Earnings Management

Question 1

Earnings are also called?

Answer 1

profit,
bottom line,
net income

Question 2

How does it measure entity’s performance?

Answer 2

By indicating extent entity has engaged in activities that add value.

Question 3

It is forecasted by?

Answer 3

analyst and managers.

Question 4

Who is Earnings used by?

Answer 4

1. Stakeholders - assess stewardship and prospects
2. Creditors - assess risk, input to debt covenants
3. Customers - assess earnings, long term survival
4. Employees - assess job security

Question 5

What is earnings management?

Answer 5

‘reasonable and legal management decision making and reporting intended to achieve stable and predictable financial results’

Question 6

What are the different earnings management styles relating to different entity objectives?

Answer 6

1. Conservative - unusual
2. Aggressive
3. Fraudulent

Question 7

List the different methods of earnings management.

Answer 7

1. Accounting Policy Choice
2. Accrual Accounting
3. Income Smoothing
4. Real Activities Management
5. Big Bath Write-Offs

Question 8

Characteristics of Accounting Policy?

Answer 8

1. most common form of earnings management

2. flexibility of choice - leads to different timing and amounts of expense recognition and asset valuation.

Question 9

Can you change accounting methods?

Answer 9

Yes, provided it can be explained to auditors how the new practice is preferred.

Question 10

What are some examples of Accounting Policy?

Answer 10

1. straight line or accelerated dep?
2. FIFO or weighted ave?
3. volunteering to be an early adopter of an acct std

Question 11

Characteristics of Accrual Accounting.

Answer 11

1. Managers prefer consistent revenues and earnings growth

2. Allows entity to delay/accelerate recognition - temporarily adjust profit figures

Question 12

What are some examples of Accrual Accounting?

Answer 12

1. Under-provision of bad debts expense
2. Delaying asset impairment
3. Adjusting inventory valuations
4. Amending depreciation

Question 13

Define income Smoothing.

Answer 13

‘Smoothing moderates year-to-year fluctuations in income by shifting earnings from peak years to less successful periods’

• S/H prefer constant growth patterns

Question 14

What is Real Activities Management?

Answer 14

1. Managing operational decisions.
2. affect cash flows and sometime accruals
3. could have negative effect on cash flows in later periods

Question 15

What are some examples of Real Activities Management?

Answer 15

1. Accelerating sales; price discounts
2. Reducing discretionary expenditures
3. Delaying R&D

Question 16

What is Big Bath Write Offs?

Answer 16

• Refers to selling subsidiaries/operational units resulting in a large loss reported against income
• Often when there is change in management or significant restructuring

Question 17

Why manage earnings ?

Answer 17

1. For the benefit of the entity

2. To meet short-term goals

Question 18

How does EM benefit the entity?

Answer 18

1. meet analysts’ and S/H expectations and predictions
2. maximise share price and company valuations
3. accurately convey private info
4. avoid violating restrictive debt covenants

Question 19

What are the 3 common methods of Entity Valuation?

Answer 19

1. Book value
2. Operating Cash Flow
3. Net income -> most aligned with this

Question 20

What is earnings quality?

Answer 20

1. Relates to how closely current earnings are aligned with future earnings
2. Difficult to observe and measure
3. Contradictory views on whether smoothed income indicates high earning quality

Question 21

What are the potential consequences of EM?

Answer 21

1. Aggressive management may lead to poor share performance
2. Increase earnings before IPO may lead to overvaluing shares and declines in the following year.
3. Negative reaction to fraudulent manipulation.