Burridge Conference for Investment Professionals January 19, 2000 Earnings Management and Market Ano

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Burridge Conference for Investment
ProfessionalsJanuary 19, 2000Earnings
Management and Market AnomaliesPhil
ShaneUniversity of Colorado at Boulder
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Presentation Outline

• I. What is earnings management?
• A. Incentives.
• B. Detection.
• II. Evidence.
• III. Earnings Management and Market Anomalies.
• IV. An Example of a Trading Strategy Based on
  Earnings Momentum and Indications of Earnings
  Management.
• V. Directions for Further Research.

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What is Earnings Management?

• Healy and Whalen (1999)
• Earnings management occurs when managers use
  judgment 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.
• Arthur Levitt, Chairman of the SEC (1998)
• "Well, today, I'd like to talk to you about
  another widespread, but too little-challenged
  custom earnings management. . . . Increasingly,
  I have become concerned that the motivation to
  meet Wall Street earnings expectations may be
  overriding common sense business practices. . . .
  In the zeal to satisfy consensus earnings
  estimates and project a smooth earnings path,
  wishful thinking may be winning the day over
  faithful representation. Managing may be giving
  way to manipulation Integrity may be losing out
  to illusion."

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Incentives for Earnings Management

• Increase the firm's stock price, particularly
  when the stock is about to be issued or used in
  a transaction.
• Decrease the firm's stock price prior to a
  management buyout.
• Meet analyst or management earnings forecast.
• Increase managers' compensation that is tied to
  earnings performance.
• Avoid violating debt covenants.
• Reduce regulatory costs or increase regulatory
  benefits.
• Reduce taxes by shifting income to lower tax
  rate years.
• If the market believes the managed earnings, an
  investor's ability to detect earnings management
  can provide profitable trading opportunities.

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A Typical Balance SheetWhere are the Soft Spots?

• Assets Liabilities
• Cash Accounts payable
  
• Marketable security investments Unearned
  revenue
• Receivables Warranty liability
• Less Allowance for Doubtful Accounts Other
  current liabilities
• Inventory Total current liabilities
• Prepaid expenses
• Other current assets Deferred tax liability
• Total current assets Long-term debt
• Other non-current liabilities
• Long-term investments Total non-current
  liabilities
• Depreciable and amortizable assets
• Less allowance for depreciation and
  amortization Total liabilities
• Other long-term assets
• Total long-term assets Common stock
• Additional paid-in capital
• Retained earnings
• Less treasury stock

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Earnings Management Examples

• Timing the sale of undervalued assets (cherry
  picking).
• Creating and managing reserve accounts.
• Creating income for future periods.
• Recognizing revenue before or after it is earned.
• LIFO and year-end inventory purchase decisions.
• Capitalizing expenditures more properly expensed.
• Adjusting depreciation and amortization rates.
• Adjusting post-employment benefit assumptions.
• Managing deferred taxes.
• Strategically timing sales or expenditures.

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Detecting Earnings Management

• A. Strategic timing of expenditure decisions.
• B. Management of specific accrual account
  balances.
• C. Evaluating total accruals to detect earnings
  management
• (1) Total accruals Net income - Cash from
  operations.
• What types of accounting judgments do total
  accruals capture?
• What earnings management devices do total
  accruals miss?
• (2) Build a model to predict nondiscretionary
  total accruals.
• (3) Estimate discretionary accruals as (1) minus
  (2).

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EvidenceSome Examples from the Academic
Literature

• Banks strategically time sales of investments
  and manage their loan loss reserves (e.g.,
  Collins et al. 1995 and Beaver and Engel 1996).
• Firms cut RD expenditures to avoid earnings
  declines if they have large institutional
  stockholders with momentum trading strategies and
  high portfolio turnover (Bushee 1998).
• Bidders pay target stockholders for accounting
  benefits in acquisitions accounted for as
  poolings (Robinson and Shane 1990).
• When earnings management is detected, stock
  prices fall (e.g., Foster 1979, Dechow et al.
  1995).
• Alternative information helps analysts see
  through earnings management (Ettredge, et al
  1995).
• Managers manipulate accruals and the inventory
  reserve account in particular to maximize bonuses
  (Guidry et al., 1999).
• Firms use current accruals to shift income from
  high to low tax rate years (Guenther 1994).
  Financial analysts' earnings forecasts do not
  fully adjust for these manipulations (Shane and
  Stock 2000).
• Earnings of firms under investigation for
  anti-trust violations or seeking tariff
  protection contain large income-decreasing
  accruals (Jones 1991 and Cahan 1992).
• Firms manage earnings to avoid losses, declines
  in earnings and negative earnings surprises
  (e.g., Burgstahler and Dichev 1997, and
  Burgstahler and Eames 1998).

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Earnings Management (EM) andMarket Anomalies

• Anomaly
• On average, downward price drifts follow IPOs and
  SEOs.
• EM explanation Firms with large
  income-increasing accruals in the year of the
  offering experience more negative price drifts
  (Teoh et al 1998a, 1998b).
• Anomaly
• Post-earnings-announcement drift -- stock prices
  drift in the direction of previous earnings news.
• EM explanation see next slide.

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Directions for Future Research(Also see Healy
and Wahlen, 1999)

• 1. Develop more powerful earnings management
  detection models.
• 2. What accounts offer biggest opportunities for
  earnings management?
• 3. What types of firms are most likely to engage
  in earnings management?
• 4. What role does earnings management play in
  market anomalies and profitable trading
  strategies?
• 5. When does the market see through earnings
  management?
• Fischer and Shane (2000) are exploring the degree
  to which the market sees through earnings
  management to avoid reporting losses.
• Shane and Stock (2000) are investigating the
  degree to which the market saw through
  tax-motivated income shifting.

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Implications for Money Managers

• "In the zeal to satisfy consensus earnings
  estimates and project a smooth earnings path ..
  managing (earnings) may be giving way to
  manipulation Integrity may be losing out to
  illusion (Levitt, 1998)."
• 1. Invest resources to detect earnings
  management.
• 2. Enhance portfolio performance by combining
  earnings management detection with current
  trading strategies.
• 3. Consider earnings momentum in combination
  with current trading strategies.