Earnings management is the use of accounting techniques to produce financial statements that present an overly positive view of a company's business activities and financial position. Many accounting rules and principles require that a company's management make judgments in following these principles. Earnings management takes advantage of how accounting rules are applied and creates financial statements that inflate or "smooth" earnings.

KEY TAKEAWAYS

In accounting, earnings management is a method of employing accounting techniques to improve the appearance of the company's financial position.

Companies use earnings management to present the appearance of consistent profits and to smooth fluctuations in earnings.

One of the most popular ways to manipulate financial records is to use an accounting policy that generates higher short-term earnings.

 

Investopedia / Paige McLaughlin

Understanding Earnings Management

Earnings refers to a company's net income or profit for a certain specified period, such as a fiscal quarter or year. Companies use earnings management to smooth out fluctuations in earnings and present more consistent profits each month, quarter, or year.

Large fluctuations in income and expenses may be a normal part of a company's operations, but the changes may alarm investors who prefer to see stability and growth. A company's stock price often rises or falls after an earnings announcement, depending on whether the earnings meet or fall short of analysts' expectations.

Management can feel pressure to manage earnings by manipulating the company's accounting practices to meet financial expectations and keep the company's stock price up. Many executives receive bonuses based on earnings performance, and others may be eligible for stock options when the stock price increases.

Many forms of earnings manipulation are eventually uncovered either by a certified public accountant (CPA) firm performing an audit or through required Securities and Exchange Commission (SEC) disclosures.

 

The Securities and Exchange Commission (SEC) requires that the financial statements of publicly traded companies be certified by the Chief Executive Officer (CEO) and Chief Financial Officer (CFO) and has pressed charges against managers who engaged in fraudulent earnings management.1

Examples of Earnings Management

One method of manipulation when managing earnings is to change to an accounting policy that generates higher earnings in the short term.

For example, assume a furniture retailer uses the last-in first-out (LIFO) method to account for the cost of inventory items sold. Under LIFO, the newest units purchased are considered to be sold first. Since inventory costs typically increase over time, the newer units are more expensive, and this creates a higher cost of sales and a lower profit.2

If the retailer switches to the first-in first-out (FIFO) method of recognizing inventory costs, the company considers the older, less-expensive units to be sold first. FIFO creates a lower cost of goods sold expense and, therefore, higher profit, so the company can post higher net income in the current period.2

 

Material changes to accounting policy must be disclosed in a company's financial statement.34

Another form of earnings management is to change company policy so more costs are capitalized rather than expensed immediately. Capitalizing costs as assets delays the recognition of expenses and increases profits in the short term.

Assume, for example, company policy dictates that every item purchased under $5,000 is immediately expensed and costs over $5,000 may be capitalized as assets. If the firm changes the policy and starts to capitalize all items over $1,000, expenses decrease in the short-term and profits increase.

Special Considerations

A change in accounting policy must be explained to financial statement readers, and that disclosure is usually stated in a footnote to the financial statements. The disclosure is required because of the accounting principle of consistency.34

Financial statements are consistent if the company uses the same accounting policies each year. This is important because it allows the financial statement user to easily identify variations when looking at the company's historical trends.

The fact that a change in policy must be explained and that all of a company's accounts are laid bare in its financial statement means that careful readers will likely discover the earnings management strategy. The problem is that not everyone has the time to go over reports in full or the knowledge to understand everything that is written.

Is Earnings Management Illegal?

Changing accounting techniques in itself is not illegal. However, if the SEC deems that a company is being creative to mislead investors and intentionally misrepresent its results then it may take action and issue fines.

Why Do Companies Engage in Earnings Management?

There are many reasons corporate managers engage in earnings management. These include higher bonuses, avoidance of falling below closely followed analyst forecasts, tax savings, boosting the value of the company, and creating a sense of stability.

What Are the Types of Earnings Management?

Several techniques are used to manage earnings. Examples include lowering capitalization limits, changing from the last-in first-out method of valuing inventory to the first-in first-out method, cutting nonmandatory expenses for short periods, or attributing regular business expenses to a one-off, nonrecurring event.

The Bottom Line

Investors should always do their homework before investing in a stock. That means analyzing the company's financial report to get a true picture of how it is doing. Don't just fixate on the headline numbers the company wants you to read or trust that analysts or somebody else will do the job on your behalf. Go through everything yourself and do it with a skeptical eye.

Answer the following questions

 

1. While a firm's sales and net income have been steady during the last three years, the firm has experienced a decrease in its accounts receivable and inventory turnovers and an increase in its accounts payable turnover. What is the likely direction of change in cash flow from operations? How would your answer be different if sales and net income were increasing?

 

2. The concept of accounting quality has several dimensions, but two characteristics often dominate: the accounting information should be a fair representation of performance for the reporting period and it should provide relevant information to forecast expected future earnings. Provide a specific example of poor accounting quality that would hinder the forecasting of expected future earnings.

 

3. Identify and explain conditions that would lead an analyst to expect that management might attempt to manage earnings upward and conditions that would lead to expectations of managing earnings downward.