Earnings Management

1
Earnings Management

2
Class Announcements

• Assignment 5 is due November 29th available
  online early next week.
• Research paper Part 4 is due November 27th
• Research Paper Part 3 returned next class
• A Frank McKenna Centre for Leadership Encounter
  Health For Everyone An evening seminar, at 7
  p.m., November 19th will discuss resilience and
  health for Aboriginal youth and families

3
Research Paper Part 4

• Discuss relationship to accounting theory - e.g.
  information perspective, measurement perspective,
  agency theory, positive accounting theory, etc.
  (pick one theory and apply to Handbook section)
• Due November 27, 2012
• Worth 2.5
• Length One page submission (double spaced) with
  Part1, Part2, Part3 and Marking Keys 1,
  Part2 Part3 attached to the back. Requires a
  cover page, concluding paragraph, and one
  bibliography for all. Only ID

4
Class Objectives

1. Consider possible set of earnings management
   techniques
2. Investigate the set and frequency of earnings
   management techniques used in real settings

5
Earnings Management

• Earnings management occurs when managers use
  judgment in financial reporting and in
  structuring transactions to alter financial
  reports to either mislead some stakeholders about
  the underlying economic performance of the
  company to influence contractual outcomes that
  depend on reported accounting numbers (Healy and
  Wahlen 1999, p. 368)
• Earnings management is the choice by a manager
  of accounting polices, or real actions, affecting
  earnings so as to achieve some specific reported
  earnings objective. (p. 423)

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Earnings Management Techniques

• Revenue Recognition
• Accounting Policy Change
• Timing of Adoption of New Standards
• Writeoffs, Provisions, Etc.
• Accruals (Discretionary)
• Direct Charges to Retained Earnings

7
Earnings Management Understanding

1. Regulators an standard setters identify areas
   most in need of regulatory change
2. Auditors evaluate and report on their clients
   quality of earnings, and train novice auditors
   about earnings management
3. CEOs, CFOs, audit committees and investors
   focus attention on those areas of the financial
   statements where they should be most skeptical
4. Managers and audit committees anticipate the
   transaction that investors will view most
   skeptically
5. Educators teach students about earnings
   management
6. Researchers focus their analysis on areas of
   high-earnings management activity

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Earnings Management Techniques Nelson et al
(2003)

• Aggressive earning management has been of concern
  to regulators for several years
• There exist little systematic research concerning
  the specific methods by which earnings management
  is attempted.
• Nelson et al (2003) tried to capture the types of
  earning management and the impact on net income
  through a survey to 532 auditors (partners and
  managers).

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Earnings Management Techniques Nelson et al
(2003)

• Expenses Other losses recognizing too much or
  too little reserve in the current year.
• Revenue Other gains approaches include cutoff
  manipulation, deferring to much or too little
  revenue , etc.
• Business Combinations over or understatement
  assets with the charge to goodwill
• Other approaches approaches include income
  statement classification issues, inappropriate
  disclosures, off balance sheet financing, etc.

10
Earnings Management Techniques Nelson et al
(2003)
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Case St. John Cruises Inc.

• Split into two groups
• 1) Compensation Committee members
• 2) Executive members
• Address
• 1. Calculate the impact of the suggested changes
  on income
• 2. Respond to each suggestion
• 3. Calculate net income to be used for bonus
  determination