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Earnings Management

Definition

Earnings management, in accounting, is the act of intentionally influencing the process of financial reporting to obtain some private gain. Earnings management involves the alteration of financial reports to mislead stakeholders about the organization's underlying performance, or to "influence contractual outcomes that depend on reported accounting numbers."

Earnings Management

What is 'Earnings Management'

Earnings management is the use of accounting techniques to produce financial reports that present an overly positive view of a company's business activities and financial position. Many accounting rules and principles require company management to make judgments. Earnings management takes advantage of how accounting rules are applied and creates financial statements that inflate earnings, revenue or total assets.

Explaining 'Earnings Management'

Companies use earnings management to smooth out fluctuations in earnings and present more consistent profits each month or year. Large fluctuations in income and expenses may be a normal part of a company's operations, but the changes may alarm investors who prefer to see stability and growth. A company's stock price often rises or falls after an earnings announcement, depending on whether the earnings meet or fall short of expectations.

How Managers Feel Pressure

Management can feel pressure to manipulate the company's accounting practices to meet financial expectations and keep the company's stock price up. Many executives receive bonuses based on earnings performance, and others may be eligible for stock options that generate a profit when the stock price increases. Many forms of earnings manipulation are eventually uncovered, either by a CPA firm performing an audit or through required SEC disclosures.

Examples of Manipulation

One method of manipulation is to change an accounting policy that generates higher earnings in the short term. For example, assume a furniture retailer uses the last-in, first-out (LIFO) method to account for the cost of inventory items sold, which means the newest units purchased are sold first. Since inventory costs typically increase over time, the newer units are more expensive, and this creates a higher cost of sales and a lower profit. If the retailer switches to the first-in, first-out (FIFO) method, the company sells the older, less-expensive units first. FIFO creates a lower cost of sales expense and a higher profit so the company can post higher profits in the short term.

Factoring in Accounting Disclosures

A change in accounting policy, however, must be explained to financial statement readers, and that disclosure is usually stated in a footnote to the financial reports. The disclosure is required because of the accounting principle of consistency. Financial statements are comparable if the company uses the same accounting policies each year, and any change in policy must be explained to the financial report reader. As a result, this type of earnings manipulation is usually uncovered.


Further Reading

Earnings management to avoid earnings decreases and lossesEarnings management to avoid earnings decreases and losses
www.sciencedirect.com [PDF]
… Page 14. 112 D. Burgstahler, L Dichev / Journal of Accounting and Economics 24 (7997) 99-126 management has changed earnings by more than 1% of the market value of equity.1 3. Evidence on the methods of earnings management to avoid losses …

Earnings management under German GAAP versus IFRSEarnings management under German GAAP versus IFRS
www.tandfonline.com [PDF]
… Page 14. 112 D. Burgstahler, L Dichev / Journal of Accounting and Economics 24 (7997) 99-126 management has changed earnings by more than 1% of the market value of equity.1 3. Evidence on the methods of earnings management to avoid losses …

Detecting earnings managementDetecting earnings management
www.jstor.org [PDF]
… Page 14. 112 D. Burgstahler, L Dichev / Journal of Accounting and Economics 24 (7997) 99-126 management has changed earnings by more than 1% of the market value of equity.1 3. Evidence on the methods of earnings management to avoid losses …

Earnings management and nonroutine executive changesEarnings management and nonroutine executive changes
www.sciencedirect.com [PDF]
… Page 14. 112 D. Burgstahler, L Dichev / Journal of Accounting and Economics 24 (7997) 99-126 management has changed earnings by more than 1% of the market value of equity.1 3. Evidence on the methods of earnings management to avoid losses …

Earnings management and earnings qualityEarnings management and earnings quality
www.sciencedirect.com [PDF]
… Page 14. 112 D. Burgstahler, L Dichev / Journal of Accounting and Economics 24 (7997) 99-126 management has changed earnings by more than 1% of the market value of equity.1 3. Evidence on the methods of earnings management to avoid losses …

Earnings management: A perspectiveEarnings management: A perspective
papers.ssrn.com [PDF]
… Page 14. 112 D. Burgstahler, L Dichev / Journal of Accounting and Economics 24 (7997) 99-126 management has changed earnings by more than 1% of the market value of equity.1 3. Evidence on the methods of earnings management to avoid losses …

Earnings management and investor protection: an international comparisonEarnings management and investor protection: an international comparison
www.sciencedirect.com [PDF]
… Page 14. 112 D. Burgstahler, L Dichev / Journal of Accounting and Economics 24 (7997) 99-126 management has changed earnings by more than 1% of the market value of equity.1 3. Evidence on the methods of earnings management to avoid losses …

Financial reporting transparency and earnings management (retracted)Financial reporting transparency and earnings management (retracted)
meridian.allenpress.com [PDF]
… Page 14. 112 D. Burgstahler, L Dichev / Journal of Accounting and Economics 24 (7997) 99-126 management has changed earnings by more than 1% of the market value of equity.1 3. Evidence on the methods of earnings management to avoid losses …

Audit committee, board of director characteristics, and earnings managementAudit committee, board of director characteristics, and earnings management
www.sciencedirect.com [PDF]
… Page 14. 112 D. Burgstahler, L Dichev / Journal of Accounting and Economics 24 (7997) 99-126 management has changed earnings by more than 1% of the market value of equity.1 3. Evidence on the methods of earnings management to avoid losses …

Female executives and earnings managementFemale executives and earnings management
www.emerald.com [PDF]
… Page 14. 112 D. Burgstahler, L Dichev / Journal of Accounting and Economics 24 (7997) 99-126 management has changed earnings by more than 1% of the market value of equity.1 3. Evidence on the methods of earnings management to avoid losses …


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Section 508

WCAG 2.0

Section 508