Earningsmanagementisamanagerschoiceofaccounting.docVIP

Earnings Management A Summary Overview Earnings management is a manager’s choice of accounting policies that achieves some specific objective. Even under GAAP, managers still retain some flexibility in accounting policy selection that may be able to positively impact their personal satisfaction and/or the market value of their firm. Accounting policy choice can be divided into two categories: accounting policies per se and discretionary accruals. Examples of the latter include the timing and amounts of extraordinary items such as write-offs and provisions for reorganization, credit losses, inventory values, etc., whereby managers are able to determine when and how much of revenue and expense to classify on a current income statement. The former, accounting policies per se, are more rigid in the sense that they dictate when and how much revenue and expense to classify in a certain period. Examples of these include amortization policies and revenue recognition. Evidence of Earnings Management for Bonus Purposes A 1985 paper entitled “The Effect of Bonus Schemes on Accounting Decisions” by Healy serves as the most popular research study on earnings management. In his study, Healy attempts to explain and predict managers’ choices of accounting theory. He hypothesizes that managers would find opportunities in which they could manage net income in an attempt to maximize their bonuses under the firm’s compensation plans. Healy refers to a bonus scheme (a contract between the firm and its managers that sets forth the basis of managerial compensation) whereby a manager’s bonus is calculated based on a linear relationship to current reported net income. The bonus, however, will begin at a minimum amount of net income (called a bogey) and either level off at a maximum amount of net income (called a cap) or continue infinitely. Healy argues that only if income is between the bogey and the cap will managers find an incentive to acquire accounting policies that increase net i