Earnings management involves utilizing various accounting techniques to produce financial statements that present an overly positive view of a company’s business activities and financial position. Management often makes judgments in applying accounting principles. Earnings management leverages these judgments to smooth or inflate a company’s earnings.
Key Insights
- Earnings management uses accounting techniques to enhance the appearance of financial stability and profitability.
- Companies adopt earnings management to portray consistent profits and minimize earnings fluctuations.
- A popular method includes adopting accounting policies that yield higher short-term earnings.
Digesting Earnings Management
Earnings refer to a company’s net income or profit over a specific period, be it monthly, quarterly, or annually. By employing earnings management, companies aim to smooth out earnings fluctuations, thus showing more stable profits.
Large variations in income and expenses are typical, yet they may worry investors who favor steady growth. Investors’ reactions to earnings announcements can significantly impact a company’s stock price based on whether the earnings meet or fall short of expectations.
Management may succumb to the pressure of meeting financial targets by manipulating accounting practices to sustain stock prices. Bonuses and stock options tied to earnings performance further drive this behavior.
Forms of earnings manipulation are often uncovered during audits by certified public accountants (CPA) or through required disclosures to regulatory bodies such as the Securities and Exchange Commission (SEC).
Important: The SEC mandates that the financial statements of publicly traded companies must be certified by the CEO and CFO, pressing charges against those who engage in fraudulent earnings management.
Demonstrations of Earnings Management
Accounting Policy Changes
One method involves switching to an accounting policy that temporarily amplifies earnings. For instance, a furniture retailer using the last-in, first-out (LIFO) method for inventory may switch to first-in, first-out (FIFO) to recognize older, cheaper inventory first, thereby lowering the cost of goods sold (COGS) and increasing short-term profits.
Another tactic is to capitalize more costs. By adjusting policies to capitalize on more expenses, such as changing the threshold for capitalizing purchases from items over $5,000 to items over $1,000, companies can reduce immediate expenses and inflate profits.
Policy Disclosure
Any policy change must be disclosed in the company’s financial statements to maintain transparency. This requirement ensures consistency, allowing users to identify historical financial trends and variations.
Legal Considerations
While changing accounting techniques isn’t inherently illegal, if the SEC deems that any adjustments are intended to mislead investors or misrepresent financial outcomes deliberately, severe actions including fines can follow.
Motivations Behind Earnings Management
Corporate managers may engage in earnings management for numerous reasons including qualifying for higher bonuses, preventing earnings from falling below analyst forecasts, achieving tax benefits, enhancing perceived company value, and demonstrating financial stability.
Techniques of Earnings Management
Earnings management techniques are diverse and include lowering capitalization limits, altering inventory valuation methods, minimizing short-term nonessential expenses, or attributing ongoing business expenses to nonrecurring events.
Final Thoughts
Investors should be diligent and skeptical when evaluating a company’s finances. Thoroughly analyzing financial reports, beyond headline numbers, helps investors gain an accurate understanding of a company’s performance. Reliance on second-hand analysis or assumptions can jeopardize the reliability of investment decisions.
Related Terms: net income, profit, expenses, earnings announcement, stock options, capitalizing costs.
References
- The CPA Journal. “The CEO/CFO Certification Requirement”.
- Internal Revenue Service. “Publication 538, Accounting Periods and Methods”.
- PwC. “30.4 Change in Accounting Principle”.
- Deloitte. “IAS 8 — Accounting Policies, Changes in Accounting Estimates and Errors”.
