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Class #8 "Detecting Earnings Management"

This document summarizes key points from a class on detecting earnings management: 1) Firms and managers have incentives to misstate earnings or balance sheet items to meet targets, avoid penalties, and maximize bonuses. 2) Earnings management can mislead investors in their valuation and assessment of a firm's financial health. Detection of misstatements causes stock price declines and legal issues. 3) Methods discussed for detecting earnings management include comparing accrual income volatility to sales and cash flow volatility, and analyzing growth rates in accounts receivable versus sales. 4) Students have a class quiz coming up and an assignment to apply earnings management detection methods to specific firms.

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192 views

Class #8 "Detecting Earnings Management"

This document summarizes key points from a class on detecting earnings management: 1) Firms and managers have incentives to misstate earnings or balance sheet items to meet targets, avoid penalties, and maximize bonuses. 2) Earnings management can mislead investors in their valuation and assessment of a firm's financial health. Detection of misstatements causes stock price declines and legal issues. 3) Methods discussed for detecting earnings management include comparing accrual income volatility to sales and cash flow volatility, and analyzing growth rates in accounts receivable versus sales. 4) Students have a class quiz coming up and an assignment to apply earnings management detection methods to specific firms.

Uploaded by

adzkiya1700
Copyright
© Attribution Non-Commercial (BY-NC)
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Download as PDF, TXT or read online on Scribd
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Class #8

“Detecting Earnings

Management”

15.535 - Class #8
1
Recap: Why firms/managers

“Cook the books?”

• Central theme: Firms & managers often have


incentives to misstate earnings/balance sheet
items:
– Contracting incentives:
• Avoid violating contracts
• Maximize bonus (managers)
• Avoid regulatory/government/union intervention

• Avoid detection of managerial shirking


– Stock market incentives: Meet analysts’ targets

15.535 - Class #8
2
Why do we care about earnings

management?

• Avoid being fooled!:


• Earnings used in deriving numbers for DCF and multiples
(P/E, PEG, etc) valuation analysis.
– Use the wrong numbers & you will misvalue the firm

• Earnings (and other accounting #’s) to determine


financial health and the ability of the firm to pay
obligations:
– Employees

– Creditors

– Suppliers

– Etc

• What is the outcome when accounting


misstatement is detected?
• Stock price reaction and legal recourse is immediate!

15.535 - Class #8 3
Watch Out for “Expectations

Management” of Analysts!

Forecast Error= (Actual EPS – Forecast EPS)

15.535 - Class #8 4
Methods for Detecting Earnings
Management
• Compare volatility of accrual income
measures with underlying volatility of sales
and CFO:

Vol(Op Inc) = stdev(Op Inc over 5 years)/average (Op Inc over 5 years)
Vol(Sales) stdev(Sales over 5 years)/average (Sales over 5 years)

Vol(Op Inc) = stdev(Op Inc over 5 years)/average (Op Inc over 5 years)
Vol(CFO) stdev(CFO over 5 years)/average (CFO over 5 years)

Vol( NI ) = stdev( NI over 5 years) / average (NI over 5 years)


Vol(CFO) stdev(CFO over 5 years)/average (CFO over 5 years)

15.535 - Class #8
5
Analysis: Shared Medical Systems

– Perform quality of sales analysis

– Test for Earnings Smoothing


AR/SALES 25.2% 26.4% 27.4% 28.0% 29.9%
% Growth in AR 23.9% 22.2% 19.6% 34.8%
% Growth in Sales 18.2% 17.9% 16.9% 26.1%

Vol(Op Inc) = Std(Op Inc)/Avg(Op Inc) 24.20%


Vol(CFO) = Std(CFO)/Avg(CFO) 32.64%

Vol(Op Inc)/Vol(CF0) 74.13%

15.535 - Class #8 6
Team Project: Methods for Detecting

Earnings Management

– What you must calculate for Part I of your Project:

• Compare % growth in sales with the % growth in AR over


the past 5 years (quarters).
• Calculate the ratio of the scaled standard deviation of
Operating Income over the past 5 years to the scaled
standard deviation of CFO over the past 5 years. Also,
calculate this same ratio for two of the firm's competitors
and then make a relative comparison of these ratios.
– Other things you might look at (depending on your
industry):
• Compare change in NI to change in Basic EPS (Is firm
“managing” the EPS number by adjusting number of
shares outstanding?)
• Check list of Diagnostics from last class.

15.535 - Class #8 7
Where Next?

• Quiz #1 in Class on Thursday.

– Open notes. No laptop

computers/PDAs/cellphones, pagers!

– Bring a calculator
– 50 minutes long.
– Priority for review:
• Review sample questions
• Review class notes
• Review all class handouts
• Skim over selected reading assigned in class
• Review Session this evening in this room.

15.535 - Class #8 8
Team Project

• Part 1 of your Team Project:

– I answer more questions in class on Thursday


(after quiz).
– Report is due by noon on Friday, March 7.

– Please ensure that the names of all team

members are on team's report.

– Your complete report should merged into one file


(either PDF or MS Word format).
– This file must be e-mailed to both Professor

Wysocki and to 2 members of your corresponding


Due Diligence Team by noon on Friday.

15.535 - Class #8
9

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