UNIVERSITY OF ZAMBIA

GRADUATE SCHOOL OF BUSINESS

Financial Reporting and Analysis Course - Evening

EARNINGS MANAGEMENT

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KEY MESSAGES

S/N Activity
1 What is earnings management?
2 Earnings Management Strategies
3 Earnings Management and ownership structures
4 Earnings Management Continuum
5 Conclusion
6 Other Issues

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KEY Questions

S/N Question
1 Identify the factors that motivate earnings
Management.

2 List the common techniques used to manage

earnings.

3 Critically discuss whether a company should

manage its earnings.

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1.0 What is earnings management?

Earnings Management Defined

A company's number one goal is to make money. Not only do
the company owners want to have a profit at the end of every
accounting period, but they also want the company financial
statements to look as good as they can. After all, the financial
statements are what potential investors and creditors look at
when they make the decision whether or not to lend the
company money or to become an investor. This is where the
concept of earnings management comes into play. Earnings
management, in a nutshell, is the creative use of different
accounting techniques to make financial statements look
better.

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Why Earnings Management?

Because of pressure from

(1) Stakeholders holders expectations

(2) Shareholders expectations.

(3) Management can feel pressure to manage earnings by

manipulating the company's accounting practices to
meet financial expectations and keep the company's
stock price up.

(4) Many executives receive bonuses based on earnings

performance, and others may be eligible for stock
options when the stock price increases.

Many forms of earnings manipulation are eventually

uncovered either by a CPA firm performing an audit or
through required SEC (Securities and Exchange
Commission) disclosures.

Because of the above, the best way to answer this question is

to use the acronym WISE. WISE stands for: Window
dressing, Internal targets, income Smoothing.

Window dressing refers to the company's decision to dress

up the financial statements for potential investors and
creditors. The goal of this is to attract new supporters by
having financial statements that look like the company's doing
great. The company needs to appear to have a history of
being profitable, even if it means lowering profits in one

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accounting period to increase profits in another. Even though
this seems fraudulent, it isn't. Overall, the company is still
reporting the same amount of profits, but is spreading the
amount evenly over a specific time period.

Internal targets are another reason that a company may

choose to use earnings management techniques. Often times,
the company has set its own internal goals, such as
departmental budgeting, and wants to be sure to meet those
goals. No department wants to be the one to blow the
proposed budget, so earnings management techniques are
used to balance this out.

Income smoothing comes into play here because of the fact

that potential investors generally like to invest in companies
that have a continuous growth pattern. Smoothing out income
generated, when there may be spikes at certain times and
drops at others, allows it to appear like the company has that
smooth growth pattern.

External expectations comes into play when the company

has already made projections as to what their profits will be
and investors now expect that exact amount of profits or
more. Management may feel the need to shift revenue from
one accounting period to another in order to meet the
projected goal. Earnings management, quite simply, takes
advantage of the different ways that accounting policies and
procedures can be applied to financial reporting.

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 Understanding Earnings Management

Earnings refers to a company's net income or profit for a

certain period, such as a fiscal quarter or year. Companies use
earnings management to smooth out fluctuations in earnings
and present more consistent profits each month, quarter, or
year. Large fluctuations in income and expenses may be a
normal part of a company's operations, but the changes may
alarm investors who prefer to see stability and growth. A
company's stock price often rises or falls after an earnings
announcement, depending on whether the earnings meet or
fall short of analysts' expectations.

The Securities and Exchange Commission (SEC) has pressed

charges against managers who engaged in fraudulent
earnings management. The SEC also requires that the
financial statements of publicly traded companies be certified
by the Chief Executive Officer (CEO) or Chief Financial Officer
(CFO).

2.0 Earnings Management Techniques

There are a number of techniques that are used to manage

earnings. The top five are as follows;

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 2.1 The big bath - This technique is often called a 1-time event.
What happens with the big bath technique is that an out of
the ordinary, or non-recurring, event occurs in a company,
and expenses associated with that event are actually inflated.
So, how can they inflate expenses and still be within GAAP
guidelines? Easily! The company reports all of its expenses,
but instead of attributing them to the correct accounts, they're
all attributed to the 1-time event. The big bath is especially
common when a new CEO takes over. The new CEO can
blame the old CEO for the current mess and then predict a
better future, knowing well that some future expenses have
already been taken. An example will help bring out the point;

2.2 Cookie jar reserves - This technique is also an income

smoothing technique. A cookie jar generally happens in a
good year and the big bath happens in a bad year. Both serve
to increase profits in future years. The name cookie jar
implies that earnings are being stored away to be used in the
future when the sweet tooth kicks in and needs it. The big
bath can include the over accruing of liability. It occurs when
expenses are based on estimates. If the company over
estimated expenses, then it may choose to use a portion of
the expenses in one accounting period and save the other for
future accounting periods.

2.3 Inventory valuation - LIFO/FIFO

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 One method of manipulation when managing earnings is to
change an accounting policy that generates higher earnings in
the short term. For example, assume a furniture retailer uses
the last-in, first-out (LIFO) method to account for the cost of
inventory items sold. Under LIFO, the newest units purchased
are considered to be sold first. Since inventory costs typically
increase over time, the newer units are more expensive, and
this creates a higher cost of sales and a lower profit. If the
retailer switches to the first-in, first-out (FIFO) method of
recognizing inventory costs, the company considers the older,
less-expensive units to be sold first. FIFO creates a lower cost
of goods sold expense and, therefore, higher profit so the
company can post higher net income in the current period.

2.4 Asset Capitalization

Another form of earnings management strategy is to change

company policy so more costs are capitalized rather than
expensed immediately. Capitalizing costs as assets delays the
recognition of expenses and increases profits in the short
term.

2.5 Materiality Rule

Materiality – This topic may not be a big deal to small

companies since nearly everything is material and, hence,
should be accounted for. But for large, publicly traded
companies with revenues and assets in the billions of
kwachas, they can potentially get away with millions of
kwachas worth of misstatements and merely write them off

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 as being “nonmaterial” in nature. Auditors are primarily
concerned with material misstatements. Materiality has the
potential to allow companies to slightly fudge their numbers,
just enough to get them to where the analysts forecasted.

2.6 Revenue Recognition

Revenue recognition – Sort of the flip-side of cookie jar

reserves, improper revenue (or expense) recognition can lead
to inflated financial statements now at the expense of future
earnings. Some companies that have dabbled with this
earnings management technique then have to inflate revenue
in the next period even more to make up for the shortfall
caused by the prior period’s acceleration of revenue. Several
of the bigger scandals of the past few years have been the
result of companies improperly, and or prematurely, recording
revenues in order to meet or exceed forecasts, only to have
the house of cards eventually come tumbling down, resulting
in massive restatements to the prior financial statements, new
management, new auditors, and very low stock prices (if not
bankruptcy).

3.0 Earnings Management Accounting

Earnings management Accounting is the use of accounting

techniques to produce financial reports that present an overly
positive view of a company's business activities and financial
position. Many accounting rules and principles require

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 company management to make judgments following these
principles. Areas of judgement include related party
transactions, write downs, revenue recognition, off balance
sheet finance, hidden reserves and bad debts write offs.

5.0 Earnings Management and ownership structures.

In a world characterised by imperfect people with different

divergent needs, a divergence of interests between
shareholders and management can lead to suboptimal
management decisions. Such decisions are possible
because the actions of managers are largely unobservable and
the goals of the managers and their shareholders are not
necessarily aligned. Managers are posited to opportunistically
manage earnings to maximise their utility at the expense of
other stakeholders. Agency theory suggests that the
monitoring mechanisms can improve the alignment. A
conflict of interests has potential agency cost such as
management decisions that do not maximize shareholder’s
interests. Managers may manage reported earnings to justify
their actions. Earnings management may lead to an agency
cost where investors make non-optimal investment decisions
from reported earnings. In a situation where a company has
a high free cash flow, the manager may be engaged in
earnings management to show better performance of the
company. This relation can be explained by using agency
theory. In this contractual context, characterized by the

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 conflict of interests between shareholders and managers,
corporate governance involves the design series mechanisms
that reconcile the interests of shareholders and managers.

The ownership structure is defined by the distribution of

equity with regard to votes and capital but also by the identity
of the equity owners. Ownership structure concerns the
internal organization of a business entity and the rights and
duties of the individuals holding a legal or equitable interest
in that business. As owner of the business entity, it is
important to understand how the ownership structure of a
particular business entity is organized and what that means
for the owner’s rights.

6.0 Classes of shares - Ownership Structure, rights and

the issue of earnings.

1.0 Ordinary Shares

These carry no special rights or restrictions. They rank after

preference shares as regards earnings (dividends) and return
of capital but carry voting rights (usually one vote per share)
not normally given to holders of preference shares (unless
their preferential dividend is in arrears). Some companies
create more than one class of ordinary shares – e.g. “A
Ordinary Shares”, “B Ordinary shares” etc. This gives flexibility
for different earnings / dividends to be paid to different
shareholders or, for example, for pre-emption rights to apply
to some shares but not others.

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 2.0 Deferred Ordinary shares

A company can issue shares which will not pay a dividend out
of earnings until all other classes of shares have received a
minimum dividend. Thereafter they will usually be fully
participating. On a winding up they will only receive
something once every other entitlement has been met.

3.0 Non-voting ordinary shares

Voting rights on ordinary shares may be restricted in some way
e.g. they only carry voting rights if certain conditions are met.
Alternatively, they may carry no voting rights at all. They may
also preclude the shareholder even attending a General
Meeting. In all other respects they will have the same rights as
ordinary shares.

4.0 Redeemable shares

The terms of redeemable shares give the company the option

to buy them back in the future; occasionally, the shareholder
may have the option to sell them back to the company,
although that’s much less common. The option may arise at or
after a specific date, between two dates or be effective at any
time the shares are in issue. The redemption price is usually
the same as the issue price, but can be set differently. A
company can only redeem shares out of earnings or the
proceeds of a new share issue, which may restrict its ability to
redeem shares even if the directors would like to exercise the
option.

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If a company chooses to have redeemable shares, it must also
have non-redeemable shares in issue. At no point can all of its
share capital be made up of redeemable shares.

5.0 Preference shares

These shares are called preference or preferred since they have
a right to receive a fixed amount of dividend from earnings
every year. This is received ahead of ordinary
shareholders. The amount of the dividend is usually expressed
as a percentage of the nominal value. The full entitlement will
be paid every year unless the distributable reserves are
insufficient to pay all or even some of it. On a winding up, the
holders of preference shares are usually entitled to any arrears
of dividends and their capital ahead of ordinary
shareholders. Preference shares are usually non-voting (or
only have a vote only when their dividend is in arrears).

6.0 Cumulative preference shares

If the dividend from earnings is missed or not paid in full then
the shortfall will be made good when the company next has
sufficient distributable reserves. It follows that ordinary
shareholders will not receive any dividends until all the arrears
on cumulative preference shares have been paid. By default,
preference shares are cumulative but many companies also
issue non-cumulative preference shares.

7.0 Redeemable preference shares

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 Redeemable preference shares combine the features of
preference shares and redeemable shares. The shareholder
therefore benefits from the preferential right to dividends from
earnings which may be cumulative or non-cumulative while the
company retains the ability to redeem the shares on pre-agreed
terms in the future.

Most companies start by just having one type of shares in the

form of an ordinary share class. These will typically carry equal
rights to voting, capital and dividends. The issue of new
shares after company incorporation will generally be allotments
of these ordinary shares, unless circumstances suggest a need
for flexibility or varied rights.

Just as a company may issue shares in multiple share classes,

there’s also nothing to stop a shareholder holding more than
one class of share in the same company and thereby benefiting
from the differing rights (e.g. voting or dividend entitlement)
that each class offers.

7.0 Earnings Management Continuum

There is a continuous argument in the audit circle on whether

earnings management is another form of fraud. Fraudulent
financial reporting engages deliberate misstatements or
exclusion of figures or dissemination in financial statements as a
part of a design to “manage earnings.”… With this therefor the
debate is whether earning management is Legitimate or
whether earnings management is a Fraud. Follow the
argument of;
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1. Chia (2006), argued that Earnings Management is another
kind of financial reporting fraud.

2. Jiraporn, Diana and Madaline (2007) argued that since it is

within the periphery of GAAP earnings management is not a
fraud.

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