DOCSLIB.ORG

Why Financial Appearances Might Matter: an Explanation for "Dirty Pooling" and Some Other Types of Financial Cosmetics

Total Page：16

File Type：pdf, Size：1020Kb

Download full-text PDF Read full-text
Why Financial Appearances Might Matter: an Explanation for ARTICLE: WHY FINANCIAL APPEARANCES MIGHT MATTER: AN EXPLANATION FOR "DIRTY POOLING" AND SOME OTHER TYPES OF FINANCIAL COSMETICS 1997 Reporter 22 Del. J. Corp. L. 141 Length: 19623 words Author: By Claire A. Hill * * Assistant Professor of Law, George Mason University School of Law. This article was written in partial fulfillment of the requirements of the Doctor of the Science of Law in the Faculty of Law, Columbia University. I wish to acknowledge helpful comments made by the participants at the Law and Economics Workshop at George Mason, particularly, Peg Brinig, Frank Buckley, Lloyd Cohen, L. Bruce Johnsen, Erin O'Hara, and Peter Letsou, Bill Lash, and participants at the Canadian Law and Economics Association Conference, particularly John Palmer. I also wish to acknowledge helpful conversations with Bernie Black, Victor Goldberg, and David Gordon. Finally, I wish to acknowledge the excellent research assistance of Sujatha Bagal and Scott Faga, both George Mason University School of Law Class of 1997. LexisNexis Summary … "What's more important, economic substance or accounting appearance? Banks are voting for appearance, hands down." … The information cost structure which gave rise to the mispricing might very well continue; thus, an arbitrageur's investment might never pay off. … Debt, too, can be "managed" using financial statement beautification techniques. … No matter how visible, the effects of financial statement beautification techniques, whether relating to debt or earnings, are not costlessly translatable. … By contrast, in a pooling, the asset's basis has stayed the same, resulting in higher gain on sale. … Because I am trying to explain financial statement beautification, my analysis considers only debt-equity swaps done for cosmetic reasons. … One money manager, in praising the accounting "aggressiveness" of Mattel, noted: "Mattel's earnings have risen for seven consecutive years, a feat that could not have been achieved without mirrors." … This should account for market neutrality as between pooling and purchase accounting, and as between leasing and debt. … Beautification would at least be earning its keep, and elicit market neutrality or perhaps even market favor, as stockholders benefitted at regulators' or lenders' expense. … Fundamental efficiency holds that there are no profitable trading opportunities because prices reflect fundamental value. … Text [*142] "What's more important, economic substance or accounting appearance? Banks are voting for appearance, hands down." 1 I. Introduction 1 Roger Lowenstein, A Modest Proposal to Stop ’Pooling,’ Wall St. J., May 9, 1996, at 1. Page 2 of 40 22 Del. J. Corp. L. 141, *144 Markets generally favor companies 2 with higher and more consistent earnings, and less debt, over companies with lower or less consistent earnings, and higher debt. 3 In the classic lemons 4 story, markets are well aware that companies have both the will, and the way, to mask an unflattering financial picture with financial cosmetics: 5 accounting techniques which help increase and/or smooth "earnings," and reduce "debt," without corresponding cash flow effects. Unless companies provide assurances that their appearances do not mask a less pleasing reality, markets will apply a lemons discount larger than all but the worst companies warrant. In this story, the aim both of companies preparing their financial statements, and market players reading them, should be full transparency. Companies using accounting techniques to [*143] render themselves more opaque should be punished in the markets; punishment, if not immediate, should be swift and certain. This is the world the lemons story predicts. The real world is dramatically different. Financial appearances matter and they matter a great deal. Or at least many people in the financial and academic communities have acted and spoken as though they mattered for a very long time. 6 Companies select a particular accounting method, or even [*144] 2 I use the term "company" to mean, generically, any business entity, regardless of its form. 3 This is almost a truism. One academic exploration of the desirability of consistent (smooth) earnings is Paul K. Chancey & Craig M. Lewis, Earnings Management and Economic Valuation Under Asymmetric Information, 1 J. Corp. Fin. 319 (1995). But cf. John R.M. Hand, Did Firms Undertake Debt-Equity Swaps for an Accounting Paper Profit or True Financial Gain?, 64 Acct. Rev. 587 (1989) (concluding that company managers may prefer smoothed earnings but that capital markets do not). Hand thinks markets might view smooth earnings as a signal that a company's earnings reports are not to be trusted, and therefore not like smooth earnings. Hand is not alone in thinking markets are suspicious of smooth earnings. See infra notes 111-12 and accompanying text. He is, however, virtually alone in thinking that markets do not like smooth earnings. Hand was studying a beautification technique that adversely affected cash flows; perhaps the cash flow effect, and the resultant signal that management cared much more about appearances than reality, was sufficient to explain the negative market reaction. 4 The word "lemons" refers, of course, to George A. Akerlof's seminal article, The Market for "Lemons": Quality Uncertainty and the Market Mechanism, 84 Q. J. Econ. 488 (1970). 5 In this area, many people, myself included, succumb to the temptation to use appearance metaphors: for instance, balance sheets may "be dressed up," "be cleaned up," "be shaped up," "get a facelift," or "use cosmetic effects." 6 See, e.g., on "managing" "earnings": James C. Freund, Anatomy of a Merger: Strategies and Techniques for Negotiating Corporate Acquisitions 484, 491, & 499 (1976) (discussing thought and effort given to obtaining pooling treatment); Chancey & Lewis, supra note 3; Michael Davis, Acquisitions Disguised as Poolings Can Lead to Misleading Improvements In Earnings, 10 J. of Acct. 99 (Oct. 1991) (some market players care more about reported earnings than cash flows; indeed, some mergers haven't occurred because pooling wasn't available); Ronald A. Dye, Earnings Management in an Overlapping Generations Model, 26 J. Acct. Res. 195 (Supp. 1988) (corporations manage earnings in part to make the firm more attractive to prospective investors); Hand, supra note 3; Robert W. Holthausen et al., Annual Bonus Schemes and the Manipulation of Earnings, 19 J. Acct. & Econ. 29 (1995) (managers manipulate accruals to reap the maximum benefit of annual compensation plans predicated on accounting earnings); O. Douglas Moses, Income Smoothing and Incentives: Empirical Tests Using Accounting Changes, 62 Acct. Rev. 358 (1987) (earnings management is motivated by several factors, including the firm's size and bonus compensation scheme); Brett Trueman & Sheridan Tittman, An Explanation for Accounting Income Smoothing, 26 J. Acct. Res. 127 (Supp. 1988) (management has the incentive to smooth income to decrease the appearance of volatility, and receive a better price for debt). See generally Victor Brudney & William W. Bratton, Brudney and Chirelstein, Cases and Materials on Corporate Finance A1-A36 (4th ed. 1993 & Supp. 1996) (unless otherwise indicated, citations are to the 1993 text); Thomas E. Copeland & J. Fred Weston, Financial Theory and Corporate Policy 362-70 (3d ed. 1988); Ronald Gilson & Bernard Black, The Law and Finance of Corporate Acquisitions 555-87 (2d ed. 1995) (choice of accounting methods generally, with particular focus on the problem in the context of purchase versus pooling); Reed Abelson, Truth or Consequence? Hardly, N.Y.Times, June 23, 1996 at 3 (nearly all companies manipulate financial statements, and markets are influenced by the manipulated numbers). See, e.g., on reducing "debt" (mostly, "off-balance-sheet financing"): Hand, supra note 3; John R. M. Hand et al., Insubstance Defeasances: Security Price Reactions and Motivations, 13 J. Acct. & Econ. 47 (1990); Richard Dieter & Arthur R. Wyatt, Get Page 3 of 40 22 Del. J. Corp. L. 141, *144 engage in a particular business transaction or practice, to improve their financial appearance: to increase or smooth their reported earnings, or reduce their reported debt. Pooling an accounting method for mergers which keeps post-merger accounting earnings higher than the alternative method is probably the most notorious example. 7 That's why it has been referred to as "dirty pooling." 8 Some financial appearance-enhancing techniques are quite visible. Companies must, for example, disclose in their financial statements that they have accounted for a merger as a pooling. Other techniques, like accumulating and releasing reserves to smooth earnings, may be less visible: company insiders may be the only ones certain of the reality behind the pleasing financial appearance. 9 And what do companies get [*145] for their trouble? An improved financial appearance, but not an improved financial reality: their cash flows stay the same, and in some cases, even decline. it Off the Balance Sheet, Fin. Executive 44 (Jan. 1980) ("By getting debt off the balance sheet, the character, or quality, of the balance sheet is improved. Ratios that have withstood the test of usefulness for generations will therefore appear more favorable to the borrower."); Jeffrey Randall, Captive Finance Subsidiaries: A Method of Off-Balance Sheet Financing, 46 Secured Lender 66 (Nov. 1990) ("By removing debt from the balance sheet, a firm can present a preferable financial situation to its creditors."); Larry R. Scott, Sale-Leaseback Versus Mere Financing: Lyon's Roar and the Aftermath, 1982 U. Ill. L. Rev. 1075, 1078 (1982) ("A . business advantage of a sale-leaseback [a type of off-balance-sheet financing] is that it may improve the seller/lessee's balance sheet. Less debt [because a company obtained funds in a sale-leaseback, rather than a borrowing] indicates a strong company, making the company attractive to potential investors."); Martha van Dijk & Ariette Dekker, Industry Faces Another Cycle When Tapping Finance Markets, 37 Pulp & Paper Int'l 23 (Sept. 1995) ("Off balance sheet financing [sale-leasebacks] enables a company to . shape up the balance sheet."). I use popular press sources as well as more technical sources.
Load more

Recommended publications
  • The Sarbanes-Oxley Yawn: Heavy Rhetoric, Light Reform (And It Might Just Work)
    GW Law Faculty Publications & Other Works Faculty Scholarship 2003 The Sarbanes-Oxley Yawn: Heavy Rhetoric, Light Reform (And it Might Just Work) Lawrence A. Cunningham George Washington University Law School, [email protected] Follow this and additional works at: https://scholarship.law.gwu.edu/faculty_publications Part of the Law Commons Recommended Citation Lawrence A. Cunningham, The Sarbanes-Oxley Yawn: Heavy Rhetoric, Light Reform (And it Might Just Work), 35 Conn. L. Rev. 915 (2003). This Article is brought to you for free and open access by the Faculty Scholarship at Scholarly Commons. It has been accepted for inclusion in GW Law Faculty Publications & Other Works by an authorized administrator of Scholarly Commons. For more information, please contact [email protected]. The Sarbanes-Oxley Yawn: Heavy Rhetoric, Light Reform (And It Might Just Work) Lawrence A. Cunningham Boston College Law School [Please cite as forthcoming 36 U. Conn. L. Rev. (2003)] Draft: October 2002 This paper can be downloaded without charge from the Social Science Research Network: http://ssrn.com/abstract_id=337280 1 The Sarbanes-Oxley Yawn: Heavy Rhetoric, Light Reform (And It Might Just Work) Lawrence A. Cunningham∗ [Please cite as forthcoming 36 U. Conn. L. Rev. (2003)] [Preliminary Draft; Comments Sought] Facing a series of accounting and corporate governance scandals from Enron Corp. to WorldCom Inc. at the dawn of the new millennium, Congress possessed that rare political and institutional capacity to address deep causes and systemic dysfunction.1 Congress used this episodic power opportunity to enact the Sarbanes-Oxley Act of 2002.2 On signing it, conservative Republican President George W.
    [Show full text]
  • Popular Earnings Management Techniques 15 Ings of the Acquiring Company If the Acquisition Is Properly Planned
    POPULAR EARNINGS 2MANAGEMENT TECHNIQUES This chapter briefly surveys a wide variety of popular legal earnings management techniques discussed in detail in later chapters. The most successful and widely used earnings management techniques can be classified into twelve categories. This chapter briefly overviews and lists some of the most common techniques within each category. More detail on these tech- niques, including the underlying concepts, GAAP requirements, illustrative numeric examples, and actual company cases containing accounting applications are to be found in later chapters. “COOKIE JAR RESERVE” TECHNIQUES A normal feature of GAAP-based accrual accounting is that management must estimate and record obligations that will paid in the future as a result of events or transactions in the current fiscal year. Since the future events cannot be known with certainty at the time of estimation, there is often substantial uncertainty sur- rounding the estimation process. In other words, there is no right answer. There is only a range of reasonably possible answers. From this range, GAAP insists that management select a single estimate. The selection process provides an opportuni- ty for earnings management. When management selects an estimation from the high end of the range of rea- sonably possible expenses, the effect is to record more expense in the current fis- cal period than would be recorded if a lower estimate had been selected. Recording more expense in the current fiscal period may make it possible to record less in a future fiscal period. Thus management creates a “cookie jar reserve” [also called “financial slack”] that they can tap into later to get an earnings boost.
    [Show full text]
  • Basic-Accounting-Vol
    Learning Goal 30: Analyze Financial Statements S1 SOLUTIONS Learning Goal 30 Multiple Choice 1. d 2. d 3. b 4. a Earnings per share is also used directly for comparing profitability on a per-share basis. 5. d 6. cAn airline would have a much greater investment in property, plant, and equipment assets than an accounting firm. Therefore, the denominator in the fraction will be much bigger, making the answer for turnover much smaller. A much bigger asset investment is needed to create a dollar of revenue in an airline. An accounting firm and an airline are service businesses and do not have merchandise inventory or cost of goods sold. 7. b First, this focuses blame on the old management. Second, future years’ results will now look better when compared to the current large loss year in which the “big bath” was recorded. 8. cBoth ratios relate to potential near-term cash flow and are also indicators of management efficiency. 9. dIf sales on account are overstated, the average balance of accounts receivable will also be overstated. Also, these overstated receivables will remain uncollected. The denominator in the ratio calculation will increase, which reduces the turnover and increases the days. Example: Assume correct amounts are: sales 100, beginning A/R 14, and ending A/R 10. Answer: [100/(14 + 10)]/2 = 8.33. Now assume sales overstated by 20. Answer: [120/(14 + 30)]/ 2 = 5.45 (lower turnover). (Note: The gross profit ratio will also provide a clue as it begins to increase above historical averages.) 10. bChanging from LIFO to FIFO in a period of rising prices reduces cost of goods sold, and the numerator of the ratio becomes smaller.
    [Show full text]
  • Finding Goodwill in Mergers
    treasury practice M&A: ACCOUNTING FINDING GOODWILL IN MERGERS TERRY HARDING OF KPMG EXPLAINS WHAT STEPS ACCOUNTING STANDARD SETTERS WORLDWIDE ARE TAKING TO TIGHTEN REGULATIONS SURROUNDING M&A ACTIVITY. he acquisitive business world has been grappling with the Goodwill itself is not amortised but is subject to regular and rigorous related issues of merger accounting and goodwill since impairment tests. consolidated accounts first appeared. For some, the debate is The proposals are helpful in that they remove the arbitrariness Tconceptual: if I pay more for a firm than its identifiable assets from the accounting for mergers and goodwill. Generally, the larger are worth, what have I paid for? Market position, a workforce or company will be the acquirer and goodwill will be recognised for the brands, perhaps? But are these assets in an accounting sense or value of the smaller company. Some would argue there are valid simply a ‘debit’ that should be lost in reserves? Does the value of mergers of equals and choosing an acquirer in such cases is itself goodwill decline over time, and should that decline be reflected in arbitrary. The standard setters’ response is that ‘fresh-start’ earnings? When two similar-sized firms merge, should the value of accounting would then be more appropriate. Goodwill should be goodwill of one or both merging companies be brought onto the recognised for both companies, but for now at least, that is not part balance sheet? Or is a merger truly different from an acquisition? of the proposals. The new rules will remove the opportunity – and For shareholders, analysts and financiers, the issues are no less therefore the cost – of structuring a deal in order to achieve an significant.
    [Show full text]
  • The Challenges and Effects of the Sarbanes-Oxley Act on the Internal
    The Challenges and Effects of the Sarbanes-Oxley Act on the Internal Audit Profession Prepared by: Jared S. Soileau, CIA, CPA, CISA Louisiana State University May 9, 2003 How must the internal auditing profession change so that it will be recognized as one of the cornerstones on which effective corporate governance must be built? How can internal auditing measure its progress toward achieving this goal? Copyright 2003, The IIA Research Foundation Introduction: The internal audit profession has achieved significant quality and quantity growth over the past 62 years since the founding of the Institute of Internal Auditors. The relatively young profession has matured with Progress Through Sharing as its trademark. The transition from a control emphasis to a Risk- Controls emphasis is perhaps even revolutionary. During the past fifty years, internal auditing has experienced dramatic change comparable to that of manufacturing businesses during the Industrial Revolution. Fortunately or unfortunately, part of this growth can be attributed to events that changed the face of business as well as unethical wrongdoings that rocked the confidence of financial markets and many corporate stakeholders. The profession in the U.S. has certainly been positively impacted by legislation including: the Foreign Corrupt Practices Act of 1977 (FCPA), the Federal Sentencing Guidelines of 1991 (FSG s), and most recently the Sarbanes-Oxley Act of 2002 (SOX). Similar events and the numerous Blue Ribbon Reports (Cadbury, King II) have impacted the profession internationally. Each of the three pieces of legislation listed was established as a deterrent to corporate wrongdoing that diminished the investors trust of corporations. The following paragraphs provide an overview of how the internal audit profession can add value and enhance corporate governance by reducing the risk of potential reoccurrences of wrongdoings.
    [Show full text]
  • A Business Lawyer's Bibliography: Books Every Dealmaker Should Read
    585 A Business Lawyer’s Bibliography: Books Every Dealmaker Should Read Robert C. Illig Introduction There exists today in America’s libraries and bookstores a superb if underappreciated resource for those interested in teaching or learning about business law. Academic historians and contemporary financial journalists have amassed a huge and varied collection of books that tell the story of how, why and for whom our modern business world operates. For those not currently on the front line of legal practice, these books offer a quick and meaningful way in. They help the reader obtain something not included in the typical three-year tour of the law school classroom—a sense of the context of our practice. Although the typical law school curriculum places an appropriately heavy emphasis on theory and doctrine, the importance of a solid grounding in context should not be underestimated. The best business lawyers provide not only legal analysis and deal execution. We offer wisdom and counsel. When we cast ourselves in the role of technocrats, as Ronald Gilson would have us do, we allow our advice to be defined downward and ultimately commoditized.1 Yet the best of us strive to be much more than legal engineers, and our advice much more than a mere commodity. When we master context, we rise to the level of counselors—purveyors of judgment, caution and insight. The question, then, for young attorneys or those who lack experience in a particular field is how best to attain the prudence and judgment that are the promise of our profession. For some, insight is gained through youthful immersion in a family business or other enterprise or experience.
    [Show full text]
  • Detecting Asset Impairment Earnings Management on Ifrs Context: Some Evidence from Greek Listed Companies
    American Journal of Applied Sciences 11 (6): 963-968, 2014 ISSN: 1546-9239 © 2014 E.C. Laskaridou et al ., This open access article is distributed under a Creative Commons Attribution (CC-BY) 3.0 license doi:10.3844/ajassp.2014.963.968 Published Online 11 (6) 2014 (http://www.thescipub.com/ajas.toc) DETECTING ASSET IMPAIRMENT EARNINGS MANAGEMENT ON IFRS CONTEXT: SOME EVIDENCE FROM GREEK LISTED COMPANIES 1Ekaterini C. Laskaridou, 2Vazakidis Athanasios and 3Athianos Stergios 1,2 Department of Applied Informatics, University of Macedonia, Thessaloniki, Greece 3Department of Financial Accounting, T.E.I of Kentriki Macedonia, Serres, Greece Received 2014-01-14; Revised 2014-01-16; Accepted 2014-04-10 ABSTRACT The purpose of this study is two fold: (a) to bring on issues of asset impairment manipulation in the IFRS context (b) to examine, any statistical inference validating impairment discretionary charges and firms’ earning experience. The Impairment Accounting Standard (IAS 36), enters new requirements for asset impairment provided to satisfying accrued loss amounts. Earning Management through the use of asset impairments within constrains of taking accounting process results to income manipulation representing (a) an external demand to meet earnings forecasts (b) internal demand for communicating board’ level performance. We expect to present a critical view of the earnings discretion and provide an answer on the prevailing content of asset impairment. The sample constituted of 236 firms, listed in the Greek Stock Exchange Market on the basis of impairment observations. We analyze the earnings levels for impairer companies, for 2004-2012 years. Findings suggest (a) firms recording impairment charges possess lower earnings than do their counterparts not recording write downs and (b) the impairment losses are likely reported as timely opportunity to taking “big bath” and increasing future earnings.
    [Show full text]
  • A Century of Ideas
    COLUMBIA BUSINESS SCHOOL A CENTURY OF IDEAS EDITED BY BRIAN THOMAS COLUMBIA BUSINESS SCHOOL Columbia University Press Publishers Since 1893 New York Chichester, West Sussex cup.columbia.edu Copyright © 2016 Columbia Business School All rights reserved Library of Congress Cataloging-in-Publication Data Names: Thomas, Brian, editor. | Columbia University. Graduate School of Business. Title: Columbia Business School : a century of ideas / edited by Brian Thomas. Description: New York City : Columbia University Press, 2016. | Includes bibliographical references and index. Identifiers: LCCN 2016014665| ISBN 9780231174022 (cloth : alk. paper) | ISBN 9780231540841 (ebook) Subjects: LCSH: Columbia University. Graduate School of Business—History. Classification: LCC HF1134.C759 C65 2016 | DDC 658.0071/17471—dc23 LC record available at https://lccn.loc.gov/2016014665 Columbia University Press books are printed on permanent and durable acid-free paper. Printed in the United States of America c 10 9 8 7 6 5 4 3 2 1 contents Foreword vii 1 Finance and Economics 1 2 Value Investing 29 3 Management 55 4 Marketing 81 5 Decision, Risk, and Operations 107 6 Accounting 143 7 Entrepreneurship 175 vi CONTENTS 8 International Business 197 9 Social Enterprise 224 Current Full-Time Faculty at Columbia Business School 243 Index 247 foreword Ideas with Impact Glenn Hubbard, Dean and Russell L. Carson Professor of Finance and Economics Columbia Business School’s first Centennial offers a chance for reflection about past success, current challenges, and future opportunities. Our hundred years in business education have been in a time of enormous growth in interest in university-based business education. Sixty-one students enrolled in 1916.
    [Show full text]
  • Management Deception, Big-Bath Accounting, and Information Asymmetry: Evidence from Linguistic Analysis
    Accounting, Organizations and Society xxx (xxxx) xxx–xxx Contents lists available at ScienceDirect Accounting, Organizations and Society journal homepage: www.elsevier.com/locate/aos Management deception, big-bath accounting, and information asymmetry: Evidence from linguistic analysis ∗ Ole-Kristian Hopea,b, Jingjing Wanga, a Rotman School of Management, University of Toronto, Canada b BI Norwegian Business School, Norway ARTICLE INFO ABSTRACT Keywords: Accounting big baths are pervasive in practice. While big baths can improve the information environment and Management deception reduce information asymmetry, they can also degrade the information environment and obscure operating Big-bath accounting performance. In this study, we examine the role of management ethics. Specifically, we investigate whether Linguistic analysis managers’ truthfulness (or conversely, deceptiveness) affects how investors perceive big baths. Using linguistic Information asymmetry analysis on earnings-conference calls to measure managerial deception and employing a difference-in-differ- ences research design with propensity-score matching, we find that information asymmetry is significantly higher following big baths taken by deceptive CEOs, compared with big baths taken by less deceptive CEOs. 1. Introduction 2006; Vitell, Lumpkin, and Rawwas 1991; Weber, 1990). Big baths are managerial decisions that can be the result of managers' ethical con- How does a firm's information environment change after accounting siderations of the firms' welfare, or can be the result of managers' in- big baths? Prior literature provides evidence on both positive (Elliott & centives to maximize their personal utility. Being truthful or deceptive Shaw, 1988; Francis, Hanna, & Vincent, 1996; Haggard, Howe, & to investors and other stakeholders also indicates management's ethical Lynch, 2015) and negative (Bens & Johnston, 2009; Kirschenheiter & choice of how they view their responsibility to the firm's stakeholders.
    [Show full text]
  • Cosmetic Earnings Management in the Post-SOX Period: an Analysis of Entity Size
    Cosmetic Earnings Management in the Post-SOX Period: An Analysis of Entity Size Charles E. Jordan Florida State University Panama City Amber B. Hatten University of Southern Mississippi Stanley J. Clark Middle Tennessee State University Cosmetic earnings management (CEM) takes place when income lies just beneath a benchmark (e.g., $2.98 billion) and management modestly enhances earnings to reach the goal (e.g., $3.00 billion). U.S. studies show that CEM occurred prior to SOX but vanished afterward. Research on CEM after SOX, though, largely ignores the relationship between entity size and earnings management. This study tests for CEM post SOX but does so by separating the sample into quintiles based on entity size. While no evidence of CEM appears for the largest 80 percent of the company-years, significant CEM emerges within the quintile containing the smallest entities. INTRODUCTION As Kinnunen and Koskela (2003) note, earnings management represents one of the most frequently researched topics in accounting. For example, a recent search of the Business Source Complete database within the EBSCOhost platform revealed a total of 1,444 articles with the keywords earnings management in the title. Jackson and Pitman (2001, p. 39) state that earnings management embodies an intentional structuring of reporting or production/investment decisions around the bottom line impact. Actually, two broad forms of earnings management exist. Discretionary or accruals earnings management results from manipulating the estimates and judgments inherent in financial reporting. For example, to boost income in the current period, management could lower the estimated rate at which they expense expected warranty costs.
    [Show full text]
  • Do New Ceos Practice Big Bath Earnings Management Via Goodwill Impairments?
    Do New CEOs Practice Big Bath Earnings Management Via Goodwill Impairments? Charles E. Jordan Florida State University – Panama City Stanley J. Clark Middle Tennessee State University Research conducted during SFAS 142’s adoption year (2002) and shortly thereafter indicated new CEOs exhibited big bath behavior by impairing goodwill early in their tenure. A new CEO could blame the impairment on prior management while also paving the way for enhanced future profitability. However, several studies indicate that various types of earnings management declined precipitously in recent years. We re-examine the propensity of new CEOs to take big baths relative to goodwill impairments and find no evidence of this manipulative reporting. Instead, goodwill impairments by new CEOs seem to be justified based on their firms’ deteriorating performance over time. INTRODUCTION The big bath theory of earnings management suggests managers charge significant non-recurring items to income in periods when earnings are already depressed. These one-time hits are taken because the market punishes a company relatively the same regardless of whether the firm just misses its earnings mark or falls well below it. Thus, there exists little downside to taking a big bath, yet a clear upside occurs because recording the heavy charge now relieves future periods of the burden, thereby making it easier to reach earnings goals in later years (Henry & Schmitt, 2001). Numerous studies document the practice of big bath earnings management in general (e.g., Elliott & Shaw, 1988; Kirschenheiter & Melumad, 2002; Walsh et al., 1991). One particular area in which big bath earnings management has been studied relates to goodwill impairments under Statement of Financial Accounting Standard (SFAS) 142, Accounting for Goodwill and Other Intangible Assets, which is now located in Accounting Standards Codification (ASC) topic 350.
    [Show full text]
  • Big Bath” Under Tighter Regulation on Goodwill Impairment
    2019 2nd International Conference on Economic Management and Green Development (ICEMGD 2019) Analysis of “Big Bath” under Tighter Regulation on Goodwill Impairment Chenwei Sun1,a 1Fujian Industry Equity Investment Fund Co., Ltd, Fuzhou, 350001, China a [email protected] Keywords: Earnings management, big bath, goodwill impairment, tighter regulation Abstract: “Big bath” is a subset of earnings management techniques. Previous studies demonstrate that goodwill impairment recognition can be used as a tool for big bath earnings management. Under circumstances that regulators have tightened regulation of goodwill impairment, goodwill write-downs surged, which indicates that Chinese listed firms with depressed earnings are still likely to overstate goodwill impairment losses by taking a bath. My study analyzes the representative case of Dalian Zeus Entertainment Co., Ltd. (Dalian Zeus) for the relationship between potential big bath reporting and goodwill impairment. My paper further discusses the combination of amortization and impairment test as an alternative treatment for subsequently measuring goodwill and proposes some guidance for the purpose of reducing big bath earnings management. The alternative measurement can decrease managerial discretion in impairment testing. 1. Introduction Many scholars consider that earnings management is within accounting principles in which managers use discretion in financial reporting to obscure the actual financial performance. William R. Scott defines earnings management as “the choice by a manager
    [Show full text]