Earnings management
- Examples of where accounting can produce different numbers legally (honestly?).
- Interesting ones - perhaps;
• LIFO, FIFO Average Cost (Physical / Perpetual)
• Depreciation
- Why does management do it (not tax)?
- Why not produce any numbers you like?
- Why not require only one method or estimate?
- Why would managers manage earnings?
- NOT TAX - we are talking about ‘managing' reported accounting profits not taxable income.
- Don't you want to look good - if you can choose which photo, which assessment marks to include etc
- Managers want to show results that make their job easier:
• High profits - great manager - she should be paid more
• Low profits - not ripping the public off - should get government protection - shouldn't be taxed more.
- Why not produce any numbers you like?
- There are rules; revenue recognition, conservatism etc but there still is ‘wiggle' room (weighted ave v's FIFO).
- Corporate law - fraud when you just make up the numbers.
- Auditors who independently check that the numbers are ‘true and fair' or ‘presented fairly' within the ‘accounting reporting framework' (e.g. HC)
- Post settling up - you can only lie so often.
- Why not require only one method or estimate?
- That adds a new kind of distortion.
- Let's consider a pair of shoes!
- How do we depreciate them; method, life, residual value?
- Accelerated? Ten years? Always have some value?
- OR Straight line? Two years? Zero residual
- Imposing structure still gives distortions!
- What are we attempting to achieve when producing financial statements?
• Useful information (SAC 2 Objective of Financial Reporting) Barth showed useful for predicting.
- How do we make the information useful?
• Make it relevant, reliable, understandable etc (IASB Framework, Qualitative Characteristics of Financial Reporting)
- But problems still remain.
• Relevant or Reliable?
• Relevant to whom?
• Investors or creditors, casual observer?
- Conceptual Framework and its application.