ACCT3321 Lecture Notes - Lecture 10: Risk Measure, Operating Cash Flow, Horizon Problem
CHAPTER 9 – RANKIN
Earnings Management
- Enron scandal
Importance of Earnings
- Sometimes called the bottom line or net income
- Indicates to users the extent to which an entity has engaged in activities that add
value to it the theoretical value of an entity’s stock is the present value of its future
earnings
- Increase = an increase in entity value
- Decrease = decrease in entity value
- Earnings are used by shareholders to assess manager’s performance and to assist in
predicting future cash flows and assessing risk
- Lenders use earnings as a component in debt covenants to reduce the risk associated
with lending and to monitor performance against covenants
What is earnings management
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- A purposeful intervention in the external financial reporting process with the intent
of obtaining some private gain
- Occurs when managers use judgement 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 the contractual
outcomes depending on reported accounting numbers
Methods of Earnings Management
-Accounting policy choice
oAccounting choices are made within the framework of applicable accounting
standards
oE.g. straight-line or reducing balance method, FIFO or weighted average…
oThese will lead to different timing amounts of expense recognition and asset
valuation
oEntities may change accounting methods in some circumstances
oProvided the entity can put a case forward to the auditors that the new
principle or practise is preferable, it is free to change this policy
oA change in accounting method could relate to a change in accounting
principle (e.g. depreciation method) or a change in accounting estimate (e.g.
useful life)
-Accrual accounting
oRather than reporting erratic changes in revenue and earnings year on year,
managers prefer to generate consistent revenues and earnings growth
oShareholders prefer to invest in an entity that exhibits consistent growth
patterns, not one that has uncertain and changing earnings patterns
oTherefore, managers use accrual accounting
oThey generally have no direct cash flow consequences and can include bad
debt expenses….
-Income Smoothing
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Document Summary
Sometimes called the bottom line or net income. Indicates to users the extent to which an entity has engaged in activities that add value to it the theoretical value of an entity"s stock is the present value of its future earnings. Earnings are used by shareholders to assess manager"s performance and to assist in predicting future cash flows and assessing risk. Lenders use earnings as a component in debt covenants to reduce the risk associated with lending and to monitor performance against covenants. A purposeful intervention in the external financial reporting process with the intent of obtaining some private gain. Income smoothing: smoothing moderates year-to-year fluctuations in income by shifting earnings from peak years to less successful periods, can relate to accrual accounting. Such as early recognition of sales revenue, variations to bad debts or warranty provisions, or delaying asset impairment.
