Lesson Preparation Project
Chapter 11: Earnings Management

11.1 Overview

“Earnings management is the choice by a manger of accounting policies so as to achieve some specific objective”

There are two ways to think about earnings management: as an opportunistic behaviour by managers to maximize their utility and from an efficient contracting perspective.

Issues arise in regards to earnings management due to the choice of accounting policies, discretionary accruals, and finally the line where management becomes mismanagement.

11.2 Evidence of Earnings Management for Bonus Purposes

In 1985 earnings management was researched to see if managers would manage net income so as to maximize their bonuses under their firm’s compensation plans. Healy examined firms whose compensation plans are based on current reported net income only, this is also known as bonus schemes. With a typical bonus scheme, reported net income will have a lower bound called bogey and upper bound called cap. A manager’s bonus will increase as reported net income increases, unless there is a cap at which point the bonus will remain the same as net income continues to increase beyond the cap. A manager will not receive any bonus when income is below the bogey. Healy predicted that when net income is between the bogey and cap is the manager motivated to adopt accounting policies to increase reported net income. Net income that is below the bogey or above the cap would motivate managers to “take a bath” whereby they will try to reduce or minimize net income. By taking a bath below the bogey, managers will then increase the probability of receiving a bonus the following year since current write-offs will reduce future amortization charges. Likewise, managers would take a bath (to a lesser extent) to decrease net income since a bonus would be permanently lost on reported net income