19.2Earnings Manipulation

The focus of the chapter is on how information considerations affect financing and

investing choices. However, it is instructive to look first at how these considerations

affect the earnings reported by firms.

Recent accounting research suggests that managers sometimes manipulate the earn-

ings numbers of their firms in ways that increase reported income in the current year

at the expense of reporting lower earnings in the future. Managers have some discretion

Grinblatt1334Titman: Financial	V. Incentives, Information,	19. The Information	© The McGraw1334Hill
Markets and Corporate	and Corporate Control	Conveyed by Financial	Companies, 2002
Strategy, Second Edition		Decisions

Chapter 19

The Information Conveyed by Financial Decisions

661

over the firm’s accounting methods, which allows them to shift reported income from

the future to the current year and vice versa. For example, if the firm elects to use

straight-line depreciation, reported earnings are initially higher since the initial depre-

ciation expenses are lower than they would be with accelerated depreciation. However,

the opposite is true in later years: Accelerated depreciation methods cause reported earn-

ings in the later years to be higher than they would be with straight-line depreciation.

Similarly, the choice of inventory valuation methods—that is, LIFO (last in, first out)

or FIFO (first in, first out)—affects current year and future earnings, depending on

whether input prices are rising or falling.

These accounting methods are typically disclosed in a company’s public financial

statements. However, other undisclosed accounting decisions also affect earnings. For

example, managers have discretion in coming up with a number of estimates, includ-

ing the service lives and salvage values of depreciable assets, the lives of intangibles,

the uncollectible rate on accounts receivable, the cost of warranty plans, the degree of

completion when the percentage-of-completion method is used for certain assets, the

actuarial cost basis for a pension plan, and the interest rates for capitalized leases and

pension accounting. As illustrated below, accounting changes can have dramatic effects

on reported earnings.

The Management of Reported Earnings by General Motors²

Between 1985 and 1989, General Motors reported slightly rising earnings despite the decline

in its car and truck sales. Although the efforts of General Motors to streamline its opera-

tions may have contributed to this earnings increase, accounting changes also affected its

reported earnings.

In 1986, General Motors raised the expected rate of return on its existing pension assets,

which allowed it to reduce the amount that it was required to add to the fund in the cur-

rent and subsequent years. This increased reported profits in 1986 by about $195 million.

In 1987, General Motors increased the estimated useful life of its plant and equipment,

which reduced depreciation and amortization charges in that year, thereby increasing its

reported earnings by about $1.2 billion.