I want to go over a topic that is given short shrift by many accounting textbooks, in my opinion: earnings management. Now I realize that this lesson could, I suppose, be interpreted as teaching people how to do it when the point of the video is how to detect it and avoid it. However, I figure the more people know about these techniques, the less effective they are for the companies that try to take advantage of them. So let's dive right in!

I want to cover this topic in three sections:

The first I want to address is the institutional basis for earnings management and why it is a problem, and what are the conditions for it.
Then I want to talk about what the motivations are for earnings management to take place.
And then finally, I want to talk with some of the techniques that are used to manage earnings.

The Institutional Basis of the Problem

We're going to look at two different aspects of the institutional basis for the earnings management problem.

We're going to look at accounting regulations and we're going to look at the financial markets and how the expectations there create the problem, or at least create the opportunity, for people to do what they do.

Accounting Regulations

In terms of accounting regulations, you have to understand that the fundamental assumption of regulators is that managers of corporations have an incentive to exaggerate. In other words, they would, if all else was equal, tend to overstate their earnings, because why would anybody understate how much that they have earned on behalf of the shareholders?

That basic incentive is what lies behind this notion that accounting is conservative. accounting is conservative in that it asks managers to not overstate their income and not overstate the value of their assets. And what this allows managers to do is to, to a certain extent, delay the recognition of revenue, but more importantly, I think, as you'll see in most of these techniques we're going to look at, it gives lots of license for managers to recognize expenses earlier than they might otherwise be recognized and appear on the income statement.

What this does is it provides managers with the opportunity to manipulate income and still stay within accounting regulations. So what we're going to be looking at is all legal things that managers can do. And these techniques that we're going to look at are very easily applied, right at the margin, to fine tune income a little bit.

And as we'll see, sometimes it even permits earnings management on a much larger scale.

Financial Market Expectations

The financial market expectations come into play because financial markets reward companies, not just with high growth, but those with stable growth, right? Firms that have very predictable rates of growth are considered to be more valuable than firms that have high volatility, even though on average they might be growing at the same rate, because stable growth gives investors the opportunity to cash out of their investment whenever they want. Whereas if it's a volatile stock that is sometimes growing really rapidly and other times not growing very rapidly, or sometimes even losing money, when the stock price goes up and down like that, that makes it a challenge for investors to time their departure from an investment, to maximize the gain on it. So for that reason, for firms with very stable growth of the stock price, and which is supported by very stable growth of their earnings, all of that contributes to the incentive that managers have to try to manage the expectations of the stock market.

So managers get compensated for not just inflating the stock price, but supporting it to keep it from falling, to make sure that it stays very stable.

Motivations for Earnings Management

So what are some of the motivations here? We're going to look at a whole bunch of things. Income smoothing, the concept of the big bath, and a whole bunch of other things that are too numerous to list right here.

Let's go through them one at a time.

Income Smoothing

One of the counterintuitive motivations for earnings management is the notion of income smoothing. You'd think that managers would always have the incentive to make their earnings look as large as possible to impress everybody. But as we saw, a less volatile stock is a more valuable stock.

So if you can manage the earnings within a narrow band, then you are going to contribute to stabilizing the value of your stock and make it look like a gold plated, very reputable investment. So in a good year, of course, what you would like to do, is to reduce some of the income that you might otherwise have and postpone it till next year.

And a simple way to do this is to recognize the expenses that might happen in the future a little bit early. As we'll see, there are multiple opportunities under IFRS to do this. And some of them apply to US GAAP as well, but I'm not going to be covering that. In a bad year. Of course, if you have the opportunity to delay or reduce some of your expenses, the recognition of them, then you are going to alleviate the dip in earnings that you might otherwise see. Now, obviously I'm focusing here on expenses because they're the most, easily manipulable under IFRS.

Big Bath

*The Roman bath in Bath, and Bath Abbey*

With a big bath, the idea is that a company is experiencing some sort of an event that everybody knows about, and this provides a plausible rationale for why the company's going to have a loss that year. What you can do then as a manager is bury a whole bunch of other smaller losses in along with that one big loss, so that other people who are looking at it from the outside, analysts or investors, don't really notice all this other bad stuff that's gone along. So, you know, if you have a big fire in your factory or a hurricane went through, that gives you an excuse for why you had a bad year. Then things that might be happening next year that might not be so good, if you can advance the recognition of those things into this year to coincide with the bigger bad news, then they kinda get buried in the noise.

Oftentimes, of course managers use this as a reason for saying that these were events beyond management control. It's not our fault! Forgetting of course, that managers are actually paid to plan for these kinds of events and insulate the company from this kind of external volatility.

Shop Window

By shop window, what I mean is that when a company is up for sale and you've got buyers coming to look, it's putting something on display in a shop window to make it look attractive.

So what this involves is just, making those kind of temporary fixes to a company's financial statements that are done without any regard for the future. A simple example of this is, if a company knows that it's up for sale, running down the inventory level. So you just stop purchasing supplies and inventory.

Now this is not strictly going to be an earnings management manipulation because whatever you sell is going to have a cost of goods sold associated with it. However, what it does is it conserves cash, making the company look more liquid, and it also reduces the inventory levels. The average inventory is an important component in ratio analysis, as we'll see when we get to the financial statement analysis section of the course.

When you've got lower inventories, it looks like you are achieving your sales with a very , efficient, lean a supply chain management system, when it could simply be because you stopped ordering inventory. So if the buyers are not aware of what you're doing, when they do take over and they go in and look around, they're going to realize that they've got a lot of money to spend, to replenish the inventory.

But this is something that can be done if you don't have to worry about the future. Similarly, if you're going to be selling the company, just stop fixing the boilers in the factory, stop fixing the trucks, and you are going to save a lot of money on routine maintenance.

This has nothing to do with the value of the capital asset. These are the kinds of regular maintenance expenses that would show up on the income statement directly when you spend the money. But by postponing them, you are simply, reducing the expenses on your income statement at the cost of a future problem that the new buyers are going to have to look after when they take over.

Managing Expectations

Managing the expectations of investors is really quite simple because their expectations are so direct. They want to have more and more earnings all the time. So one of the things that managers do is to sometimes temper the enthusiasm of analysts and investors. If it's likely to be a good year, they can dampen expectations a little bit and make it easier to manipulate their earnings around a given level and postpone some of the recognition of income until the next year. Once of course, the managers have made an earnings estimate and earnings announcement close to their year end, then it becomes really important that they meet that target and the incentive doubles then to manage those earnings around that particular target that they've created for themselves.

Post-Acquisition

Another motivation for earnings management is something I'd associate with a post-acquisition scenario, where a company has taken over another company and decides to strip it down to what it feels is the nugget of the business. You know, this is all well and good if there's negative synergies between the core business and the underperforming divisions. Capitalism is ruthless.

Managers do not take into account the jobs that are lost to the degree that you or I might want. They don't take into account the devotion that customers might have to products or services that might be lost to the degree that you or I might want. But this happens and just got nothing to do with accounting, it's simply maximizing the value of their investment by, stripping it down to what they feel is the core business. Oftentimes, what they're left with is more valuable than what they purchased. And they've got rid of a whole bunch of what they consider dead weight. And they've got a core business that is of some value, which they can then run and sell investments in themselves, or they can turn it over to other investors at some kind of an overall profit based on the work that they did to clean out the so-called dead wood. It's not always pretty, but it is done and this has nothing to do with accounting at all. Except for the fact that this creates an opportunity for managers to allocate some expenses from the core business to these divisions that are being got rid of. When you close a division and take a loss on an investment that the company made in that division and allocate to it some cost of intangible assets or other things that the core business is facing, then the cost of that write off of that division can be inflated, in order to leave the core business with less future expenses.

So it leaves this remnant of the business looking better financially than it otherwise would. And that part of it is earnings management.

Internal Goals

Finally, I think, is this notion of simply having internal goals that the outside world doesn't know about. The managers know stuff that's going on inside the company and analysts and investors will never know what's going on.

If a manager, for instance, is going to be leaving the company, there's no incentive for the manager to leave it in good financial shape. They can take all the accruals they can to make the company look really good and leave with their reputation glowing, and leave the problem for someone else to clean up.

Even if they're staying on, if they know that they've met a major target of some sort, as we mentioned in the previous slide, they can postpone some of the income through expense manipulation and stuff to meet next year's target, if they know they've already met this year's target. And that's particularly an internal goal when the manager knows that they had a goal in their performance contract for executive compensation that no one else will know about.

But if they've met that target internally, they can postpone income just so that they can make next year's bonus target in a much easier fashion.

And similarly, if they know that they cannot possibly meet this year's target for various reasons, they may want to accrue certain expenses this year in order to improve the chances of meeting next year's target.

And finally, companies are made up of a whole bunch of different divisions, large companies like apple and Microsoft and so forth. They face the same problem in auditing and accounting for the, the work that's being done in remote divisions of the company that any external investor does.

So those divisions have an incentive to manage their earnings upwardly to the head office in order to meet their own internal targets.

Technical Methods

So with all those motivations, as potential reasons for engaging in earnings management, none of them requiring anybody to manage earnings in any kind of an aggressive fashion, but all of them providing all kinds of reasons for why managers might want to get away with it, I want to look at some of these specific techniques that managers use to manage earnings in their financial statements.

Allowances

The first category of techniques that I want to talk about is allowances. These are very routine things. As you know, managers are expected under accounting regulations to disclose their income and their assets conservatively, because if they weren't, they would have supposedly the incentive to always exaggerate those things.

So in order to be conservative about these things, it's necessary for managers to make estimates of things that are going to happen in the future, that only they are in a position to really give a good estimate for. These are very routine things, right? So anything that happens in terms of sales around the end of a fiscal year, you just before the end of the year is subject to the possibility that you know, a customers going to return the goods in the next fiscal year. If it's a sale to a business customer and they get a discount of 2% for paying the invoice within 10 days, if the sale took place one day before the end of the year, they might take that discount in the next week, but it would be in the next fiscal year. So in order to do the financial statements at the end of the year, managers have to make estimates of what those events are going to be that don't apply to the next fiscal year. They apply to the year in which the original sale took place. Same thing for warranties. What's the possibility that a particular product is going to suffer warranty expenses that are going to take place in the following years, but they actually pertain to the sale itself.

You know, this matching principle. You recognize the revenue and then you associate with that date all the expenses that go along with that particular revenue event. One of those is warranty expenses. And then, of course, on the asset side, your accounts receivable is going to be disclosed at a particular value that must incorporate according to accounting regulations, the possibility that some of the customers might not pay. It happens all the time, but it happens at different rates in different businesses and in different economic climates.

And only the managers are in a good enough position to make this estimate. This is all very routine stuff. It's so routine that these, kinds of accruals that are necessary are referred to as discretionary accruals, because they're done at the discretion of the management. And, within reason the auditors, aren't going to argue with what is done. And what this does is it gives managers the opportunity and the ability to play a little bit at the margin with the income for the year, because they can inflate or deflate these allowances as needed.

Fair Value Manipulations

Something that is much more open to manipulation is the concept of fair value, particularly as it's embedded in IFRS.

The notion of fair value of financial assets, in particular, as they go up and down the gains and losses are expected to be recognized on the P&L, on the income statement, but you can elect to move those assets into a category where the volatility is parked in the other comprehensive income category.

So it gets buried in the accumulated other comprehensive income, in equity section of the balance sheet. And only when you dispose of that asset does the gain or the loss get triggered. The idea being that you may have a financial asset that's expected to go up and down, but hopefully when it comes time to actually close it out, it'll be back to neutral. Derivatives and hedges, for instance, on other assets that you own, are classic examples of assets that fall into this category.

What can happen with some of these things is simply that you move them from the P&L statement to the OCI, so that volatility is postponed. You're actually encouraged to do this in financial accounting, under IFRS, but the opportunity is there to postpone the decision to do that until you feel that it's advantageous for you.

Now, this is possibly not as big a problem as you'd expect because it's something that eventually will come back to haunt the company when the asset is sold. But at the very least it can stabilize and insulate the income statement this year from volatility that otherwise would move it around.

Write-downs and Write-offs

Finally, just the opportunity to choose the timing of when you dispose of an asset is always there.

If you've got a financial asset, that's not locked into a particular date, you can trigger a gain or a loss on it, as needed, if you decide you no longer need that asset. A loss on an asset that's never going to come back into the black can be quite useful to a company that wants to deflate their earnings downwards a little bit. Selling off an asset, ahead of schedule would trigger the gain or loss at that point. This is not purely an accounting manipulation, it's not a discretionary accrual or anything. It's an actual, real event that's done by the managers, but they do control the timing of those things.

And once they no longer own it, no amount of arguing from the auditors can insist that they still have it on the books at the value it was there at.

With any asset, of course, you've got the idea that is disclosed at something roughly resembling is value through continued depreciation of a tangible asset or amortization of an intangible asset.

You end up with an asset sitting on the balance sheet at a particular value. And, if managers know that this asset is overstated, they are expected under IFRS to write it down to something resembling it's more reasonable or fair value. And the auditors would go along with this, quite quickly because they don't want the managers to overstate the value of assets.

But of course, the opportunity is there to do this ahead of schedule. If you feel that the asset is overvalued because of something that's happened, you could either write it down further than you need by arguing that it's in worse shape, or perhaps not write it down as much as you could in order to preserve the value of the asset.

And the auditors would have to, to a certain extent, take your word for that. They can investigate it, but ultimately you are going to know more about the asset than they are, and it'll be difficult for them to argue back, to too great a degree. You also have, of course, control of the timing, because you can decide to write down an asset this year, even though you're expecting the possibility that it might last a little longer. This is something that's fairly simple for managers to do because they're actually encouraged by IFRS to do that. On top of that, IFRS does give you the opportunity to write an asset back up if the circumstances change.

So there's tremendous opportunity for managers to abuse this, and the only brake on this behavior is their own credibility. If they try to do this too often, the auditors will lose faith in them. And if they try to do this in a way that is visible to investors, then the investors will lose faith in them.

Tax Asset Manipulations

The most technical aspect of earnings management that I want to talk about has to do with tax asset manipulations. You have to understand the corporations are taxed differently than individuals. When a corporation loses money in a given year, it's actually allowed to ask for a refund of income tax that it paid in a previous year. It's just corporate tax law. It's different than individual tax law.

But what about a company like a startup that loses money and there was no previous income tax payments made that it can claim as a refund? What happens is that this tax loss gets to be carried forward for a number of years, and it's called a tax asset. The loss of money in a given year would create a situation where your income tax, if you calculated it out at the regular tax rate, would be a negative tax amount, and you can't apply that against any positive taxes that you paid because there weren't any.

So this loss then becomes an asset because it's something that can be applied to future taxable income to reduce your tax payments in those future years. So it's a real asset. But what is the value of this?

Like any other asset, the corporations are expected to disclose it at an appropriate value, that is the real economic value of it. And if there's no expectation of earning taxable income before that tax asset expires, you shouldn't be disclosing it at face value.

And so what you have is this concept in accounting of valuation allowances. A valuation allowance is just like all the other allowances that we'll talk about in this course: it’s a contra account created by managers to adjust the disclosed value of an important account — that is, the value of the account that is disclosed to external audiences — for the anticipated impact of future events. An example is the allowance for doubtful accounts, which is used to estimate the impact of potential bad debts on the financial value of a company’s accounts receivable. Despite its generic-sounding name, a valuation allowance has to do specifically with the value of a tax asset. If there's no expectation of future taxable income, then a company’s tax asset should be disclosed at a very low value or even at zero, by creating a large valuation allowance. The disclosed value of the tax asset would be the raw value of the tax asset itself (a debit balance) netted with the value of the contra account (a credit balance). The maximum size of the valuation allowance would be the size of the tax asset itself.

If there's an expectation that the future's going to be bright and that there is going to be taxable income, then this tax loss actually is a valuable asset, because it will mean the company can apply previous tax losses against this taxable income, and therefore pay less tax. In such a case, the tax asset should be disclosed on the balance sheet as an asset with some kind of positive value. The managers would do this simply by reducing the valuation allowance. You can easily imagine the potential for manipulation here, because who knows more than the managers do about the future income expectations of the company?

This is a huge opportunity for managers to manipulate not only the value of the asset on their balance sheet, but as a result, the value of the expense that's associated with the income tax. The valuation allowance is often very large, because tax losses for a corporation can be very large. An adjustment in the allowance can therefore result in a large impact on the income statement, compared to the impact of adjusting smaller allowances, such as the allowance for doubtful accounts. The valuation allowance is therefore ripe for manipulation. Elsewhere on this website, I explain examples of companies that are doing this deliberately and out in the open. It's all there for people to see if they only take the time to read the notes to the financial statements.

Summary

So let's sum up what we've learned. We've learned about the institutional basis for the earnings management problem, the accounting regulations and the financial market expectations that create the conditions by which earnings management becomes this very tempting and profitable thing to do.

We've looked at specific motivations for earnings management, like income smoothing and the big bath idea. And then we've looked at, in fair detail, the different techniques that managers use to manage their earnings, like playing with allowances or writing off assets ahead of schedule if that's useful to them, and a bunch of other techniques.

So these are all problematic things that are there. They're legal, they're available to managers and they go on all the time and I'm kind of surprised that the textbook doesn't pay more attention to them.

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Title photo: paper sculpture from a show in Paris in 2012. I can’t remember the artist, unfortunately, but whoever it was successfully managed the paper to create an impressive result out of almost nothing.