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An Overview
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DefinitionChoice of accounting policies to achieve some specific manager objective
Under GAAP, managers 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.
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Accounting policy choice divided into two categories: accounting policies per se and discretionary accruals
Accruals such as accounts receivables, inventory, accounts payable and accrual liabilities Discretionary in that they allow for some flexibility by management to control
That managers would change accounting policies just after an introduction or amendment of a bonus plan Manager may be motivated at that time to adopt an income-increasing accounting policy change if a period of healthy earnings is forecasted
Political Motivations
Taxation Motivations
Contractual motivations
Contractual motivations: the incentive of earnings management (EM) arises from contracts between the firm and its managers that set forth the basis of managerial compensation.
A violation the terms of a debt contract would be highly costly to the manager and could affect his/her ability to freely operate the firm
Earnings management gives a manager the flexibility to choose those accounting policies that avoid a close proximity to covenant violation.
Political Motivations
Jones (1991) and Cahan (1992). To the extent that firms are politically visible, that is, they are often in the public eye or subject to governmental scrutiny, firms will use earnings measurement to reduce reported net income. This will circumvent external bodies from forcing a politically visible firm to lower its profitability
Taxation Motivations
Taxation Motivations
Taxation authorities impose their own accounting rules for calculation of taxable income, reducing the firms ability to manoeuvre. Ex LIFO versus FIFO inventory method
Changes of CEO
CEOs engage in behaviour that maximizes their utility. Thus a new CEO will manage earnings so as to increase his/her future income potential.
Clarkson, Dontoh, Richardson, and Shefix (1992) noted that the market responds positively to earnings forecasts and this can be a measure of the firms value
Income Minimization
May be chosen by a politically visible firm during periods of high profitability
Income Smoothing
Managers have incentive to smooth income so it remains between the bogey and the cap
Income Maximization
Managers may do this for bonus purposes or May occur when firms are close to debt covenant violations
When a contract imposes strict or incomplete terms on a manger, earnings management can provide an option of flexibility
Good
(Subramanyam 1996)
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