Question

Motivation for Earnings Management

Earnings Guidance

During the 1990s and early 2000s, meeting or beating analysts’ earnings expectations emerged as an important earnings benchmark. Bartov et al. found that the stock market has been found to award firms that meet or beat analysts’ forecasts and punish firms that miss earnings targets.

Meeting or beating earnings through earnings and expectations management has drawn concerns over the integrity of managers. For instance, an analysis of Nortel Networks Corporation by Fogarty et al. (separate from case 7 -1 later in this chapter) reveals that earnings expectations management is tied to many other missteps of managers that collectively contributed to the downfall of the giant telecommunications firm.

Consistent with Fuller and Jensen, this suggests that earnings expectations management sets in motion a variety of organizational behaviors that often end up damaging the firm. Erhard et al. suggest that meeting or beating earnings by manipulating earnings and analysts’ earnings expectations is Page 409indicative of low integrity in relations with the capital markets, resulting in calls for boards of directors to take accountability for integrity of the entire corporate system.

Graham et al. also advocate changes in the culture of boards of directors by focusing on long-term strategic goals and shielding managers from the short-term pressure from the capital markets. Taken collectively, the arguments suggest that, while managing earnings expectations may help the firm avoid missing earnings targets and market penalties, it can be detrimental to the long-term value of the firm and the capital markets, point out Liu et al.

These behaviors link to Burchard’s Ethical Dissonance Model described in Chapter 3 (Links to an external site.) with low organizational ethics in the person-organization fit, and if accompanied by low individual ethics, the ethical culture of the organization is more likely to lead to unethical choices than any other fit.

So what does earnings management look like?

Earnings management occurs when companies artificially inflate (or deflate) their revenues or profits, or earnings per share (EPS) figures. Well-publicized ways of managing earnings during the period of financial fraud in the early 2000s were: (1) by using aggressive accounting techniques such as capitalizing costs that should have been expensed (e.g., WorldCom accounted for its line costs as capital expenditures rather than expensing them against revenue); and (2) by establishing or altering the elements of an estimate to achieve a desired goal (e.g., Waste Management’s lengthening of the useful lives on trash hauling equipment to slow down depreciation each year).

Another perspective on earnings management is to divide the techniques into two categories: operating earnings management and accounting earnings management. Operating earnings management deals with altering operating decisions to affect cash flows and net income for a period such as easing credit terms to increase sales. Accounting earnings management deals with using the flexibility in accounting standards to alter earnings numbers.

Answer the following discussion question:

What role do financial analysts’ earnings expectations play in the quality of earnings?

Answer 1

Hi there,

Here is my View on the Topic asked for.

Meeting or beating analysts’ earnings expectations:(MBE)

The Managers have strong incentives to ‘beat benchmarks,’ implying that firms just beating benchmarks are potentially more likely to be engaging in earnings management.” Investors can use three thresholds to benchmark firms’ quarterly earnings – meeting or beating analyst forecasts, avoiding losses, and avoiding earnings decreases. Early benchmark research identified and explored the avoidance of either losses or earnings decreasesthis valuation consequence may distort voluntary disclosure policy, which managers use opportunistically in order to maintain consistency in MBE. This investigates whether managers' decisions on and analyst reaction to management forecasts are significantly related to consistency in MBE, after controlling for the historical tendency of earnings or expectations management. First, I find that the firms with consistent MBE provide more frequent and pessimistic management forecasts than other firms. This suggests that managers of firms having achieved consistent MBE are more likely to guide analysts' expectations downward in order to avoid breaking their string of MBE. I also find that analysts discount the credibility of management forecasts of these firms in their revision process. This implies that analysts understand the opportunism behind the management forecasts of these firms. Finally, I provide evidence that Regulation FD intensified the tendency of these firms to issue more frequent and pessimistic forecasts. This suggests that Regulation FD has reinforced the propensity of these firms to use management forecasts as a guidance mechanism in attaining MBE.

Burchard’s Ethical Dissonance Model

Ethical dissonance is the psychological tension between an employee and the organization when the ethical fit is not a good one. When your standards of behavior differ from the organization’s standards, you may feel uncomfortable and torn between doing what you know is the right thing to do as opposed to what may be expected of you by the business entity

" Burchard’s Ethical Dissonance Model” to illustrate the interaction between the individual and the organization, based on the person-organization ethical fit at various stages of the contractual relationship in each potential ethical fit scenario. The model is complex, so I will restrict my explanation to the basics of the person-organization interchange and its implications for ethical behavior within organizations. This is an important consideration because the ethics of an individual influences the values that one brings to the workplace and decision making, while the ethics (through its culture) of an organization influences that behavior.

Role do financial analysts’ earnings expectations play in the quality of earnings:

To derive estimates of future earnings (and cash flows) for use in the valuation process, analysts observe historical performance (using accounting data) and adjust for changing conditions. We use empirical data to illustrate that while analyst forecasts are imprecise pointestimates of future earnings (a well-known result), these estimates can help investors distinguish between firms most likely, and least likely, to experience a large earnings change. Yet, this information will not necessarily make an investor rich, as a firm's future stock return is not directly related to its realized earnings growth. Instead, a firm's stock return depends on whether its future performance exceeds, or falls short of, expectations.

Quality Earnings:

The term quality of earnings refers to the degree to which earnings reported on the company's income statement are a direct result of sustainable and ongoing business operations. Factors lowering the quality of earnings include inflation and other economic conditions, one-time events, and liberal accounting practices.

Explanation

While a company's income statement is a very important document to investors and creditors, it does have limitations. Of particular importance is the quality of earnings reported by companies. Flexibility is oftentimes found in written accounting standards, allowing accountants to establish what might be deemed liberal or conservative practices. When taken to extremes, earnings can be grossly overstated and are said to be of low quality.

When assessing the overall quality of earnings, the analyst, auditor, or investor will examine the company's accounting practices, as well as other factors, to determine the long-term sustainability of those earnings. Factors lowering the quality of earnings typically serve to understate expenses or overstate revenues in the near term. Examples include:

• Accounting Practices: liberal or manipulative policies with respect to accruals, depreciation expense, and recording of revenues.
• Economy: affects associated with inflation or currency exchange rates.
• One-Time or External Events: includes unusual gains or losses, changes in accounting practices, special charges, extraordinary items, and prior period adjustments.

In addition to the above, there can be non-quantifiable indicators as to the quality of the company's earnings. For example, management's opinion, completeness of disclosures, and notes to financial statements oftentimes provide insights into the sustainability of earnings.

Role of Financial Analysts:

• Maintaning high standrads of loyalty
• Importance to be given to every factor that contributes
• Being ethical is most important than Being Honest

To be precise Financial Anaylst plays a vital role in quality of earinings.

I Appreciate student fedback on this answer.