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CCMRM hosts discussion on Earnings Management for Investors

Srinivasan Rangan

22 April, 2021: The Centre for Capital Markets and Risk Management at IIM Bangalore hosted a discussion forum between Professor Srinivasan Rangan, faculty from the Finance & Accounting area of IIMB, and Prabhu Venkatachalam, doctoral student in the Finance area, as part of the Global Money Week 2021 celebrations. 

The forum was streamed live on Zoom webinar, YouTube channel of IIMB and Platform for Investors’ Education. A large number of students, academicians and working professionals attended the live streaming of the session. The day’s discussion detailed few aspects. 

Earnings Management

Earnings is the company’s profit, the bottomline number that is mentioned in its annual report. Portfolio managers closely follow these annual reports to look at the firm’s profit margin, earnings per share, turnover ratio, return on assets and related earning measures. Earnings is the difference between the revenue made by a firm and their expenses over a specific horizon. Earnings management is the use of accounting techniques, both legal and illegal, to distort performance and produce a disguised palatable report to the investors. Reported performance of a company is the combination of the true performance and the earnings management. Earnings management is incorporated by a firm to produce a positive performance report over a conventional time horizon. This could affect revenues, expenses or any other aspect of the firm’s performance evaluation factors.

A few reasons for engaging in this process can be listed as:

  • The firm can be in the process of raising capital or renegotiating borrowing: For instance, if a firm is going ahead with an Initial Public Offering (IPO) or indulging in a secondary offering to raise capital, the management tends to boost the performance numbers to create a recency bias in the investors. Most investors tend to follow the herd when buying an IPO and end up paying a higher price due to the firm’s exaggerated profit numbers. 

  • Debt covenants are likely to be violated: Both accrual and real earnings management affect future accounting and stock market performance. Shareholders are affected by covenant violations as this might lead to a structural growth in loan repayment, but the excess cost is borne by the shareholders themselves.

  • Insiders (promoters) selling shares: The objective of promoters is ‘sell the share at the highest price possible’. They tend to inject some earnings management to the actual earnings to create a make-belief outperformance report of the firm. Investors happen to buy more shares without analyzing the authenticity of the news. The promoters generally exit the company after selling whereas the investors are left with the shares of a firm that does not have a high earnings ratio.

  • An auditor change: Auditors play an important role in evaluating the quality of the financial statements. They undertake disposal, sampling, verify transactions and evaluate the estimates that the accountants made. Empirical evidence has shown that managers manipulate income to round up earnings per share (EPS). The concept of ‘making more money in a shorts span’ propels the firms to engage in such nefarious activities.

  • Management bonuses are tied to earnings: Executive compensation affects earnings management in proximity of predesigned earnings of a firm. Compensation contract design influences earnings management on the pretext that managers behave opportunistically.

  • A weak governance structure: The inside management of a firm might have a stronghold over the revenues, in turn dominating the Board of Directors. This could also arise due to an unhealthy audit committee that fails to picture the discrepancy in the cash flow data.

Several firms view earnings per share as the key metric for an external audience, more than the cash flows. For instance, managers tend to reject an upcoming project with a positive Net Present Value (NPV) that has a tendency to fall short of the current quarter’s consensus earnings. Investors should be cognizant of the steps taken by a firm to superficially customize its earnings.

Performance deviations of a firm from true performance: The adjustment procedures during the end of a financial year are undertaken by a committee, likely to comprise accountants, CFO and managers. Some of these adjustments could be bona fide whereas most likely they fall under earnings management. Due to the sampling nature of audit, there are cases where the auditor fails to catch hold of such illegal business.

  • Accrual Based Earnings Management: Firms tend to manipulate the numbers. Accrual earning management methods are manipulation of the economic performance of the firms within accepted accounting principles. 

  • Real Earnings Management: Firms alter the execution of real-time business transactions underlying the numbers. This is the prevalent strategy even though it is more expensive practically to manipulate the business paradigm policies. This is mostly done to mask the gains that is derived from suspicious transactions.

Indicators of ‘Earnings Management’ that should be looked at when choosing a firm for investment: If the cash flows from operations are lower than the net profit, it indicates a manipulation in the net income. Under Generally Accepted Accounting Principles (GAAP), operating cash flow (OCF) is more difficult to tamper than net income. Since a regular cash flow is important to generate revenue, a company with lower OCF is tending towards credit default.

A sudden change in accounting principles or estimates bucketed with commensurate non-recurring income is a clear indication of earnings management looking at the footnotes. Large companies like Xerox, Procter & Gamble as well as Microsoft have been caught managing their earnings. Very low earnings or small increases in profit margins is a prima facie case of earnings management. A firm just meets or beats analysts’ earnings expectations to meet targets or forecasts, attempts to tamper their earnings to make it look good on paper. It indicates the firm has barely managed to avoid a loss. Differences in expenses for tax reporting and financial reporting clearly indicates a discrepancy between the real-time performance and its profit report. This contains a high level of accruals to somehow manage a slip into the non-default credit group. 

Regulators and auditors are working on a refined auditing process to catch hold of any minor alteration to the true performance of a firm. Investors should do a thorough fundamental and technical analysis of a firm before buying shares from them and concentrate on the long-term return horizon, preferably over a period of seven years. Earnings management overall is unhealthy for the economy as unacceptable projects get funded. 

Create Date
23 APRIL

22 April, 2021: The Centre for Capital Markets and Risk Management at IIM Bangalore hosted a discussion forum between Professor Srinivasan Rangan, faculty from the Finance & Accounting area of IIMB, and Prabhu Venkatachalam, doctoral student in the Finance area, as part of the Global Money Week 2021 celebrations. 

The forum was streamed live on Zoom webinar, YouTube channel of IIMB and Platform for Investors’ Education. A large number of students, academicians and working professionals attended the live streaming of the session. The day’s discussion detailed few aspects. 

Earnings Management

Earnings is the company’s profit, the bottomline number that is mentioned in its annual report. Portfolio managers closely follow these annual reports to look at the firm’s profit margin, earnings per share, turnover ratio, return on assets and related earning measures. Earnings is the difference between the revenue made by a firm and their expenses over a specific horizon. Earnings management is the use of accounting techniques, both legal and illegal, to distort performance and produce a disguised palatable report to the investors. Reported performance of a company is the combination of the true performance and the earnings management. Earnings management is incorporated by a firm to produce a positive performance report over a conventional time horizon. This could affect revenues, expenses or any other aspect of the firm’s performance evaluation factors.

A few reasons for engaging in this process can be listed as:

  • The firm can be in the process of raising capital or renegotiating borrowing: For instance, if a firm is going ahead with an Initial Public Offering (IPO) or indulging in a secondary offering to raise capital, the management tends to boost the performance numbers to create a recency bias in the investors. Most investors tend to follow the herd when buying an IPO and end up paying a higher price due to the firm’s exaggerated profit numbers. 

  • Debt covenants are likely to be violated: Both accrual and real earnings management affect future accounting and stock market performance. Shareholders are affected by covenant violations as this might lead to a structural growth in loan repayment, but the excess cost is borne by the shareholders themselves.

  • Insiders (promoters) selling shares: The objective of promoters is ‘sell the share at the highest price possible’. They tend to inject some earnings management to the actual earnings to create a make-belief outperformance report of the firm. Investors happen to buy more shares without analyzing the authenticity of the news. The promoters generally exit the company after selling whereas the investors are left with the shares of a firm that does not have a high earnings ratio.

  • An auditor change: Auditors play an important role in evaluating the quality of the financial statements. They undertake disposal, sampling, verify transactions and evaluate the estimates that the accountants made. Empirical evidence has shown that managers manipulate income to round up earnings per share (EPS). The concept of ‘making more money in a shorts span’ propels the firms to engage in such nefarious activities.

  • Management bonuses are tied to earnings: Executive compensation affects earnings management in proximity of predesigned earnings of a firm. Compensation contract design influences earnings management on the pretext that managers behave opportunistically.

  • A weak governance structure: The inside management of a firm might have a stronghold over the revenues, in turn dominating the Board of Directors. This could also arise due to an unhealthy audit committee that fails to picture the discrepancy in the cash flow data.

Several firms view earnings per share as the key metric for an external audience, more than the cash flows. For instance, managers tend to reject an upcoming project with a positive Net Present Value (NPV) that has a tendency to fall short of the current quarter’s consensus earnings. Investors should be cognizant of the steps taken by a firm to superficially customize its earnings.

Performance deviations of a firm from true performance: The adjustment procedures during the end of a financial year are undertaken by a committee, likely to comprise accountants, CFO and managers. Some of these adjustments could be bona fide whereas most likely they fall under earnings management. Due to the sampling nature of audit, there are cases where the auditor fails to catch hold of such illegal business.

  • Accrual Based Earnings Management: Firms tend to manipulate the numbers. Accrual earning management methods are manipulation of the economic performance of the firms within accepted accounting principles. 

  • Real Earnings Management: Firms alter the execution of real-time business transactions underlying the numbers. This is the prevalent strategy even though it is more expensive practically to manipulate the business paradigm policies. This is mostly done to mask the gains that is derived from suspicious transactions.

Indicators of ‘Earnings Management’ that should be looked at when choosing a firm for investment: If the cash flows from operations are lower than the net profit, it indicates a manipulation in the net income. Under Generally Accepted Accounting Principles (GAAP), operating cash flow (OCF) is more difficult to tamper than net income. Since a regular cash flow is important to generate revenue, a company with lower OCF is tending towards credit default.

A sudden change in accounting principles or estimates bucketed with commensurate non-recurring income is a clear indication of earnings management looking at the footnotes. Large companies like Xerox, Procter & Gamble as well as Microsoft have been caught managing their earnings. Very low earnings or small increases in profit margins is a prima facie case of earnings management. A firm just meets or beats analysts’ earnings expectations to meet targets or forecasts, attempts to tamper their earnings to make it look good on paper. It indicates the firm has barely managed to avoid a loss. Differences in expenses for tax reporting and financial reporting clearly indicates a discrepancy between the real-time performance and its profit report. This contains a high level of accruals to somehow manage a slip into the non-default credit group. 

Regulators and auditors are working on a refined auditing process to catch hold of any minor alteration to the true performance of a firm. Investors should do a thorough fundamental and technical analysis of a firm before buying shares from them and concentrate on the long-term return horizon, preferably over a period of seven years. Earnings management overall is unhealthy for the economy as unacceptable projects get funded.