Chapter 11 Notes
is a manager’s choice of accounting policies or actions affecting
earnings, so as to achieve some specific reported earnings objective.
It is convenient to divide accounting policy choice into two categories.
One is the choice of
accounting policies per se, such as straight line versus declining-balance amortization, or
policies for revenue recognition. The other category is discretionary accruals, such as
provisions for credit losses, warranty costs, inventory values, and timing and amounts of non-
recurring and extraordinary items such as write-offs and provisions for reorganization.
Accruals reverse is an iron law surrounding accruals-based earnings management. Thus, a
manager who manages earnings upwards to an amount greater than can be sustained will find
that the reversal of these accruals in subsequent periods will force future earnings downwards
just as current earnings were raised.
Another way to manage earnings is by means of real variables, such as advertising, R&D,
maintenance, timing of purchases and disposals of capital assets. These devices may be
costly, since they directly affect the firm’s longer run interests.
Managing real variables to meet earnings targets and/or smoothing earnings may be costly,
since they directly affect the firm’s longer run interests.
However, managers may use them since the costs of managing earnings using accounting
variables has increased of late, due to reporting failures such as Enron and WorldCom and
resulting legislation, notably Sarbanes-Oxley.
11.2 Patterns of Earnings Management
This can take place during periods of organizational stress or reorganization.
If a firm must report a loss, management may feel it might as well report a large one by the
overstatement of restructuring charges, as it has little to lose at this point.
Consequently, it will reduce assets to reduce expected future costs (e.g., future amortization
charges). Because of accruals reversal, this enhances the probability of future reported
This is similar to the big bath, but less extreme. Such a pattern may be
chosen by a politically visible firm during periods of high profitability.