ADMS 2500.03 WEEK 10
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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