Managers engage in different ways to manage their earnings. They take on a specific pattern depending on the economic condition or their characteristic – that is, whether they are risk-averse or not. In the next few slides, I will describe four different patterns of earnings management: taking a bath, income minimization, income maximization, and income smoothing.
Taking a Bath pattern can take place during period of organizational stress or when a company is undergoing major reorganization. In this pattern, managers feel that if they must report a loss, they might as well “clear the decks” and report a large one. They do so by writing-off assets in order to provide for future costs. Because of accrual reversal, this enhances the probability of future reported profits.
The next pattern is Income Minimization. This is similar to Taking a Bath but it’s less extreme. Firms going through periods of high profitability usually take on such a pattern. Policies that suggest income minimization include rapid write-offs of capital and intangible assets and expensing A&P and research & development expenditures. It can also be noted that Canada’s progressive tax rate provides another incentive for this pattern.
Looking at the other end of the spectrum, managers also manage their earnings upwards. This pattern is usually common in companies where managers are driven by bonuses. Another incentive to choose this pattern is to avoid debt covenant violation which I will explain in detail later on in the presentation.
Income smoothing is the use of accounting techniques to level out net income fluctuations from one period to the next. Companies indulge in this practice because investors are generally willing to pay a premium for stocks with steady and predictable earnings streams, compared with stocks whose earnings are subject to wild fluctuations. Managers also choose this