Earnings Management
It is the practice of using accounting techniques to manipulate earnings in financial statements
Updated:
September 15, 2022Earnings management uses accounting techniques to manipulate financial statements, particularly earnings, to make them appear excessively better. To anyone unfamiliar with earnings, it represents the company's profit for a specific period.
The critical role of this management technique is to take advantage of the accounting principles and rules to make income appear more consistent (also known as income smoothing) and to create constant profits over different periods or quarters.
If a firm experiences financial struggles or is performing poorly in a specific period, this is where this management technique can be used to conceal (or at least improve) such information to create stronger financial reports.
However, this is not the only purpose where. There are other various intentions on why management uses this technique.
In the financial statements, earnings are usually represented as the "net income," which appears in the income or profit and loss statement. A common question frequently is: How to detect it in financial statements?
The answer is in the footnotes of the organization's financial statements. Reading and analyzing the footnotes can unveil the accounting policy changes manipulated by the organization.
There are several indications when a company is practicing this manipulation technique. One of the signs comes from the company's declaration of its revenue increase without corresponding increases in its cash flow.
Another indication comes from the increase in income in the final quarter of the year, when companies would like to close their fiscal year with a positive outlook to the public.
When the life of the fixed assets is expanding, this might also signify this management technique taking place. Finally, the last indication occurs when an asset's value is inflated without using the true depreciation schedule.
Another question that is commonly asked is: Is it legal for companies to practice this management technique?
The answer is a simple yes. As long as the accounting choices fall under GAAP or generally accepted accounting principles, then it is perfectly fine.
To people unfamiliar with this term, it is a set of accounting rules and standards that includes the definitions of concepts, principles, and industry-specific rules.
The importance of earnings management is for companies to reduce the fluctuations in earnings, maximize profits and keep the value of their stock high.
Usually, after a company publishes its earnings, the stock price will rise and fall depending on whether the result meets the analyst's expectations.
Therefore, it is important for management to use accounting practices to manipulate the result to meet financial expectations to keep the stock price relatively high.
Motives
This manipulation technique's primary motive is to make stakeholders feel that the company is performing well. When income is high, executives of the companies are normally rewarded with incentives and bonuses, which encourage them to maintain high levels of income.
Also, earnings management increased the overall wealth of the stakeholders, such as the owners. For this to occur, management aligns analysts' forecasts to meet present and future periods.
As such, the benefit leads to the appreciation of the stock, which will enhance the overall wealth of the owners or stakeholders of the company.
Likewise, on the other hand, the consequences to the company are that if it fails to meet the expectation of analysts, it might otherwise cause a reduction in the stock value leading to an overall decrease in wealth to owners/stakeholders.
Other motivation factors include stock market incentives, internal motives, concealing or signaling hidden information, and many more.
Purpose
There are various reasons why many companies adopt this management technique. The main ones involve window dressing, achieving internal targets, income smoothing, and external expectations.
1. Internal targets
Another reason earnings management is used to achieve the internal targets set by the company. Managers often employ this technique to achieve internal targets such as income expectations or departmental budgets. This way, they can achieve and realize the incentives set by the company.
2. Income smoothing
Income smoothing balances fluctuations or volatility in net income from one reporting period to another. To level out these fluctuations, companies often use accounting techniques to achieve continuous growth patterns where companies will likely appear to have stable incomes.
3. External expectations
External expectations occur when companies have already made estimates or forecasts of their profits. Investors will expect the amount of profit to be similar to or greater than the figure projected by the company.
Likewise, management will likely shift the revenue from one accounting period to another to meet investors' expectations. With earnings management, the company can utilize accounting policies to manipulate financial reports.
Techniques in Earnings management
There are many techniques. The main ones include "One-time charges," "Cookie Jar Reserves," "Operating activities," "Revenue and expense recognition," and "Changing accounting method."
1. One-time charges
One-time charges usually consist of large one-time charges or expenses (for example, writing off costs of a failed project) in their financial report.
This technique involves allocating the charges or expenses to periods where income is relatively high. It usually occurs when companies can " absorb the hit" due to strong performances in that period.
Likewise, if a company might incur big one-time charges in the current period, it might take advantage of allocating future expenses to that period as well, which is known as "The Big bath." Therefore companies will take large hits in the current period to make future periods appear more profitable.
2. Cookie jar reserves
Cookie jar reserves are another technique when companies set reserves in the previous quarter to use in periods where profits are relatively low.
This technique can deceive investors by making a company's earnings seem consistent. Likewise, it will mislead investors into valuing the stock higher than its actual worth.
This technique can be achieved by overestimating common reserves such as expected legal settlements or bad debts or taking large, once-expected losses from a specific event.
For example, suppose a company overestimates bad debts of $5mil in the previous quarter. In that case, it can use the proportion of the expense to compensate for periods where the company experiences terrible quarters.
3. Revenue and expense recognition
The "Revenue and expense recognition" technique manipulates the dates when revenue or expense is recognized. For example, the company can increase income in the current period by recognizing the revenue of future periods to the current period.
Likewise, if the company wants to decrease expenses in the current period, it can also recognize current expenses in future periods.
The company may also transfer the extra income that the company receives from the current period to the next period, which delays the revenue recognized in the current period. Similarly, expenses from future periods can be recognized in current periods to make future income appear better.
4. Changing accounting method
The last technique is called the changing accounting method. As its name suggests, the method involves using different accounting methods to work what's best for the company.
When changing the accounting method results in income changes, the company is engaging in earnings management.
An example of choosing different accounting methods can start with changing the inventory method such as using FIFO or LIFO to account for their inventory, changing depreciation methods such as straight line or diminishing balance method, using cash basis or accrual accounting methods, and many more.
Is it ethical or unethical?
Opinions on whether earnings management is ethical or unethical are different. The most crucial factor in differentiating between "good" or "bad" management is the managerial intent of the company.
With this being unknown, it leaves uncertainty to know the true purpose and leave a conclusion on this matter.
Earnings management is a bad practice but is a necessary evil of the business. It is usually used to smooth out performance, giving a steadier picture of the company. Still, it becomes problematic when it is misused to manipulate numbers and create a false narrative about the bottom line.
Every management and accountant has their personal opinion of it.
A lot of times, it could be used to motivate employees to achieve targets and bonuses, which will then protect the interest of employees.
To conclude this question, many opinions divide whether this management technique is morally wrong or correct. However, survey evidence suggests and supports the opinion on how earnings management is unethical and morally wrong to use in companies.
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