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Earnings Management and Accrual Accounting

Contents (Jump to)
Motivations for Earnings Management
11 Groups to Manage Earnings
Modified Jones Model
Limitations of the Earnings Management Models
Implications and Application of Earnings Management
There has been significant attention placed on earnings management from regulators, the financial press, and academic researchers in recent years. Most are in agreement that earnings management does occur; however, there is no uniform definition for what it is or how to detect it.
What are earnings and what is earnings management? Simply stated, earnings are the accounting profits of a company. Stakeholders (current or potential providers of debt and equity capital, employees, suppliers, customers, auditors, analysts, rating agencies, and regulators) use earnings to make important financial decisions. Many investors view earnings as value relevant data that is more informative than cash flow data. (Healy and Wahlen 1999) Others have suggested that current earnings are better predictors of future cash flows than are current cash flows. (Dechow 1994) In the US, these profits are derived using Generally Accepted Accounting Principles (GAAP) – a system based on the accrual method, which measures the performance and position of a company by recognizing economic events regardless of when cash transactions occur. The generalidea is thateconomic events are recognized by matching revenues to expensesat the time in which the transactionoccurs rather than when payment is made (or received). This methodallows the current cashinflows/outflowsto be combined withfuture expected cash inflows/outflowsto give a more accurate picture of a company’s current financial condition.The objectives of financial reporting and how these relate to the definition of accrual accounting, as laid out by the FASB in various “Statement of Financial Accounting Concepts:”
The primary focus of financial reporting is information about an enterprise’s performance provided by measures of earnings and its components [CON1, para. 43]. Accrual accounting attempts to record the financial effects on an entity of transactions, events, and circumstances that have cash consequences for the entity in the periods in which those transactions, events, and circumstances occur rather than only in the periods in which cash is received or paid by the entity [CON6, para. 139]. It uses accrual, deferral, and allocation procedures whose goal is to relate revenues, expenses, gains, and losses to periods to reflect an entity’s performance during a period instead of merely listing its cash receipts and outlays. Thus, recognition of revenues, expenses, gains, and losses and the related increments or decrements in assets and liabilities – including matching of costs and revenues, allocation, and amortization – is the essence of using accrual accounting to measure performance of entities [CON6, para. 145].
The principal goal of accrual accounting is to help investors assess the entity’s economic performance during a period through the use of basic accounting principles such as revenue recognition and matching. There is evidence that as a result of the accruals process, reported earnings tend to be smoother than underlying cash flows (accruals tend to be negatively related to cash flows) and that earnings provide better information about economic performance to investors than cash flows (Dechow 1994) This idea raises the following key questions:
What is the objective of accrual accounting? How far should management go in helping investors form “rational expectations” about the firm’s performance through their accruals choices and when does this activity become earnings management? To the extent that these accruals choices often operate to smooth reported earnings relative to the underlying cash flows, when does the appropriate exercise of managerial discretion become earnings management? Perhaps by its very nature, accrual accounting dampens the fluctuations in an entity’s underlying cash flows to generate a number that is more useful to investors (for assessing economic performance and predicting future cash flows) than current-period operating cash flows. To characterize this as earnings management, we need to define the point at which managers’ accrual decisions result in “too much” smoothing and becomes earnings management.
To think more generally about how earnings management is defined, consider the following representative definitions from the academic literature:
“…a purposeful intervention in the external financial reporting process, with the intent of obtaining some private gain…” Schipper (1989)
“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, or to influence contractual outcomes that depend on reported accounting numbers.” Healy and Wahlen (1999)
Although widely accepted, these definitions are difficult to operationalize directly using attributes of reported accounting numbers since they center on managerial intent, which is unobservable. Turning to the professional literature, clear definitions of earnings management are just as difficult to discern from pronouncements, statements, and speeches by regulators. An extreme form of earnings management, financial fraud, is well-defined (again in terms of managerial intent) as:
“…the deliberate misrepresentation of the financial condition of an enterprise accomplished through the intentional misstatement or omission of amounts or disclosures in the financial statements to deceive financial statement users.” (Certified Fraud Examiners, 1993)
In recent speeches and writings, regulators at the SEC seem to have a broader concept in mind than financial fraud when they talk about earnings management, although a strict definition has not been made explicit. In particular, while financial reporting choices that explicitly violate GAAP can clearly constitute both fraud and earnings management, it also seems that systematic choices made within GAAP can also constitute earnings management according to recent SEC discussions. The notion that earnings management can occur within the bounds of GAAP is consistent with the academic definitions described above but is somewhat startling if the idea is that this type of earnings management will lead to explicit adverse consequences for managers and firms (in the form of SEC enforcement activity) in the same way as financial fraud. This is an important point because of the question as to whether income smoothing and other similar processes constitute earnings management and whether they are to be treated in the same manner as fraud.
Former SEC Chairman Levitt indicated that “flexibility in accounting allows firms to keep pace with business innovations. Abuses such as earnings management occur when people exploit this pliancy. Trickery is employed to obscure actual financial volatility. This in turn, masks the true consequences of management’s decisions.” (1998). This implies that within-GAAP choices can be considered to be earnings management if they are used to obscure or mask true economic performance, bringing us back again to managerial intent. This idea is reinforced by our reading of SAB 99, which also points to the intent to deceive. As accounting researchers have discovered, implementing this type of definition requires a reliable measure of “the true consequences of management’s decisions” – that is, the earnings number that would have resulted from a “neutral operation of the process” (absent some form of managerial intent).
The crucial issues seems to be why firms choose to manage earnings, how do firms manage their earnings, how do we measure earnings management given that implementing GAAP requires management to make judgments and estimates, and what are the implications of earnings management.
Management can have many motivations for managing their earnings. The ultimate motive for earnings management, however, is to aesthetically enhance the performance of a company in the eyes of its stakeholders. The literature cites motives such as stock market incentives, signaling or concealing private information, political cost, internal motives, lending contracts, management compensation contracts, and regulatory issues. A primary purpose of earnings management is to enhance the wealth of its stakeholders such as owners since they are hired by the board of directors and the board of directors is hired by the owners. To enhance the benefits of the owners of a firm, management may manage earnings in order to meet analyst forecasts for present and future periods (Burgstahler and Eames 1998). An owner of that firm’s stock may be rewarded by the appreciation of its stock value which directly relates to the owner’s wealth. Meeting earnings forecast is an important factor on the stock’s price. The more consensuses among analysts’ forecasts, the stronger incentive management has to meet those forecasts (Payne and Robb 2000). Moreover, the direction of analysts’ recommendation (buy or sell) about a company can bias management’s decision to manage earnings. If the company misses its earnings this can have a negative impact on stock returns and negatively impact management’s compensation (Matsunaga and Park 2001). However, if management can meet or beat analyst expectations, then this can result in higher stock returns (Bartov et al., 2002). The management of earnings has also been seen prior to a firm’s equity offering such as seasoned equity offers (Teoh, Welch, and Wong 1998b), initial public offerings (Teoh, Welch, and Wong 1998a; Teoh, Wong, and Rao 1998), and stock financed acquisitions (Erickson and Wang 1999).
Management may have the incentive to signal positive information or to conceal negative information. If a firm is performing poorly or having financial struggles, management may conceal this performance using earnings management (Rosner 2003). On the other hand, management may want to signal the firm’s future performance by revealing more information about a company’s future earnings and cash flow prospects (Tucker and Zarowin 2006). Earnings management can also be used to shift earnings to other periods for optimal tax planning (Shane and Stock 2006). The shifting of earnings for tax purposes can be a sign of strength. Other reasons to manage earnings can include meeting bank loan covenants. In order to maintain bank loan covenants, management may have to achieve a certain level of earnings. Failure to reach the requisite earnings can cause the lender to call the loans due, creating liquidity problems for the firm and signaling firm weakness to the bank and other creditors. The literature finds that firms that have violated covenants are more likely to manage earnings, possibly to prevent future defaults (Sweeney 1994).
When earnings management is conducted, managers use it as a tool to enhance perception of their management capabilities during the current reporting period, implying that this type of performance will continue in future reporting periods. They expect to be compensated handsomely for their “business acumen.” However, Guidry et al. (1998) found that divisional managers for large multinational firms are likely to defer income when the earnings target in their bonus plan will not be met. This indicates that management is willing to take a bath in the current period in order to reap the benefits in a future period. Moreover, it was found in Murphy (2001) that management is more likely to smooth earnings when using internal performance standards (budget goals and prior year) than external standards. Another form of compensation manipulation happens when there is a cap on the bonus awards. Then management is more likely to report an accrual that defers income when the cap is reached (Healy 1985 and Hotausen et al, 1995). Furthermore, management may manage earnings depending on whether they are joining or leaving the firm. A new CEO may be inclined to downwards earnings management (transferring the benefit to future periods), while a retiring CEO may use upward earnings management (reaping the benefits in the current period) (Godfrey et al., 2003).
Certain businesses have regulatory requirements to stay in business. A popular study of earnings management in the literature is the application by banks to manage earnings in order to meet capital requirements and by insurance companies to manage earnings to meet risk regulatory requirements. The literature supports evidence that when banks are close to minimum capital requirements they overstate loan loss provisions, understate loan write-offs, and recognize abnormal realized gains on securities portfolios (Moyer 1990; Scholes et al. 1990; Beatty et al. 1995; Collins et al. 1995). Additionally, financially weak property casualty insurers that risk regulatory attention understate claim loss reserves (Petroni 1992). The literature has also shown that firms facing anti-trust or potential anti-trust scrutiny are likely to use earnings management. These firms or others vulnerable to adverse political consequences have incentives to manage earnings to appear less profitable (Watts and Zimmerman 1978). Moreover, firms under investigation for anti-trust violations reported income decreasing abnormal accruals in investigation years (Cahan 1992).
Earnings Management can take place by underestimating or overestimating either revenues or expenses. It can be done to affect future earnings as well as current earnings. There are two main types:
Cosmetic Earnings Management using accounting choices from GAAP: also called accrual based earnings management. It happens when managers use their judgment and discretion to make choices related to accounting principles that can alter earnings in the current or a future period. An example is the modification of depreciation rates, where an increase (decrease) in the expense may occur in the current period leading to a decrease (increase) in the future (Nelson et. al. 2003).
Real-Activity Earnings Management using operating decisions: this type of earnings management is when managers make decisions that affect the real operations in the firm. This type is more dangerous both to the firm and to the managers. Managers would be at a higher risk of being caught. As for the firms, real activities earnings management affects the cash flow, and consequently has a higher impact on the company’s future. For example, a manager can give discounted sales prices in order to boost sales and consequently meet some target revenues (Roychowdhury 2006).
The most popular and successful techniques used to manage earnings can be categorized into 11 groups:
1. Cookie jar (Cosmetic): managers create a “reserve” or a “financial slack” to boost earnings in future periods by recording more expenses in the present. For example, when the manager reports higher inventory cost in the current period, it will allow him to reduce this in the future. (Levitt 1998)
2. Big bath (Cosmetic): when the management decides to eliminate or restructure a subsidiary or an operation, GAAP permits the management to record an estimate charge against the income. Managers can record higher charges to dissimulate other charges. (Levitt 1998)
3. Big bet on the future (Cosmetic): when a company acquires another one, managers can get an immediate earnings boost by including the acquired company’s earnings in consolidated earnings. On the other hand, to boost future earnings, managers can write-off the acquired in-progress R

Influences of Culture on Accounting Standards

The impact of culture on the social institutions like accounting cannot be underestimated. Before the increase in immigration and cross-border businesses, culture has been in the domain of anthropology and archaeology. This work considers whether culture affect unified global accounting practices and whether an understanding of cultural role in accounting can help to understand international accounting standards. These prove will be made evidence using the Anglo-American and Euro-Continental accounting models (Canada and France) as case study. Although there are other factors (historical, economic, and institutional, legal system, the tax laws etc) that can affect accounting harmonization, culture is a major obstacle.
There is no commonly accepted definition of culture. Violet (1983a) sees culture as a system that encompasses and determines the evolution of social institutions and social phenomena. Perera (1989) regarded culture as an expression of norms, values and customs that reflect typical behavioral characteristics within a defined social grouping. Kuper 1999, (cited in Baskerville, p.2) simply defines it as “a matter of ideas and values, a collective cast of mind”.
Hofstede 1997 defined culture as “the collective programming of the mind which distinguishes the members of one group or category of people from another.”He sees cultural differences at four different levels – symbols, heroes, rituals, and values.
From the definitions, it shows that culture is shared among individuals belonging to a group or society, formed over a relatively long period and relatively stable.
In accounting context Askary, Saeed (p.2) defined culture as those environmental factors that strongly impact national accounting systems – a likely causal factor of different national accounting practices in accord with differing national cultures.
It is a near impossibility to discuss culture without mentioning Hofstede. He conducted the most comprehensive study of how workplace values are influenced by culture from 1967 to 1973, while working at IBM as a psychologist. He analyzed data from over 100,000 individuals from 40 countries. In 1980 he identified four distinct contrasting sets of dimensions of culture which has enjoyed considerable attention. They are: (1) Power distance, showing measure of interpersonal power between people, (2) Individualism versus collectivism showing measure of personal autonomy between individuals and collectives, (3) uncertainty avoidance showing anxiety level of society members towards the future and (4) Masculinity-allocation of roles between sexes. In 2007, he added a fifth dimension that is not too relevant for our study which is Long-Term Orientation – LTO; which is associated with perseverance. His study was seen as a catalyst in international accounting research which later accounting researchers like Gray 1988, Perera 1989, Wuthnow 1994 adopted into accounting context. According to Sudarwan and Fogarty (1996, p.2), his work has been cited in 583studies from 1981-1992 and this justifies its use in accounting research.
Gray (1988) developed significant accounting hypotheses using cultural values as developed by Hofstede to establish relationship to accounting values. He addressed cultural influence on accounting of different countries from the distinct societal values perspective. He identified the possibility of significantly relating accounting values, at the level of the accounting subculture, to societal values, by giving the following ‘accounting’ values for consideration;
(1) Professionalism; meaning preference on individual professional judgment and self regulation as opposed to prescriptive legal requirements and statutory control. It linked Hofstede’s high individualism, weak uncertainty avoidance, masculinity, given the concept of assertiveness, and small power distance.
(2) Uniformity; He shows preference for uniform accounting practices between companies as against flexibility of unique circumstance of a company. It reflects societies with high uncertainty-avoidance and large power-distance indexes of Hofstede.
(3) Conservatism: Here there is preference for caution to measurement, as it helps one to cope with future uncertainty. It contrasts with a “more optimistic, risk taking approach”. This links high uncertainty-avoidance, individualism, and masculinity dimensions by Hofstede.
(4) Secrecy; Here information is shared amongst the close managers and financiers as against more open, transparent, publicly accountable approach. This is associated with societies that have strong uncertainty-avoidance and power-distance dimensions.
Chua 1988 (cited in Askary p.5) like Gray said that “Values and beliefs play a fundamental role in the constitution of accounting knowledge….”therefore, culture and accounting are inextricably linked.
Perera 1989 (cited by Askary p.6) sees two associated ways of analyzing the cultural influences on accounting practices: determining a set of specific societal values/cultural factors likely to be directly linked with accounting practice and verification of any association between societal values and specific accounting practices. To him accounting practices/systems of different countries are influenced by their cultural values that, in turn, shape their accounting practices.
Applicability of Hofstede’s framework has been questioned in accounting context. Critics see his cultural dimension in accounting research as causing misleading dependence on cultural indices. Gernon and Wallace 1995 (cited in Ding Y., Jeanjean T.,