Question

Please explain what is meant by earnings management. Consider multiple stakeholders and comment on whether earnings management is a positive or negative occurrence? Explain your answer fully and provide relevant examples.

Answer 1

Earnings management refers to the use of various accounting techniques used to manipulate financial statements to misrepresent the financial position and performance of a company as being overly positive than it actual is. Here the management takes advantage of certain decision making resposibilities entrusted to them under the accounting framework. Several accounting rules and principles require company's management to make judgments, estimates and decisions. By using earnings management, the management inflates earnings by taking advantage of how accounting rules are applied.

The reason companies use earnings management is to create an image of smooth and consistent profits without major fluctuations. Even though the fluctuations may arise from normal occurences in business but they may alarm investors who prefer to see stability and growth. Not only the investors, but other stakeholders like government, consumers, suppliers and creditors seem to view a stable profit as favorable and it increases their trust in the company. Further, if a company is listed then the declaration of financial results directly affects the stock price of the shares of the company. Negative trend in the stock price can result in dissatisfaction among majority of stakeholders and therefore the company may resort to earnings management to avoid such situations. Further there are many top level executives whose remuneration might be based on the earnings of the company which might motivate them to inflate the earnings.

Examples of Earnings Management

The management is required to make estimates for various items in balance sheet and the management may use such estimates to manipulate earnings. One of these is the provision for doubtful debts. The management may change their estimate to affect the profits of the company in the way they want it to be viewed by the stakeholders.

Another method of manipulation is to change an accounting policy. For example, while recording inventory the company has the option to measure it by various methods like LIFO (Last in first out), FIFO (First in first out) or Weighted Average method. The management may try to use the accounting policy of recording inventory which gives the highest value and thus increases profit of the company.

Further, there are numerous estimates and decisions that the management is required to make for the financial statements. If the management decides to exploit these rights then it will be serious concern for the various stakeholders. Since the company is dependent upon the stakeholders and the stakeholders are also dependent upon the company, it is very much necessary that the company present fair and true position of their financial condition for the stakeholders to take informed decisions. Earnings management though might help the company gain the trust of stakeholders in short run, it will definitely become burdensome and tarnish company reputation in the long run. Further there are various regulations that are placed so that the management takes responsibility for fair and transparent reporting system. For example the Securities and Exchange Commission (SEC) has in many cases, pressed charges against managers who have engaged in fraudulent earnings management. The requirement to get the financial systems audited by a certified auditor is also a regulation in place to check that the management is doing its job with sincereity. Thus, earning management however beneficial is not a tool that can be or should be used by a company's management.