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Chapter 11_Notes

Chapter 11_Notes - Chapter 11 Notes 11.1 Overview Earnings...

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Chapter 11 Notes 11.1 Overview Earnings management 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 Big bath: 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 profits. Income minimization: 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.
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Chapter 11 Notes Policies that suggest income minimization include: rapid write-offs of capital assets and intangibles; expensing of advertising and R&D expenditures; successful efforts accounting for oil and gas exploration costs; LIFO Income maximization: From positive accounting theory, managers may engage in a pattern of maximization of reported net income for bonus purposes, providing this does not put them above the cap. Firms that are close to debt covenant violations may also maximize income. Income smoothing:
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Chapter 11_Notes - Chapter 11 Notes 11.1 Overview Earnings...

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