Smeal College of Business Managerial Accounting: B A 521Pennsylvania State University Professor HuddartEarnings Management1. Objectives and Applications11.1 Reducing political costs• influencing the outcomes from regulatory oversight by watchdog agen-cies:– 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 taxpayerpositions before the IRS• influencing labor’s bargaining strategy during contract negotiations1.2 Reducing financing costs• increasing the price of a public offering (e.g., in an IPO)• avoiding debt covenant violations• renegotiating loans1.3 Increasing the wealth of managers• increasing short-term bonus payments• management buyouts• proxy contests1Modified from Denis Cormier and Michel Magnan “Decisions, decisions: Whatmotivates managers to choose certain policies and methods?” (September, 1996) CAMagazine 38–41.cSteven Huddart, 1995–2008. All rights reserved. www.personal.psu.edu/sjh11B A 521 Earnings Management2. Using Stock Price, Cash Flows, and Earnings to Set PayStock Price+ difficult to manipulate+ An inclusive measureof the value generatedby management0 permits risk managerand shareholders to sharerisk—of dubious value− unavailable for privatelyheld firms or sub-unitsof any firm− conditioned only on pub-lic information− strongly affected by macroe-conomic factors beyondthe control of manage-ment− Paul (1993) argues thatthe weighting of infor-mation in the price func-tion can be sub-optimalin the compensation func-tionCash Flows− easy to manipulate− mixes operations withinvestments and financ-ing uses of cashEarnings+ available for all firmsand subunits of firms+ matches revenues withexpenses and, perhaps,effort with outcomes,or “delivered perfor-mance”0 somewhat manipulable0 reflects private judge-ments of managementand auditors− omits many componentsof value, (e.g., humancapital), and misval-ues others (e.g., R&D)− historical orientation (e.g.,historical depreciation)Page