Table of Contents

1. Introduction
2. GAAP and GAAP Application Quality
3. Earnings Management
4. Why Do Companies Manage Earnings
5. Summary

1. Introduction

The quality of accounting refers to the ability of financial statements to provide users and analysts with
information that helps them forecast or predict the future profitability, risk and cash flow of a company. If
accounting quality is poor, users and analysts will be misled into making incorrect forecasts or predictions.
The analysis of accounting quality focuses on the analysis of the Generally Accepted Accounting Principles
(GAAP) quality as well as GAAP application quality.

Objectives: Accounting Quality Analysis

Upon completion of this topic, you should be able to

• identify the quality standards for analysing accounting quality
• identify the incentives for companies to manage earnings

2. GAAP and GAAP Application Quality

GAAP quality is about the ability of GAAP to capture relevant information that helps users and analysts to
assess the performance of companies. Many users of the financial statements expressed their concern about
the eroding relevance of GAAP over time. Market participants have called for significant improvement to
the relevance of GAAP and the quality of reported earnings figures. For example, in 1998 Alan Greenspan,
the chairman of the US Federal Reserve Bank, noted that
"'Under the old economic' paradigm, generally accepted accounting principles did a reasonable job at
reporting economic reality. But, with a shifting economic paradigm, which finds companies relying more on
technology and intellectual property, and less on bricks and mortar, generally accepted accounting
principles seem to be falling short. In recent years, there is evidence that spending on technology has
outpaced the growth in reported corporate earnings."
Accounting standards add value if they enable financial statements to effectively portray differences in
companies' economic positions and performance in a timely and credible manner. Statements similar to that
of Alan Greenspan clearly suggest that this objective of financial reporting is not being fulfilled using
existing accounting standards. Others claim that many current accounting standards are based on outdated,
arbitrary and perhaps flawed concepts, principles and conventions.
In spite of their concerns about GAAP quality, users expect that companies apply GAAPs in the preparation
of the financial statements. However, regulators in many international jurisdictions have recently voiced
explicit concerns about the credibility of the financial reporting system. Some of these concerns relate to the
allegation that a number of companies are manipulating the reported figures in the financial statements and,
in particular, reported earnings. For example, the former chairman of the US Securities and Exchange
Commission (SEC), Arthur Levitt, warned that, "the quality of earnings is eroding because managing may be
giving way to manipulation, and integrity may be losing out to illusion."

3. Earnings Management
Earnings management encompasses financial fraud, as well as any choice and judgement made within
GAAP if it is used with the intent of misleading current and perspective users about true economic
performance. For example, Schipper (1989) defines earnings management as, "a purposeful intervention in
the external financial reporting process, with the intent of obtaining some private gain." Similarly, Healy and
Wahlen (1999) state that, "earnings management occurs when managers use judgements 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."

Financial Fraud

An extreme form of earnings management is financial fraud. This form of earnings management effectively
violates GAAP. Examples of such fraudulent accounting practices include improperly recording revenues,
recording uncollectible sales, hiding losses and expenses, and using special-purpose entities to inflate profits.

Implications for the Audit Profession

Needless to say, earnings management has significant implications for the audit profession and raises
significant concerns about the effectiveness of the audit process. It also raises significant concerns about the
independence and the integrity of auditors. Users of the financial statements rely on the figures reported in
the financial statements on the basis that independent auditors have checked these figures and that they do
not violate GAAP. However, within GAAP, there are a number of grey areas, and audit failure is a
possibility. In addition, the independence of auditors might erode in some cases. Recent corporate collapses
clearly suggest that the audit function is not failure-proof.
Earnings management may also take place within the boundaries of GAAP. Some common examples of this
form of earnings management include alleged abuses to assumptions and estimates associated with what is
called "big bath" and other write down charges. The apparent abuse of what are called "cookie jar" reserves,
as well as abuses resulting from inadequate recognition of certain liabilities, are among many others.
• "Big bath" takes place, for example, when companies clean up their balance sheet by recording large
charges associated with restructuring and writing-off certain segments of their operations. New chief
executives are especially keen
on this tactic because it allows them to blame the bad news on the previous chief executive officer,
and because it creates illusory improvements to profitability ratios in the years ahead.
• The use of unrealistic assumptions to estimate accruals, such as sales returns, loan losses and warranty
costs, effectively stores accruals in "cookie jars" during good times and reach into them when needed
during bad times. Naturally, a tremendous amount of judgement goes into deciding the amount of the
write-off and the estimated accruals, and it is extremely difficult to isolate charges that may be
considered aggressive and opportunistic earnings management from those that reflect legitimate
exercise of judgement.

4. Why Do Companies Manage Earnings

The incentives to manage earnings can be divided into three types:

• market-related incentives
• contracting-related incentives
• regulatory-related incentives

Capital Market Incentives

These include managing earnings surrounding

 1. certain capital markets transactions, such as seasoned and initial equity offerings and management
buy-outs
2. the release of periodic earnings figures to smooth earnings time series, or more importantly, to meet
the expectations of financial analysts
In fact, managing earnings in order to meet analysts' expectations has recently been cited by regulators as the
main incentive for earnings management. For example, the former US SEC chairman, Arthur Levitt, stated
that, "the motivation to meet earnings expectations may be overriding common-sense business practices and
that too many corporate managers, auditors and analysts are participating in a game of nods and winks."

Contracting Incentives

These include managing earnings in order to avoid violating lending covenants that are written in terms of
accounting numbers, as well as managing earnings to optimise earnings-based management compensation.

Regulatory Incentives

These include managing earnings in order to avoid industry regulations, to reduce the risk of political
exposure, and to take advantage of certain governmental benefits and grants.
These incentives lead management to manipulate reported earnings and/or other financial statement figures.
Penman (2001) notes a number of situations where manipulation of reported figures is more likely. In these
situations, analysts and other users of the financial statements should conduct a diagnostic analysis of the
relevant financial statement figures.
Examples of the situations when this is likely to occur are listed below.
Institutional situations
• when the firm is in the process of raising capital or renegotiating borrowing
• when debt covenants are likely to be violated
• during a management change
• during an auditor change
• when management rewards (eg, bonuses) are tied to earnings when there is a weak governance
structure

o inside management dominate the board o a weak audit

committee or none at all
• when regulatory ratio requirements (eg, capital ratios for banks and insurance companies) are likely to
be violated
• when transactions are with related parties rather than at arm's length
• during special events, such as union negotiations and proxy fights
• when the firm is "in play" as a take-over target
• when financial reports are used for other purposes, eg, tax reporting and union negotiations
Accounting situations
• during a change in accounting principles or estimates
• when there is an earnings surprise
• when there is a drop in profitability after a period of good profitability
• when sales are constant or falling
• when earnings are growing faster than sales
• when there are small or zero increases in profit margins (that might be a decrease without
manipulation)
• when there are small profits (that might be losses without manipulation)
• when there are differences in expenses for tax reporting and financial reporting
• during accounting adjustments in the last quarter of the year

5. Summary
The following are the main points covered in this topic:
• The quality of accounting affects analysts' ability to forecast the future profitability, risk and cash
flows of companies.
• The analysis of accounting quality focuses on the analysis of Generally Accepted Accounting
Principles (GAAP) quality as well as GAAP application quality.
• GAAP quality refers to the ability of GAAP to capture all of the relevant information that helps users
and analysts to assess the performance of companies.
• GAAP application quality refers to the application level of standards, methods and concepts
embedded in GAAP.
• Earnings management encompasses financial fraud as well as any choice and judgement made within
GAAP if it is used with the intent of misleading current and perspective users about true economic
performance.
• The incentives to manipulate reported earnings may be driven by capital markets, contracting
relationships and governmental regulations.

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