The innocuous-sounding phrase ‘earnings management’ refers to a set of manipulative accounting techniques that are used to artificially improve a company’s financial picture during a specific period of time. The field of accounting requires company executives to follow a set of principles and rules when compiling financial statements. However, there are some areas in accounting where the company must make judgment calls on how things are handled.
What is Earnings Management? A Closer Look
The techniques involved in earnings management are used to generate financial reports that exaggerate a company’s performance. They accomplish this by inflating profits, minimizing expenses, or changing the timing of when expenses are recorded. In short, earnings management is an unethical set of accounting practices that do not provide an accurate picture of a company’s financial position. As such, accountants should avoid these methods at all times.
To start answering the question ‘what is earnings management,’ it will help to look at the motives behind it. Generally speaking, companies use earnings management techniques to make their financial picture seem more robust and profitable than it actually is. These techniques can also be used to flatten extreme fluctuations in expenses or profits.
As you can probably glean, the overall intent of earnings management is to appease investors. Investors can become alarmed when they see fluctuations in a company’s performance. By reducing these fluctuations, earnings management can inspire investor confidence and drive stock prices up.
The Effects of Investor Pressure
Company executives often feel intense pressure to meet investor expectations. As a result, managers sometimes change up their accounting methods in misleading ways. Another reason executives engage in unethical accounting changes is because their bonuses are often contingent upon their company’s earnings performance.
Needless to say, these twin pressures prompt far too many executives to engage in unethical accounting techniques. However, it’s important to understand that this type of earnings manipulation will eventually be discovered during an audit or through one of the required Securities and Exchange Commission’s disclosures.
Examples of Earnings Management
One common way to manipulate earnings involves changing accounting methods for a short time to inflate reported profits. For example, LIFO (last in, first out) accounting methods might be used to account for assets that have already been sold. In these scenarios, the newest assets are sold first. This is because a company’s inventory costs tend to increase over any significant period of time, which makes the newest assets the most expensive. The result of this technique is lower profits.
Conversely, when using FIFO (first in, first out) inventory accounting methods, companies record the sales of older items first, which allows them to report higher levels of profit for a short period of time.
Another earnings management technique involves modifying company policies on how costs are reported. By delaying costs, a company can report increased profits during a specific period of time. For example, consider a policy which states that all expenses under $2,000 must be reported immediately while costs over $2,000 may be capitalized. If this policy is changed, the company can increase profits for short periods of time.
In answering the question ‘what is earnings management?’ the final thing to consider is accounting disclosures. Whenever a company changes its accounting policies, the changes must be disclosed on subsequent financial statements. This is to ensure consistency in accounting practices or to stay in compliance with the GAAP Finance Rules. Typically, a company should use the same accounting policies every year. Whenever a change is made, the financial report should acknowledge the change explicitly and explain the reasons behind it. These requirements make this type of earnings manipulations fairly easy to discover.
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