4. The iron law surrounding earnings management suggests that managing current
earnings upwards will lead to higher future net income.
True False
5. The market would better reflect insider information if earnings management was
eliminated through standardization.
True False

Part Three Long Answer Questions (40 points)

Question One (14 points, 9 minutes)
How does earnings management help to mitigate the fundamental problem of financial
accounting theory, which suggests that accounting information attempts to meet both
managers and investors interests? Provide an example.

10
Question Two (14 points, 9 minutes)
What implications does the attached article Investors wont get fooled again (Jonathan
Chevreau, Financial Post, February 22, 2002), which discusses the investor confidence
effects of earnings management, have for accountants?

11
February 22, 2002

Investors won't get fooled again

Companies can no longer play games with earnings
Jonathan Chevreau
Financial Post

It's the earnings, dummy. Before taking offence, let me clarify I am merely parodying the
famous Bill Clinton election campaign: "It's the economy, stupid."
If ever there were a book title crying out for inclusion in IDG Books' ubiquitous Dummies
series, it would be Earnings for Dummies.
If indeed average investors have been dummies when it comes to swallowing corporate
earnings reports, it appears their collective innocence has been shattered. If so, it could spell
the end of the corporate shell game of "beating earnings by a penny."
A bellwether in the shift in mood may be the current [Feb. 25] cover story in Business Week
magazine. 'The Betrayed Investor" describes the shattered retirement dreams of middle-class
suburban Americans who uncritically bought into the 1990s cult of equity.
Their rage over growing stock market losses is hardly assuaged by the knowledge that
executives at Enron and other failed enterprises made millions as the rank and file watched
their pensions vanish.
Similarly, those who took flyers on vanished Internet IPOs can only gnash their teeth at the
pied pipers on Wall Street who lured them to their financial destruction. Former Internet queen
Mary Meeker and king Henry Blodgett made millions for themselves, despite massive losses
suffered by investors who followed their recommendations.
Investor distrust of stated official earnings is now migrating from the dot cons and isolated
frauds like Enron to such blue chips as General Electric and IBM.
Writing at Grant's Investor, bear Bill Fleckenstein dubs IBM "the poster boy for misleading
accounting." But Big Blue is only one example of "how corporations cut every conceivable
corner to try to puff up their earnings." He suggests the "next Enron" may well be all of
corporate America.
Admittedly, Fleckenstein is on the short side of the market, since he runs a hedge fund. But
his comments are echoed by other prominent observers of Wall Street.
Richard Russell, the seasoned editor of Dow Theory Letters, says "I don't think in my half
century of watching the stock market that I've ever seen anything like the circus, the phony
circus, that is taking place today." There are two types of earnings, Russell says. One is the
"downright deceitful earnings" of enterprises like Enron or Global Crossing.
The other is what he calls "deceptive earnings," masquerading as operating earnings. These
are earnings before interest, taxes, depreciation and amortization, and often before
extraordinary losses. These losses can often be defined as "exactly enough to make operating
earnings beat expectations by a penny."

12
In a similar vein, former Deutsche Bank chief investment strategist Ed Yardeni penned an
essay titled "Are profits a mirage?"
"Profits growth was great from 1992 through 1998, but was increasingly difficult to sustain. So
earnings management became a widespread practice during the late 1990s. Mostly, it was
legitimate and legal, but it pushed the envelope of good sound accounting practices ... "
It's bad enough that, measured by price/earnings ratios, the U.S. market is still arguably
overvalued. It's even worse that the E's in the P/E ratios could be overstated, which is what
Robert Barbera, chief economist at Hoenig & Co., told Business Week.
Barbera calculates most of the 26% operating earnings growth reported by S&P 500
companies from 1997 through 2000 was the result of accounting shenanigans.
So how to act on such depressing analysis? Short of beating a belated retreat to the safety of
cash, bonds and gold, it tells me that if you don't have the skills to assess earnings on your
own, you need to find an advisor who can.
Alternatively, mutual fund investors need advisors who can select funds run by veterans
steeped in traditional fundamentals of valuation. This list might include fund managers like
Irwin Michael at ABC Funds; Peter Cundill or the managers of the Ivy funds at Mackenzie;
Charles Brandes or John Arnold at AGF; Kim Shannon at Spectrum Investments; Larry Sarbit
at AIC; and Bill Kanko and others at the Trimark division of AIM Funds.
By voting with your wallet for managers with a sane perspective on valuation, you will in turn
put pressure on the corporations they invest in to clean up their acts and end the accounting
shenanigans.
jchevreau@nationalpost.com

13
Question Three (12 points, 6 minutes)
Describe four motivations for earnings management.

14

Chapter 11
Earnings Management Quiz
(Solutions)
Part One Multiple Choice (5 points)
Select the best alternative for each question.
1. What tools do managers have at their disposal to manage net income?
f)
g)
h)
i)
j)

Accruals and discretionary accruals

Fraud and under-the-table transactions
Discretionary accruals and accounting policy
Inventory sell-offs and accounts receivable write-downs
Discretionary accruals and corporate bonuses tied to net income

2. Which of the following is not a reason that management would use earnings
management to decrease net income?
a)
b)
c)
d)

Net income has exceeded managements bonus cap.

Net income is significantly lower that managements bonus bogey.
A firm under investigation for monopolistic practices.
Net income is slightly below managements bonus bogey.

3. Which of the following is an example of an earnings management pattern?

a)
b)
c)
d)
e)

Taking a bath
Taking a shower
Income manipulation
Juggling the books
Income balancing

4. Earnings management is:

f) The decision to pay dividends or not.
g) Marketing during slow periods to try and increase sales.
h) A financial ratio used to better understand the relationship between earnings and
sales.
i) The choice by a manager of accounting policies so as to achieve some specific
objective.
j) Predicting the effects of new accounting standards on earnings.
5. Why does earnings management still persist if it allows managers to manipulate
earnings?

15
f)
g)
h)
i)
j)

It is not cost effective to eliminate.

It provides investors with insider information.
It allows investors to choose between honest and dishonest companies.
Both a) and b)
All of the above

Part Two True and False (5 points)

1. Research has found that stock markets do not react to earnings management.
True False
2. One would expect that the changes to GAAP regarding extraordinary items (Jan
1990) would increase the use of earnings management.
True False
3. Earnings management is irrelevant for taxation purposes because taxation authorities
impose their own accounting rules for calculation of taxable net income.
True False
4. The iron law surrounding earnings management suggests that managing current
earnings upwards will lead to higher future net income.
True False
5. The market would better reflect insider information if earnings management was
eliminated through standardization.
True False
Part Three Long Answer Questions (40 points)
Question One (14 points)
How does earnings management help to mitigate the fundamental problem of financial
accounting theory, which suggests that accounting information attempts to meet both
managers and investors interests? Provide an example.
Solution
-

Earnings management addresses the fundamental problem of financial accounting

theory because it serves a dual purpose. That is, earnings management caters to
both investors and managers interests.

Earnings management serves managers interests because it provides managers

with the tools to manage reported earnings towards their goals, whether they are
long-term or short-term. Managers can use accounting policy decisions such as
taking a bath, income maximization or minimization, and income smoothing to
better reflect managements abilities and efforts in running the firm.

16
-

Earnings management serves the investors interests through the conveyance of

insider information. Insider information is provided by management through their
ability to manage earnings and better reflect the future earning potential of the
firm.

For example, a firm purchases a costly capital asset using internal funds.
Management has a choice of amortization policies for this asset. Management
can serve their interests by choosing the amortization policy that best matches
expenses to expected revenues, providing consistent earnings over the life of the
asset. Managements decision also serves investors interests because it provides
them with insider information through the expected future earning potential of the
asset.

Question Two (14 points)

What implications does the attached article Investors wont get fooled again (Jonathan
Chevreau, Financial Post, February 22, 2002), which discusses the investor confidence
effects of earnings management, have for accountants?
Solution
-

The article suggests that earnings management has lead to a decrease in investors
ability to trust stated net income and makes it difficult to use this information in
evaluating a firm.

In order for accountants work, especially that of public accountants, to be

meaningful investors must be able to trust accounting information. Investors
rely on accountants to provide them with useful information and the information
accountants provide is useless if investors do not have faith in the accounting
profession. The investor reluctance to rely on reported earnings reflects a mistrust
of accounting information and negatively affects the publics view of accounting
professionals. This in turn reduces the reliability of the information provided in
the financial statements.

Accountants must be aware of the potential effects that their decisions will have to
investors when setting accounting standards, auditing and preparing financial
statements.

Question Three (12 points)

Describe four motivations for earnings management.
Solution (Any four of the six listed)
1. Contractual Motivations. Earnings management may be used to take advantage
of covenants or avoid the violation of covenants in contracts. For instance,

17
managements bonuses may be structured so that they are reflective of reported
net income for the current year. As such a management may use earnings
management to raise net income in the current year.
2. Political Motivations. Firms whose actions affect many individuals may use
earnings management to reduce their visibility to the public. An example of this
would be a regulated company, such as MTS or Centra Gas, which uses incomedecreasing accruals to avoid a reduction in regulated service rates.
3. Taxation Motivations. Some countries allow the choice of accounting policies
that may lead to a lower taxable income. This is not the case in Canada; however,
in the U. S. firms have the ability to choose between the LIFO and FIFO
inventory valuation methods. Relative to the FIFO method, LIFO results in a
lower reported net income in periods of rising prices.
4. Changes of CEO. Earnings management may be used to manipulate earnings in
the manner that is most beneficial to the Chief Executive Officers goals. A CEO
may use earnings management to avoid being fired if he or she feels that a lower
net income may lead to his or her firing.
5. Initial Public Offerings. In order to receive a higher price for their shares, a firm
may use earnings management to improve current reported income. The higher
share price will allow the firm to raise more capital for an equal number of shares.
6. To communicate information to investors. The managers may use earnings
management to provide investors with the information that best reflects the future
earning potential of the firm. Earnings management can be used to reveal inside
information to investors and improve their ability to evaluate the firm.