Scott-3rdEd_Ch11.pdf

Scott-3rdEd_Ch11.pdf - Scott, Financial Accounting Theory,...

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Scott, Financial Accounting Theory, 3 rd Edition Instructor’s Manual Chapter 11 Page 1 1 S UGGESTED S OLUTIONS TO Q UESTIONS AND P ROBLEMS 1. Some reasons why a firm’s management might both believe in securities market efficiency and engage in earnings management are: Income taxation. The firm may be able to postpone payment of taxes if it can minimize its reported income, for example by managing accruals, or using LIFO (if allowed by the tax authority). Managerial bonus plan. As Healy documents, managers have incentives to maximize their bonuses, consistent with the bonus plan hypothesis of positive accounting theory. Consequently, they may adopt accounting policies to increase reported net income, or to reduce reported net income if it is below the bogey or above the cap of the bonus plan. Covenants in lending agreements. Managers may adopt policies to increase reported net income, or other financial statement variables, to avoid covenant violation or even to avoid being too close to violation. Lending agreements may also induce income-smoothing behaviour. A smooth sequence of reported net incomes will reduce the probability of covenant violation. A smooth earnings sequence may increase the willingness of lenders and suppliers to grant short-term credit. Political visibility. By reducing its reported net income the firm may forestall government intervention which might ensue if the public felt the firm was earning excessive profits. Question 15 of Chapter 8 illustrates this point. Earnings management can be a credible way to communicate the firm’s inside information about its long-term expected profitability to the market. Scott, Financial Accounting Theory, 3 rd Edition Instructor’s Manual Chapter 11 Page 2 2 Poor disclosure. The manager may feel he/she can manage earnings but hide behind poor disclosure to prevent the efficient market from detecting it. None of the above reasons are inconsistent with a belief by management in securities market efficiency. 2. Taking a bath involves writing off assets against the current year’s operations and/or providing currently for future costs. As a result, future years’ reported earnings are relieved of the amortization and other charges that would otherwise be made. Consequently, future years’ reported earnings will be higher (or losses lower) than they would otherwise be, and the probability of the manager receiving a bonus correspondingly increases. 3. Next year’s earnings will be reduced by $1,300 due to the “iron law” of accruals reversal. With respect to credit losses, there is a $500 lower cushion to absorb credit losses in the following year. Consequently, next year’s credit losses expense will be $500 higher, other things equal. With respect to warranty costs, a similar argument applies. The lower the
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Scott-3rdEd_Ch11.pdf - Scott, Financial Accounting Theory,...

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