Earnings management is a practice followed by the management of a company to influence the earnings reported in financial statements. It is executed to match a set target and is different from managing the underlying business of the company. An earnings management strategy uses accounting methods to present an excessively positive view of a company’s financial positions, inflating earnings.
Earnings management is used by companies to flatten out earnings variations and present profits that are consistent each quarter or year. Variations in earnings may be common for the operation of a large company. However, they create doubts among investors, as they prefer to invest in stocks of companies that show growth and stability.
The share price of a company usually increases or decreases once the announcement is made and is determined by whether the company meets or fails to meet earnings forecasts. The management tries to influence accounting practices to meet the earnings estimates and hold share prices up.
Earnings management is a method used by a company’s management to manipulate its financials.
Companies use earnings management to show consistent profits, flatten out earnings variations, and hold the share price up.
Earnings management happens when a company’s management team makes decisions solely to meet expectations or when they alter accounting policies to show an increase in its quarterly or annual earnings.
Earnings Management Approaches
Companies use several strategies used for earnings management. The most commonly used strategies are as follows:
1. Earnings-focused decisions
Decisions taken by the management are solely focused on meeting earnings estimates. The easiest way for earnings management is to control the company’s expenses. Companies look to cut any optional expenses to meet earnings estimates.
Certain activities – such as research, advertising, or staff training – can be suspended temporarily. Companies suspend such activities for a short time, assuming that the business will perform better in the upcoming periods, and the suspended activities can be resumed thereafter.
However, for companies that are performing well, the management focuses on the long-term success of the business and does not usually resort to artificially enhancing the earnings.
2. Biased accounting judgments
Accrual accounting presents opportunities for earnings management; however, a company’s management needs to exercise some difficult judgments when accrual accounting is applied.
There are formal policies, accounting manuals, and processes followed at well-performing companies to ensure that the judgments are bias-free. Earnings management happens when the management team distorts judgments and mends policies to meet expectations.
3. Altering accounting principles
U.S. accounting standards provide different rules of accounting for the same transactions. For example, both the inventory cost and fixed asset cost can be accounted for in three different but acceptable ways.
The management of well-run companies chooses the accounting rule that best reflects the implicit economic factors. Earnings management happens when a company’s management selects an alternative of a certain accounting standard, which will cause the earnings number to meet the expectations.
Investors should perform due diligence before investing in the stocks of any company. Some investors analyze a company’s financial reports and can identify earnings management.
Listed below are the signs that an investor needs to look for to determine if a company is exercising earnings management to manipulate its financials:
The company claims an increase in revenue without a corresponding increase in cash flows.
The company reports an increase in earnings only in the final quarter of the fiscal year.
The fixed assets of the company are expanding beyond the normal standard for the industry or company.
The net worth of an asset is inflated by ignoring the use of the true depreciation schedule.
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