Earnings Management – Meaning and Mechanism

The relationship between managers and shareholders in the business world cannot be disputable. This relationship is interpreted under Agency Theory. They are very dependent each other, even somehow there exist conflict of interest among these two parties. In example the shareholders put on trust to agency by contributing huge amount of money in terms of paid up capital, so that agency can generate business and obtain profit and increase the firm’s value as principles return. Meanwhile agency (managers) is dependent to the principles for remunerations and bonuses as compensation. Because of the great pressure from principles (shareholders) towards the high performance of firms values, so agency commonly practice earnings management in order to be sustained in market place.

Earnings Management Mechanism

Earnings management may involve manipulation of accounting record, intentional omission or intentional misapplication of accounting o accounting principles. Earnings management is defined as the intentional misstatement of earnings leading to bottom line numbers that would have different in the absence of any manipulation. Earnings management is the process of intentionally exploiting or violating the GAAP or the law to present financial statements according to one’s interests. The earnings management activities can break the reliability and credibility of management towards the shareholders.

Earnings management also known as creative accounting or ‘cooked the book’ may have twofold purposes. First to stop shareholders from withdrawing capital and second, as a means of reporting favorably on stewardship and performance. Perhaps, the main reason why companies use earnings management is because of the pressure placed upon management to show favorable returns on their investor’s money. This idea of seeking to please shareholders is reinforced by Agency Theory. Agency Theory agency states that individuals seek to maximize their own utility, and act only in the individual best interest. So, acting in the company’s best interest, management will manage the earnings to enhance their financial reporting, and therefore protect the basis of their contract. Pressure from management, therefore, may cause accountants and auditors to accept in producing favorable reports to shareholders using earnings management techniques to improve results.

Earnings Management Mechanism

The practice of earnings management occurs because of the availability of different acceptability accounting accrual choice to be applied for determinant of reporting income. There are several mechanisms of implementing earnings management.

First, is what they called as ‘big bath’. This type of earnings management is when the company could not reach their target in certain period. Normally companies’ target is based on previous performance. Then when firms are way below their target, they have an incentive to make things look even worse. There are several ways to make it worse such as the company will take large reconstructing charges, increase in provision for bad debt, and take other income decreasing accounting decision. This kind of practices are bound under two reasons which is firstly it is highly impossible that any amount of earning management will get them over the target and secondly the cost to make it worse are typically minimal. Therefore, any improvements in performance will perceive that managers are more credible and greater credit for turning around a firm. Some other way of perception regarding big bath is when manager takes over responsibility for a unit there is a motivation to make as much as provision that ensure any losses appear as the responsibility of the previous manager.

Second mechanism is what they called “cookie jar” accounting. This practice of earning management is when the company relatively to achieve above target, they may again have an incentive to reduce earnings. Typically there is little benefit in going way above a benchmark. Consider a firm which expects to report an EPS of 3.80 for a given quarter when expectations hover around 3.00. Especially when economic boom-up. Such a firm may report an EPS of 3.30, but it still beating expectations. The remaining 50 cents of EPS reduction may come in handy in future quarters when the firm is slightly below targets. By reducing current period income, firms implicitly save some of these excess earnings for the future when they may be more valuable.

Creative Accounting

Earning management also be called as creative accounting. Creative accounting enable managers to ‘cook the book’ and ‘window dress’ their company by taking advantage of the loopholes in accounting standards. Due to this activity of earning management and thus provide doubtful of information in financial statement, so such information become unreliable. Therefore the users of financial statement will make wrong decision based on manipulated accounting numbers. Unfortunately, GAAP make such a room to accountant to make a manipulation since it allow accountants to use their discretion to make decision which is needed. In addition creative accounting is not against the law, in the hands of less a scrupulous managements, it can be dangerous instrument of deception. The common methods used by changing the assumptions for accounting standard.

The very common method of manage earnings that normally applied by practitioners is as below:

  1. Changing the assumptions for accounting standards. For example change in depreciation policy by extending depreciable lives periodically and justify it on the grounds that the change brings them in line with industry standards.
  2. Capitalization of expenses that previously expensed, increasing the extent of capitalization, slowing down amortization of previously capitalized expenses
  3. Reducing the provisions for bad debts. This is what people say of accrual discrepancies.
  4. Reducing income by taking on large one-time charges. For example restructuring charges.
  5. Managing transactions, whereby companies will create last minute sales by sending up a bundle of inventories to the customers by free charge for 3 months (let say) and recorded in a book of account receivables.

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