Understanding Earnings Management in Accounting

Introduction

In accounting, management of earnings involves the manipulation of financial records with the intention of improving the appearance of the financial position of a firm. There exists two means through which to go about management of earnings: real earnings management and accruals management. Real earnings management is achieved through the overproduction of inventory with the intention of lowering the costs of goods that have been sold or for cutting on the discretionary expenses like development, research and advertising. On the other hand, accrual-based earnings management aims at obscuring financial performance through the alteration of accounting methods. That has to be within the generally accepted principles for accounting.

Motivations of earnings management

There are different factors that motivate the management of earnings and these range from the intentions of satisfying the expectation of analysts to the maintenance of competitive positions within financial markets to the bonus realisation incentives (Habbash and Alghamdi, 2015).

The management of different organisations could be pushed towards earnings management by interactions between accounting numbers and the reaction of stock markets (Neifar, Halioui and Ben Abdelaziz, 2016). Often, investors rely on stock market analysts’ forecasts and views to compile portfolios of potentially successful firms. Those firms that either meet or beat the forecasts of analysts get to enjoy returns that are higher and that is even in those situations when there is a chance of achieving that through management of expectations and management of earnings (Wasiuzzaman, Sahafzadeh and Nejad, 2015). CEO compensation and stock returns would be affected negatively by the failure to miss benchmarks earnings. To beat or meet the forecasts, managers resort to managing earnings. Whenever the forecasts are higher than the pre-managed earnings, income-increasing management becomes the resort of managers. On the other hand, whenever there are lower forecasts in comparison to the earnings pre-managed, managers get to choose between not managing the earnings with the hope of increments in stock returns or income-decreasing earnings management that is done in a bid to save for rainy days (Sayari and Omri, 2017).

For the purposes of alignment of the goals of shareholders to the objectives of managers and to further minimise the room for agency conflicts, often, equity incentives are used to compensate senior managers. Reported earnings are also managed by firms through changing of financial statements so as to influence the decisions and opinions of shareholders. Tax laws and government regulations are obvious candidates for analysis as possible sources of the motivations for management of earnings (Makhaiel and Sherer, 2017). With no doubt, for any company, appearing less profitable would be good if it helps avoid interference from the government. As such, political costs are also strong incentives for earnings management in firms. That is clearly proven in those economies that lack efficient stock markets and where the government gets to appoint CEO`s (Xue and Hog, 2016).

Earning`s management motivation could also arise from speculative motivation. That is related to the motive of personal gains derivation. Possibly, the motivation for earnings management could also come about from the needs to increase personal remunerations and bonuses, to meet the profit targets that have been set and to also gain opportunities for promotions (Li et al., 2015). Often, managers use earnings as the basis for the awarding of bonuses.

There are also motivations for earnings management that are internal. It could be useful, within companies to structure transactions and alter financial reports in ways that performance standards are met and budget ratcheting is avoided. Whenever the earnings innovations are transitory, managers could decide on using income-decreasing unexpected accruals (Goel, 2016). Companies that make use of standards that are determined externally, that is, standards that are relatively not affected by factors like cost of capital, have a lower likelihood of smooth earnings in comparison to those companies that where internal standards are used. The internal standards include; subjective standards and budget goals.

Another major motivation is the debt covenant hypothesis. The basis of the theory is that restrictions are often imposed by creditors on the payment of dividend, the issuing of additional debts and share buybacks in terms of reported accounting ratios and figures. That is done to ensure that the borrowings of the firm are repaid. As such, in line with the lending contracts motivation hypothesis, those firms that have higher debts have more incentives of managing earnings to avoid breaching their debt covenants.

Methods of massaging earnings

The requirement that managers estimate and further record payable future obligations as a result of the current year`s transactions is a normal feature of the GAAP-based accrual accounting. Because it really is not possible to be certain about the future, often, there exists uncertainty with the process of estimation. What that means is that there are no right answers. Only a range of reasonably possible answers is available. Generally accepted accounting principles require that management must always settle on single estimates. Opportunities for massaging earnings are created by the selection process.

The recording of less I future fiscal periods becomes possible through the recording of extra expenses in the current fiscal periods (Chhabra, 2016). As such, a cookie jar is created by management that they can always tap into in the event they need to boost their earnings in the future.

Big batch techniques

The restructuring and elimination of subsidiaries is a strategy companies adopt whenever they need to remain competitive. GAAP allows for the recording of charges that have been estimated against earnings for the change implementation costs whenever such happens. Usually, the estimated losses are recorded as no-recurring charges against income. What that means is that, the reporting of the loss does not happen in the regular reporting of earnings.

The charging of losses against current earnings negatively affects current stock prices. That is because there is an association between the charging of losses and reporting on the competitiveness of a company. The use these techniques is informed by the belief that in the event it becomes necessary to report bad news, reporting it all at once and getting it out of the way all together is the best option (Nia, Ching and Abidin, 2015). In line with that, because estimates inform most of those charges, it is better to do estimations of losses on the high side as that avoids latter possible earnings surprises that would come about if middle and low-side estimates were selected only to establish later on that the expenses came in on the higher side.

Techniques that bet big on the future

A company that buys out another company could be said to be making bets on the future. In relation to an increase to the acquiring company reported earnings, the bet could be a sure thing. However, that, only happens when there was a proper plan of the acquisition. Some of these techniques include;

The writing off of the development and in-process research costs of the company that has been acquired. Through this, it becomes possible to write off substantial amounts of the purchase prices against the acquisition years` current earnings (Dalkilic, 2017). That implies that future earnings would end up being higher that they would have otherwise been.

Integration of the acquired companies earnings and corporate consolidated earnings. It is possible to consolidate the acquired company’s current earnings with those of the parent company. That provides automatic earning boosts. However, that is, only if the terms of purchase of the subsidiary were favourable (Cao, Shaari and Donnelly, 2018)..

Basically, through the big bet techniques, companies are able to buy guaranteed boosts in future and current earnings through the acquisition of other companies.

Sale/Leaseback and asset exchange techniques

There are two methods through which the sale of long term productive assets could be achieved and these include;

Outright sale. Companies could sell their long term assets that have gains and losses that are unrealised in those years when such sales would enhance their financial statements best (Hussein, Kassim and Arumugam, 2015). For instance, in the event a property owned by a company is carried in a balance sheet at $40 million while it’s real worth is $60 million. In the event of sale of the building, current period earnings would get a boost of $20 million.

Sale/leaseback. It is quite common for companies to sell assets to other companies and lease them back immediately. There are detailed rules in GAAP on whether a lease qualifies as an operating lease or as a capital lease. The mere renting of properties and operating leases are equivalent while capital leases and the retaining of ownership are equivalent. Losses that come about in leaseback and sales transactions are normally recognised immediately in the books of the seller (Brian Lee and Vetter, 2015).

Leaseback/sale transactions provide companies with opportunities for managing earnings through the recording of the losses and gains.

How corporate governance mechanisms constraint firms earnings management practices

The independence of the auditing committee goes a long way in constraining earnings and the opportunistic behaviours of managers (Abbadi et al., 2016). Independent audit committees who are not influenced by management in any way would easily identify misstatements and have a higher willingness of reporting their findings exactly as they are. Additionally, it is important to separate the functions of management and control as that guarantees well established financial statements and also curbs the manipulation of accounts.

Those organisations that have large board sizes are less prone to engage in behaviours of earnings management that are opportunistic and that have the potential of affecting the quality of earnings numbers to parties that are interested. Large boards tend to minimise the incidences of earnings management. the board of directors plays a role that is critical in the monitoring of the management`s activities to protect the shareholder`s interests. There is a close association between the boards composition with confidence in the financial reporting systems of the firms (Muda et al., 2018).

Earnings management is also constrained by ownership concentration. Large shareholders have stronger incentives of actively monitoring and further influencing the management of rims to protect their investments that are significant. That in turn reduces the scope of managerial opportunism to take part in management of earnings.

Conclusion

This essay discussed the motives of management of earnings, the different earings massaging techniques and the ways through which corporate governance constraints management of earnings.

Whenever the management of earnings falls outside the bounds of the practices of accounting that are acceptable, into morphs into financial reporting that is fraudulent. As such, companies should only get involved in the practice when there are higher benefits related to earnings management in relation to the involved risks and costs. Corporate governance mechanisms provide different mechanisms with the capabilities of constraining management of earnings and behaviours that are fraudulent.

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References

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