Unless you’re familiar with accounting lingo, ‘earnings management’ probably sounds like a technical name for legitimate financial activity. Unfortunately, this isn’t the case. As innocent as it may sound, the phrase refers to a set of practices that manipulate the appearance of a company’s earnings. Accountants use specific earnings management techniques to manipulate entries in ways that a) present profits in a way that seems consistent with past performance, or b) make profits seem higher than they actually are.
Earnings management techniques are questionable at best and become brazenly unethical when they’re used to give lenders and investors an inflated picture of company performance. Therefore, it’s essential that business owners and management teams recognize the various techniques used in earnings management. Here are four of the most common.
1. Expenses and Revenues
In this context, ‘earnings’ means the same thing as ‘profits.’ Profits are calculated by subtracting expenses from revenue, so the easiest way to manipulate (or ‘manage’) earnings is to alter the date upon which certain expenses and revenues are entered into the company’s books.
It’s like a financial juggling act. If a company wishes to inflate earnings during a given period, it can record anticipated revenue as though it were already earned. Delaying the recording of certain expenses accomplishes the same thing. Either way, the company appears to be more profitable than it actually is during this period of time.
2. Cookie Jar Accounting Practices
The rules of accounting stipulate that companies record associated future expenses at the time that the revenue is earned. A product that comes with a warranty is a prime opportunity to engage in ‘cookie jar accounting.’ If the cost of honoring the warranty is omitted when the revenue is earned, the profits during that period end up being skewed.
There are other instances when a company can shift earnings from the current fiscal period to future times. No matter what method of ‘cookie jar accounting’ a company uses, it’s unethical because it presents a false picture of its performance.
3. Switching Up Accounting Methods
A company can switch from one type of reporting to another – to one that paints a better financial picture during a specific period. This can include the method the company uses to calculate the value of its inventory and the depreciation schedule it uses for cash assets.
Over an extended period, these varying methods will typically produce identical results. However, the accounting method a company uses can have a substantial impact on its earnings during a specific period. There are times when a company changes its accounting methods for legitimate reasons, but when it’s done to give an inaccurate picture of performance, it’s simply unethical earnings management.
4. One Time Charges
If a company incurs a particularly large expense – such as a failed project or new office equipment – it can have a significant impact on the company’s bottom line. When engaged in earnings management, the company may delay recording this large expense until such time that revenues are high enough to subsume it. Analogously, the company can enter the expense early if profits are high during a fiscal period before the expensive transaction occurs.
Another way of manipulating a large expense is to increase several other types of spending during the same time period. This practice is referred to as the ‘big bath,’ and it’s based on the idea that the company can get several expenditures out of the way in order to create the illusion of improved performance at a later time.
As you can see, all of these earnings’ management techniques represent attempts to deceive stakeholders and present consistent levels of performance. Hopefully, you also recognize that earnings management is something that a reputable accountant should ever do.
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