Earnings Management 101
Earnings management is a very popular topic in the academic finance and accounting world. There have been several papers which seek to define, understand the causes and look at the consequences of the same.
What is earnings management?
There exist various definitions in the field about earnings management. Here are certain ways it is defined:
“Purposeful intervention in the external financial reporting process, with the intent of obtaining some private gain” (Schipper, 1989).
“Managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers” (Healy and Wahlen, 1999).
Thus, according to these definitions earnings management help managers achieve some private benefits (eg., increasing their compensation) by manipulation of external reports. For example, recent research shows how CEOs who hold equity holdings can pressure the CFOs to influence short-term performance (Feng et al., 2011).
Is Earnings Management equivalent to Fraud?
However, a concept easily confused with earnings management is fraud. Is earnings management equivalent to fraud? There are few distinctions between the two:
- On one hand, fraud involves a violation of Generally Accepted Accounting Principles (GAAP). On the other hand, in earnings management there is no violation of accounting principles.
- Earnings management might be harmful or beneficial dependig on the consequences. For example, it might be harmful if it decreases the firm value but beneficial when it signals firms prospects in the future. Fraud follows aggressive earnings management behavior and thus is harmful to the firm.
What are some examples of earnings management?
- Firms can use earnings management techniques to inflate earnings or reduce volatility to influence perception of their suppliers about their future prospects. This is especially true when firms have more relation-ship specific investments with their suppliers. Further, firms can also influence their suppliers investment behavior through earnings management (Raman and Shahrur, 2008).
- Firms also use earnings management to overstate their financials at the time of Seasoned equity offerings (SEOs). However, Cohen et al, (2010) finds that such firms have negative performance in the future.
What are some ways of measuring earnings management?
There are few popular ways of measuring earnings management:
- Accrual based earnings management
In accrual-based earnings management, managers show discretion regarding accounting choices and misrepresent firm’s underlying operating performance. For example, research in this area looks at “abnormal” vs “normal” accruals. While, normal accruals captures the fundamental performance and adjustments to it, abnormal accruals are associated with earnings management.
- Real earnings management
In real earnings management, managers depart from normal operations in order to mislead. For example, firms can decrease research and development (R&D), advertising and maintenance expenditures, or postpone a project, in order to boost earnings.
- Earnings Smoothing
Earnings smoothing is another way of management discretion which gives managers a chance to decrease the volatility of their earnings that might influence how stakeholders view the riskiness of the firm (Walker 2013). It can be appealing to managers as it helps present the business as more stable.
In conclusion, it can be summed up as “use of managerial discretion over (within GAAP) accounting choices, earnings reporting choices, and real economic decisions to influence how underlying economic events are reflected in one or more measures of earnings” (Walker, 2013).
References —
Cohen, Daniel A., and Paul Zarowin. “Accrual-based and real earnings management activities around seasoned equity offerings.” Journal of accounting and Economics 50.1 (2010): 2–19.
Feng, Mei, et al. “Why do CFOs become involved in material accounting manipulations?.” Journal of accounting and economics 51.1–2 (2011): 21–36.
Healy, Paul M., and James M. Wahlen. “A review of the earnings management literature and its implications for standard setting.” Accounting horizons 13.4 (1999): 365–383
Raman, Kartik, and Husayn Shahrur. “Relationship-specific investments and earnings management: Evidence on corporate suppliers and customers.” The Accounting Review 83.4 (2008): 1041–1081.
Schipper, Katherine. “Earnings management.” Accounting horizons 3.4 (1989): 91.
Walker, Martin. “How far can we trust earnings numbers? What research tells us about earnings management.” Accounting and Business Research 43.4 (2013): 445–481.
