Earnings Management

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What is Earnings Management?

Earnings Management refers to accounting practices used by the management of a company to deliberately manipulate the company's earnings to smooth income over several accounting periods and/or to meet other pre-determined targets.

As the application of Revenue Recognition rules under IAS/IFRS and U.S. GAAP in specific settings still leaves room for considerable latitude and judgment by management (e.g. determining when revenue has been earned and is realizable), managers can sometimes exploit the flexibility in the accounting standards to manipulate Reported Earnings in ways that mask the underlying performance of the companies.

Some typical forms of earnings management are the following:

• Inaccurate revenue recognition.
• Unsuitable accruals and estimates of liabilities.
• Excessive provisions and generous reserve accounting.
• Intentional minor breaches of financial reporting requirements that aggregate to a material breach.
  

Although Earnings Management is not new, it has become increasingly common in today's marketplace due to pressure to meet analysts' earnings forecasts. Some managers have even resorted to outright financial fraud (e.g. Enron, Global Crossing, WorldCom), which led former SEC (Security and Exchange Commission) Chairman Arthur Levitt to warn that "the motivation to meet Wall Street earnings expectations may be overriding common sense business practices. (...) As a result, I fear that we are witnessing an erosion in the quality of earnings, and therefore, the quality of financial reporting".

Quality of Earnings

The term 'quality of earnings' usually refers to the degree of conservatism in a firm’s reported earnings. Indicators of high earnings quality include the following:

• Use of the completed contract method of accounting.
• Minimal capitalization of interest and overhead.
• Minimal capitalization of computer software costs.
• Expensing of startup costs of new operations.
• Conservative revenue and expense recognition methods.
• Bad-debt reserves that are high relative to receivables and past credit losses.
• Rapid write-off of acquisition-related intangible assets.
• Use of LIFO inventory accounting (under the assumption of rising prices).
• Use of accelerated depreciation methods and short useful lives.
• Minimal use of off-balance-sheet financing techniques.
• Clear and adequate disclosures.
• Absence of nonrecurring gains and non-cash earnings.
• Conservative assumptions used for employee benefit plans.
• Adequate provisions for lawsuits and other loss contingencies

Management Discretion

The discretionary nature of income recognition permits an examination of the degree of management manipulation of earnings under one or more of the following guises:

• Classification of Good News/Bad News: Management prefers to report good news “above the line” as part of continuing business and bad news “below the line” as extraordinary or discontinued business.
• Income Smoothing: Some companies reduce earnings in good years (defer gains or recognize losses) and inflate earnings in bad years (recognize gains or defer losses).
• Big-Bath Accounting: In contrast to income smoothing, the big-baht accounting suggests that management will report additional losses in bad years in the hope that, by taking all additional losses at one time, they will “clear the decks” once and for all.
• Accounting Changes: Regardless of whether accounting changes are voluntary or mandatory, they typically have no direct cash flow impact and consequences. Therefore, such changes can be viewed as a form of earnings manipulation.

Earning management is also referred to as Creative Accounting.

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