Page 237 - Encyclopedia of Business and Finance

eobf_E 7/5/06 3:00 PM Page 214

Earnings Management

maintain their credibility with the analyst commu- • If the company is sued, management must estimate
nity, and (ii) maintain the relative price of the com- the likelihood that the suit will result in an assess-
pany’s stock. ment against the company, and how much that
• Where the normal operations of the business do not assessment is likely to be.
produce earnings equal to the investment commu- The financial community has agreed that an accrual-
nity’s expectations, managements are pressured to based measure of earnings, subject to these judgments, is
find ways to manage the reported earnings. a much better measure of business success than a simple
• Auditors, who want to retain their clients, bend measure of cash results. The increase in information in an
under their own set of pressures to let this process accrual-based income statement is largely the result of the
continue. exercise of managements’ judgments.
In well-run companies, managements exercise those
APPROACHES TO MANAGING judgments, issue by issue, without regard to the effect
EARNINGS those judgments have on the entity’s reported earnings. To
make sure that those judgments are free from bias, well-
Many strategies are used by companies to manage earn-
run companies outline—in formal policies and written
ings in ways that are inappropriate. These are strategies
that have as their outcome the achievement of predeter- accounting manuals—the processes to be followed in
mined earnings figures. Only a few of the most popular developing accrual judgments. Earnings management
will be discussed here. occurs when the decision makers skew issue-by-issue judg-
ments, perhaps skirting their own policies, with an objec-
tive of forcing the earnings to a predetermined number.
Decisions Solely to Meet Earnings Goal. Perhaps the
simplest way to manage earnings is to control the expense
spigot. Even the most lean company can find discre- Changing Accounting Principles to Meet Earnings Goal.
tionary expenses that can be trimmed to help meet the The opportunity to manage earnings is also inherent in
U.S. accounting standards. For many reasons, the finan-
earnings target for a period. Advertising, research, staff
cial community has agreed that it was better if the
training, or maintenance programs can be deferred, at
standards to be followed in preparing financial state-
least in the short run. There is a great temptation to cut
ments—and measuring earnings—were set by commu-
these programs “in the short run” on the assumption that
nity consensus, rather than by government fiat. That
business will pick up in subsequent periods and the
deferred programs can then be resumed. notion of an underlying consensus is embedded in the
name given to that body of standards—GAAP.
In well-run companies, managements are focused on
the long-run success of the entity, and they avoid tempta- Understandably (and perhaps unfortunately), that
tions to enhance, artificially, the results for any single consensus approach has allowed different accounting rules
to be available for similar transactions. There are, for
quarter or year.
example, at least three different generally accepted ways to
account for the cost of inventory items; there are also at
Making Necessary Judgments to Meet Earnings Goal.
least three different generally accepted ways to allocate the
Opportunities for earnings management are inherent in
cost of a fixed asset over its useful life.
accrual accounting. Under the accrual method, manage-
In well-run companies, management selects among
ment is asked to look beyond the simple cash inflows and
outflows the company experienced during a period and the alternative accounting standards the one that most
give a more nuanced picture of the company’s operations. closely reflects the underlying relevant economic factors.
Earnings management occurs when those making deci-
But the application of accrual accounting requires some sions select among the allowable alternatives of a particu-
difficult judgments. For example:
lar generally accepted accounting standard the one that
• Revenues are recorded when the sale transaction is will result in earnings that meet the predetermined
complete, not when the customer makes payment, number.
but management must then estimate what propor-
tion of those credit sales will not be collected in the FULL DISCLOSURE IS A KEY
future. DEFENSE
• When the company pays cash for a fixed asset, that Most financial and accounting personnel accept at least
cash outflow is allocated as an expense over future the semistrong version of the efficient market hypothe-
years; but management must then estimate how sis—that is, an understanding that the financial market-
many years will be benefited from the acquisition. place will incorporate all available information in the

214 ENCYCLOPEDIA OF BUSINESS AND FINANCE, SECOND EDITION