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9.403 Lesson Summary
Chapter 11 Earnings Management
Lesson Preparation Project
Chapter 11: Earnings Management
11.1 Overview
“Earnings management is the choice by a manger of accounting policies so as to
achieve some specific objective”
There are two ways to think about earnings management: as an opportunistic behaviour
by managers to maximize their utility and from an efficient contracting perspective.
Issues arise in regards to earnings management due to the choice of accounting policies,
discretionary accruals, and finally the line where management becomes mismanagement.
11.2 Evidence of Earnings Management for Bonus Purposes
In 1985 earnings management was researched to see if managers would manage net
income so as to maximize their bonuses under their firm’s compensation plans. Healy
examined firms whose compensation plans are based on current reported net income
only, this is also known as bonus schemes. With a typical bonus scheme, reported net
income will have a lower bound called bogey and upper bound called cap. A manager’s
bonus will increase as reported net income increases, unless there is a cap at which point
the bonus will remain the same as net income continues to increase beyond the cap. A
manager will not receive any bonus when income is below the bogey. Healy predicted
that when net income is between the bogey and cap is the manager motivated to adopt
accounting policies to increase reported net income. Net income that is below the bogey
or above the cap would motivate managers to “take a bath” whereby they will try to
reduce or minimize net income. By taking a bath below the bogey, managers will then
increase the probability of receiving a bonus the following year since current write-offs
will reduce future amortization charges. Likewise, managers would take a bath (to a
lesser extent) to decrease net income since a bonus would be permanently lost on
reported net income greater than the cap.
One way managers may manage net income is by the controlling of various accruals.
Accruals such as accounts receivables, inventory, accounts payable and accrual liabilities
are discretionary in that they allow for some flexibility by management to control. For
example, a manager may decide to become more optimistic about warranty claims on its
products its current year than in previous years to decrease the accounts payable and
accrual liabilities thereby increasing reported net income. This in turn would be difficult
for an auditor to discover as part of earnings management since the technique just
described falls within GAAP.
Given that Healy did not have access to the books and records to view the specific
discretionary accruals made by firm managers, Healy examined the total accruals of 94
industrial companies from the period of 1930-1980 of which 447 observations of firm
years contained a bogey and a cap, Healy found empirical evidence supporting his
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predictions. That is, firm managers whose net incomes are below the bogey and above
the cap will tend to adopt income decreasing accruals and only managers with net income
between the two will tend to adopt income-increasing accruals.
A second way for managers to engage in earnings management is the changing of
accounting policies. Healy believed that managers would change accounting policies just
after an introduction or amendment of a bonus plan. For example, a manager may be
motivated at that time to adopt an income-increasing accounting policy change if a period
of healthy earnings is forecasted. From the same sample as his previous study, Healy
examined 242 accounting policy changes over the 12 years 1968 to 1980 for which the
effect of net income could be determined and divided them into two portfolios. One
consisted of firms that adopted or modified their bonus plan in the year and the other
consisted of firms that did not. Healy found that in 9 of the 12 years, the portfolio of
firms with bonus plans changes had more accounting policy changes. This provides
significant evidence that managers also use such changes as an earnings management
vehicle.
11.3 Other Motivations for Earnings Management
11.3.1 Other Contractual Motivations
Contractual motivations: the incentive of earnings management (EM) arises from
contracts between the firm and its managers that set forth the basis of managerial
compensation.
Long-term contracts normally contain covenants to protect the lenders from the actions of
managers. EM for covenant purposes is predicted by the debt covenant hypothesis of
positive accounting theory (PAT). Covenant violations can impose heavy costs so EM
can arise as a device to reduce the probability of covenant violation.
Sweeney (1994) found greater use of income-increasing accounting changes relative to a
control sample and defaulting firms tended to undertake early adoption of new
accounting standards when these increased reported net income. DeFond and Jiambalvo
(1994) found firms using discretionary accruals to increase reported income in the year
prior to and in the year of the covenant violation.
DeAngelo, DeAngelo, and Skinner (1994) found somewhat different results. Rather than
firms using accruals to manage earnings upwards, they were exhibiting large earningsreducing accruals.
11.3.2 Political Motivations
Many companies are quite politically visible and may manage earnings to reduce their
visibility, achieved through accounting practices and procedures to minimize reported net
income, especially in highly prosperous periods. If they do not, public pressures may
lead to increased government regulation or other means to lower profitability. This
motivation underlies the size hypothesis of PAT.
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Jones (1991) found use of greater income-decreasing accruals during the year of ITC
investigation than in years outside the investigation. Cahan (1992) found that firms under
investigation for monopolistic practices used more income-decreasing accruals during
investigation years relative to other years sampled.
11.3.3 Taxation Motivations
Taxation authorities impose their own accounting rules for calculation of taxable income,
reducing the firm’s ability to manoeuvre. Taxation should not play a major role in EM
decisions in general. An exception occurs with respect to the choice of LIFO versus
FIFO inventory method. During periods of rising prices, LIFO will usually result in lower
reported profits and lower taxes, relative to FIFO.
Much PAT research has tried to explain and predict firms’ inventory policy choices.
Dopuch and Pincus (1988) reported evidence that tax savings are high for LIFO firms and
that firms keep using FIFO do not suffer large tax consequences, for reasons including
low amounts of inventory, high variability of inventory levels, high inventory turnover,
and low effective tax rates.
11.3.4 Changes of CEO
The bonus plan hypothesis predicts that CEOs approaching retirement would be
particularly likely to engage in a strategy of income-maximization. CEOs of poorly
performing firms may income-maximize to postpone termination. This motivation also
applies to new CEOs, especially if large write-offs can be blamed on the previous CEO.
Murphy and Zimmerman (1993) (MZ) examined the behaviour of four discretionary
variables: research and development, advertising, capital expenditures, and accruals. MZ
found that reducing R&D, advertising, and capital expenditures might be effective to
increase current earnings but can potentially be quite costly. The accrual and accounting
policy variables are less costly, since for the most part they are strictly paper devices.
These studies face difficult methodological problems. (1) Could be difficult to tell
whether lower discretionary variable values are due to EM or poor operation
performance. (2) Could be difficult to tell whether any apparent EM is due to the new
CEO or the old.
It is possible that some managers use EM successfully to avoid termination. DeFond and
Park (1997) found evidence of managers’ use of discretionary accruals to “borrow”
earnings from future periods when future earnings are expected to be relatively good and
“save” current earnings when future earnings were expected to be relatively poor.
Consequently, income smoothing to avoid reporting poor earnings enhances job security.
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11.3.5 Initial Public Offerings
Firms making initial public offerings (IPOs) do not have an established market price,
which raises the question of how to value the shares. Evidence found by Clarkson,
Dontoh, Richardson, and Sefcik (1992) raises the possibility that managers of firms going
public may manage the earnings reported in their prospectuses in the hope of receiving a
higher price for their shares.
Friedlan (1994) concluded that IPO firms did indeed make income-increasing
discretionary accruals in the latest period prior to the IPO, relative to accruals in a
comparable previous period. Accrual management seemed to be concentrated in the
poorer-performing sample firms and in the smaller sample firms.
11.3.6 To Communicate Information to Investors
Earnings management used to communicate information to investors may seem
questionable in view of efficient securities market theory. However, markets are only
efficient in terms on publicly available information so if earnings management can reveal
inside information, it can actually improve the informative nature of financial reporting.
Management has the best (inside) information about future earnings prospects. So,
responsible use of EM can increase the main diagonal probabilities of the information
system.
11.4 Patterns of Earnings Management
1. Taking a Bath
 Can take place during periods of organizational stress or reorganizations
 If a firm must report a loss, management might think it is beneficial to
report a large loss, which will enhance the probability of future profits.
 May also occur when net income is below the bogey of the bonus plan; it
may enhance the probability of future bonuses.
2. Income Minimization
 May be chosen by a politically visible firm during periods of high
profitability
 Policies that include income minimization: rapid write-offs of capital
assets and intangibles, expensing of advertising and R&D, successfulefforts, etc.
3. Income Maximization
 Managers may do this for bonus purposes if it does not put them over the
cap
 May occur when firms are close to debt covenant violations
4. Income Smoothing
 So that they don’t lose bonuses or so that they can reduce the chance of
being fired, managers have incentive to smooth income so it remains
between the bogey and the cap
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 To reduce volatility of reported net income so as to smooth covenant ratios
 For external reporting purposes
11.5 Is Earnings Management “Good” or “Bad”?
“Whether earnings management is good or bad depends on how it is used”
There are various examples of why earnings management is good and why it is bad, but
as with other accounting issues there are tradeoffs and no definitive answer. In this case,
earnings management may increase the relevance of the publicly available information
due to the increased availability of information previously limited only to insiders. At the
same time, the information lacks reliability due to the presence of management bias.
11.6 Stock Market Reaction to Earnings Management
Does the market react to earnings management information as if it were good or bad?
Sburamanyam (1996) separated accruals into discretionary and non-discretionary
components and found that the stock market responded positively to discretionary
accruals, consistent with managers, using earnings management responsibly to reveal
inside information about future earning power.
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Quiz
The quiz consists of 5 multiple-choice questions (5 marks), 3 short answer questions
(9 marks), and one long answer question (6 marks)
Multiple Choice (5 minutes)
1. Healy found empirical evidence supporting his predictions. Which of the following
did he find?
a) Firm managers whose net incomes are above the cap will tend to adopt
income-decreasing accruals
b) Firm managers whose net incomes below the bogey will tend to adopt
income-increasing accruals
c) Firms managers with net incomes between the bogey and cap will tend adopt
income-increasing accruals
d) A) and C)
e) All of the above
2. Which one of the following is not one of the ways a manager can manage net
income?
a) Changing accounting policies.
b) Increase or decrease inventory
c) Controlling various accruals
d) All of the above
e) None of the above
3. Managers are motivated to manipulate income with earnings management. Which of
the following is a (are) reason(s) for them engaging in this kind of behaviour?
a) Reduce the probability of covenant violation
b) Reduce the companies visibility
c) Raise price of initial public offering
d) All of the above
e) None of the above
4. Income maximization is one of the earnings management patterns that managers
employ. Which of the following is an (are) other earnings management pattern(s) that
managers engage in?
a) Income smoothing
b) Income levelling
c) Taking a bath
d) A) and B)
e) A) and C)
f) None of the above
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5. Which of the following is (are) not true regarding earnings management?
a) Earnings management increases reliability of financial statements
b) Earnings management reflects the desires of management rather than the
performance of the company
c) It is cost effective for others to attain insider information that is revealed in
earnings management
d) A) and B)
e) A) and C)
f) None of the above
Short Answer (10 minutes)
1. Explain why earnings management is difficult for an auditor to discover.
2. One reason for managers to engage in earnings management is to communicate
information to investors. Explain how this can be viewed as a good thing by
relating your answer from the rational investor perspective.
3. Besides a bonus scheme, list the other reasons that would motivate managers to
engage in earnings management.
Long Answer (15 minutes)
From previous readings and the following article, Twenty Pressures to Manage Earnings,
discuss the pressure to manage earnings and why earnings management can be viewed as
both good and bad.
Twenty pressures to manage earnings
The CPA Journal;
New York; Jul 2001; James R Duncan;
71
7
32-37
07328435
Earnings
Financial reporting
Corporate culture
Problems
Financial statements
Classification Codes: 9190: United States
4120: Accounting policies & procedures
Geographic Names: United States
US
Abstract:
Volume:
Issue:
Start Page:
ISSN:
Subject Terms:
SEC Chairman Arthur Levitt's attack on corporate earnings management turned up
the heat on the quality of financial reporting that underpins the success of US capital
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markets. The results so far have included an examination of the audit process for
public companies, stronger guidelines for corporate audit committees, and 3 staff
accounting bulletins to circumscribe interpretations of materiality, guide restructuring
and impairment charges, and restrict improper revenue recognition. Increasing
awareness of earnings management will promote its identification and treatment and
enhance financial statement users' trust in the accounting system.
Full Text:
Copyright New York State Society of Certified Public Accountants Jul 2001
[Headnote]
A Cluster of Contributing Factors
SEC Chairman Arthur Levitt's attack on corporate earnings management turned up the heat on the quality of
financial reporting that underpins the success of U.S.capital markets. The results so far have included an
examination of the audit process for public companies, stronger guidelines for corporate audit committees, and
three staff accounting bulletins (SAB) to circumscribe interpretations of materiality, guide restructuring and
impairment charges, and restrict improper revenue recognition.
Studies show that, rather than having a single cause, earnings pressure results from multiple factors in a
company's environment culture, or management and can lead to erosion in the quality of financial reporting.
Increasing awareness of earnings management will promote its identification and treatment and enhance
financial statement users’ trust in the accounting system.
[Illustration]
Caption:
Since SEC Chairman Arthur Levitt's "Numbers Game" speech before the NYU Center for
Law and Business in September 1998, earnings management has been the focus of
regulatory attention. Levitt attacked accounting "hocus-pocus" as a serious threat to the
viability of the financial reporting that underpins the U.S. capital markets. His speech
contained a nine-point attack on earnings management and provided the impetus for three
new Staff Accounting Bulletins (SAB; see Sidebar), a report from the Public Oversight
Board's (POB) Panel on Audit Effectiveness, and new recommendations from the Blue
Ribbon Panel on Improving the Effectiveness of Corporate Audit Committees.
Levitt defined earnings management as practices by which "earnings reports reflect the
desires of management rather than the underlying financial performance of the
company." Companies use various devices to influence earnings outcomes, including
"big bath" charges, "cookie jar" reserves, and the abuse of materiality and revenue
recognition principles. These practices tend to erode the quality of earnings and financial
reporting and deceive financial statement users.
A 1998 Business Week poll reported that 12% of CFOs had managed earnings at the
request of their superiors and an additional 55% of CFOs said they were asked to manage
earnings but refused to do so. According to CFO Magazine (September 1999), 60% of
CFOs have felt pressure to manage earnings. This pressure is often most strongly felt by
those in middle management, including controllers and divisional personnel. This
author's own research ("Investigating Behavioral Antecedents of Earnings Management,"
Research on Accounting Ethics, v.6) found that earnings pressure was by far the most
significant factor affecting earnings management behavior.
Pressure to manage earnings does not stem from a single source. Pressure to influence
reported results can arise from forces outside the company, from conditions and programs
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within the company, or from motivations held by individuals that choose to engage in
earnings management activity.
External Forces
Analysts' forecasts. Companies that fail to reach analysts' estimates for multiple quarters
can see their stocks drop precipitously. When Procter & Gamble warned that it would not
meet analysts' consensus forecast in the first quarter of 2000, its stock price fell 30%.
When P&G issued further warnings just before the end of the second quarter of 2000, the
stock price fell another 10% and P&G's CFO was fired. As reported in CFO Magazine
(December 1998), one CFO told SEC Chief Accountant Lynn Turner that when the CFO
warned an analyst that the company might just miss consensus estimates, the analyst told
him, "You're a bright guy; you'll figure out how to make it."
Access to debt markets. Many companies depend on financial leverage in optimizing
returns to stakeholders. To establish a business's creditworthiness, debt rating agencies
use much of the same information as stock analysts. A slight drop in earnings or negative
expectations about future prospects could cause a decline in a company's debt rating,
increasing its cost of capital and diminishing prospects for new debt issues.
Competition. Companies in highly competitive industries may want to maintain an edge
in revenues or market share. In 1998, Sensormatic Electronics, a maker of security
systems, actually stopped its clocks, which stamped shipping dates and times on finished
products, 15 minutes before noon on the last day of a quarter, so it could continue to
make customer shipments within the quarter until it had reached its sales target. The SEC
brought charges and Sensormatic settled without admitting or denying misconduct.
Contractual obligations. Many debt and lease agreements, as well as other contractual
arrangements, contain covenants in which a company agrees to attain certain earnings,
debt, or other ratios, or limit payments to shareholders. When a company is in danger of
missing one of the covenants, the agreement may provide for immediate repayment or
other specified performance. Manipulating earnings slightly can improve ratios enough to
avert such dangers.
Roaring stock market. A red-hot stock market continues upward pressure on investor
expectations and companies to achieve those outlooks. To support rising stock prices,
firms could risk the improper recognition of revenues by recording false sales, shipping
products before customers agree to buy, and recording up-front revenue from long-term
contracts. Some observers say this pressure is strongest in the technology sector.
According to National Economic Research Associates, in the first half of 1999 more than
50% of securities fraud lawsuits involved improper revenue recognition practices,
compared to 20% for the preceding year.
New financial transactions. Emerging financial instruments (e.g., derivatives) allow room
for discretion in accounting treatment. Accounting guidance specifies treating derivatives
as hedges or speculative transactions, depending on facts and management intent and
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capability. Authoritative guidance for derivative accounting is complex, and different
entities with similar derivatives might document these transactions in a wide variety of
ways in order to obtain favorable outcomes. For software companies, another significant
decision is when to treat large investments in software development as an asset.
Market disregard of big charges. The financial markets seem conditioned to disregard big
nonoperating charges, thereby providing incentive for managers to make them as big as
possible. Frequently, earnings announcements quote numbers "before one-time items."
Warren Buffett cites an R.G. Associates 1998 compilation of charges recorded for
restructuring, in-process research and development, merger-related items, and writedowns. The list totaled more than 1,300 charges aggregating more than $72 billion.
Company Cullum
Merger attractiveness. Good financial performance can enhance the attractiveness of
merger target companies. Prior to the merger of HFS Incorporated and CUC International
into Cendant Corporation, certain business units of CUC engaged in accounting
irregularities that inflated company revenues by nearly $500 million. When the situation
came to light, Cendant restated earnings and agreed to change its revenue accounting
practices. Cendant's stock price and reputation suffered in the process, and several
members of its board of directors resigned.
Management compensation. Companies frequently tie executive stock option and bonus
programs to earnings performance, attempting to align management's objectives with
ownership's but also creating powerful incentives for managers to manipulate earnings to
achieve compensation payouts. Some companies even increase the pressure by lending
money to employees for the purchase of company stock. Last year, Conseco, Inc., an
Indiana-based financial services company, guaranteed about $600 million in employee
loans to purchase its stock. This practice can create pressure to meet optimistic earnings
projections intended to maintain the stock price.
Short-term focus. Inevitably, some companies focus on short-term performance
regardless of the future. Austerity programs are implemented, investment spending is
delayed, and employees are fired to achieve a short-term earnings goal while
undermining long-term performance. Occasionally, firms will defer or capitalize
expenditures that should be expensed. A few years ago, America Online recorded a $385
million charge because it had inappropriately deferred marketing expenses; the charge
wiped out all of AOL's earnings to that point.
Unrealistic plans and budgets. Companies sometimes establish unrealistic annual plans
and budgets to push managers to overachieve. One such company consistently establishes
internal plans 20% over the previous year, regardless of economic or business factors.
The idea is solid: Unless the bar is set high, managers won't try to jump it. Setting
budgets beyond the achievable, however, encourages managers to fudge the numbers to
get as close as possible.
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Period-end requests from superiors. A significant pressure to manage earnings often
derives from corporate superiors requesting that division personnel provide additional
profit to meet quarterly and year-end targets. The late-quarter phone call asking, "What
else can you do?" provides a cultural incentive for managers to learn to play the earnings
game.
Excessive profit followed by fear of decline. Some companies fear that a famine will
follow feast years. W.R. Grace & Co. held back excess earnings from a medical
subsidiary to create a $60 million reserve to smooth earnings over future, less profitable
years. Grace used "materiality" to convince auditors that adjustment of the reserve was
not required. Upon SEC investigation, Grace was fined, cease-and-desist orders were
filed against two auditors, and civil charges were brought against the CFO.
Concealing unlawful transactions. Companies fear that disclosing unlawful transactions
will damage their reputations. Companies and individuals can use earnings manipulation
practices to cover up embezzlement, fraud, misappropriation, and bribery. ZZZZ Best
Company, Inc., went to great lengths to create a paper trail of false transactions to cover
for a lack of business. The CEO even issued a press release reporting record profits just
before his schemes unraveled and the company collapsed.
Personal Factors
Personal bonuses. Company executive compensation policies are frequently weighted
more heavily toward incentives than a base salary. With a few good years, individuals
can establish their personal finances for retirement. The prospect of a giant bonus may
provide sufficient motivation to fudge a few accounting numbers.
Promotions. Some individuals will do whatever it takes to get the next promotion. Their
obsession with climbing the corporate ladder engenders behavior that will shed the best
light on their actions. The combination of personal ambition and a corporate tendency to
reward the "best" performers can create an incendiary situation.
Focus on team. In a company that stresses a team culture, "team players" receive the
promotions and raises. Often, the financial team has the greatest opportunity to impact
reported results at the last minute. Individuals striving for team success can undermine
financial reporting by making the late adjustments that will achieve financial targets.
Job retention. In the 1990s, downsizing became the preferred method for cutting costs
and enhancing profitability. When companies struggle to meet expectations, managers of
under performing areas risk losing their jobs. A little judicious earnings manipulation
could improve the profit picture and keep a manager's position secure.
Hero or turnaround specialist. Individuals can be motivated to manage earnings in order
to be viewed as heroes or turnaround specialists. Sunbeam hired Al Dunlap to reverse
their performance trends, but some have alleged that he pursued "accounting gimmicks"
as part of his efforts to improve company performance. Dunlap resigned in 1998 after the
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start of an SEC investigation, and the company subsequently restated results for 1997 and
part of 1998.
Low regard for auditors. In Rewarding Results, Kenneth Merchant indicated that
managers have a low opinion of an auditor's ability to detect earnings management. In
large companies, almost nothing in an individual division is material to the overall
financial statements; consequently, managers believe they can manipulate earnings in
ways that an auditor will not detect. Some managers believe that even if the manipulation
is detected, they can invent a satisfactory justification. In this author's experience,
likelihood of detection was the least significant factor in a manager's decision to engage
in earnings management practices.
Interaction of pressures. Earnings management can also be the product of interaction
between various pressures. The external and company-culture forces may have greater
effects on managers overly concerned with compensation or job security. Conversely, a
company culture that respects genuine and ethical achievement is less likely to encourage
managers to respond to external pressures in inappropriate ways. In any situation, factors
in all three categories must be evaluated in order to understand the pressures that lead to
earnings management.
Is There an Upside?
Many of the pressures that can lead to earnings management have positive aspects as
well:
* Analysts and debt rating agencies provide valuable services to investors and creditors
by absorbing and summarizing volumes of financial information in easy-to-understand
formats.
* Investors seeking to use historical results to predict future performance should ignore
legitimate nonrecurring charges.
* Management compensation structures and team focus can be effective tools to align
manager objectives with those of other stakeholders.
* Downsizing and cost-reduction programs can be a necessary belt-tightening for
companies that have built unnecessary layers of bureaucracy.
Some observers even declare that a certain amount of earnings management is good for
companies and individual stakeholders, based on a belief that companies should make
operating decisions that propel long-term performance by sometimes deferring spending
or taking one-time charges that benefit the future. Actions that manipulate perceptions
but have no lasting impact-actions solely directed toward controlling the decisions of
financial statement users-may, however, cross the line.
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The initiatives that have followed in the wake of the "Numbers Game" mark the start of
addressing the problem of earnings management. Nevertheless, one cannot help but think
these actions will fall short in creating the environmental, corporate, and individual
cultures necessary to reverse the erosion of quality in financial reporting. If we are to
fully understand the phenomenon of earnings management, we must comprehend the
pressures that lead to this behavior. If financial statement users understand the existence
of these pressures, they have the opportunity to adjust their decisions accordingly. 0
[Sidebar]
SUMMARY OF SABs 99, 100, 101
[Sidebar]
Staff accounting bulletins (SAB) are intended to describe the SEC staffs interpretation of existing GAAP, not
develop new or modified GAAP. All SABs are available online at www.sec.gov.
[Sidebar]
To mitigate earnings management by public companies, the SEC issued three SABs in 1999: SAB 99, Materiality
(August 12, 1999); SAB 100, Restructuring and Impairment Charges (November 24, 1999); SAB 101, Revenue
Recognition (December 3, 1999).
The SEC believed public companies focus their earnings management activity in these three areas. SAB 101 was
so sweeping in its implications that the SEC twice deferred its effective date in response to requests from
companies and auditors.
Materiality. Under SAB 99, companies cannot rely exclusively on numerical thresholds to ascertain the materiality
of an item. The SEC claimed that many companies and auditors had developed a practice of declaring items to be
immaterial merely because they were less than 5% or 10% of a particular financial statement amount.
Furthermore, SAB 99 indicates that misstatements are not immaterial and must be corrected.
Materiality decisions incorporate both quantitative and qualitative factors. Qualitative factors may render even
small amounts material. The qualitative factors to be considered include
[Sidebar]
* whether the item is capable of precise measurement;
* whether a misstatement distorts financial trends;
* whether a misstatement covers the failure to meet analysts' earnings forecasts;
* whether a misstatement produces income when a loss might otherwise exist;
* whether a misstatement affects compliance with loan covenants or regulatory requirements, or conceals an
unlawful transaction; and
* whether a misstatement increases management compensation.
Managing earnings to a specified target could be considered a violation of SAB 99's materiality requirements. SAB
99 also urges caution in aggregating or offsetting known misstatements. Known misstatements should not be
recorded, and known errors should be corrected.
Restructuring and impairment charges. SAB 100 describes accounting and disclosures for employee termination
costs and impairment costs associated with restructurings and business combinations. The SEC believed that
these areas are susceptible to earnings management.
In a purchase business combination, liabilities for product warranties and environmental costs of the acquired
company should be recorded at fair value. If the acquired company did not follow GAAP in establishing those
liabilities, the correction should not be made as a part of the purchase price allocation; rather, it should be made
to the historical financial statements of the acquired company. In addition, including "cushions" to such liabilities
in the purchase price allocation is inappropriate.
Accrual of employee severance and other exit costs pursuant to a restructuring plan should not be made until a
detailed plan exists and management at the appropriate authority level approves the plan. A detailed plan must
include specific actions and timetables, and the effects of the plan's actions must be reasonably estimable. The
exit plan must be contemplated within a time period that makes significant changes unlikely. Exit costs should
[Sidebar]
* not relate to any continuing activities;
* not contribute to any future revenues;
* be an incremental and direct result of the exit plan or incurred under a continuing contractual obligation with no
economic benefit or be a penalty for cancellation of a commitment.
Regarding impairment charges, SAB 100 describes the elements of a plan to dispose of assets, which are similar
to the elements required for a plan to discontinue operations. The SEC staff will challenge impairment charges
when a company
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[Sidebar]
has failed to evaluate and adjust useful lives and residual values of long-lived assets. SAB 100 provides guidance
for evaluation of the impairment of enterprise level goodwill and gives the staff s interpretation of cash flow
estimates used in assessing and measuring impairment losses.
Revenue recognition. SAB 101 provides guidance on revenue recognition issues. The bulletin cites a study
sponsored by the Committee of Sponsoring Organizations (COSO; "Fraudulent Financial Reporting: 1987-1997:
An Analysis of U. S. Public Companies," March 1999) indicating that one-half of financial reporting frauds involve
overstated revenue. SAB 101 discusses accounting for the following:
* Bill-and-hold transactions,
* Up-front fees with seller continuing involvement,
* Long-term service transactions,
* Refundable membership fees, and
* Contingent rental income.
In general, revenue should be recognized only when realized or realizable and earned. The SEC staffs consider
that all of the following conditions must be met:
* Persuasive evidence of an arrangement exists.
* Delivery has occurred or services have been rendered.
* The seller's price is fixed or determinable.
* Collectability is reasonably assured.
The SAB provides SEC staff guidance for the following issues:
[Sidebar]
* Execution of a written sales agreement;
* Recognition involving bill-and-hold arrangements, layaway transactions, nonrefundable up-front fees, and setup fees;
* The effects of side agreements, customer cancellation provisions, refundable membership fees, and contingent
lease arrangements on a fixed or determinable price; and
* The recording of revenue when a company acts as an agent or broker in a transaction.
Companies must include their revenue recognition policies in the footnotes to financial statements. In addition,
management's discussion and analysis (MD&A) must discuss any unusual or infrequent revenue transactions that
would help in understanding revenue results and trends. The SEC staff will not object if the accounting
interpretations in the SAB have not been followed in the past, provided that the company reports a change in
accounting principles. Companies that have not complied with GAAP in the past should account for the change as
a prior period adjustment for the correction of an error.
Deferral of SAB 101. The original effective date for SAB 101 was years beginning after December 15, 1999, even
though the bulletin was only issued December 3, 1999. Companies and auditors complained that SAB 101
effectively changed historically accepted revenue recognition practices and asked for more time to study and
evaluate the effects of the interpretations. The SEC initially deferred the effective date to fiscal years beginning
after March 15, 2000.
In June 1999, the Financial Executives Institute (FEI) Committee on Corporate Reporting, in a letter to SEC Chief
Accountant Lynn Turner, urged the SEC to further delay the effective date of SAB 101 until the fourth quarter of
2000. FEI said that its members needed more time to study and implement the provisions of the bulletin,
because its implications were more significant than anticipated. The FEI also main
[Sidebar]
tained that SAB 101 effectively changed accepted recognition practices, an action that would have been better
addressed by the FASB through due process.
After agreeing to defer SAB 101 until the fourth quarter of 2000, the SEC issued a question-and-answer
document ("SAB 101: Revenue Recognition in Financial Statements-Frequently Asked Questions and Answers,"
October 12, 2000) in response to inquiries from auditors, preparers, and analysts about applying SAB 101 to
specific transactions. The document addresses 31 questions on eight topics. LI
[Author note]
James R. Duncan, PhD, CPA, is an assistant professor of accounting at Ball State University, Muncie, Ind. From
19 76 to 1985 he practiced public accounting with Ernst & Young, and from 1985 to 1993 he was vice president
and controller of KFC Corporation.
Reproduced with permission of the copyright owner. Further reproduction or distribution is prohibited
without permission.
Page 14 of 16
9.403 Lesson Summary
Chapter 11 Earnings Management
Answer Key
Multiple Choice
1. d
2. e
3. d
4. e
5. e
Short Answer
1. The controlling of many discretionary accruals by management to report net
income are within the rules of GAAP, therefore it is difficult for auditors to object
to any kinds of techniques used on discretionary accruals that could be suspicious
of earnings management.
2. A rational investor’s will use current earnings information to determine what the
future performance of a firm will be. Earnings management can be used by
managers to report earnings that reflect their best estimates of a firm’s earning
power. Since managers know the inside information of a firm, and assuming the
earnings reported by management should reflect that, if this is realized by the
market, the share price will quickly reflect the inside information. Therefore
earnings management if used responsibly can seen as increasing the main
diagonal probabilities of the information system and hence the quality of the
information.
3. Other Contractual Motivations
Political Motivations
Taxation Motivations
Changes of CEO
Initial Public Offerings
To Communicate Information to Investors
Long Answer
* Answers will vary, points awarded for presentation of both good and bad aspects and
incorporation of both article and text book material
Possible Arguments: Good vs. Bad



Considered bad because of decreased reliability of financial statements due to
management bias
As described by Levitt, “reflects desires of management rather than the
underlying financial performance of the company”
It is costly for others to attain insider information that is revealed in earnings
management
Page 15 of 16
9.403 Lesson Summary



Chapter 11 Earnings Management
It is desirable to give managers some ability to manage earnings under efficient
contracting when they are dealing with incomplete and rigid contracts
The best net income for contracting need not be the same as the most useful net
income for informing investors
According to Dye’s model: A manger acting on behalf of the current shareholders
has an ability and incentive to manage earnings so as to maximize the selling
price received by the current shareholders effectively minimizing its cost of
capital
Possible Discussions: Pressures to manage earnings

Meeting analyst’s forecasts and the dependence on financial leverage: If a
company does not meet expectations, their debt rating may be affected as well as
their prospects for new debt issue

Contractual obligations: when a company is in danger of missing one of the
covenants a company may manipulate earnings to improve ratios

A rising stock market may put upward pressure on expectations and on companies
to reach these outlooks

Compensation: when a manager’s compensation is tied to the earnings of the
company there may be incentive to manage earnings

Unrealistic expectations: sometimes setting goals that are unachievable may
pressure managers to manage earnings

Bonuses, Promotions, Job Retention: when the manager has a personal tie to the
earnings there is incentive to manage the earnings
Page 16 of 16