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Earnings Management and the Threshold Model Case Study

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Updated: Jul 15th, 2020

Introduction

Earnings are perceived as the most significant part of the financial reporting by both insiders and outsiders of the company. Moreover, the investors, market analysts, and customers seem to evaluate the overall performance based on the reported earnings. Also, the rewards and achievements of the executives are judged by the merit of the accumulated value of the company’s earnings under their leadership. Therefore, despite generally following the accounting standards of the GAAP, the managers are tempted to engage in earnings management. There are several areas, in which managers are more flexible in their methods, including different inventory options, managing debt allowance, recognizing transactions and sales that were not finished, etc. (Degeorge and Zeckhauser 3).

Thus, there are a considerable number of the explicit and implicit factors, to which earnings management is a response. In this perspective, earnings management is defined as strategic restructuring the information about the earnings presented in the financial reports presented to the audience to create a certain impression about the company’s performance (Schipper 100).

When studying the reasons behind the earnings management, it is important to identify the possible implications for the different specialists in the sphere of accounting because it would improve the standards of financial reporting. For example, one of the ways to explain the antecedents and reasons for earnings management is a threshold model.

A Threshold Model of Earnings Management

A threshold model is a pattern that anticipates the executives’ decisions to make an impact on the earnings reported to the external audience. The model is based on the data of the different interactions between the agents of the financial sphere, including executives, customers, investors, standards-setters, analysts, etc. However, the cases of the earnings management are all very different, and, therefore, there are three thresholds for different situations.

The first threshold concerns reporting positive profits, cash flow, and revenues. The motivation, in this case, is the necessity to represent the company’s performance in the right light. The cash flow is always one of the most significant aspects of the welfare of the firm (Hayn 125). The second threshold is an attempt to sustain the performance of the company in comparison to the previous financial periods.

The managers might try to boost the cash flow and revenues by different means, including both real economic actions and actions of misreporting (Easton, Harris and Ohlson 119). The typical example of misreporting is to include the same information in the reports from different periods. It may be either the profits from the previous accounting period or the profits from sales that were not yet shipped. Such type of earnings management is used to create an impression of the company’s growth.

The second threshold is meeting the expectations of the outside audience, and it can include the opposite type of earnings management, which is earnings delay. In such a case, the managers who are unwilling to pay the cost associated with the company’s profits, such as stakeholders’ dividends, postpone reporting the profits. Another example of timing the cash flow is reporting pro forma earnings (Kothari and Sloan 145). The motivation for such type of earnings management lies in the external factors, like the stakeholders’ interests or the government regulations imposed on the earnings.

Evidence of Earnings Management to Exceed Thresholds

The influential potential that those thresholds have resulted in an increase in earnings management among the executives. Furthermore, in most cases, earnings management is hard to monitor because to identify it the analyst would need to see the unmanaged data. However, the first step is to recognize the patterns of earnings management based on such variables as the earnings distribution and earnings management potential (Degeorge and Zeckhauser 15).

For example, the so-called optimistic bias of the analysts concerning the company’s profits triggers the threshold of earnings management in terms of meeting the analysts’ expectations. However, for the threshold of making a positive profit, the executives do not even need the forecast from the market analysts because it is a self-evident factor. Both the psychological perception of the company and the executives’ benefits depend on positive profits. Therefore, the thresholds are distributed unequally, and the threshold of making positive profits is dominant because it applies to all the companies and is triggered by a larger number of factors.

The Effect on Future Earnings from Earnings Management

Whenever the executives manipulate earnings, they borrow the reported profits from the upcoming financial periods (Healy and Palepu 409). It cannot help but influence their future earnings. In this respect, the important correlation is that the companies who easily beat the benchmark of their last year’s performance are less likely to be involved in the earnings management than the companies who just meet or merely exceed the recent benchmark. Moreover, it has an accumulative effect, and the longer the company tries to sustain the performance, the more it needs to borrow from its future earnings.

Concluding Discussion

Thus, three major thresholds motivating the earnings management among the executives include making positive profits, sustaining the previous performance, and meeting the forecast of the analysts. However, the threshold of making positive profits is the dominant one since it applies to all the companies and is triggered by a larger number of factors.

Works Cited

Easton, Peter D., Trevor S. Harris, and James A. Ohlson. “Aggregate accounting earnings can explain most of security returns: The case of long return intervals.” Journal of Accounting and Economics 15.2-3 (1992): 119-142. Print.

Degeorge, Francois, Jayendu Patel, and Richard Zeckhauser. “Earnings management to exceed thresholds*.” The Journal of Business 72.1 (1999): 1-33. Print.

Hayn, Carla. “The information content of losses.” Journal of accounting and economics 20.2 (1995): 125-153. Print.

Healy, Paul M., and Krishna G. Palepu. “Information asymmetry, corporate disclosure, and the capital markets: A review of the empirical disclosure literature.” Journal of accounting and economics 31.1 (2001): 405-440. Print.

Kothari, Stephen P., and Richard G. Sloan. “Information in prices about future earnings: Implications for earnings response coefficients.” Journal of Accounting and Economics 15.2 (1992): 143-171. Print.

Schipper, Katherine. “Commentary on earnings management.” Accounting Horizons 3.4 (1989): 91-102. Print.

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