Transcript ADMS 2500.03 WEEK 10

ADMS 4510 - SESSION 4
ACCOUNTING THEORY
OVERVIEW
Earnings management
• How it is detected
• How it is done
• Implications
Framework of accounting theory - Figure 1-1
Inside
information
Investment
decision
Regulation
- Accounting
standard
setting
Value-based
accounting
(Ideal)
Unobservable
manager
effort
Full
disclosure
Contracts
-compensation
-debt covenants
‘Hard’
Net Income
EARNINGS MANAGEMENT (EM)
Can be viewed from contracting and
financial reporting perspective
Contracting:
• EM used as low cost way to protect firm
from “consequences of unforeseen state
realizations in the presence of rigid and
incomplete contracts.” (Scott p.368)
• Example ?
EARNINGS MANAGEMENT
Financial reporting:
• EM may allow managers to affect market
value of firm’s shares
E.g. “smoothing” can communicate
inside information to the market
• How does this affect share price?
EARNINGS MANAGEMENT
Earnings MANAGEMENT or
Earnings MANIPULATION ?
Key feature of double-entry
accounting model is a strength
here:
--> ACCRUALS REVERSE
EARNINGS MANAGEMENT EVIDENCE
Research provides strong evidence that
 EM occurs
e.g. Healy 1985 Bonus plan study
e.g. tax rules like CCA remove discretion
 and may affect share prices
e.g. Bradshaw et al. 2001 (session 3)
HOW ARE EARNINGS MANAGED?
Discretionary versus non-discretionary
accruals (no cash flow)
 Amortization
 Working capital accruals
 Restructuring accruals
 Capital asset write-down
 Contigent liability accrual
HOW ARE EARNINGS MANAGED?
Discretionary versus non-discretionary
expenditures (affects cash flow)
 Advertising
 Research & development
 Capital asset investment
 Some restructuring (‘packages’)
EARNINGS MANAGEMENT
Can distinguish -
Opportunistic EM
 increases manager’s welfare
Efficient EM
 increases value of the firm,
probablility of survival, shareholders’
wealth
EARNINGS MANAGEMENT
PATTERNS
Big Bath
Income minimization
Income maximization
Income smoothing
--> the ‘COOKIE JAR’ concept
EARNINGS MANAGEMENT
CLASS DISCUSSION
Why can earnings management be
A) a good thing ?
B) a bad thing ?
Consider (apply theory):
• investors’ perspective
• economic consequences for managers and
investors
• role of Board of Directors
• game theory
• public vs. private information
etc.
EARNINGS - DISCLOSURE
What kind of earnings reporting will help
investors assess persistence ?
 full disclosure of non-recurring items
in current earnings
 effect on core earnings of past nonrecurring write-offs
ACCOUNTING RECOGNITION and
INFORMATION CONTENT
Liang article (2001)
 linking measurement perspective
(accounting practices) to information
economics
 need to relate measurement/recognition
techniques to economic decisions
 key role of accounting information is in
confirming other (perhaps less reliable)
information