Give a definition of Earnings Management and illustrate your answer showing how earnings management techniques can be undertaken.
discuss to what degree earnings management techniques are used in practice,
Earnings are profits made by the company. Since these earning are what investors are most interested in during the valuation of a company, Earning direcly impact the share price of a company. And since most managers are employed in the company by investors to make their share price higher, management of the company thinks it is ethical to do earning management.
hence from the above we can understand that earning management is the accounting techniques used by the management of a company to provide more positive figures of the operations of the company (like high earning, lower losses etc) to the outside world that actual figures. Due to these false information market price of shares are increased and more and more investors are interested in investing in the company.
the methods of undertaking earning management techniques are :
1. Changing Closing Inventory Methods: Under inflation(Prices are rising), Companies use FIFO method to value inventory which will reduce the cost of sales and will increase the closing stock both of which increases the profit of the company. And if the company wants to report lower profits it may use LIFO method to increase the cost of sales and reduce the amount of closing inventory which will reduce the amount profit.
2. Capitalizing Costs: Companies may remove revenue expenses from the P&L A/c and carry forward these expenses to be amortized over the years, such act may increase the profit in short term. if the company charge capital expense as revenue expense this shall reduce the profits.
3. Change in Accounting Policy: Since in the financial Statements a company has to make many assumptions like going concern, consistency etc. A company may do window dressing by over or under estimating these estimates to their benefits which will impact the financial statement of the company.
4. Revenue Recognition: Improper revenue recognisition may lead to inflated earning recognised in the financial statements. Some companies try to inflate their earning specially at the close of year end by recognising the earning of april in the month of march only.
Even though SEC and all other coutries have put in many laws which make Earning management very tough for companies but still these techniques are employed at large and it is very difficult to find such mis-statements since managers are under heavy presure to perform or lose their jobs which makes them to do such management to acheieve their targets.
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