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Chapter 9: Earnings management Contemporary issue 9.1 Considering earnings quality in investment decisions Questions Explain the three criteria usually considered important in assessing earnings quality. Outline two advantages to a company from having high quality earnings. Given the information you have already addressed in this chapter, what are some methods companies could use to ensure they present consistent profits? 1. The three criteria considered important in assessing earnings quality are: Trend in profit results: This related to consistency over a significant time period. Assessing trends requires analysis of how much profits vary from year to year. If profits are increasingly steadily over time the company is assumed to be a more attractive investment than a company with volatile earnings. Operating/non-operating mix: It is important to assess whether profits are generated from operations or whether they are related to abnormal items. Abnormal items are generally non-recurring, and a company should be attempting to generate most of its profits from normal operations. Earnings base: the more diversified the sources of earnings are, the more attractive an entity is likely to be. If a company earns profits across a range of geographic regions and markets it is less likely to be at risk if one of those markets fails. 2. High quality earnings provide information to analysts and shareholders about the quality of management of the company, and meets their expectations and predictions. As pointed out in the article, the better the quality of earnings, ‘the more consistently the company should be able to deliver solid results’. Quality of earnings is likely to lead to a more accurate future earnings forecast. As such it can affect company share price. 3. Entities can use a number of methods to present consistent profits. These include: Accounting policy choice – where managers have flexibility in making accounting choices, they can chose policies that manage timing differences and the amounts of expense recognition and asset valuation, for example. Accrual accounting – companies will manage accruals to generate consistent revenue and earnings growth. Income smoothing – managing fluctuations in income by shifting earnings from peak periods to less successful periods. This is also related to accrual management. Real activities management – managing operational decisions rather than accounting policies and accruals. This can relate to discretionary spending on research and development or advertising, offering price discounts to maximize sales towards the end of an accounting period etc. Review questions 9.1 Define what is meant by ‘earnings’ and outline why it is important to shareholders. Earnings is another name for net income or profit. Earnings are important to shareholders as a measure of entity performance, as they indicate the extent to which the entity has engaged in activities that add value to it. They are used by shareholders to assess managers’ performance, and to assist in predicting future cash flows and assess risk. 9.2 Explain what is meant by ‘earnings management’. Earnings management has been defined in a number of ways including: to ‘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’ from Healy and Wahlen (1999), or the more conservative definition by McKee (2005) as ‘reasonable and legal management decision making and reporting intended to achieve stable and predictable financial results’. The above definitions differ on whether normal financial decisions are part of the definition, or whether the purpose of earnings management is to mislead. 9.3 Is earnings management always bad? Explain your answer. No, earnings management is not always bad. Ronen and Yaari (2008) classify some earnings management decisions as ‘white’, referring to beneficial earnings management that enhances the transparency of financial reports. It can signal long-term value to stakeholders. 9.4 How can accounting policy choice be considered earnings management? Explain your answer. Accounting policy choices are made within a framework of applicable accounting standards. Standards provide flexibility to management in making accounting choices. These can include valuation of inventory, straight-line or accelerated depreciation etc. A choice between different accounting methods will lead to different timing of expenses, the amount of expenses that are recognized and recognition of expenses. As such accounting methods can be used to manage asset values and earnings. 9.5 What is income smoothing and how is it commonly used to manage earnings? Income smoothing moderates year-to-year fluctuations in income by shifting earnings from peak years to less successful periods. It relies on accrual accounting practices such as early recognition of sales revenues, variations in bad debts and delaying asset impairments. It is commonly used in earnings management to present consistent firm value over time and continuous growth – evidence of high quality earnings. 9.6 Why, and in what circumstances, would a management team consider engaging in big bath accounting? Big bath accounting refers to large losses reported against income. Management might consider using big bath accounting when there is a change in the management team, with the need to write-off assets or operational units that were under-performing under the previous management team. They are also used when restructuring operations, when there is a need to restructure debt, with significant asset impairment or disposal of operating units. 9.7 Provide two reasons why entities might engage in earnings management. There are two main reasons for engaging in earnings management: Earnings are managed for the benefit of the entity, including to meet analysts’ and shareholder expectations and predictions, and to maximize the value of the entity, to convey private information or to avoid violating restrictive debt covenants. To meet short-term goals which lead to maximizing managerial remuneration and bonuses. 9.8 How is earnings management related to entity valuation? A number of methods are used to value an entity including which rely on using current values to forecast future value. One of the following are commonly used: book value, operating cash flow and net income. Share prices are more highly aligned with net income than with operating cash flow, so income, or earnings, is commonly used to determine entity value. As this is very important to analysts and shareholders it leads to managers ensuring earnings are smooth, with little volatility. Earnings volatility can be an indication of the increased chance of insolvency. They want to send a message to shareholders that the firm is a strong investment. 9.9 What is ‘earnings quality’ and how is it related to earnings management? Earnings quality relates to how closely current earnings are aligned with future earnings. Current earnings, which are highly correlated to future earnings, are said to have high earnings quality and lead to a more accurate future earnings forecast. This leads to more confidence in the entity, and greater demand for shares. Because of this, managers have incentives to manage earnings to limit volatility – ensure smooth earnings and to improve earnings quality. 9.10 Explain why managers who receive a cash bonus as part of their remuneration might wish to manage earnings. Managerial bonuses are generally tied to a range of firm performance measures, including earnings. Agency theory assumes managers are self-interested and wish to maximize any financial rewards. As such, they will manage earnings, including income smoothing, accruals management and accounting policy choices to maximize earnings, and consequently their bonus. 9.11 How does the threat of corporate failure lead to earnings management? The threat of corporate failure might be evident when there is default on a debt agreement. Because a default, and subsequent threat of corporate failure is costly to the firm, earnings management may be used to assist the firm to avoid default. Firms may use earnings management to increase earnings through the use of accruals, to move any earnings based debt covenants away from a breach. 9.12 Why is corporate governance important for evaluating corporate earnings management? The board of directors is responsible for approving plans strategies and investment decisions made by the management team. How the board functions – corporate governance – is essential to the overall operation and future of the company. The constitution of the board, including their expertise and independence are important in determining how likely it is that managers are able to manage earnings. Strong governance means a balance between corporate performance and an appropriate level of monitoring. When the board fails in this role, and is seen to merely ‘rubber stamp’ managerial decisions, it is more likely that inappropriate earnings management can result. Application questions 9.13 Table 9.1 presents examples of some common accounting decisions, and how companies following a conservative, moderate, aggressive or fraudulent strategy might use these to manage earnings. Prepare a similar table and complete it in relation to the following accounting decisions: revenue recognition from services intangible assets impairment of non-current assets revaluation of non-current assets. Conservative Moderate Aggressive Fraud Revenue recognition from services Services are prepaid and performed in full Services prepaid and partially performed Services are agreed to but not yet performed Fraudulent scheme Intangible assets Regularly impair, do not revalue even in an active market Slow to record impairment losses Revalue intangibles even when no active market Overstate intangibles where non-existent intangibles are recognised Impairment of non-current assets Conservative impairment policy used Slow to record impairment losses Non-current assets are impaired but no impairment loss recorded Fictitious non-current assets recorded to bolster asset balances Revaluation of non-current assets Use cost basis of accounting Record revaluations annually using generous valuations Revalue non-current assets when no change in fair value Upwardly Revalue impaired non-current assets estimates to meet earnings targets 9.14 Examine the 2014 annual report of Qantas Airways Ltd, available at www.qantas.com.au. Review the corporate governance statement and evaluate how successful you think the board structure is likely to be in limiting earnings management. In particular, consider the board size, independence, and committees in place. Prepare a report of your findings. The corporate governance statement starts on page 38 of the annual report. This details committees, and how the company meets the ASX good corporate governance recommendations. Other information that is useful to the completion of a report on Qantas governance strategies that are likely to limit earnings management is found on pages 24-26 of the annual report – details of the board of directors, their experience and qualifications. A report should include the following information: The Qantas board is a large board, with nine members. Eight of these members are independent non-executive directors (the only non-independent executive director is the CEO Alan Joyce). A large, independent board is less likely to merely ‘rubber stamp’ decisions of the executives and the CEO so is more likely to limit the use of earnings management. The committee most relevant to earnings management is the audit committee. The audit committee of the Qantas board is comprised of four independent directors (though these directors changed during the year as a result of retirements from the board). The CEO is not a member of the audit committee. All members are financially literate. A review of their qualifications on pages 24-26 indicate that the chair is a fellow of the Institute of Chartered Accountants and is a CPA. He previously held the role of senior partner of Ernst & Young, which is likely to indicate he is well versed in appropriate accounting methods, use of accruals and income smoothing techniques. All other members have experience in finance or banking roles, meaning they are also in a position to be critical of any aggressive earnings management techniques management use. Other relevant corporate governance strategies relate to executive remuneration. The remuneration report is developed by the remuneration committee, and the report is disclosed in the financial statements of the company. It is important that it includes a range of both short-term and long-term performance targets, and they are not all linked to metrics that executives can ‘manage’ – such as earnings. 9.15 Outline the five methods discussed in this chapter that entities can use to manage earnings. Discuss the circumstances in which entities are likely to use each method. The five methods entities can use to manage earnings include: Accounting policy choice – where managers have flexibility in making accounting choices, they can chose policies that manage timing differences and the amounts of expense recognition and asset valuation, for example. Entities may choose to alter change accounting policies at a time when they change an accounting estimate (for example extending the useful life of an asset) or changing the use pattern of an asset (e.g. changing form straight line to reducing balance depreciation). If a company changes accounting policies they will need to provide the auditor with documentation to justify the decision. As such, it is more costly than accrual accounting or income smoothing. Accrual accounting – Accrual accounting techniques generally have no direct cash flow consequences. They can include recalculating impairment of accounts receivables (provisioning for bad debts), delaying asset impairment, adjusting inventory valuations, amending depreciation and amortization estimates, including expected useful life and residual values. Companies will manage accruals to generate consistent revenue and earnings growth. Income smoothing – relates to managing fluctuations in income by shifting earnings from peak periods to less successful periods. This is also related to accrual management. It can include such activities as early recognition of sales revenues, variations in bad debts or warranty provisions, or delaying asset impairments. Income smoothing is used to present the appearance of constant growth, and limit volatility in earnings. companies will manage accruals to generate consistent revenue and earnings growth. Real activities management – earnings are managed through operational decisions. This could include accelerating sales, offering price discounts, reducing discretionary expenditures, altering shipment schedules or delaying R&D or maintenance expenditures. Real activities management tends to occur throughout the year, whereas accruals management occurs at the end of the fiscal or financial year. Real activities management is less likely to draw the attention of auditors. Big bath write-offs – relates to large losses reported against income as a result of significant restructuring. This would involve selling or writing down assets. It often occurs when a new management team moves in, or when a business sells off a poor performing subsidiary or business unit. 9.16 You have recently been appointed as a researcher for a firm of share analysts. As one of your first roles you are required to prepare a report for your manager to outline common techniques used to manage or manipulate earnings. From your prior accounting knowledge you would have gained an understanding of techniques you can use to examine entity performance and profitability, including trend analysis. Document what strategies you might use as an analyst to detect earnings management using accounting information. There is a range of techniques analysts can use to examine financial data to detect earnings management. A number of these are outlined in Contemporary Issue 9.1. These can include: Examine trend in profit results – the analyst should be able to determine if profits are consistent, and growing gradually over time, or if they vary significantly from one year to the next. Analysts can also access half yearly, and sometimes quarterly data that can assist in this assessment. Is the company subject to seasonal variations? Are they meeting forecasts on a half yearly basis? Operating/non-operating mix – analysts need to determine which part of the business is generating profits. If earnings are being generated through non-recurring items such as gain on sale of fixed assets, rather than current operations, it may indicate a problem with meeting earnings forecasts and continued increases in earnings. Earnings base – analysts should examine from where the company sources earnings. If they are spread across a number of operations or sectors there is a higher likelihood of longer-term success than if the company relies on only one operation, or even one major customer. Analysts should also look at the change in debt arrangements in place, and leverage ratios. This may give an indication of earnings management being used to avoid breaches of covenants etc. Similarly, executive compensation arrangements and performance hurdles managers are required to meet to obtain bonuses are going to provide an indication of the extent to which earnings management is likely, if they are heavily based on earnings targets. 9.17 Obtain the Remuneration Report for a publicly listed company. Examine the compensation contract for the Chief Executive Officer (CEO). Document the range of remuneration components used in the CEO pay arrangements and what performance targets are used to determine both cash and equity payments. What earnings management techniques would the management team be likely to use in these circumstances to maximise their short-term and long-term remuneration? Explain your answer. A range of remuneration components and performance targets are used in the remuneration contract of CEOs. As an example, in the 2011 financial report of David Jones Ltd: The remuneration of the CEO consists of fixed pay, short term incentives and long term incentives. Page 39 of the annual report indicates that fixed pay constitutes 39%, short term incentives are 19% and long term incentives are 42%. The table on page 45 indicates the range of performance targets that the CEO and other executives need to meet to receive short term bonuses. These include: net profit after tax, capital expenditure, and costs. Long term incentives are based on: net profit after tax and total shareholder return. Given both short term and long term incentives are linked to earnings/profits there are incentives for the executive team to manage earnings to maximize these performance measures. This can include use of accruals and income smoothing. Real earnings management through, for instance, managing costs are also likely to be used. 9.18 Identify a delisted Australian company from the website www.delisted.com.au. Access the financial reports for the three years before delisting. Work in teams to determine and calculate a range of financial ratios that indicate the extent to which companies might have been affected by debt covenant violations. As a result of browsing the above website you should have been able to identify a large number of companies. One of these is A.B.C. Learning Centres Ltd, which collapsed in 2008. A search of the internet will provide access to annual reports on a number of websites. Alternatively they may be available through a range of databases normally held by university libraries, such as Aspect Huntley FinAnalysis or Connect 4. Share prices to calculate market value of equity can be downloaded from FinAnalysis if this is available to you under the ‘Charts and Prices’ tab. You could calculate the ratios used in the Altman’s Z-Score, in addition to a cash flow ratio such as operating cash flow ratio (cash flow from operations/total liabilities). For A.B.C. Learning these ratios for five years are as follows (note sales/TA has not been calculated as the firm was a service provider): Ratio 2007 2006 2005 2004 2003 Working capital/TA -26.11% 5.69% 3.21% 4.12% 1.28% Retained earnings/TA 4.24% 4.29% 4.68% 7.85% 9.14% EBIT/TA 7.13% 6.65% 6.40% 10.43% 12.12% Market value of equity/Book value of TL 1.32:1 5.88:1 2.89:1 5.67:1 4.45:1 CFO/TL 9.55% 20.8% 14.60% 17.81% 16.60% 9.19 In early March 2015, Myer changed both its CEO and CFO. Examine the financial statements of Myer for the two years before and the year after to determine if there is evidence of earnings management that could reflect an earnings bath, either leading up to or following the CEO and CFO departure. Use the information provided in this chapter to determine appropriate financial ratios to examine. Myer reports are available from http://investor.myer.com.au/Reports/. Some relevant information is presented in the table below. Importantly, is the restructuring, strategic review, brand and store costs in 2016. Ratio 2013 2014 2015 2016 EPS (cents) 21.8 16.8 13.2 8.8 Gross profit margin 41.5% 40.9 40.4 38.7 Strategic review, restructuring, store impairment ($) 0 0 0 0 9.20 While auditing the accounts of a publicly listed company you notice that some of the items have not been prepared in accordance with relevant accounting standards. On further investigation you see that this has been occurring over the past few accounting periods. None of these items are material in themselves and their combined effect is not financially material. Management of the company are aware of this practice and see it as normal management of earnings. Explain how you, as the independent auditor, should respond. The following points should be considered in formulating a response to this question: You could view an inconsequential misstatement differently from one that is more significant. The extent of judgment and interpretation of the accounting standards should also be considered. Is this an issue of interpretation, or is it misstating something where the guidance in accounting standards is clear and unambiguous? If this is the case then it should be corrected. The manner in which the misstatement arose should be considered. Regardless of whether the misstatement was material or immaterial, if this is a technique that is sanctioned by management as part of ongoing earnings management initiatives then this is not likely to be acceptable. Intentional misstatements are more important than unintentional misstatements (e.g. a clerical error) because an intentional error reflects on the integrity and reliability of management and employees. Does an immaterial misstatement affect the trend in earnings? Immaterial misstatements may in fact be material if they allow the client to avoid violation of a contractual debt agreement. Does the immaterial misstatement allow the company to meet financial analyst forecasts? Does the immaterial misstatement result in meeting the threshold for managerial bonuses where bonus compensation is based on earnings? 9.21 You have recently been appointed as a graduate accountant for a publicly listed firm. The firm is facing some temporary financial difficulties and your manager has asked you to investigate and prepare a report on what earnings management techniques the firm could carry out that would be less likely to be scrutinised by auditors, but would assist the firm meeting its earnings targets. Auditors are less likely to detect ‘real activities management’ as a form of earnings management than other types of earnings management. Some examples of real activities management are: accelerating sales, offering price discounts, reducing discretionary expenditures, altering shipment schedules and delaying research and development and maintenance expenditures. Graham, Harvey and Rajgopal (2005) report that ‘auditors can second-guess the firm’s accounting policies, however they cannot readily challenge real economic actions to meet earnings targets that are taken in the ordinary course of business’ (p. 36). 9.22 Real activities management is an increasingly common form of earnings management examined in academic literature. The paper by Graham, Harvey and Rajgopal referenced in this chapter explores the range of earnings management techniques commonly used by managers in the United States. Find this paper, read it and prepare a summary of the most common techniques used by the surveyed managers, and highlight the advantages of each technique. Method: 1. Decrease discretionary spending 2. Delay starting a new project 3. Book revenues now rather than next quarter 4. Provide incentives for customers to buy more this quarter 5. Draw down on reserves 6. Postpone taking an accounting charge 7. Sell investments or assets to recognise gains this quarter 8. Repurchase common shares 9. Alter accounting assumptions The survey points to a preference for ‘real activities’ rather than accounting techniques. In the above table real activities are numbers 1, 2, 4, 7 and 8. One CFO who was interviewed pointed out that ‘auditors can second-guess the firm’s accounting policies, however they cannot readily challenge real economic actions to meet earnings targets that are taken in the ordinary course of business’ (p. 36). Another said that since the accounting scandals uncovered at Enron and WorldCom in the early 2000s, managers go out of their way to assure stakeholders there is no accounting-based earnings management in their books. Case study questions Case study 9.1 The ethics of earnings management Questions Why would the NZSO wish to smooth income? Were the earnings management techniques the NZSO used ethical? Explain your answer. What factors would you consider when determining whether such a decision was ethical? 1. The NZSO would wish to smooth income because it needs to assure government (which provides grants) and sponsors that it is using the funds provided to it on an annual basis, and does not have a significant surplus over the medium term. This is important to ensure the continued support of these bodies for the NZSO. It is also important that the NZSO does not show large deficits in any year, as this can mean the management of the body will be questioned. 2. The earnings management techniques were not used to mislead users, by presenting financial data that was entirely inaccurate. The difficulty with having the end of the financial year finishing in the middle of a concert season means the total costs and income for the entire season are going to be spread over two financial periods. The NZSO is not using methods to hide costs or overstate profits, they are merely using methods to smooth out costs and income over the medium term in order to ensure there are no periods with a large surplus followed by another with a large deficit. As such it would appear the management techniques are ethical. 3. Some of the factors you would consider are: Are the decisions designed to mislead stakeholders? Is the management of the NZSO using funds for alternative purposes? Do costs and income align over the medium term – e.g. over two or three reporting periods? What are the reasons behind the decision to smooth income? Case study 9.2 Mastering corporate governance: when earnings management becomes cooking the books Questions What earnings management techniques are outlined in the above article? What role can the audit committee play in detecting and/or limiting earnings management? What relationship does the audit committee have with the external auditors in ensuring earnings management is within acceptable limits? 1. The article refers to both legitimate and less than legitimate techniques to manage earnings. These include: looking for loopholes in generally accepted accounting principles, earnings smoothing, accounting estimates and other discretionary judgments. 2. The audit committee needs to overview the policies used in measuring and reporting transactions, and ensure the methods used reflect a ‘true and fair view’ of the underlying transactions. They need to, identify and use their judgment to examine whether earnings management techniques are appropriate given the circumstances, whether they are legitimate, or whether they in fact obscure the true financial position of the company. 3. The audit committee appoints the external auditors and ensures they are independent. The external auditors will examine the policy and processes the audit committee uses to assure the truth and fairness of the financial information they are auditing. The audit committee represents the company in any dealings with the external auditors, and need to be in a position to answer any of their questions and provide justification for any earnings management techniques used. Solution Manual for Contemporary Issues in Accounting Michaela Rankin, Kimberly Ferlauto, Susan McGowan, Patricia McGowan 9780730343530
