Session 3 - Brooks - Earnings management Flashcards
Give a definition of earnings management
Earnings management occurs when efforts are made successfully to change reported earnings from those that would be normally reported, often with the intent to mislead investors and lenders. Earnings management refers to a degradation of earnings quality: the ability of reported earnings to reflect firm’s true earnings and to help predict future earnings
What is the purpose of earnings management by executives ?
It is to gain some advantages over current a/o prospectives owners of the company or their elected representatives
What are the 5 advantages of an overstatement of earnings, in the short term, for executives ?
- Higher bonuses
- Higher stock prices (leading to additional gains on sale)
- Meetings or exceeding analysts’ expectations
- Favorable impact on executive reputation
- Avoidance of termination
What are the 4 advantages of an overstatement of earnings, in the short term, for corporation ?
- Lower cost of capital
- Easier borrowing
- Easier sale of new shares
- Avoidance of thresholds for regulations and debt covenants
What are the motivation to use earnings management ?
It is used to smooth income and earnings an an attempt to make a favorable impression on investors who have a high regard for earnings predictability and consistent growth.
Explain Cookie jar accounting
Build a cushion of costs, creating reserves, release later
Explain Big bath accounting
Earnings are depressed by incoming management
Explain Window dressing
Make earnings appear better
Explain Thresholds management
Reported earnings are on the good side of a threshold
How to do earnings management ?
- Falsely inflated accruals for the following adjustments to assets will decrease earnings
- Conversely, accruals that overstate liabilities will decrease earnings
- Real transactions: chosen to mislead investors but recorded using GAAP, maybe questionable policies
Ethical analysis of earnings management - Analyses are need to differentiate an ethical from an unethical act. Name the 3 approaches
- Consequentialism: Study the consequences
- Deontology: study the impact on individual rights, duties and justice or fairness.
- Virtue ethics: study of the virtues expected
Leadership and governance implications - Name the criteria for judging existing or proposed CxOs (CEO, CFO, …) regarding earnings management
- Do they have a reputation for honesty, fair dealing, openness, transparency, consideration for stakeholders and leadership in ethical matters
- Have they been involved in any ethical or questionable actions
- Have they been forthcoming with past auditors and board audit committees
- Do they have an understanding of the approaches to ethical analysis
Leader and governance implications - Name the criteria that show evidence of corporation’s ethical culture
- There is a code of conduct
- Senior executives support ethical behaviour and the code of conduct visibly
- The code is integrated in strategy and operations
- Performance is in accord with the code monitored and is reported quarterly
- An effective whistleblowing program is in place with quarterly reports to senior management and audit/governance committee
- An annual review by the board of ethics policies, etc as well as its leadership and ressources framework is in place
Give potential indicators of earnings management
- Lack of independent directors noted for their independence, ability and willingness to challenge proposed transactions
- Trends in earnings that do not reflect the volatility of the underlying economic realities that the company faces
- Consistent surpassing of analyst forecasts
- Changes in depreciation or amortisation methods or other accounting policies
- Real transactions that add proportionately more earnings than to cash flow
- Increasing gap between net assets and earnings
- Unexpected (large) assets sales, write-offs, or write-downs
- Large 4th quarter adjustments
- Qualified audit opinions or change in auditors
- Large related-party transactions
