Reliance on Accounting Numbers

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Earnings Management Pre-Sarbanes Oxley Scandals Backdating of Options Madoff


TW 5

Reliance on Accounting Numbers

Critically analyse reliance on financial information

What we will do this week
Understand the concept of “quality” accounting information Develop the skills to know when and how to adjust current earnings for i f income not expected to persist t t dt i t Understand issues the financial analyst faces when dealing with retroactively restated financial statements Understand how to deal with differences in accounting principles across countries

Lecture 5 - Reliance on Accounting Numbers


Sources of Accounting Distortions Accounting Standards – attributed to (1) political process of standardsetting, (2) accounting principles and assumptions, and (3) conservatism Estimation Errors – attributed to estimation errors inherent in accrual accounting Reliability R li bilit vs R l Relevance – attributed t over-emphasis on reliability at tt ib t d to h i li bilit t the loss of relevance Earnings Management – attributed to window-dressing of financial statements by managers to achieve personal benefits

Sources of Analysis Objectives y j
Comparatives Analysis – demand for financial comparisons across companies and/or across p time Income Measurement -- demand for (1) equity wealth changes and (2) measure of earning power. These h d f i Th correspond to two alternative income concepts: (1) Economic Income (or empirically, economic profit) (2) Permanent Income (or empirically, sustainable profit)

Chapter 6 discusses these measures in detail

Earnings Management – Frequent Source of Distortion

Three common strategies: Increasing Income – managers adjust accruals to increase reported income Big Bath – managers record huge write offs write-offs in one period to relieve other periods of expenses p Income Smoothing– managers decrease or increase reported income p to reduce its volatility

Earnings Management – Motivations
Contracting Incentives -- managers adjust numbers used in contracts that affect their wealth (e.g., compensation contracts) Stock Prices – managers adjust numbers to influence stock prices f S f for personal benefits (e.g., mergers, option or stock offering) Other Reasons -- managers adjust numbers to impact (1) labor demands, (2) management changes, (3) societal views, (4) lending environments and mitigate debt covenant violation, and (5) avoid industry specific actions and anti-trust actions Attitudes may differ between companies Analysts must identify situations and understand avenues that may be used by managers

Earnings Management – Mechanics
Incoming Shifting – Accelerate or delay recognition of revenues or expenses to shift income from one period to another Classificatory Earnings Management – Selectively classify revenues and expenses in certain parts of the income statement to affect analysis inferences anal sis regarding the recurring nature of these items

Disincentives for managers performing earnings management:
◦ Earnings and cash flow ultimately coincide, so firms can g y , not manage earnings forever! ◦ Flagrant earnings managers are penalised ◦ Legal conseq ences from aggressive earnings consequences aggressi e management, since could become earnings manipulation and fraud

 

1997: 116 firms restated earnings in US 2001: 270 restated earnings in US

Lecture 5 - Reliance on Accounting Numbers


A. A B. C. D. E.

higher management compensation better job security to influence stock price SEC fines None of the above

Lecture 5 - Reliance on Accounting Numbers Slide 9


A. Significant related party A Si ifi t l t d t transactions B. B Excessive pressure on managers to meet earnings target C. Loss of market share or g lower margins D. High management turnover E. All of the above

Lecture 5 - Reliance on Accounting Numbers Slide 10


Read ‘Catching up with GE’ (in additional Catching GE readings) and...
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