It is suggested that corporate managers are not indifferent to the selection of accounting principles or to the earnings management [earnings numbers reported by their firms]. Managers have these preferences because accounting numbers (particularly earnings) can affect the well-being either of themselves, their firms, or both. Because of this, managers are motivated to engage in earnings management, which involves making accounting-related decisions that will result in favorable consequences for themselves and their firms. This post demonstrate how reported accounting earnings can affect managers and their firms, and how managers can undertake actions that will affect the income number reported on the financial statements.
What Would You Do?
Let’s assume that you are as the chief financial officer for LieDharma Enterprises. Sarah Bronson, the chief executive officer (CEO) has asked your advice regarding an accounting principle change she is considering. Many firms in your industry have recently adopted LIFO. These adoptions were motivated by substantial increases in inventory costs. Under such conditions, LIFO can provide significant tax savings. LieDharma’s inventory costs have also risen, but not as much as your competitor’s prices.
However, another issue concerns you. Your compensation package includes a bonus based on reported net income and the bonus is not activated unless net income exceeds $500,000. Your analysis shows that if LIFO is adopted, net income will approximate $750,000. If FIFO is adopted, net income will be about $475,000. What would you tell the CEO?
Unethical managers most likely will recommend the LIFO method, so that they can earn bonus for the period. I believe you will not!
Note: Financial statement readers must be diligent in their efforts to uncover these practices. Everyone in the accounting world knows that LIFO method is no longer allowed by GAAP. And beware with the creative accounting [accounting gimmick or financial shenanigans] that maybe taken into practices by managers when it is fallen into their interest area.
Motivations for Earnings Management
The wealth of corporations and their managers can be affected by reported accounting earnings in the following ways:
- Lending agreements typically place restrictions on borrowers stated in terms of accounting numbers. Restrictions include minimum levels of retained earnings and current ratios, and maximum levels of debt-to-equity ratios. Higher reported net income reduces the likelihood that an agreement would be violated. Since violations can result in higher interest rates or other adverse consequences to the borrower, managers have an incentive to inflate reported earnings.
- Managers’ bonuses are often based on reported accounting earnings. Managers’ personal wealth can therefore be increased by making accounting decisions that maximize the bonus.
- Governments have the power to significantly affect the financial well-being of corporations through taxes, subsidies, antitrust actions, and a variety of other regulations and restrictions. Reported accounting earnings can affect the likelihood that a firm will reap a benefit or incur the cost of a governmental intervention. Because of this, some firms and their managers have an incentive to reduce reported income.
- Stock market analysts pay close attention to a firm’s earnings and the trend in earnings. Most valuation models place a positive weight on earnings growth. Consequently, corporations are motivated to report higher earnings, year after year. Also, analysts seek to minimize risk. Since highly variable earnings are a sign of riskiness, corporations seek to smooth peaks and troughs in reported earnings.
- Earnings are also used as a basis for bargaining. When negotiating with an employee’s union over wages and benefits, for example, a corporation’s best interest might be served by reporting low earnings. The corporation can then claim that it doesn’t have the financial resources to meet demands for higher employee compensation.
Methods of Earnings Management
GAAP provides corporate managers with a tremendous amount of discretion regarding accounting-related decisions and estimates. This latitude can be used by managers to shift income across years in order to achieve the objectives outlined in the previous section. Corporations can also time certain transactions in order to manage earnings.
Specific earnings management tools include the following:
- GAAP often permits a firm to choose its accounting methods from several acceptable alternatives. For example, the straight-line method of depreciating fixed assets.
- A variety of assumptions and estimates are needed to implement GAAP. For example, to actually calculate depreciation charges, estimates of useful lives and salvage values are needed. Other estimates required by GAAP include uncollectible accounts and product warranty liabilities. Managers often know considerably more about these issues than do the firm’s auditors. Although manager’s estimates must be reasonable, the range of reasonableness is fairly large.
- Newly promulgated FASB standards usually provide a period of time, often two or three years, during which firms can initially adopt the new rules. Adoption dates selected by individual firms depend on the projected effects of the standard on the firm’s financial statements (which could be in the billions of dollars), and on the firm’s earnings management objectives.
- During the past decade, numerous firms have taken large restructuring charges. These charges arise when firms revamp operations. They mostly include writing down assets and recognizing the severance benefits liability to employees who have been (or will be) terminated. Most restructurings take several years to complete. Restructuring charges can be an earnings management tool because of the many difficult estimates they entail.
- Earnings can also be managed by cleverly timing certain transactions. For example, recall the accounting for securities classified as available-for-sale. Changes in the market value of these securities are not reflected in earnings while the securities are held. At the time securities are sold, the entire gain or loss (the difference between the historical cost and the selling price) is recorded. By carefully selecting to sell certain securities from its portfolio, a firm can predetermine if a gain or loss will be included in earnings.
Implications of Earnings Management
Accounting-related decisions [the selection of accounting principles and the development of accounting estimates] affect the well-being of corporations and their managers. The wide latitude provided by GAAP to corporate managers ensures that earnings management will continue to be practiced. As a result, the quality of information contained in the financial statements can be compromised. Financial statement readers must be diligent in their efforts to uncover these practices and inter-temporal comparisons of financial statement numbers (such as the allowance for uncollectible accounts) can help. An examination of detailed disclosures in the financial statement notes is also important. Finally, a thorough knowledge of the firm and its industry is essential.