Earnings management, in simple words, could be defined as an attempt—usually by the management—to influence reported earnings by using:
- specific accounting methods (or changing methods); or
- recognizing one-time non-recurring items; or
- deferring or accelerating expense; or
- deferring or accelerating revenue transactions; or
- using other methods designed to influence short-term earnings; or
- combinations of them.
Earnings management is not a new topic in the accounting discussions. It is worth refreshing, however, to make sure we (accountants) always aware of and prevent it from happening, at the first place.
Moreover, non-accountants are often under the impression of believing that, there is only a GAAP point, a single quantity that represents the one, true earnings number. Managers must be aware that because of this attitude the public can be very unforgiving of companies that are found to have “innocently” managed earnings.
The truth is that a manager has flexibility, in within the accounting standard (the US-GAAP), to report one earnings number from among many possibilities based on different methods and assumptions that accountants often use. This is famously known as “the GAAP Oval”.
The key thing to remember (and we should always remember) is that the forces encouraging managers and accountants to manage earnings are real, and if one is not aware of those forces it is easy to gradually slip from small and legitimate activities to outright fraud.
Reasons behind Earning Management Attempts
Earning report is everyone’s of interest. An earning figure could make shareholders happy or unhappy. So powerful that it could bring a group of manager fat bonuses or pink slip, let the company’s CEO stays or leaves the board for good. These are reasons, among the other, why earning—by theory and facts—tend to be “managed.”
Since as early as Enron’s issue, the public have been demanding greater assurance about the truthfulness of earning report. FASB has actually responded the expectation. On its conceptual framework, FASB refers to what is called “earning quality’—that not only about truthfulness, but also relevance and predictive value of information presented in financial statements—as one of its major objective.
However, it would probably be better to admit that, accounting standard (any of them) is not perfect; the use of estimates and assumptions. Using the concepts of accrual accounting and the accounting standards that have been issued, accountants add information value by using estimates and assumptions—considered as “professional judgment”—to convert the raw cash flow data into accrual data. These, on the other side, inevitably create some rooms to the company’s management to “work around” (read: manage) the reported earning numbers.
But they don’t play such activities for fun. They, either (a) are innocent; or (b) have serious reasons (motivations) of why they might manage the reported earning numbers. While most aren’t accounting savvy and fall into the first possibility, some (if not many) of them are and fall into the later.
Four famous motivations behind earnings management issues are:
1. Meeting internal earning demand – Big corporations demand managers to achieve certain earning level before providing bonuses and benefits. There is nothing wrong with demanding earning target nor the incentive, though, but as with any performance review system, it is inevitable that managers being evaluated will have a tendency to forget the economic factors underlying the measurement and instead focus on the measured number itself. I mean, who does not like bonuses?
2. Meeting external expectations – External stakeholders have an interest in the financial performance of a company, too. E.g. vendors want a company to do well so that it can survive for the long run and make good on its warranty obligations. Vendors want assurance that they will receive payment. For these stakeholders, a negative earning report is surely bad news. One shouldn’t be surprised that in some companies when the initial computations reveal that a company will report a net loss, the company’s accountants are asked to go back to the accrual judgments and estimates to see if just a few more dollars of earnings can be squeezed in order to get earnings to be positive.
3. Income Smoothing – The term of “income smoothing”, in this particular topic, referred to a practice (usually by the management team) to carefully timing the recognition of revenues and expenses to even out the amount of reported earnings from one year to the next—therefore they end up with steady earning growth report, instead of volatile. A steady earning growth gives investors and creditors sense of stability, reliability. It’s very well known that through aggressive accounting assumptions, the management can strategically defer or accelerate the recognition of some revenues as well as expenses, and smooth the reported earnings. Many cases (in the past) shown bad managements didn’t let such chance gone without utilizing that. By making a company appear to be less volatile, income smoothing can make it easier for a company to obtain a loan on favorable terms and to attract investors.
4. Window Dressing for an IPO (or a Loan) – For companies entering phases where it is critical that reported earnings look good, accounting assumptions can be stretched—sometimes to the breaking point. Such phases include just before making a large loan application or just before the initial public offering (IPO) of stock. Many studies have demonstrated the tendency of managers in U.S. companies to boost their reported earnings using accounting assumptions in the period before an IPO.
With all of the incentives to manage earnings, it isn’t surprising that managers occasionally do use the flexibility inherent in accrual accounting to actually manage earnings. And the more accounting training one has, the easier it is to see ways in which accounting judgments and estimates can be used to “enhance” the reported numbers.
Earnings Management Could Come In Some Different Flavors
Not all earnings management schemes are created in the same “flavor”. It can range from savvy timing of transactions to outright fraud.
In most companies, earnings management does not extend beyond the savvy transaction timing. However, because of the importance (and economic significance) of the catastrophic reporting failures that are sometimes associated with companies that engage in more elaborate earnings management, I am going to discuss the entire flavors. Read on…
Earnings management can come in five different flavors. Here they are:
1. Careful timing of transactions – It is referred to as “strategic matching”. As it is noted on the above income smoothing motivation, through awareness of the benefits of consistently meeting earnings targets or of reporting a stable income stream, a company can make extra efforts to ensure that certain key transactions are completed quickly, or delayed, in order for them to be recognized in the most advantageous quarter.
2. Changing accounting methods or estimates with full disclosure – Companies frequently change accounting estimates regarding bad debts, return on pension funds, depreciation lives, and so forth. Although such changes are a routine part of adjusting accounting estimates to reflect the most current information available, they can be used to manage the amount of reported earnings. Because the impact of such changes is fully disclosed, any earnings management motivation could be detected by financial statement users willing to do a little detective work.
3. Changing accounting methods or estimates WITHOUT adequate disclosure – In contrast to the accounting changes referred to in the preceding paragraph, other accounting changes are sometimes made without full disclosure. For example, a company change the estimated interest rate used in recording sales-type leases without describing the change in the notes to the financial statements. While one might debate whether the new estimated interest rate was more appropriate, what is certain is that failing to disclose the impact of the change resulted in financial statement users being misled.
4. Fraudulent reporting – A more polite label for this practice, maybe, “Non-GAAP Accounting” although it can also be the result of inadvertent errors. We, accountants, very well know that some of the Enron’s accounting practices (though certainly not all) were established for the express purpose of hiding information from financial statement users. In so doing, Enron violated the spirit of the accounting standards. In some cases, Enron also violated the letter of the standards by using some accounting practices that were not allowed under GAAP. This is obviously fraudulent reporting.
5. Fictitious Transactions – A practice one or a management team takes to inflate earnings number by, either: (a) making and recording transactions that actually never existed; or (b) hiding existed transaction (e.g. returned merchandises). This is an example of outright fraud, which is the deceptive concealment of transactions (like the sales returns) or the creation of fictitious transactions.
In an instant way, the five activities above shows that large scale of accounting fraud could start small, legitimate and really reflect nothing more than the strategic timing of transactions to smooth reported results. In the face of operating results that fall short of targets, a company might make some cosmetic changes in accounting estimates in order to meet earnings expectations, but would fully disclose these changes to avoid deceiving serious financial statement users.
However, if operating results are far short of expectations, an increasingly desperate management might cross the line into deceptive accounting by making accounting changes that are not disclosed or by violating the US-GAAP (or IFRS) completely.
Finally, when the gap between expected results and actual results is so great that it cannot be closed by any accounting assumption, a manager who is still fixated on making the target number must resort to out-and-out fraud by inventing transactions and customers.
Is It Wrong for Managers to Try to Use Accounting Flexibility to Report Earning?
Whether a manager actually does manage earnings, and whether he or she crosses the line and violates the accounting standard (US-GAAP or IFRS) to do so, is partially a function of the fear (and risk) of getting caught and of the general ethical culture of the company. But it is also a function of the personal ethics of the manager, and the manager’s ability to recognize that fraudulent and deceptive financial reporting is part of a serial that starts with innocent window dressing but can end with full-scale fraud.
Boards of directors and financial statement preparers should also be aware that, as a group, managers are notoriously overoptimistic about the future business prospects of their companies. Therefore, a company policy of having a consistently conservative approach to accounting is a good counterbalance to the tendency.