Facts About Earnings Management To Avoid Earnings Decreases And Losses

Literature Overview

Describe about the facts about Earnings Management to Avoid Earnings Decreases and Losses?

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.

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 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.

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).

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.

Other Comprehensive Income

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).

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).

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.

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.

Annual Reports for study of GAP INC

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.

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).

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 Dichev’s 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 year’s earnings-last year’s earnings)/Last year’s 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.

Charles et al study and FASB

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 Inc’s filings for 2015. Specifically, all the Form 8-K filings made by the company during the year have been taken.

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.

Entry into a material definitive agreement on Oct 16, 2015; May 21, 201;

Change in directors or principal officer, Financial condition, Financial ‘statements and Exhibits on Oct 21, 2015; Sep 30, 2015;

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;

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 8^th 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.

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.

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>.