Chapter 2 : Literature Review

There are a number of areas on the earnings statement that provide management with opportunities for influencing the outcome of reported earnings.

I included some information of earnings management first. Earnings management is managers’ accounting choices. Managers may use different accounting techniques to create some opportunities within the boundary of GAAP, so that they can make financial statements look better. I stated the top 5 techniques of earnings management and relevant examples:

We use the updated empirical analysis to assess the extent to which the findings in three seminal papers still hold, and provide some additional results that do not appear in the original work. This paper can serve as a resource for those interested in a deeper appreciation for the capital market consequences associated with accounting earnings. We organize this review using the three theoretical links between earnings and share prices developed by Beaver (1998). These “three links” are: 1) current period earnings provides information to predict future periods’ earnings, which 2) provide information to develop expectations about dividends in future periods, which 3) provide information to determine share value, which represents the present value of expected future dividends. We describe how this theoretical structure provides a practical framework for analyzing and understanding the valuation implications of earnings information in the capital market. We then provide empirical evidence on the relation between earnings and stock returns by extending three classic studies using data from 1988 through 2002. Our first set of empirical results provides evidence on links 1–3 by showing a

This case study is the first of a two-part Earnings Management Case. The purpose of Part

Companies often are under pressure to meet or beat Wall Street earnings projections in order to increase stock prices and also to increase the value of stock options. Some resort to earnings management practices to artificially create desired results.

Several main reasons for the occurrence of earnings management include influencing the stock market, growing management compensation, decreasing the possibility of violating lending agreements, and averting government intervention. It is believed that managers might attempt to manage earnings because they believe reported earnings impact investor and creditor decisions. In most cases, earnings management techniques are designed to improve reported income effects and to lower the company’s capital cost. However, in order to increase future profits, management might take the chance to report more bad news in low performance

The first topic area involves an observation of how managers and accountants currently utilize loopholes in FASB accounting standards to present better earnings results to investors, creditors, and regulatory authorities. Many business professionals support earnings management as routine practices that stay within authoritative boundaries, while other business professionals view these activities as unethical. The practitioners of earnings management misapply discretionary judgment to avoid the intent of accounting standards. In his speech The Numbers Game, on earnings manipulation, Arthur Levitt listed five, accrual-based earnings management practices: (a) “big bath” restructuring charges, (b) creative acquisition accounting, (c) “cookie jar reserves”, (d)

The majority of managers find that it is not immoral to manage earnings. They are convinced that if a practice is not explicitly prohibited or slightly deviating from the rules, it is considered an ethical practice. Though the methods they use to manage short-term earnings are not consistent with an ethical framework, they believe that they are not doing anything wrong

It is found that managers are more likely to manage earnings because it is hard to verify whether the estimated fair value figures are well-intentioned or manipulated. Having to rely on their estimates introduces informational asymmetry. As in the case of Level 3 inputs, since managers have private information regarding appropriate values to select for model inputs as well as the underlying economic value of an asset (or liability), the informational asymmetry will create two problems- adverse selection and moral hazard.

The companies use earnings management as a strategy by which they can easily control and manipulate their earnings to reach their pre-determined earning target.

Jim will appear to making less money than it actually did and therefore have to report fewer taxes. In other words, Jim is seeking for a tax saving. It can be explain by using the contracting perspective where manager will choose accounting techniques that will maximizes his or her utility at the expenses and also maximize bonuses. Furthermore, by creating LIFO inventory layer adjustment it will give lower reported earnings. If the company can avoid the inventory increase for the year and instead having a reduction, they can take a credit adjustment to cost of sale and increase their profit. Under literature Scott (2000), this proposal fall under opportunistic earning management where the management report earnings opportunistically to maximize own profit. Related study are Burgstahler and Dichev (1997) conclude that managers engage in earning management to avoid reporting losses or earning decline. Research show that there is negative relationship between unexpected discretionary accruals and stock returns around the earnings announcement date. This result indicates that the market views discretionary accruals as opportunistic.

There are several acceptable ways of earning management which managers can use in smoothing their accounts though such can be very complex and confusing. However, the major aim of earning management is to facilitate the organization to achieve a pre-set target, which is more often than not the analysts ' consensus. The most successful and widely acceptable earning management techniques assume twelve categories. However, both are bound some common underlying concepts, GAAP requirements, the actual company cases that outline its accounting applications as well as the real numerical illustrations of the company. However, some of the most common earnings management techniques include cookie jar reserve techniques. This is a normal concept of GAAP anchored accrual accounting under which the company management must estimate as well as record all the obligations which have to be paid in future due to events or transactions in Each financial year. However, under this concept, since the future events may not be known for sure, during the time of estimation, the method provides a substantial uncertainty over the estimation process. This leads to a situation of a

There are several ways that analysts can identify when it is likely that impairment has been used to manage earnings. They can do this by seeing whether any impairments (particularly if they are abnormally large) are preceded by conditions that might be conducive to earnings management.

A corporation’s value is based on the size and stability of future cash flows. Reducing earnings volatility

Professor Messod Beneish created the Beneish M-score Model in 1999 in his research entitled The Detection of Earning Manipulation. He identified that earnings management is important for financial statement users to assess current economic performance, to predict future profitability, and to determine firm value (Jansen et al, 2012)