Earnings management, in
accounting
Accounting, also known as accountancy, is the process of recording and processing information about economic entity, economic entities, such as businesses and corporations. Accounting measures the results of an organization's economic activit ...
, is the act of intentionally influencing the process of
financial reporting to obtain some private gain.
[Schipper, Katherine. 1989. “Commentary on Earnings Management.” ''Accounting Horizons'' (December): 91–102.] Earnings management involves the alteration of
financial reports to mislead
stakeholders about the organization's underlying performance, or to "influence contractual outcomes that depend on reported accounting numbers."
[Healy, Paul M., and James Wong. Wahlen. 1999. “A Review of the Earnings Management Literature and Its Implications for Standard Setting.” ''Accounting Horizons'' 13 (4): 365–383.]
Earnings management has a negative effect on
earnings quality,
and may weaken the credibility of
financial reporting.
Furthermore, in a 1998 speech
Securities and Exchange Commission
The United States Securities and Exchange Commission (SEC) is an independent agency of the United States federal government, created in the aftermath of the Wall Street crash of 1929. Its primary purpose is to enforce laws against market m ...
chairman
Arthur Levitt called earnings management "widespread".
Despite its pervasiveness, the complexity of accounting rules can make earnings management difficult for individual investors to detect.
Occurrence and response by regulators
Earnings management is believed to be widespread. A 1990 report on earnings management situations stated that "short-term earnings are being managed in many, if not all companies",
and in a 1998 speech,
Securities and Exchange Commission (SEC) chairman
Arthur Levitt called earnings management a "widespread, but too little-challenged custom".
In a 2013 essay,
Ray Ball, while opining that
accounting research was not reliably documenting earnings management, wrote: "''Of course'' earnings management goes on.
..People have been tried and convicted."
A 2020 report indicated that earnings management was the most common type of accounting fraud the SEC has taken action against under its whistleblower program.
The SEC has criticized earnings management as having adverse consequences for financial reporting, and for masking "the true consequences of management's decisions".
It has called on standard-setters to make changes to
accounting standards
Publicly traded companies typically are subject to rigorous standards. Small and midsized businesses often follow more simplified standards, plus any specific disclosures required by their specific lenders and shareholders. Some firms operate on t ...
to improve
financial statement
Financial statements (or financial reports) are formal records of the financial activities and position of a business, person, or other entity.
Relevant financial information is presented in a structured manner and in a form which is easy to un ...
transparency, and has called for increased oversight over the financial reporting process.
The SEC has also pressed charges against the management of firms involved in
fraud
In law, fraud is intent (law), intentional deception to deprive a victim of a legal right or to gain from a victim unlawfully or unfairly. Fraud can violate Civil law (common law), civil law (e.g., a fraud victim may sue the fraud perpetrato ...
ulent earnings management.
Motivations and methods
Earnings management involves the manipulation of company earnings towards a pre-determined target. This target can be motivated by a preference for more stable earnings, in which case management is said to be carrying out ''income smoothing''.
Opportunistic income smoothing can in turn signal lower risk and increase a firm's market value.
Other possible motivations for earnings management include the need to maintain the levels of certain
accounting ratios due to
debt
Debt is an obligation that requires one party, the debtor, to pay money Loan, borrowed or otherwise withheld from another party, the creditor. Debt may be owed by a sovereign state or country, local government, company, or an individual. Co ...
covenants, and the pressure to maintain increasing earnings and to beat analyst targets.
Earnings management may involve exploiting opportunities to make accounting decisions that change the earnings figure reported on the
financial statements. Accounting decisions can in turn affect earnings because they can influence the timing of transactions and the estimates used in financial reporting. For example, a comparatively small change in the estimates for
uncollectible accounts can have a significant effect on
net income
In business and Accountancy, accounting, net income (also total comprehensive income, net earnings, net profit, bottom line, sales profit, or credit sales) is an entity's income minus cost of goods sold, expenses, depreciation and Amortization (a ...
, and a company using
last-in, first-out accounting for
inventories
Inventory (British English) or stock (American English) is a quantity of the goods and materials that a business holds for the ultimate goal of resale, production or utilisation.
Inventory management is a discipline primarily about specifying ...
can increase net income in times of rising prices by delaying purchases to future periods.
Detecting earnings management
Earnings management may be difficult for individual investors to detect due to the complexity of accounting rules,
although
accounting researchers have proposed several methods. For example, research has shown that firms with large
accruals and weak governance structures are more likely to be engaging in earnings management.
More recent research suggested that linguistics-based methods can detect financial manipulation, for example studies in 2012 found that whether a subsequent irregularity or deceptive restatement occurred is related to the linguistics used by top management in
earnings conference calls.
Further reading
* Vladu, A. B., Amat, O., & Cuzdriorean, D. D. (2014)
Truthfulness in accounting: How to discriminate accounting manipulators from non-manipulators Economics Working Papers 1434, Department of Economics and Business, Universitat Pompeu Fabra.
References
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Accounting research
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