Motivation for Earnings Management

Earnings Guidance

During the 1990s and early 2000s, meeting or beating analysts earnings expectations emerged as an important earnings benchmark. Bartov et al. found that the stock market has been found to award firms that meet or beat analysts forecasts and punish firms that miss earnings targets.

Meeting or beating earnings through earnings and expectations management has drawn concerns over the integrity of managers. For instance, an analysis of Nortel Networks Corporation by Fogarty et al. (separate from case 7 -1 later in this chapter) reveals that earnings expectations management is tied to many other missteps of managers that collectively contributed to the downfall of the giant telecommunications firm.

Consistent with Fuller and Jensen, this suggests that earnings expectations management sets in motion a variety of organizational behaviors that often end up damaging the firm. Erhard et al. suggest that meeting or beating earnings by manipulating earnings and analysts earnings expectations is Page 409indicative of low integrity in relations with the capital markets, resulting in calls for boards of directors to take accountability for integrity of the entire corporate system.

Graham et al. also advocate changes in the culture of boards of directors by focusing on long-term strategic goals and shielding managers from the short-term pressure from the capital markets. Taken collectively, the arguments suggest that, while managing earnings expectations may help the firm avoid missing earnings targets and market penalties, it can be detrimental to the long-term value of the firm and the capital markets, point out Liu et al.

These behaviors link to Burchards Ethical Dissonance Model described in Chapter 3 (Links to an external site.) with low organizational ethics in the person-organization fit, and if accompanied by low individual ethics, the ethical culture of the organization is more likely to lead to unethical choices than any other fit.

So what does earnings management look like?

Earnings management occurs when companies artificially inflate (or deflate) their revenues or profits, or earnings per share (EPS) figures. Well-publicized ways of managing earnings during the period of financial fraud in the early 2000s were: (1) by using aggressive accounting techniques such as capitalizing costs that should have been expensed (e.g., WorldCom accounted for its line costs as capital expenditures rather than expensing them against revenue); and (2) by establishing or altering the elements of an estimate to achieve a desired goal (e.g., Waste Managements lengthening of the useful lives on trash hauling equipment to slow down depreciation each year).

Another perspective on earnings management is to divide the techniques into two categories: operating earnings management and accounting earnings management. Operating earnings management deals with altering operating decisions to affect cash flows and net income for a period such as easing credit terms to increase sales. Accounting earnings management deals with using the flexibility in accounting standards to alter earnings numbers.

Answer the following discussion question:

What role do financial analysts earnings expectations play in the quality of earnings?