Lecture 14 - Earnnigs Management

Question 1

What is earnings management?

Answer 1

Earnings management is the use of accounting techniques to produce financial statements that present an overly positive view of a company’s business activities and financial performance

Question 2

Earnings management techniques can be split into two classifications, what are they?

Answer 2

1. Accounting EM

2. Real EM

Question 3

What techniques form part of Accounting EM?

Answer 3

Cost vs revaluation model?
Classification options for financial instruments.
Recognition of development costs.
Impairment or not?
Recognition of revenue

Question 4

What techniques form Real EM?

Answer 4

Keeping debt of the balance sheet.
Cutting expenses
Bill and hold (delay payment)

Question 5

There are three main reasons why a manager would engage in earnings management, what are they?

Answer 5

1. Contracting - earnings often form part of the managers remuneration package (bonuses).
2. Earnings can be linked to regulatory assessment (competition laws, tariffs etc).
3. Capital markets - earnings are a central figure used by capital market participants (financial analysts, investors etc)

Question 6

What is meant by a ‘compensation contract’?

Answer 6

A compensation contract is a contract often held between an employee and a firm which outlines the circumstances under which the employee will be entitled to receive a certain level of remuneration.

Question 7

How are ‘compensation contracts’ structured?

Answer 7

Often in 2 parts, a fixed portion (basic salary) and a variable portion (bonus).

Question 8

Give three variable elements that may be included in c compensation contract.

Answer 8

1. Bonuses
2. Stock options
3. Shares

Question 9

What is a debt covenant?

Answer 9

A debt covenants are financial ratios used by lenders to assess whether a borrower has sufficient means to pay back existing and new debt.

They also state the limit at which the borrower can further lend.

Question 10

Is a debt covenant is violated, what are the possible implications?

Answer 10

• may need to immediately pay back the loan.

- may have to renegotiate lending conditions.

Question 11

List a few examples of commonly used best covenants.

Answer 11

• Max debt to EBITDA
• Max leverage ratio
• Max current ratio
• Max debt to equity
• Max debt to tangible net worth

Question 12

Government and regualtory bodies often use accounting number in making policy decisions, therefore…

Answer 12

This can create incentives for management to adjust their numbers in order to create favorable regulatory outcomes.

Question 13

When thinking about capital markets, a firm showing higher earnings will likely…

Answer 13

Have a higher stock price (short and long term).

Question 14

What is a pressure faced by firms that operate in the capital market?

Answer 14

The pressure to meet analysts earnings forecasts.