Earnings Management in Accounting

Earnings management in accounting refers to the practice of intentionally influencing a company's financial statements to present a desired image of its financial performance. This can involve actions such as timing revenue recognition, altering expense reporting, or utilizing accounting policies that may comply with regulations but still distort the true financial picture. While some view earnings management as a legitimate tool for navigating the complexities of financial reporting, others criticize it for potentially misleading stakeholders, including investors and creditors.

The motivations behind earnings management can vary widely, ranging from meeting analyst forecasts to securing favorable loan terms. It is important to note that while some forms of earnings management may fall within the boundaries of accepted accounting practices, they can raise ethical concerns and lead to questions about the integrity of financial information. The implications of earnings management are significant, as they can impact stock prices, investment decisions, and overall market confidence. Understanding the nuances of this practice is essential for those interested in the field of finance and accounting.

Published in: 2021

By: Joseph Dewey, PhD

Subject Terms

Earnings Management in Accounting

Last reviewed: February 2017

Abstract

“Earnings management” describes accounting strategies used by companies to cast business profiles in the most favorable light. Stakeholders periodically review company financial reports, and on these occasions it is in the best interest of the company to appear as prosperous and healthy as possible. Earnings management seeks to satisfy or impress outside interests, especially banks who might be interested in extending credit to the company and stockholders, or potential stockholders, who own a part of the company and need to be reassured that their investment is paying off.

Overview

The logic behind earnings management is simple: A business needs to appear healthy and profitable regardless of problems that may in fact exist. For the purpose of presenting an overall positive picture, accountants can use certain legal maneuvers to minimize negative areas. An analogy illustrates the concept:

A student in an English class earns 210 points out of an available 250 for an 84 percent or a midrange B. The point total is divided into three areas: a major paper, worth 100 points; a major exam, worth 100 points; and an attendance grade, worth 50 points. The scoring grid indicates the student earned an 80 on the paper and an 80 on the test and attended every class for 50 points, equaling 210. The impression given is that student is clearly working at a stable and effective pace. However, the teacher has done some creative bookkeeping. In reality, the student bombed the test but did well on the paper, so the teacher manipulated the numbers just a bit, moving some of the grade points earned on the paper over to the test grade column.

The student point total is exactly the same, but the overall picture, instead of showing strength in one area and weakness in another, indicates stability and steady progress in all areas. By redistributing the points the instructor has created a student profile that is more balanced and more reassuring to parents. No one is alarmed by the end of the period grading report, and the student returns to the classroom, hopefully better focused on future tests, without having to deal with the drama the low test score might have occasioned.

Like the student, a business also maintains a public profile, one generated and sustained by quarterly financial statements that reveal appropriate metrics for gauging a company’s financial stability and potential. The use of these statements by external stakeholders, for example, in valuing stocks, can result in pressure on company financial officers to manipulate earnings to present a rosier picture than the unmanipulated figures might suggest (Goel, 2016).

An accountant theoretically holds allegiance not to the company that has hired them but rather to the numbers. Internally, a company must rely on accurate numbers to position itself for growth and to maintain its operations. Honesty in financial reporting is therefore essential, even when a company pitches into a downward period. Externally, a range of stakeholders also rely on transparent financial reporting. Stockholders who are invested in the company, clients who rely on the company for critical products or services, potential stockholders who are hunting for smart investments, and banks who may hold a financial stake in the company or who might be approached by the company for some future financial investment as a way to expand and evolve, all depend on honest self-reporting by the company to protect their own financial interests.

A healthy financial statement creates the picture of a company’s stability and consistency. The company, for its part, creates a public perception of itself by releasing quarterly projections that set particular revenue goals. Many of these are shared with stockholders and banks, and some projections are designed for internal use and are used to gauge company performance. Companies naturally have a compelling need to be perceived as financially sound. If necessary, accountants can use certain legal strategies to create narratives intended to control stakeholders’ perceptions of a company’s financial condition.

In most cases, earnings management will come into play when a company faces a difficult quarter, a period in which the company experiences either an “abnormal and extraordinary” (Nieken & Sliwka, 2015) catastrophic financial setback or a more sustained downward trend that the company could not manage.

Short-term setbacks can be caused by events such as major technology upgrades, work stoppages, fuel price spikes, or natural disasters. A company may make or lose a major investment, introduce a disappointing new product line, or experience the turnover of key operating officers without suffering long-term harm, but any event that shows lower revenue in a quarter can give the impression that a company is experiencing a financial downturn.

The specter of investors shying away, banks second guessing loans, creates an incentive for the company accountant to look for creative ways to smooth the company’s financial numbers to lessen the impact of these down spikes. The overall earnings numbers can be carefully reapportioned to cover the dimensions of the decreases; investments can be carried over into the next quarter; holdings can be sold off to lessen the apparent impact. The numbers are not generated, which would be fraudulent and illegal, but rather they are deftly, cleverly moved around.

In fact, although companies most often use earnings management to soften bad economic news, companies can use the same principle to manage what is apparently good news. In quarters in which the company’s financial health is robust—that is, earnings beyond the company’s own public or even internal projections—the accountant can actually squirrel away some percentage of that excess (called a cookie jar) as a kind of rainy day fund against a future quarter in which the news may not be so good or larger market events may make profits more difficult to secure. That rainy-day backup can cover quarters in which the company plans on raising expenses by, for example, retooling facilities or updating operations.

The idea of earnings management is not to deceive investors but rather to present a rosy picture of financial stability. These financial statements, regardless of how they present the numbers, can also be used with confidence by auditors checking the company financials (Commerford, Hermanson, Houston & Peters, 2016).

Applications

A company may use earnings management in four specific areas, each one clearly limited in its impact so as not to create the appearance of fraud. A company might pursue earnings management as a way to impress potential investors by simply moving around numbers to create a positive impression for a specific quarter. If a company, for instance, is interested in a major expansion and wants to pitch for investments, by dressing up a single quarterly report, that investment pitch, made either to stockholders or to a lending bank, can be critical.

Second, a company can use earnings management internally as a way to carry on the appearance of soundness as a strategy to reassure supervisors and executive management teams that operations are steady. If a department or a division sets an internal goal for earnings in a particular quarter and fails to meet that goal, creative bookkeeping can soften that failure and encourage staff operations to maintain efficiency without creating worry and/or anxiety. If moving numbers, borrowing from previous quarters or paying problems forward to the next quarter, creates a sense of stability without creating a sense of false security, then earnings management is a way for a company to maintain its financial equilibrium.

Third, a company can commit to earnings management for the long term if that company cycles through expected and entirely predictable periods of revenue spikes and drops.

Department stores, for example, or car dealerships experience predictable busy seasons. The intention—called smoothing—is to creatively move numbers quarter to quarter, season after season, as a way to sustain company confidence. Accountant to accountant, year to year, the practice becomes methodology and the company comes to rely on smoothing as a way to avoid the ups and downs of a business cycle. This is the most common earnings management practice and really comes to be expected by company executives, stockholders, and sponsoring banks. It is better for a company to maintain a stable and reasonable profit margin over years than to have spikes in income followed by drops (Rosenfeld, 2000).

However, the fourth occasion in which earnings management becomes a strategy of choice represents the most potentially problematic. A company may broadcast an especially upbeat projection picture for a particular quarter, literally banking on those projections as a way to encourage investment and stock confidence. In such a case, however, any measure of financial success that fails to meet the company’s projections, can appear to indicate the company is in trouble and set off repercussions that can dramatically impact the long-term viability of the company itself. Rumors begin to spread, investors begin to panic, banks reconsider their financial support, executive management lose lucrative bonuses, employees sweat out the possibility of large-scale cutbacks, and potential investors opt to find more stable investments.

Compelled by such external and internal pressures, the accounting department can execute far more sophisticated methods of earnings manipulation to make the company appear to be far closer to its optimistic projections. If the next quarter of operations does not help, the practice of massaging numbers to meet increasingly too-optimistic projections can in turn become the status quo, the way a business does business. Quarter to quarter, earnings management can create an increasingly un-real financial profile. Those numbers become increasingly interrelated and more and more borderline fictions—and if the company comes to rely on that perception rather than on the reality, the company will face drastic financial consequences, in the most extreme cases bankruptcy.

Earnings management was at the heart of the 2002 Enron scandal. Enron, a massive global energy and utilities conglomerate and stock trading giant headquartered in Houston, elevated earnings management to extraordinary levels of fraud as a way to raise capital against a non-existent revenue portfolio, stimulating growth and investment while padding its senior management’s own income levels. The company would build a utility plant, for example, or invest in an existing resource excavation and project its profit levels into the millions, then maintain its company portfolio (and its company incentives and bonuses) against those projections rather than any actual numbers. Losses were never figured into the books—rather losses were constantly moved about. The company so altered its actual income profile that when the magnitude of the deception was finally realized the company went into forced bankruptcy, shaking the foundations of the investment market itself. The scheme was driven almost entirely by rampant personal greed at a level that simply boggled the layers of public utilities investigatory commissions subsequently empaneled to investigate the collapse of the company.

Viewpoints

Earnings management has the potential to blur lines of basic business ethics. Nevertheless, earnings management is a necessary element of accounting itself—numbers must be aligned into narratives. Numbers by themselves cannot tell a complete financial story, and accountants must realize the dimensions of a company’s operations and tailor their financial statements and earnings reports to match as nearly as possible the reality of the company’s financial profile. Companies must operate against their own operations as a way to build toward their own future. Financial statements are the best way for a company to stake its position.

Some business ethicists dismiss earnings management entirely as a means of distortion and fraud and do not allow even the possibility that anything but corresponding accounting, that is dollar for dollar clear tallying of a business’s income against its expenses, can maintain a company’s financial health. Companies—specifically their senior level executives—face enormous pressures to meet their own financial projections as a way to maintain the image of a robust company, attract new investment, and meet their fiduciary duty to shareholders. Not incidentally, their own income levels and bonuses are often tied to meeting these projections (Almadi & Lazic, 2015). Critics warn that such a model tends toward high-risk behavior and corruption. Further, greed can become a driving force, with irresponsibility directing the process.

Rather than simply account for causes (larger market downturns, resource scarcity, energy spikes, labor disputes, management ineptitude, and personnel issues) and then train their entire operations to minimize those causes in the future, a company may opt to “create its own success.” In a top-down organization, such an approach creates within the company an environment of moral relativity. An unethical climate emanating from the top is “likely to minimize the importance of corporate ethics” and result in the rationalization of unethical decision making and reckless earnings management (Shafer, 2015).

The result, of course, is a profound loss of trust in the integrity of the accounting field itself and generally expands a larger culture in which fraud and deception and greed are simply accepted as inevitable. One company’s practice then encourages other companies to follow suit. The investment climate becomes unstable (Ming-Chia & Chieg-Wen, 2013). In such circumstances, accountants face pressure to maintain what is at best a thin line between legal financial sleight-of-hand and intentional fraud.

Terms & Concepts

Cash Accounting: A system of correspondence in which an accountant tracks expenses absolutely against revenue.

Cookie Jar: In accounting, the practice of setting aside revenue above projections and then factoring that into financial statements for later quarters in which the company does not perform as well.

Financial Statement: An involved summary, for public perusal, of a company’s expenses and revenues as a way to define the solvency of that company.

Impact Factor: In accounting, events that affect a company’s financial position in any given quarter.

Integrity: A cornerstone trait for accountants, the honest interpretation of reliable data.

Internal Goals: Projections the company sets within its own operational perimeter and seldom makes public.

Smoothing: The entirely legal accounting practice of redistributing revenue during a specific quarter to minimize the appearance of spikes and drops in company performance.

Bibliography

Almadi, M., & Lazic, P. (2015). CEO incentive motivation and earnings management. Management Decision, 54(10), 2447–2461. Retrieved October 23, 2016, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=119313138&site=ehost-live

Bratten, B., Payne, J. L., & Thomas, W. B. (2016). Earnings management: Do firms play “follow the leader”? Contemporary Accounting Research, 33(2), 616–643. Retrieved October 23, 2016, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=115813093&site=ehost-live

Commerford, B. P., Hermanson, D. R., Houston, R. W., & Peters, M. F. (2016). Real earnings management: A threat to auditor comfort? Auditing: A Journal of Practice & Theory, 35(4), 39–56. Retrieved October 23, 2016, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=118891515&site=ehost-live

Goel, S. (2016) The earnings management motivation: Accrual accounting vs. cash accounting. Australasian Accounting Business & Finance Journal, 10(3), 48–66. Retrieved October 23, 2016, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=118528310&site=ehost-live

Ming-Chia, C., & Chieh-Wen, SW. (2013). Workplace spirituality and earnings management motivations. International Journal of Business & Information, 8(2), 267–298. Retrieved October 23, 2016, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=95589708&site=ehost-live

Nieken, P., & Sliwka, D. (2015). Management changes, reputations, and “big bath”-earnings management. Journal of Economics and Management Strategy, 24(3), 501–522. Retrieved October 23, 2016, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=108562739&site=ehost-live

Rosenfield, P. (2000). What drives earnings management? Journal of Accountancy, 190(4), 106–110. Retrieved October 23, 2016, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=3624402&site=ehost-live

Shafer, W. (2015). Ethical climate, social responsibility, and earnings management. Journal of Business Ethics, 126(1),43–60. Retrieved October 23, 2016, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=100256477&site=ehost-live

Earnings Management in Accounting

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Subject Terms

Earnings Management in Accounting

Abstract

Overview

Applications

Viewpoints

Terms & Concepts

Bibliography

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