Earnings Management

Knowledge Center

   

Contents

  1. Summary
  2. Forum
  3. Best Practices
  4. Expert Tips
  5. Resources
  6. Print
 
Earnings Management

Definition Earnings Management. Description


Earnings Management refers to accounting practices used by the management of a company to deliberately manipulate the company's earnings to smooth income over several accounting periods and/or to meet other pre-determined targets.


As the application of Revenue Recognition rules under IAS/IFRS and U.S. GAAP in specific settings still leaves room for considerable latitude and judgment by management (e.g. determining when revenue has been earned and is realizable), managers can sometimes exploit the flexibility in the accounting standards to manipulate Reported Earnings in ways that mask the underlying performance of the companies.

 

Some typical forms of earnings management are the following:

  • Inaccurate revenue recognition.
  • Unsuitable accruals and estimates of liabilities.
  • Excessive provisions and generous reserve accounting.
  • Intentional minor breaches of financial reporting requirements that aggregate to a material breach.

Although Earnings Management is not new, it has become increasingly common in today's marketplace due to pressure to meet analysts' earnings forecasts. Some managers have even resorted to outright financial fraud (e.g. Enron, Global Crossing, WorldCom), which led former SEC (Security and Exchange Commission) Chairman Arthur Levitt to warn that "the motivation to meet Wall Street earnings expectations may be overriding common sense business practices. (...) As a result, I fear that we are witnessing an erosion in the quality of earnings, and therefore, the quality of financial reporting".

 

Quality of Earnings

 

The term 'quality of earnings' usually refers to the degree of conservatism in a firm’s reported earnings. Indicators of high earnings quality include the following:

  • Use of the completed contract method of accounting.
  • Minimal capitalization of interest and overhead.
  • Minimal capitalization of computer software costs.
  • Expensing of startup costs of new operations.
  • Conservative revenue and expense recognition methods.
  • Bad-debt reserves that are high relative to receivables and past credit losses.
  • Rapid write-off of acquisition-related intangible assets.
  • Use of LIFO inventory accounting (under the assumption of rising prices).
  • Use of accelerated depreciation methods and short useful lives.
  • Minimal use of off-balance-sheet financing techniques.
  • Clear and adequate disclosures.
  • Absence of nonrecurring gains and non-cash earnings.
  • Conservative assumptions used for employee benefit plans.
  • Adequate provisions for lawsuits and other loss contingencies

Management Discretion


The discretionary nature of income recognition permits an examination of the degree of management manipulation of earnings under one or more of the following guises:

  • Classification of Good News/Bad News: Management prefers to report good news “above the line” as part of continuing business and bad news “below the line” as extraordinary or discontinued business.
  • Income Smoothing: Some companies reduce earnings in good years (defer gains or recognize losses) and inflate earnings in bad years (recognize gains or defer losses).
  • Big-Bath Accounting: In contrast to income smoothing, the big-baht accounting suggests that management will report additional losses in bad years in the hope that, by taking all additional losses at one time, they will “clear the decks” once and for all.
  • Accounting Changes: Regardless of whether accounting changes are voluntary or mandatory, they typically have no direct cash flow impact and consequences. Therefore, such changes can be viewed as a form of earnings manipulation.

 

Earning management is also referred to as Creative Accounting.


Earnings Management Forum
  Ethical Issues in Working with a Dubious Accounting Firm
What are the ethical issues in co-operating with an international accountancy and consultancy company on a government sponsored review when that company has been repeatedly fined and censured for malpractice?

As a director, does one argue ...
     
 
  Stock Markets Look Beyond Published Earnings to Determine the Value of a Firm
Most listed companies rely on published earnings figures as a key driver of stock market value. But earnings are only one of the signals the financial markets is waiting for.
This is not to say that accounting earnings information is not importa...
     
 
  Managing Expectations Before Results
How can we avoid too positive / optimistic expectations for the results before their release? How to supress the anxiousness about the results?...
     
 
  Earnings Management Erodes Shareholder Value
The phenomenal called earnings management or creative accounting has led to the failure of numerous companies world over. Various governments shoud put in place appropriate legislation to culb the menace. The real owners of companies (i.e. shareholde...
     
 
  Earning Management or Fraudulent Accounting
To me it seems out of place to refer to fraudulent practices as either earning management or creative accounting.
An alternative name should be considered to refer to the positive impression the name connotes....
     
 
  Why are the Regulators not Stopping Earnings Management?
If we are aware that "earnings management" is causing lots of companies to run into liquidation, what are the regulators doing? Are we protecting the vulnerable owners or do we want them to lose confidence in accounting and business practices?...
     
 
  Strict Criminal Rules Required
We need to curb the menace of earning management. The key to the solution lies in the recognition of earning management as a criminal offense (financial crime) by the society in general and the shareholding community in particular.
This w...
     
 
  Managing Expectations is a Crucial Accounting Skill
If I were evaluating the management of a mature business in a mature industry, I'd expect the finance function to be able to manage expectations and deliver results accordingly with no surprises.
Similarly, the CFO would have the same exp...
     
 
  Causes of Earning Management
Earning management is a human reaction to the usual rules to evaluate management performance. Nobody wants to be criticized owing to not to obtain the expected results.
We should focus on the way this performance is evaluated. If the "ana...
     
 
  Absence of Earnings Management
In case the top management of a public company completely abstains from any form of earnings management, what influences may this have on the firm's short or long term financial results?...
     
 
  When is an Accounting Practice Ethical?
Do you agree that if an accounting practice is not explicitly prohibited, or is only a slight deviation from the rules, it should be considered an ethical practice? Why?...
     
 

Earnings Management Special Interest Group


Special Interest Group

 

Best Practices - Earnings Management Premium
  Who Teaches the Customer?
Budgets and forecasts are imperfect and risk is associated with them.
But it seems that the "customer" wants perfection every time. Perhaps the "customer" also needs to be educated as to what she or he could expect of companies.
If s...
     
 

Expert Tips - Earnings Management Premium
 

Stock Buybacks as a Means of Value Extraction

According to Prof. Lazonick, in the USA the increased corporate profitability over the last couple of years did not lead to higher economic prosperity...
Usage (application): Stock Buybacks, Stock Repurchases, Corporate Profitability, Economic Prosperity, Executive Compensation, EPS
 
 

Resources - Earnings Management Premium

Dealing with Complexity / Transparency in Financial Information

This presentation is about information transparency, and includes the following sections:
1. Introduction: an experiment
2. Transparency: th...
Usage (application): Corporate Transparency, Financial Complexity, Information Complexity, Information Transparancy
 

Earnings Management: Motivations and Techniques

Presentation about the motivations of earnings management; common techniques; it’s appropriateness and elements of an earnings meltdown. The presenta...
Usage (application): Earnings Management, Income Smoothing, Window Dressing
 

Ethics and Ethical Dilemmas in Business

Presentation about ethical behavior and ethical dilemmas. The presentation includes the following sections:
1. Introduction
2. What are ‘Eth...
Usage (application): Ethics, Ethical Behavior, Business Ethics, Ethical Decision-making
 

Unethical Behavior: Why do we Do it and how to Recognize it?

Presentation that basically explains why business people are so often behaving unethical and why it is more apparent in hard times. The presentation a...
Usage (application): Business Ethics, Human Behavior, Ethical Behavior, Corporate Ethics, Creative Accounting
 

Earning Management: Creative Accounting, Fraud and Accounting Scandals

Presentation about the similar concepts of Creative Accounting, Impression Management and Fraud, by M. Jones. The following sections are presented: Usage (application): Accounting, Controlling
 

Transparency of Financials: Case Studies

Presentation about transparency during the credit crisis, based on two different cases. The presentation includes the following sections:
1. Summ...
Usage (application): Corporate Transparency, Financial Transparency, Lehman Brothers, Barclays, Financial Crisis
 
 

News

Earnings Management
     
 

Videos

Earnings Management
     
 

Presentations

Earnings Management
     
 

More

Earnings Management
     
Special Interest Group Leader

You here


 

Return to Management Hub: Finance & Investing


More on Management  |  Return to Management Dictionary  | 

 

This ends our Earnings Management summary and forum.

About 12manage | Advertising | Link to us | Privacy | Terms of Service
Copyright 2016 12manage - The Executive Fast Track. V14.1 - Last updated: 27-9-2016. All names tm by their owners.