Earnings management (accounting)
Earnings management in accounting refers to the practice of using various accounting methods to present a company’s financial performance in a more favorable light. This can involve altering financial statements to mislead stakeholders about a company's true economic condition, often with the intention of meeting or exceeding earnings expectations set by investors and analysts. Managers may feel compelled to inflate earnings to secure bonuses and compensation linked to financial performance, which can create conflicts of interest. The methods employed can range from legitimate practices within generally accepted accounting principles (GAAP) to more questionable techniques that can border on fraud, such as "cooking the books."
The practice of earnings management has grown notably since the 1990s, particularly as stock prices and shareholder expectations became increasingly prioritized. Scandals involving high-profile companies like Enron and WorldCom in the early 2000s drew significant criticism and led to regulatory reforms, such as the Sarbanes-Oxley Act, aimed at enhancing the integrity of financial reporting. Techniques for earnings management include accrual-based earnings management, real activities-based management, and the "big bath" approach, all of which can potentially compromise the reliability of financial information. Ultimately, while some aspects of earnings management are legal, they raise concerns about the quality and transparency of reported earnings, affecting investors' perceptions and trust in financial markets.
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Subject Terms
Earnings management (accounting)
Earnings management is the selection of accounting practices to produce financial reports that make a company's economic performance look better. The process concerns altering financial reports to mislead investors about a company's finances and to obtain desirable outcomes dependent upon reported earnings. Managers are pressured to inflate earnings numbers to meet shareholder and analyst expectations and to secure compensation and bonuses that are based on earnings performance.
Earnings management occurs within the framework of generally accepted accounting principles (GAAP), the rules that govern how companies record and report financial statements. The practice utilizes loopholes within GAAP through legitimate and illegitimate techniques.
The process can benefit companies by using the flexibility of accounting procedures to convey private information to investors. The practice ventures into a gray area if the manipulation of financial reports is efficient or opportunistic. Earnings management escalates into fraud if the company misrepresents its financial results, a practice known as "cooking the books."
The practice of earnings management can diminish the integrity of financial reporting and earnings quality, which is the ability to forecast a company's future performance accurately.
Background
Earnings management goes by several names, including income smoothing, accounting hocus-pocus, the numbers game, aggressive accounting, and creative accounting, among others. The management of accounting numbers comes down squarely to earnings. Earnings are the most important indicator of a company's performance. An increase in earnings signals a boost in a company's value, while a decrease in earnings points to a reduction in value. The financial reporting of earnings often affects a company's stock prices. Share prices typically rise if disclosed earnings meet or exceed Wall Street expectations. Prices fall if earnings come in short of forecasts.
The use of earnings management techniques among companies grew during the 1990s as managers placed more significance on stock value and prices. The growing practice soon captured the attention of federal regulators. In a speech in 1998, Securities and Exchange Commission Chairman Arthur Levitt said the practice of earnings management was extensive in the business world and that accounting was being corrupted in an effort to meet market expectations.
Several companies were caught in public accounting scandals in the early 2000s. One of the most prominent scandals involved energy-trading giant Enron, which committed corporate fraud by inflating its earnings. Another involved telecommunications company WorldCom, whose bankruptcy filing in 2002 remains the largest insolvency in US history. The scandals turned attention to the accounting practices of large firms and upset investor confidence in financial reports.
The fall of Enron, WorldCom, and other corporations led to an overhaul of securities regulations in the form of the Sarbanes-Oxley Act. The landmark legislation, passed by Congress in 2002, instituted reforms to remedy inadequacies in financial reporting and prevent instances of accounting fraud.
Overview
Earnings management involves "moving money around." Fluctuations in income and expenses are smoothed out by shifting earnings from one fiscal period to another. This make profits look more stable and consistent to shareholders.
Managers have different motivations for engaging in earnings management. Their objectives may match or conflict with those of investors. They may choose accounting practices that inflate earnings to meet or beat the expectations of shareholders and market analysts. When the financial reports are released, the company's stock price will continue to rise as long as earnings match or exceed projections. The deliberate influencing of financial reports to raise the firm's value is efficient, meaning that managers put the interests of the shareholders first.
Managers may also select procedures that boost earnings numbers because these numbers affect compensation and bonuses. Those in charge may also receive stock options, which generate profits when share prices rise. As earnings are the most important indicator of performance, bonuses are often contingent upon meeting accounting numbers. The manipulation of financial reports for compensation or bonuses is opportunistic, meaning that managers put their own interests ahead of shareholders' interests.
Various earnings management techniques can be used to alter financial reports. Three common methods of earnings management are accrual-based earnings management (AEM), real activities-based earnings management (REM), and the "big bath" technique.
Under AEM, management can shift money from profitable years into less profitable ones. Accruals are increasing or decreasing estimates of expenses. Management estimates the expenses that the company will pay in the future and records them in the current fiscal period. By recording a higher expense in the current fiscal period, management can record less in a future period. This is sometimes known as cookie jar reserves because management has created a reserve of profits that it can dip into later.
REM is the convenient timing of actual business activities to obtain a desired outcome in financial reporting. A sale of equipment may be scheduled during a fiscal period that can benefit from the additional earnings. Repairs, capital projects, and other expenses are pushed back when earnings are low in the current period.
Another method of earnings management is the "big bath" technique. This method follows the theory that if a company must report bad news, then it should report it all at once, or take a "big bath." If a company incurs a major loss due to restructuring, it can report a one-time charge against earnings. The one-time charge includes all expenses and write-offs incurred during the year. By overstating its "big bath" expenses, the company can inflate earnings in the future.
The practice of earnings management could harm the credibility of financial reporting. Investors may question if a company's reports reflect its true financial state. Although the Sarbanes-Oxley Act implemented provisions to improve financial reporting, several methods of earnings management are legal and work within the boundaries of GAAP, despite being efficient or opportunistic. Earnings management could also erode earnings quality. If reported earnings are inflated, then the forecast of a company's future performance may be based on inaccurate or unreliable data. The forecast itself may be unrepresentative of the company's actual financial picture. While earnings management techniques allow companies to benefit from the loopholes of GAAP, the process itself straddles a fine line between legal and illegal accounting practices.
Bibliography
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