Smeal College of Business Pennsylvania State University Managerial Accounting B A 521 Professor Huddart Earnings Management 1 1 1 Objectives and Applications1 Reducing political costs influencing the outcomes from regulatory oversight by watchdog agencies insurance regulators banking regulators US International Trade Commission Antitrust Division of the US Department of Justice minimizing tax in many countries book income is taxable income in the US book tax conformity is argued to bolster taxpayer positions before the IRS influencing labor s bargaining strategy during contract negotiations 1 2 Reducing financing costs increasing the price of a public offering e g in an IPO avoiding debt covenant violations renegotiating loans 1 3 Increasing the wealth of managers increasing short term bonus payments management buyouts proxy contests 1 Modified from Denis Cormier and Michel Magnan Decisions decisions What motivates managers to choose certain policies and methods September 1996 CA Magazine 38 41 c Steven Huddart 1995 2008 All rights reserved www personal psu edu sjh11 B A 521 2 Earnings Management Using Stock Price Cash Flows and Earnings to Set Pay Cash Flows Stock Price difficult to manipulate easy to manipulate An inclusive measure mixes operations with investments and financ of the value generated by management ing uses of cash 0 permits risk manager and shareholders to share risk of dubious value unavailable for privately 0 held firms or sub units 0 of any firm conditioned only on public information strongly affected by macroeconomic factors beyond the control of management Paul 1993 argues that the weighting of information in the price function can be sub optimal in the compensation function Page 2 Earnings available for all firms and subunits of firms matches revenues with expenses and perhaps effort with outcomes or delivered performance somewhat manipulable reflects private judgements of management and auditors omits many components of value e g human capital and misvalues others e g R D historical orientation e g historical depreciation