Wiedman 2004. Managers can use their position to influence the firms’ financial reporting, giving them opportunity to manage earnings Marquardt
and Wiedman 2004. The objective is to sell managers’ stocks at higher price in seasoned equity offerings.
2.1.2 MethodsMechanism of Earnings Management
Earnings management can be managed either through accounting accrual or real activities.
1. Accruals earnings management
The measurement of accruals earnings management itself, originally, is through total accruals. It is because accruals earnings management focuses
on the choice of accounting policies. A particular model is then assumed to generate the non-discretionary component of total accruals, thus, it allows
total accruals to be divided into non-discretionary accruals and discretionary accruals Dechow et al. 1995.
Healey 1985 and DeAngelo 1986 model fit well for an assumption that non-discretionary accruals is constant over time. However, Kaplan
1985 argues that non-discretionary accruals is not constant over time, it changes to response the changes in economic circumstances. As a result,
there is a need to propose a new non-discretionary accruals model, and the Jones model set in place.
Jones 1991 model attempts to control the effect of changes in firms’ economic circumstances on non-discretionary model. The Jones model for
non-discretionary accruals can be seen below. NDA
߬ = ߙ
1
1A ߬
– 1
+ ߙ
2
ᇞREV߬+ ߙ
3
PPE ߬
in seasoned equity offerin n
gs gs.
2.1.2 Method
d s
s M
Mechanism of Earnings Manage geme
m nt
Ea Earnings managem
me ent
t ca
c n
n be
be man
an aged either
th th
ro r
ugh accounting ac
c cr
crual or real ac c
ti t
vi vi
ti i
e es.
1. Ac
Ac cr
cr u
uals ear ar
ni ni
ng s
ma nagement
The e
m me
asur em
ent of acc rual
s earnings m an
ag em
ment i
itse se
lf lf
, ,
or o
igin n
al a
ly, is
is t
throu u
gh total accru al
s. It is bec au
se accrual s
earnings m an
nagem men
en t
t focuse es
on t t
h he
c hoice of accou
nt ing poli
cies . A p
ar ticular model is
the hen as
as su
su me
me d to
ge e
n ne
rate the n on
-discretio na
ry c
om po
nent of to
tal ac
cruals, th u
us, it allow ws
s to
o ta
l accruals to be div ided
i nt
o non-di sc
reti on
ary accruals and d
discretio onary
ry ac
ac cr
c ua
ls Dech
ow w
e e
t t
al al.
19 19
95 9
. Healey 1985 and DeAn
An ge
ge lo
lo 1986 model fit well for an assump
mp ti
tion on
th th
at non-discretionary accruals is constant over time. Howev v
er er, Ka
Kapl pl
an 1
98 98
5 5
a a
rg rg
ue ues
th th
at at
n non-d
d i
is cr
cr et
etio iona
nary ry a
accrual l
s s
is is
n n
ot ot
c on
on st
st an
t t over
er t
t im
im e, it
ch ch
an an
ge g
s to r r
es esponse the ch
h an
anges in e economic circum
umstances. A As a result,
there is a need to propose a a new non-
-discretionary accruals model, and the Jones model set in place.
Jones 1991 model attem empts
s to control the effect of changes in firms’
economic circumstances on non- d
discretionary model. The Jones model for
Explanation: A
߬
– 1
: total assets at ߬
– 1
ᇞREV߬ : revenue in year ߬ minus revenue in year ߬
– 1
scaled by total assets at
߬
– 1
PPE ߬
: gross property, plant, and equipment in year ߬ scaled by
total assets at ߬
– 1
ߙ
1
ǡ ߙ
2
ǡ ߙ
3
: firms specific parameters
The assumption used is that revenue is part of non-discretionary accruals. However, some part of revenue is established by managers’ discretion. There
is probability that managers accrue revenues when cash is not yet received at the year-end, thus it will be questionable whether revenues have been earned
or not Dechow et al. 1995. If revenues is accrued, but not yet earned, the revenues amount and total accruals receivables are more likely to be
increased Dechow et al. 1995. To adjust with the assumption that not all revenues are non-
discretionary accruals, the modified Jones completed the model. NDA
߬ = ן
1
1 A ߬
– 1
+ ן
2
οREV߬- οREC߬ + ן
3
PPE ߬
Explanation: A
߬
– 1
: total assets at ߬
– 1
ᇞREV߬ : revenue in year ߬ minus revenue in year ߬
– 1
scaled by total assets at
߬
– 1
οREC߬ : net receivables in year ߬ minus net receivables in year ߬
– 1
scaled by total assets at ߬
– 1
PPE ߬
: gross property, plant, and equipment in year ߬ scaled by
total assets at ߬
– 1
ߙ
1
ǡ ߙ
2
ǡ ߙ
3
: firms specific parameters
The assumption prevails is all changes in credit sales results from earnings management Dechow et al. 1995. It is easier to manage earnings through
g p p
y y
, p ,
q p y
y total
l as
as se
ts at ߬
– 1 –
ߙ
1
ǡ ߙ
2
ǡ ߙ ߙ
3 3
: :
f firms specific parameters
The assu su
mp tion used is tha
ha t re
e ve
ve nu
nu e
e is
i p
p art of non-discr
cret e
ionary accruals. Ho
Ho we
ver, some pa
part rt
o o
f revenue is establi h
sh ed
ed b
b y
y ma
m nagers’ disc
c re
re tion. There
is proba babi
bili i
ty ty
that m ma
na gers accru
e revenu
es w w
he he
n cash h i
is s
no not
t yet rece
ceived at th
th e
e ye ye
a ar-end
nd ,
th us i
t will be questi
on able wheth
er rev
en n
ue u
s ha ha
ve ve b
bee ee
n ea a
r rned
or not De
chow et al
. 1995. If
re venues is
ac crued, but n
ot ot yet
t e
ear arned, th
he reve
e nu
es amount and to
tal ac cr
ua ls re
ce iv
ables are mor e
like ke
ly ly
t t
o o be
in c
cr eased D
ec how
et al. 1 99
5 .
To adjust wi th
the assumpt io
n th at not all revenue
s s are
non n-
di di
s sc
re ti
onary ac
c cr
cr ua
ua ls
ls, th
th e
e mo
m dified Jones
es c
c om
om pl
pl et
et ed
ed t
he m
od el.
NDA ߬ = ן
1
1 A ߬
– 1
1 –
+ +
ן ן
2
οREV߬- οREC߬ + ן
3
PPE ߬
Explanation: A
A ߬
– –
1 1
– –
: :
t t
ot al ass
et et
s s
at at
߬ ߬
– –
1 1
– –
ᇞ ᇞRE
REV V
߬ ߬
: : revenu
u e
e in y
y e
ear ߬ mi
minus reve ve
nu n
e in
in y
y ea
ea r
r ߬
߬
– 1
–
sc scaled by
total asse e
ts t
at ߬
– 1
1 –
οREC߬ : net recei i
v vables in
ye y
ar ߬ minus net receivables in year ߬
– 1
scaled by total ass
sets at ߬
– 1 –
PPE ߬
: gross pr roperty, pl
a ant, and equipment in year
߬ scaled by total asse
ets at ߬
– 1 1
–
ߙ
1
ǡ ߙ
2
ǡ ߙ
3
: firms spe ecific p
p a
arameters
The assumption prevails is all changes in credit sales results from earnings
discretion over revenue recognition on credit sales than cash sales Dechow et al. 1995.
2. Real earnings management
Real earnings management uses real activities manipulation to manage earnings. Roychowdhury 2006 defines real activities manipulation
as departures from normal operational practices, motivated by managers’ desire to mislead at least some stakeholders into believing certain financial
reporting goals have been met in the normal course of operations. It usually results in abnormal cash flow from operation, discretionary expenses, and
production costs. There are three manipulation methods that raise the abnormal value;
sales manipulation, reduction of discretionary expenses, and overproduction Roychowdhury 2006.
A. Sales manipulation
Sales manipulation is an attempt by managers to increase sales temporarily through price discount offer or more lenient credit terms
Roychowdhury 2006. The price discount offer will likely to retain higher current sales because higher current sales volume. However, the increased
sales volume will disappear, as the old price is re-established Roychowdhury 2006. The consequence, it will make the lower future cash flows because
customers expectation regard future discount price Wardani and Kusuma 2011. The higher the sales volume, the lower the margins, thus it will make
the production costs relative to sales to be abnormally high. Real earnings ma
ma n
nagement u u
se se
s s
real activities manipulation to manage earning
ng s
s. Roychowdhury 2006 defines r r
ea ea
l activities manipulation as depar
ar tu
tures from norma a
l l
op o
er e
at at
io io
na na
l l
pr pr
actices, motiv at
at ed by managers’
de e
si sire to mislea
a d
d at at
l l
e east some stakeh
h l
ol de
de r
rs i int
nto o
b believing cert
rtai a
n financial report
t in
ing g go
go a
als have ve
b b
een met in the
norma l
l co
cour u
se of f op
op er
er at
a ions. It
It usually re
e su
sult lts
s in a
a bn
bn orma
l cash flow
fr om
operation, disc re
ti ti
onary y
ex ex
pe pe
ns n
es, and
pr pr
o oduc
c ti
ti on
costs. Th
ere are three ma
nipula tion
metho ds
that raise the ab
b no
n rm
m al
al v
v al
a ue;
sa l
le s manipu
la ti
on , reduct
ion of
dis cr
et io
nary exp en
se s, and o
ve erpro
d ductio
on n
R R
oychowdhury 2006 .
A. A.
Sa le
s ma ni
ni pu
pu la
la ti
ti on
on Sales manipulation is
a an
a a
t ttempt by managers to increase
s s
al al
e es
te te
mp m
orarily through price discount offer or more lenient c c
re re
d dit
t te erm
rms R
oy h
ch ow
ow dh
dhury y 20
20 06
06 . T
he he
p pri
rice ce
d dis
isco count
of of
fe fe
r r
wi wi
ll ll
l l
ik ik
el el
y t
to retai ai
n n
hi higher
cu cu
rr rr
ent sale le
s s
be because higher
r current
s sales volume.
H H
ow ow
ever, th th
e e increased
sales volume will disappear, as the old p
price is re-established Roychowdhury 2006. The consequence, it
w w
ill make e the lower future cash flows because
customers expectation regard f
f utur
r e
e discount price Wardani and Kusuma 2011. The higher the sales volume
m , the lower the margins, thus it will make
Another method to boost sales is through more lenient credit terms. The more lenient credit terms, the lower cash inflow regards with the future
receivable collectability Wardani and Kusuma 2011. It can be concluded that sales manipulation results higher production cost and lower current
period CFO than the normal level Roychowdhury 2006. B.
Reduction of discretionary expenses Managers will reduce the discretionary expenses RD, advertising,
and SGA expenses because they do not generate immediately revenue and income. It will result in unusually low discretionary expenses, and if it is in
the form of cash, it leads to lower cash outflows Roychowdhury 2006. In the end, it gives positive effect on abnormal cash flow from operation in the
current period Roychowdhury 2006. C.
Overproduction Overproduction means lower fixed costs per unit, hence, reduction in
total cost per unit. In the income statement, it will affect the cost of goods sold number; it becomes lower and firms report higher operating margins.
The incremental marginal costs incurred in producing more inventories, results in higher annual production costs relative to sales Roychowdhury
2006.
2.1.3 Patterns of Earnings Management
