Earnings Management to Avoid Earnings Decreases and Losses

Question: Describe about the facts about Earnings Management to Avoid Earnings Decreases and Losses? Answer: Introduction The company taken for the study is GAP INC. It is a retail operator in global apparel which operates in 90 countries. The hypothesis is tested through the annual reports of Gap Inc. taken between the years 2010 and 2015. Particular emphasis is given to the years 2011, 2012, 2013, and 2014. The study is made in three parts. The first part is about the finding of Charles et al. on Other Comprehensive Income (OCI) and AOCI. The second part is about earnings management and trends in estimates according to the findings of Burgstahler and Dichev. The third part is about News Disclosures, their timeline and market reaction. Literature Overview Other Comprehensive Income From the financial reports of Gap Inc, we find that the comprehensive income comprises of net income as well as other gains and losses that affect equity and excluded from net income. The OCI components are Foreign currency translation gains and losses, net of tax; Changes in the fair value of derivative financial instruments, net of tax Adjustments reclassified for realized gains and losses on derivative financial instruments, net of tax. Annual Reports for study of GAP INC Annual Report 2011(Murphy, 2011 Annual Report) Annual Report 2012(Murphy, 2012 Annual Report) Annual Report 2013(Murphy, 2013 Annual Report) Annual Report 2014(Peck) Proxy Report 2015(Yahoo) Charles et al study and FASB(Chambers, Lismeier and Shakespeare) Charles et al have made a study comparing findings between tests, where comprehensive income using as-reported income post-SFAS 130 period and pre-SFAS 130 period to ascertain the measurement error effect on returns-relevance tests on OCI. The study is made to show that OCI is not priced by investors. Two components of ICI, which are unrealized gains/losses on securities available-for-sale, are priced by investors. According to archival evident, OCI report in shareholders equity in the statement of changes is weighted heavier than OCI as present in performance statements by investors. Pension adjustments in performance statements have been weighted negatively while that, which is reported in statement of changes in equity, provides a positive weight by investors. OCI is priced as predicted by the economic theory relating to transitory income items post-SFAS 130 on a dollar-for-dollar basis. Financial statement of GAP INC. The financial statements of Gap Inc help to study findings of Charles et al for a period of five years from 2010 to 2016 (February). OCI in financial statement or footnotes We find that Gap Inc has incorporated the updated FASB accounting standards in their annual reports from 2012 with unrealized gain/loss for each component both in the financial statements and in footnotes. Unrealized gains and losses that relate to investments, derivative hedges and foreign currency fluctuations are main components of OCI. The derivative financial instruments gains and losses which are designated as cash flow hedges are reported as a component of OCI. Unrealized gains and losses on marketable securities and foreign currency translations are two components that are estimated by Item 238- marketable securities adjustment and item 230- retained earnings-cumulative translation adjustment respectively. It is (in $M) 28 in 2014; 17 in 2013 and 6 in 2012(Peck). The footnotes of Gap Inc. state long-term debt in note 5 including interest expense; share-based compensation in note 10; leases in note 11; income taxes in note 12; employee benefits plans in note 13; earnings per share in note 14 and segment information in note 16 (Murphy, 2013 Annual Report). Prominent display for user to incorporate in their analysis Derivatives in cash flow hedging relationship show gains recognized in OCI as $166 in 2014; $78 in 2013 and $46 in 2012. Derivates in net investment hedging relationships, show gain in OCI as $4 in 2014; $17 in 2013 and none in 2012 ($million). Pattern of each OCI component over time ($ in millions) Table 1: Foreign Currency Transaction Component 2014 2013 2012 Mean Variance Standard Deviation Foreign currency transaction gain/loss -$34 $1 -$3 12.67 342.33 18.50 Realized and unrealized gain from certain derivative financial instruments 28 16 9 17.67 92.33 9.61 Net foreign exchange gain/loss -$6 $7 $6 6.33 0.33 0.58 Source: Annual Report of Gap Inc. Table 1 shows that foreign currency transaction gain/loss appear relatively independent and fluctuate randomly up and down across the years. Table 2: Derivatives in Cash Flow Hedging Relationships Component 2014 2013 2012 Mean Variance Standard Deviation Derivatives in cash flow hedging relationships 166 78 $76 106.67 2641.33 51.39 Gain recognized in other comprehensive income $53 $59 $5 39 876 29.60 Gain reclassified into cost of goods sold and occupancy expenses $8 $11 $4 7.67 12.33 3.51 Derivatives in net investment hedging relationship Gain recognized in other comprehensive income $4 $17 - 7 79 8.89 Source: Annual Report of Gap Inc. The consistency in cash flow helps to measure earnings over time. The publication of separate statements helps to establish the relevance of the components of OCI. The asset group is available at its lowest level with identifiable cash flows and is largely independent of its cash flows within another group of assets. Footnote disclosure of AOCI As the company did not liquidate or sell its hedged subsidiaries during these periods, the accumulated OCI has not been reclassified into derivative financial instruments income under net investment hedging relationship. Table 3: Accumulated Other Comprehensive Income under Note 10 in Annual Report 2014(Peck) $ in millions Foreign Currency Transaction Cash Flow Hedges Total Mean Variance Standard Deviation Balance at Feb 2014 107 29 135 90.33 3017.33 54.93 Foreign currency transaction -47 - -47 -31.33 736.33 27.14 Change in fair value of derivative financial instruments - 118 118 68.67 4641.33 68.13 Amounts reclassified from accumulated OCI - -41 -41 -27.33 560.33 23.67 OCI -47 77 30 20 3919 62.60 Balance at Jan 31, 2015 60 105 165 110 2775 52.68 Source: Annual Report of Gap Inc. Additional disclosures are provided in note 8 regarding reclassification of AOCI and its effect on the consolidated statement of income under their respective items. Table 4: Other comprehensive income or loss, net of tax according to financial reports of GAP INC.(Murphy, 2013 Annual Report) Other comprehensive income or loss, net of tax in $ 2014 2013 2012 2011 Mean Variance Standard Deviation Foreign currency translation, net of tax -47 -51 -71 24 -36.25 1723.58 1.52 Change in fair value of derivative financial instruments, net of tax 118 48 28 -11 45.75 2920.25 54.04 Adjustments reclassified for realized gains or losses on derivative financial instruments, net of tax benefit -41 -43 -5 31 -14.50 1225 35 Other comprehensive income or loss, net of tax 30 -46 -48 44 -5 2385.33 48.84 Source: Annual Report of Gap Inc. Consistent signals in companies about earnings quality have low persistent earnings. This is due to negative forecast revisions and high accruals or positive forecast revisions and low accruals. We find that Charles et al has made the study stating that unrealized gains and losses which are components of OCI are from 1) sponsoring defined benefit pension plans 2) re-measure of net assets from foreign subsidiaries 3) Hedging derivatives 4) holding marketable securities. Earnings Management/Trends in Earnings (Burgstahler and Dichev) Burgstahler and Dichev have found strong evidence to the fact the earnings are managed by firms to control loss and decrease in income. About 12% manage earnings and avoid a decrease in earnings. About 44% manage earnings to show positive earnings. They point out that the cash flow from operations is used to manage earnings (Burgstahler and Dichev). Long-term summary of income in the annual report. Table 5: Trends in Earnings Year Market Value (in million USD) Income (in million USD) Scaled Value (in million USD) Earnings per share Estimated Earnings per share 2010 - 1204 - 1.89 1.87 2011 9354.7 833 -0.040 1.57 1.59 2012 12362.2 1135 0.024 2.35 2.45 2013 16471.9 1280 0.009 2.78 2.60 2014 17906.9 1262 -0.001 2.90 2.80 2015 18145 2390 0.062 2.43 2.43 Source: Fortune 500 Using Burgstahler and Dichevs methodology in the annual report of Gap Inc. we find that Gap Inc. has shown a steady increase in income from the year 2011 to 2015. Though its income fell in 2011 from $1204m to $833 m, it has been steadily increasing from $833m to $2390m in 2015. The market value of the company for the beginning of each year as well as the earnings per share has been taken from Fortune 500. The scaled changes in yearly earnings are calculated as: Scaled changes = (This years earnings-last years earnings)/Last years beginning market value. From Table 4.1we find that the scaled earnings have fallen less than zero in 2011 and 2014 due to lower earnings. In 2014 it is very close to zero and has missed it very marginally; however it has recorded a steep fall in 2011. In 2012, 2013 and 2015, it has fallen on the positive side of zero. This scaling shows systematic relations between signs of market price and earnings(Gardner). The scaled value has fallen most in 2011(Huddleston). Burgstahler and Dichev show that scaled earnings distribution exhibit discontinuities at zero and that mangers have to take both accounting and real actions to avoid loss. It also shows that managers feel inclined to incur real costs in order to reach targets. The estimated earnings per share have been taken from the website Fortune 500. By comparing the actual with the estimated earnings, we find that the actual earnings per share is more than the estimate marginally in 2010 while in 2011 it has decreased marginally. However in 2015 the actual and estimated earnings per share are equal. An investor appreciates a company that shows positive movement and is able to surpass estimates. It makes him retain his investment in the company as he would get good returns. Good News / Bad News Disclosures This is the third part of the project that looks at the news that the company has announced for its calendar year of 2015 from the SEC website to EDGAR to find Gap Incs filings for 2015. Specifically, all the Form 8-K filings made by the company during the year have been taken. Form-8 filing (Yahoo!)(SEC) Form 8-K, filed with the SEC, helps to notify investors in US public companies regarding specific important events like bankruptcy, change of CEO, etc., have to be filed on Form 8-K as a Current Report within four business days. Good News Entry into a material definitive agreement on Oct 16, 2015; May 21, 201; Bad News Change in directors or principal officer, Financial condition, Financial statements and Exhibits on Oct 21, 2015; Sep 30, 2015; Mixed News Bylaws amended and restated on Nov 14, 2014 Indenture by and between Registries and Wells Fargo Bank on April 12, 2011 To a Vote of Security Holders, Submission of Matters on May 20, 2015; Neutral News Results of Operations and Financial Conditions on Feb 8, 2016; Nov 19, 2015; Nov 9, 2015; Aug 20, 2015; Aug 10, 2015; Feb 26, 2015; Feb 9, 2015. Regulation FD Disclosure, Exhibits and Financial Statements on Jan 7, 2016; Dec 3, 2015; October 8, 2015; September 3, 2015; July 9, 2015; June 4. 2015; April 9, 2015; March 5, 2015 Other Events, Financial Statements and Exhibits on Mar 6, 2015; Time line The earnings announcements are made through quarterly reports. The dates of these quarterly reports are Dec 8, 2015; Sept 8, 2015; June 8, 2015; March 23, 2015. The earnings announcements through quarterly reports are made on the 8th of June, September and December 2015 while in March it is on the 23 Results of operations and financial condition, financial statement and exhibits are made twice in November, August and February The Regulation FD disclosure, financial statement and exhibits are made for two consecutive months but not on the third month. They occur in March and April but not in May June and July but not in August September and October but not in November Other events like a change in directors, entry into a material definitive agreement, and to a vote of security holders, submission of matters do not occur frequently but once or twice a year. Market reaction The market price for 2014 shows a high of $44.59, 42.37. $46.85 and $43.85 in the first, second, third and fourth quarter respectively. It shows a low of $37.00, 38.38, $35.46 and $37.20 for first, second, third and fourth quarter respectively. It has increased during the first and last quarter but decreased during the second and third quarter from its previous year. Through credible future signals, managers can enhance earnings quality. Markets react to good news when statements of disclosures accompany them. Investors seek credibility in the market forecast through disclosures. Conclusion With the proposed change to the 2007 amendment to IAS 1, the users make use of OCI components information regarding the timing and amount of future cash flows, financial instruments and employee benefits(Norwalk). Chambers et al. have found that two components of OCI which are foreign currency translation adjustment as well as unrealized gains/losses on available-for-sale securities have been priced by investors. Burgstahler and Dichev methodology has also been applied to show that income is manipulated to project a better picture to the user. The market fluctuates to good, bad, neutral and mixed news and it is found true through the analysis of the reports of Gap Inc. Though the analysis is limited, the findings are relevant for the welfare of the user. Works Cited Burgstahler, David and LLia Dichev. "Earnings Management to Avoid Earnings Decreases and Losses." Journal of Accounting and Economics (1997): 99-126. Chambers, Dennis J, et al. "An evaluation of Sfas No. 130 Comprehensive Income Disclosures." Social Science Research Network (2006): 557-593. Gardner, David. Motley Fool . 5 December 2015. 25 February 2016 . Huddleston, Tom. Fortune. 16 February 2016. 24 February 2016 https://fortune.com/fortune500. Murphy, Glenn. "2011 Annual Report." Sharing American Style (2012): 1-100. . 2012 Annual Report. Annual Report 2012. California: Gap Inc., 2013. . 2013 Annual Report. Annual Report 2013. California: Gap Inc., 2013. Norwalk, C T. "Presentation of Items of Other Comprehensive Income." IFRS (2011): 1-12. Peck, Art. 2014 Annual Report. Annual Report. California: Gap Inc., 2015. SEC. SEC. 31 January 2015. 25 February 2016 https://www.sec.gov/Archives/edgar. Yahoo. GPS Proxy Statement 2015. 24 February 2016. 24 February 2016 https://finance.yahoo.com. Yahoo! Yahoo! Finance. 24 February 2016. 25 February 2016 https://finance.yahoo.