Question

Earnings Management

Most accounting students think that accounting reporting is a precise measurement. The ability to use estimates to report financial results may affect earnings quality. Do you think that earnings quality is affected because of needed estimates? Why or why not? Depending on your answer here, does the FASB need to continue to allow estimates? If not, what should replace the estimates?

Regarding the ethical aspects of manipulating the accounting standards to present better or worse results of financial statements, would a manager manage earnings to make the bottom line look worse? Is earnings management unethical or illegal? What is the difference?

Answer 1

Earnings quality is not essentially affected because of needed estimates. This is because use of accounting estimates (including fair value estimates) has to be within the range set by the auditor. If the estimates are within this range then the management’s estimates are regarded as reasonable and it will be considered that there is no misstatement in the estimates. As such FASB does need to continue to allow estimates because estimates are used in financial reports only when it is impossible or impractical to provide exact numbers. For instance estimates like warranty liability, bad debt allowance etc. cannot be determined in a precise and exact manner and so it is only prudent to continue to allow estimates.

Yes, managers do manage earnings to make the bottom line look worse. This does not happen as often as managing earnings to improve the bottom line but they do happen. Managing of earnings to make the bottom line look worse is done in different cases like when there is a need to dissuade potential acquirers, postpone good financial information to a future period when it is more likely to be recognized etc.

Earnings management is unethical but is usually legal. To understand this let us first see what exactly earnings management entail. It entails using accounting techniques to produce financial statements that present an overly positive view of a company's business activities and financial position. Now earnings management is unethical because there is a deliberate misrepresentation of the company’s quality of earnings. On the other hand it is mostly legal because most of the time managers make use of a change in accounting policy to put into effect earnings management. For example a company may switch from LIFO inventory accounting to FIFO inventory accounting just to lower its cost of goods sold. Another example would be changing company’s policy so that more costs are capitalized and hence earnings receive a boost. Both these methods are legal provided that these changes are explained to readers of financial statements in the form of disclosures as footnotes to the financial statements.