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Earnings Management Insights

This document provides an overview of earnings management, including: 1) Earnings management is the purposeful intervention in financial reporting to mislead stakeholders or influence contractual outcomes. There are two types: accrual-based and real earnings management. 2) Accrual-based earnings management exploits accounting discretion over accruals like depreciation rates. Real earnings management changes actual business decisions. 3) Common patterns of earnings management include big bath restructuring, cookie jar reserves, big bets like acquisitions, and shrinking the company through share repurchases.

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44 views10 pages

Earnings Management Insights

This document provides an overview of earnings management, including: 1) Earnings management is the purposeful intervention in financial reporting to mislead stakeholders or influence contractual outcomes. There are two types: accrual-based and real earnings management. 2) Accrual-based earnings management exploits accounting discretion over accruals like depreciation rates. Real earnings management changes actual business decisions. 3) Common patterns of earnings management include big bath restructuring, cookie jar reserves, big bets like acquisitions, and shrinking the company through share repurchases.

Uploaded by

SHAMRAIZKHAN
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Lecture 13

Earnings Management

1
Chapter overview:
Overview of Earnings Management
Types of Earnings Management
Patterns of Earnings Management

2
Earnings Management
 Purposeful intervention in the external financial reporting process,
with the intent of obtaining some private gain. (Schipper 1989)

 Earnings management occurs when managers use judgment 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 contractual
outcomes that depend on reported accounting numbers. (Healy
and Wahlen 1999).

 The active manipulation of earnings towards a predetermined


target. (Mulford and Comiskey 2002)
3
Types of Earnings management

 There are two types of Earnings


management
 Accrual based Earnings management
 Real Earnings management

4
Accrual based Earnings management

 The exploitation of within-GAAP discretion over the level of


accruals is by far the most studied EM method. Examples of
discretionary accounting choices include accounting
depreciation rates; deferred tax assumptions; stock (inventory)
valuation assumptions; bad debt provisions; and revenue
recognition.

 Accruals are the accounting adjustments that explain the


difference between free cash flows and operating income:

 Operating Income = Free Cash Flows + Accruals.

5
Real Earnings management

 RM is different because, since it is now


assumed that firms may change economic
decisions to achieve financial targets, there
may be real free cash flow consequences.

6
Patterns of Earnings Management

Big Bath
Cookie Jar Reserve
Big Bet
Shrink the ship

7
Big Bath

 Big bath technique based on a belief that if


you must report bad news, it is better to
report all at once and get away from it.
Common circumstances are

 Operations Restructuring
 Operations Disposals

8
Cookie Jar Reserve

Record more expanses in current period


may take it possible to report less expanse
in future period. Common areas are
Estimating Sales return and allowances
Estimating Bad Debts writes off.

9
Big Bet and Shrink the ship

Big Bet permit companies to boost in current


or future earnings. Common circumstance is
Acquisition
Shrink the ship allow companies to increase
its earnings per share. Common
circumstance is
Share Repurchase

10

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