Earnings Management Strategies
There are three typical strategies to earnings management. (1) Managers increase current period income. (2) Managers take a big bath by markedly reducing current period income. (3) Managers reduce earnings volatility by income smoothing. Managers sometimes apply these strategies in combination or singly at different points in time to achieve long-term earnings management objectives.
Increasing Income One earnings management strategy is to increase a period’s reported income to portray a company more favorably. It is possible to increase income in this manner over several periods. In a growth scenario, the accrual reversals are smaller than current accruals that increase income. This leads to a case where a company can report higher income from aggressive earnings management over long periods of time. Also, companies can manage earnings upward for several years and then reverse accruals all at once with a one-time charge. This one-time charge is often reported “below the line” (i.e., below the income from continuing operations line in the income statement) and, therefore, might be perceived as less relevant.
Big Bath. A “big bath strategy” involves taking as many write-offs as possible in one period. The period chosen is usually one with markedly poor performance (often in a recession when most other companies also report poor earnings) or one with unusual events such as a management change, a merger, or a restructuring. The big bath strategy also is often used in conjunction with an income-increasing strategy for other years. Because of the unusual and nonrecurring nature of a big bath, users tend to discount its financial effect. This affords an opportunity to write off all past sins and also clears the deck for future earnings increases.
Income Smoothing. Income smoothing is a common form of earnings management. Under this strategy, managers decrease or increase reported income so as to reduce its volatility. Income smoothing involves not reporting a portion of earnings in good years through creating reserves or earnings “banks,” and then reporting these earnings in bad years. Many companies use this form of earnings management.
There are three typical strategies to earnings management. (1) Managers increase current period income. (2) Managers take a big bath by markedly reducing current period income. (3) Managers reduce earnings volatility by income smoothing. Managers sometimes apply these strategies in combination or singly at different points in time to achieve long-term earnings management objectives.
Increasing Income One earnings management strategy is to increase a period’s reported income to portray a company more favorably. It is possible to increase income in this manner over several periods. In a growth scenario, the accrual reversals are smaller than current accruals that increase income. This leads to a case where a company can report higher income from aggressive earnings management over long periods of time. Also, companies can manage earnings upward for several years and then reverse accruals all at once with a one-time charge. This one-time charge is often reported “below the line” (i.e., below the income from continuing operations line in the income statement) and, therefore, might be perceived as less relevant.
Big Bath. A “big bath strategy” involves taking as many write-offs as possible in one period. The period chosen is usually one with markedly poor performance (often in a recession when most other companies also report poor earnings) or one with unusual events such as a management change, a merger, or a restructuring. The big bath strategy also is often used in conjunction with an income-increasing strategy for other years. Because of the unusual and nonrecurring nature of a big bath, users tend to discount its financial effect. This affords an opportunity to write off all past sins and also clears the deck for future earnings increases.
Income Smoothing. Income smoothing is a common form of earnings management. Under this strategy, managers decrease or increase reported income so as to reduce its volatility. Income smoothing involves not reporting a portion of earnings in good years through creating reserves or earnings “banks,” and then reporting these earnings in bad years. Many companies use this form of earnings management.
Motivations for Earnings Management
There are several reasons for managing earnings, including increasing manager compensation tied to reported earnings, increasing stock price, and lobbying for government subsidies. We identify the major incentives for earnings management in this section.
Contracting Incentives
There are several reasons for managing earnings, including increasing manager compensation tied to reported earnings, increasing stock price, and lobbying for government subsidies. We identify the major incentives for earnings management in this section.
Contracting Incentives
Many contracts use accounting numbers. For example, managerial compensation contracts often include bonuses based on earnings. Typical bonus contracts have a lower and an upper bound, meaning that managers are not given a bonus if earnings fall below the lower bound and cannot earn any additional bonus when earnings exceed the upper bound. This means managers have incentives to increase or decrease earnings based on the unmanaged earnings level in relation to the upper and lower bounds. When unmanaged earnings are within the upper and lower bounds, managers have an incentive to increase earnings. When earnings are above the maximum bound or below the minimum bound, managers have an incentive to decrease earnings and create reserves for future bonuses. Another example of a contractual incentive is debt covenants that often are based on ratios using accounting numbers such as earnings. Since violations of debt covenants are costly for managers, they will manage earnings (usually upward) to avoid them.
Stock Price Effects
Stock Price Effects
Another incentive for earnings management is the potential impact on stock price. For example, managers may increase earnings to temporarily boost company stock price for events such as a forthcoming merger or security offering, or plans to sell stock or exercise options. Managers also smooth income to lower market perceptions of risk and to decrease the cost of capital. Still another related incentive for earnings management is to beat market expectations. This strategy often takes the following form: managers lower market expectations through pessimistic voluntary disclosures (preannouncements) and then manage earnings upward to beat market expectations. The growing importance of momentum investors and their ability to brutally punish stocks that don’t meet expectations has created increasing pressure on managers to use all available means to beat market expectations.
Other Incentives
Other Incentives
There are several other reasons for managing earnings. Earnings sometimes are managed downward to reduce political costs and scrutiny from government agencies such as antitrust regulators and the IRS. In addition, companies may manage earnings downward to gain favors from the government, including subsidies and protection from foreign competition. Companies also decrease earnings to combat labor union demands. Another common incentive for earnings management is a change in management. This usually results in a big bath for several reasons. First, it can be blamed on incumbent managers. Second, it signals that the new managers will make tough decisions to improve the company. Third, and probably most important, it clears the deck for future earnings increases. One of the largest big baths occurred when Louis Gerstner became CEO at IBM. Gerstner wrote off nearly $4 billion in the year he took charge. While a large part of this charge comprised expenses related to the turnaround, it also included many items that were future business expenses. Analysts estimate that the earnings increases reported by IBM in subsequent years were in large part attributed to this big bath.
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