Interests between managers and shareholders due to separation of control and ownership

While the struggle of involvements between directors and stockholders due to separation of control and ownership is good understood, an of import facet of pull offing those differing involvements is the demand to command directors ‘ behaviors through monitoring mechanisms ( Jensen and Meckling, 1976 ; Watts and Zimmerman, 1986 ) . At the root of many of the large-scale corporate dirts in the US and Europe during the recent old ages lies the phenomenon of the timeserving net incomes direction ( Goncharov, 2005 ) . Net incomes direction is a effect of struggle of involvements between directors ( agents ) and stockholders ( principals ) and can be described as the discretional change of income statements to convey information about the house ‘s public presentation with the purpose of bettering directors ‘ place ( Iturriaga and Hoffmann, 2005 ) .

In their seminal work “ A Review of the Earnings Management Literature and its Deductions for Standard Setting ” , Healy and Wahlen ( 1999 ) conclude that net incomes direction remains a fruitful country for academic research and suggest that future research parts “ will come from documenting its extent and magnitude for specific accrualsaˆ¦from identifying factors that limit net incomes direction ” ( p. 380 ) . The impact of debt funding on net incomes direction is an empirical controversial issue and both a positive and a negative consequence can be justified. It may be hypothesised that purchase is positively related to house ‘s net incomes direction behavior ( e.g. Mohrman, 1996, Gu et Al. 2005 ) . Others believe that a negative relation should be expected between debt funding and the discretional scope of directors ‘ accounting determinations.

With mention to the academic theoretical and empirical literature:

Critically evaluate net incomes direction phenomena ; ( 30 Markss )

Discourse the impact of purchase ( and other house features ) on net incomes direction. ( 70 Markss )

( Entire: 100 Markss )


This essay intends to sketch the happening of net incomes direction. For the intent of showing valid statements, theoretical and empirical literature has been used where able possible. For the easiness of presentation, the essay has been structured in two parts. Part I includes the account of the phenomenon of net incomes direction in general and farther discusses the bureau theory, techniques of pull offing net incomes among other basicss of net incomes direction. Part II highlights the factors which impact net incomes direction and besides mentions the effects the house has to bear one time net incomes direction is revealed. It farther sheds light on agencies which should be looked into in order to avoid net incomes direction.

Part I

Net incomes, sometimes called ‘bottom line ‘ or ‘net income ‘ , indicate the extent to which a company has engaged in value-added activities and are a signal that helps direct resource allotment in capital markets. In fact, the theoretical value of a company ‘s stock is the present value of its future net incomes. Increased net incomes represent an addition in company value and reduced net incomes signal a lessening in that value ( Lev, 1989 ) . Thus holding said this, since net incomes signify the value of a house, in order to increase the house ‘s value it is indispensable to increase its net incomes. An addition in net incomes can be brought about through legal and ethical ways. However, an addition in net incomes can besides be counterfeited and shown on fiscal statements when in fact much less has really been earned. This phenomenon gives rise to the construct of net incomes direction.

Healy and Wahlen ( 1998 ) have defined net incomes direction to happen when directors use opinion in fiscal coverage and in structuring minutess to change fiscal studies to either misdirect some stakeholders about the implicit in economic public presentation of the company, or to act upon contractual results that depend on reported accounting Numberss.

The inclination to act upon contractual results is elucidated though the bureau job. Copeland, Weston and Shastri ( 2009 ) explain that bureau jobs arise in houses because corporate determinations are made by directors ( agents ) on behalf of the house ‘s capital providers ( principals ) ( pg. 461 ) . They province that there is evidently a difference between ownership and control, and there is no ground to believe that the director, who serves as an agent for the proprietors, will ever move in the best involvement of the stockholders ( pg. 41 ) . The bureau job therefore arises when there is struggle of involvement originating between creditors, stockholders and direction because of differing ends ( ) . Optimum undertaking agreements might name for really big sums of compensation for executives, provided that such compensation is designed to supply directors with powerful inducements to heighten stockholder value ( Jensen and Murphy, 1990 ) . The bureau job emanates from the agreement where the involvements of the agent differ well from those of the principal because of the impossibleness of absolutely undertaking for every possible action of an agent whose determinations affect both his ain public assistance and the public assistance of the principal ( Brennan, 1994 ) .

Therefore we can comprehend that bureau job further gives rise to the activity of net incomes direction. Iturriaga and Hoffmann ( 2005 ) province that net incomes direction is a effect of struggle of involvements between directors ( agents ) and stockholders ( principals ) and can be described as the discretional change of income statements to convey information about the house ‘s public presentation with the purpose of bettering directors ‘ place. Arya, Glover and Sunder ( 1998 ) discuss that when directors choose accounting accumulations, impersonal communicating of the house ‘s implicit in economic world to the readers of fiscal studies is non needfully their lone end. This end can go intermeshed with directors ‘ desire to utilize fiscal studies, particularly net incomes, opportunistically to function their ain personal terminals.

Assorted techniques are used to pull off net incomes. Big bath is a technique to pull off net incomes where a company manipulates its income statement to do hapless consequences look even worse and is frequently utilized in a bad twelvemonth to unnaturally heighten following twelvemonth ‘s net incomes ( Hoje and Yongtae, 2007 ) . Income maximization and income minimizations, as the names suggest, are techniques used to increase or diminish the income. Bonus schemes create an inducement for directors to choose accounting processs and accumulations to increase the present value of their awards ( Watts and Zimmerman, 1978 ) ; pull offing net incomes where the accounting methods lead to an lessening in income is seen to be adopted before direction buyouts ( Woody, 1997 ) . Another technique where in houses use accounting processs to smooth or normalise net incomes in known as income smoothing and the same been widely discussed in accounting literature ( Moses, 1987 ) .

From above we can acquire an thought about certain motivations behind the net incomes direction phenomenon. But to acquire a comprehensive image we need to look at assorted other aspects of gaining direction. Gaining direction can be put to pattern by using assorted tactics. We will look at these in the succeeding portion.

A authoritative instance where net incomes direction has brought about a ruin of a house can be seen in instance of the Enron dirt. O’Connell and Webb ( 2002 ) have pointed out that the so CFO, Andrew Fastow ‘s, complex funding through particular purpose entities ( SPEs ) and stock options were carefully structured to avoid consolidation and revelation whilst understating revenue enhancement duties. The aims sought by direction were to accomplish favorable accounting Numberss to heighten the perceptual experience of their public presentation at the disbursal of bona fide economic aims and transparence of fiscal information for the proprietors and stakeholders.

Part II

2.1 Factors which impact net incomes direction

As mentioned in the definition above, net incomes direction may be undertaken to misdirect some stakeholders about the implicit in economic public presentation of the company. Assorted surveies have been carried out to analyze the impact of debt funding, revelation quality, issue of initial public offers ( IPOs ) , direction buyouts and assorted other activities on gaining direction. Information found in literature in discussed below.

Impact of Debt Financing

The grounds on the impact of debt funding on net incomes direction is non definite towards the positive or negative side. Sweeney ( 1994 ) examines the clip series of directors ‘ accounting determinations before and after houses violate accounting-based limitations, found in debt understandings and provides a direct nexus between accounting alterations and intimacy to debt-covenant restraints. The survey finds that in comparing to directors of the control houses, directors of the default houses make a greater figure of cash-increasing and non-cash-increasing accounting alterations in the old ages environing proficient defaults. DeFond and Jiambalvo ( 1994 ) carried out a research to verify the influence of debt compact limitations on accounting picks in the twelvemonth preceding and the twelvemonth of misdemeanor. They examined the unnatural sum and working capital accumulations of a sample of 94 houses that reported covenant misdemeanors in one-year studies during financial old ages 1985 through 1988 and found that in the twelvemonth prior to misdemeanor, the misdemeanor houses have unnatural sum and working capital accumulations that are significantly positive while in the twelvemonth of misdemeanor, there is grounds of positive use but non significantly different from nothing. Dechow, Sloan and Sweeney ( 1995 ) performed an analysis on the houses subject to accounting enforcement actions by the Securities and Exchange Commission for alleged misdemeanors of Generally Accepted Accounting Principles and chiefly investigated the motivations for and effects of net incomes use. They discover that the SEC houses are more extremely levered than the control group. The average purchase for the SEC houses is 26 % , which is significantly greater than the average purchase for the control houses of 16 % . The consequences besides indicate that 18 SEC houses ( 19.6 % ) have proficient misdemeanors of debt compacts while the corresponding degree of defaults for the control group is 9.8 % . On footing of these consequences they conclude that of import motives for net incomes use are the desire to raise external funding at low cost and to avoid debt compact limitations. However, there exist surveies which counter the aforesaid decisions. DeAngelo, DeAngelo and Skinner ( 1994 ) studied the accounting pick in 76 NYSE houses with relentless losingss and dividend decreases. Their research inferred that the accounting picks made by directors of 76 troubled houses chiefly reflect acknowledgment of their houses ‘ fiscal troubles, instead than systematic efforts to blow up net incomes to avoid debt compact misdemeanors or to otherwise portray the house as less troubled. They besides point out that troubled houses are capable to careful monitoring by private loaners. Once loaners are alerted to the chance of fiscal trouble because, e.g. , a given client studies losingss and/or reduces dividends, they perceive greater benefits from supervising direction and will therefore more readily ‘see through ‘ accounting gambits designed to paint a rosier-than-warranted fiscal image. A similar determination noted by Iturriaga and Hoffmann ( 2005 ) is that a negative relation should be expected between debt funding and the discretional scope of directors ‘ accounting determinations since higher the purchase, the more in-depth is the control undertaken by loaners. Thus precise impact of purchase on net incomes direction remains inconclusive.

Impact of Issue of Initial Public Offers ( IPOs )

Teoh, Wong and Rao ( 1998 ) province that relative to a matched sample of non-IPO houses, IPO houses are more likely to hold income-increasing depreciation policies and bed debt allowances in the IPO twelvemonth and for several subsequent old ages. They report that the average unexpected accumulations in the offer twelvemonth for houses doing initial public offers are 4-5 % of assets and about 62 % of houses doing initial public offers have higher unexpected accumulations than a matched sample of control houses. However Aharony, Lin and Loeb ( 1993 ) found really weak support for the hypothesis that entrepreneurs choose accounting methods to increase reported net income in the period prior to the public offering. They place an account that direction may waver to pull strings net incomes because they believe that investors closely analyze the prospectus so that use will non be rewarded with a higher monetary value.

Impact of analysts ‘ prognosiss and inclination to act upon investing in stock

Burgstahler and Eames ( 1998 ) find that houses manage net incomes to run into analysts ‘ prognosiss. Their consequences suggest that both ‘real ‘ operating actions, reflected in hard currency from operations, and actions of a ‘bookkeeping ‘ nature, reflected in discretional accumulations, contribute to net incomes direction to accomplish zero net incomes surprises. Kellogg and Kellogg ( 1991 ) province that the first two grounds for fraud, deceit, and use in fiscal statements are: ( a ) to promote investors to purchase an involvement in a company ‘s stock as proprietors, or in bonds as creditors ; and ( B ) to increase the value of the stock of present stockholders of the company. Similarly, the National Association of Certified Fraud Examiners ( 1993 ) states that the first ground why fiscal statement use is committed is to promote investing through the sale of stock.

Impact of Contracts

The definition given in portion I besides affirms that net incomes direction may be undertaken with a inclination to act upon contractual results. Contracts can be formed for managerial compensation which may act upon net incomes direction. Healy ( 1985 ) finds that there is a strong association between accumulations and director ‘s income-reporting inducements under their fillip contracts and fillip strategies create inducements for directors to choose accounting processs and accumulations to maximise the value of their fillip awards. Holthausen et Al ( 1995 ) further support this and happen grounds of directors pull stringsing net incomes in an attempt to maximise their performance-based compensation. Gaver et Al ( 1995 ) finds grounds that directors with fillip programs make earnings-increasing determinations, even if the house ‘s public presentation is below the threshold that would ensue in a payout from the fillip program. Debt related contracts or debt compacts have mixed consequence for their influence on net incomes direction which we have seen earlier.

2.2 Consequences of net incomes direction

The survey conducted by Dechow, Sloan and Sweeney ( 1996 ) studies that pull stringsing net incomes ab initio enables the houses to bask lower costs of capital, but that one time the net incomes use is revealed, the houses experience important additions in their costs of capital. This addition in costs of capital is because investors revise downward ( I ) their estimations of house value ; and ( two ) their beliefs refering the credibleness of the houses ‘ fiscal coverage system and the repute of direction. They besides report that houses subject to a SEC probe for gaining direction show an mean stock monetary value diminution of 9 % when the net incomes direction is foremost announced. Firms criticized in the fiscal imperativeness by Abraham Briloff for misdirecting fiscal patterns suffered an mean bead in stock monetary value of 8 % on publication day of the month ( Foster, 1979 as cited in Healy and Wahlen, 1998 )

Meanss to avoid net incomes direction

Lobo and Zhou ( 2001 ) behavior empirical analysis on a sample of 1,444 steadfast twelvemonth observations over the 1990-1995 period. Consistent with the hypothesis, a important negative relationship is found between corporate revelation and discretional accumulations. The empirical analysis indicates that corporate revelation and net incomes direction are significantly negatively related. Firms with lower revelation evaluations tend to prosecute more in net incomes direction and houses that engage more in net incomes direction tend to hold lower quality revelations. Therefore houses should pattern high quality corporate revelation. Dechow, Sloan and Sweeney ( 1996 ) find that their sample of net incomes operators are less likely to hold an audit commission, more likely to hold a company laminitis as CEO, more likely to hold a Chief executive officer who besides serves as the Chairman of the Board, more likely to hold a board of managers dominated by insiders, and less likely to hold an external blockholder monitoring direction. Jensen ( 1993 ) argues that boards of managers are ineffective proctors when the board is excessively big, when the board ‘s equity ownership is little, and when the CEO is besides the Chairman of the Board. In add-on, CEOs who are the company laminitiss are likely to hold greater influence over their houses ‘ operations and be less accountable to the board of managers. Similar thought is generated in Rosenstein and Wyatt ( 1990 ) which explains that boards composed mostly of foreigners are more effectual than boards with few seats taken by foreigners. Harmonizing to Holthausen and Larcker ( 1993 ) , an outside blockholder on the board of managers plays a important monitoring function. BECKER et. Al ( 1998 ) study consequences which add to the literature on audit quality by showing a direct relation between audit quality and net incomes direction. DeFond and Jiambalvo ( 1994 ) support this by indicating out that houses with accounting mistakes are less likely to hold audit commissions.


This essay intends to sketch the happening of net incomes direction. For the intent of showing valid statements, theoretical and empirical literature has been used where able possible. For the easiness of presentation, the essay has been structured in two parts. In portion I the phenomenon of gaining direction is highlighted where as portion II illustrates assorted theoretical and empirical consequences. The findings do turn out that net incomes direction is in being and undertaken by certain houses. However, the causes or determiners which influence net incomes direction are non wholly clear and farther surveies in this field are required to pull steadfast decisions.