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Contents:

1. Introduction………………………………………………………………….2

2. Earnings Management has been described by a number of phrases…….…..3

3. Earnings Management affects the firm investment decisions……………….5

4. Earnings Management to avoid losses…………………………………...….7

5. Ethics and Earnings Management………………………………………...…9

6. Earnings Management to smooth income…………………………….……11

7. Earnings Management to meet analyst forecasts………………..…………13

8. Conclusion…………………………………………………………….……15

9. Reference………………………………………………………………...…16

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Introduction:

Earnings, sometimes also referred as the “bottom line” or “net income, are

one of the most important things in financial statements. They show the

engagement of the company in value-added activities. This helps the direct

resource allocation in capital markets. Also, earnings sometimes show the value of

a company, for example, a rise in the earnings of the company will show an

increase in the value of the company, while a decrease will indicate a fall in the

company value.

Through this importance of earnings, there is no surprise of the interest of

company management in the way earnings is reported. Hence, each and every

executive must understand the implications of their accounting choices so as to

make the most suitable decision for the company. In other words, they must learn

to manage their earnings.

Earnings management can be described as the manipulation of the financial

earnings of a company directly or indirectly through accounting methods. It is the

use of financial techniques to produce financial reports that may show an overly

positive image of the activities of the business and its financial position. Earnings

management takes into advantage of how accounting rules can be used in their

favors.

Earnings management is more likely to take place when a business company

consistently is not capable to meet the investor expectations or in periods of

volatile earnings. Earnings management is frequently considered as materiality

deceptive and thus a deceitful activity. Even though the changes may tag on all of

the accounting standards and laws, they may go against what the standards and

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laws were initially trying to establish. For instance, a change from LIFO to FIFO in

inventory management may aid a company’s financial ratios but may not indicate

the true value of its inventory.

Company use Earnings Management to smooth out variations in earnings

and/or to meet stock analyst’s predictions. Large fluctuations in income and

expenses may be a normal part of a company’s activities, but the changes may

alarm investors who have a preference for stability and growth, alluring managers

to take benefit of accounting gimmicks. Also, a company’s stock will often

increase or fall after an earnings declaration, depending on whether it meets,

exceeds or falls short of expectations.

Managers can feel the pressure to maneuver the company’s accounting

practices and therefore its financial reports. Hence, earnings Management takes

place when managers use judgements in financial reporting and in structuring

dealings to modify financial reports to either deceive some stakeholders about the

underlying economic performance of the company, or to manipulate contractual

outcomes that depend on reported accounting numbers.

Earnings Management has been described by

a number of phrases:

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Income smoothing

Accounting hocus-pocus

Financial Statements management

The numbers game

Aggressive accounting

Reengineering the Income Statement

Juggling the books

Creative accounting

Financial Statement manipulation

Accounting magic

Borrowing income from future

Banking income for future

Financial shenanigans

Window dressing

Accounting alchemy

“There is no standard, universally accepted definition for any of these terms.

People use them in different degrees of appreciation to cover a wide variety of

activities, many perfectly legal. This tends to blurs the distinction between the

entirely legal earnings management and illegally cooking the books”.1

Earnings Management affect the firm’s

investment decisions:

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Investment decisions depend on expectations of the profits of the

investment, which in turn are based on expectations of upcoming growth and

product demand. Expectations of future growth depend on information that

consists of revenues and earnings. In addition to merely hiding the true

performance during the period, misstated financial numbers can hide underlying

trends in revenue and earnings growth. Thus, overstatements of revenues and

earnings are probable to disfigure expectations of growth by those unaware of the

misstatement.

One might assume that if management decides to paint a better view for

investors in the results they report externally, then they would not allow this to

have an impact on internal investment decisions. However, it is likely that

investment decision makers in the firm accept as true the misreported growth trend

because they are either over-confident or uninformed of the misstatement and

invest accordingly. On the other hand, investment decision makers might recognize

the actual state of the firm but choose to over-invest in a high-risk way to turn

around performance.

In spite of of the motive for the over-investment, truthful reporting might

have disallowed it. Several parties are normally implicated in investment decisions,

consisting of managers who make the decision to invest, boards who appraise the

capital budget, and external suppliers of finds. If financial data are reported

truthfully, then other parties could step in to restrain the investment. As a result,

firms spend more than they otherwise would have, and tries to meet capital market

expectations or meet bonus objectives, that could for example affect investors,

employees, customers, and a large set of related parties.

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Earnings Management to avoid losses:

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In most cases, firms with negative returns in the period face a higher

pressure to apply Earnings Management, and that their final aim is to conceal from

credit markets a signal (loss) that could negatively influence their cost of debt.

The transaction costs theory states that the costs of information treatment

may direct some stakeholders to find out the terms of the transactions with the

firm. A loss (earnings fall) may thus express a hint to outsiders assessing the

company, in particular credit raters and stock analysts, affecting the company’

credit ratings and their cost of debt in a negative way. However, such a sign might

be weighed in a different way by outsiders, depending on the firms’ previous

signals.

For example consider a firm with negative returns and pre-managed earnings

a little below zero; it is probable that this company had positive earnings in the

previous years, so a indication is being sent to credit markets. Managers may evade

the cost of a rating change if they manipulate earnings upward. They have a high

reason to do so.

Now take into consideration a firm with positive returns and pre-managed

earnings a little below zero. Optimistically, this suggests that the firm’s pasts

earnings were also negative. The indication was sent out the pasts year and the cost

incurred. As it is improbable that credit markets use zero earnings as a signal on

the up side the management is not significant to the cost. Consequently, less

Earnings Management will be anticipated for this firm. Hence, companies might

face an asymmetric encouragement to influence, depending on the sign of their

market returns and on which they use to take on the earnings target – from above

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or from below –, and a larger incentive is expected to be converted into greater

Earnings Management.

This seems to emphasize on the significance of the cost of debt as firms’

final incentive to undertake earnings management to keep away from losses. Given

that the sensitivity of a company to this cost depends on its contact to credit

markets, there is expectation for such an incentive to be more significant for

businesses with higher needs of debt.

Ethics and Earnings Management:

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The aim of financial statements is to deliver data about the financial

position, performance and modifications in financial position of a company that is

helpful to numerous users in making economic decisions. There are several users

of financial statements. These groups consist of employees, investors, suppliers,

lenders, clients, governments and the last but not least the general public. All these

users are important, however main concern is usually given to investors and their

information needs as they provide risk capital to companies. Hence, it is

management’s responsibility to present timely and accurate data to all these groups

of users about the company’s financial standing. Internal management reporting

regularly needs the manager to implement judgment. This judgment usually relates

to issues involving cut off of either revenue or expenditure.

“The main motivator for earnings management is greed”2 by Bitner. Arnott

even emphasizes that “if investors cannot trust the numbers, the investment world

may well price equities to offer not merely a risk premium but also a credibility

premium”3. Merchant and Rockness stresses “earnings management and

manipulation as the greatest threats to ethics in accounting”4.

There are 2 types of earnings management: operating earnings management

and accounting earnings management. Operating earnings management deals with

changing operating decisions to influence cash flows and net income for a period

such as facilitating credit terms to raise up sales. Accounting earnings management

deals with the use of flexibility in accounting standards to modify earnings

numbers.

Earnings Management can be considered as an unethical behavior in contrast

with accounting smartness as while modifying accounting numbers, management

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are also affecting directly or indirectly other users of financial information such as

employees, investors, suppliers, lenders, clients, governments as well as the

general public.

Earnings Management to smooth income:

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Healy and Wahlen: “Earnings management occurs when managers use

judgment in financial reporting and in structuring transactions to alter financial

reports to either mislead some stakeholders about the underlying economic

performance of the company or to influence contractual outcomes that depend on

reported accounting practices.”5

Accounting information have no significance without being compared to

some benchmark. Companies thus have incentives to manipulate earnings to

overcome such benchmarks as zero earnings, expected variations in earnings

between parallel periods, and analysts’ predictions. Evidence demonstrate that

there are high pressure to keep away from reporting losses. There are

psychological explanations to this, such as the idea that investors would like to see

positive earnings.

An earnings management strategy that has resisted the test of time is

smoothing. Income smoothing has been there for decades, and there are in general

two thought as to what encourages managers to smooth their earnings. Firstly,

smoothing presents an arguably efficient way for managers to disclose private

accounting results. Secondly, smoothing is a form of “garbling”, that is, smoothing

is an method used by managers in an effort to fool analysts and others and to

enhance managerial compensation. Hence it can be assumed that only firms with

good prospects elect to smooth. Basically, the first thought holds that income

smoothing may help in the disclosure of private information in much the same way

that dividend smoothing can occasion information revelation.

The second thought is the fact that garbling is considered as a form of

smoothing abuse. “For example, the Federal Home Loan Mortgage Corporation

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was found by the government to have illicitly altered the volatility mark on its put

swaptions in order to achieve a smoother earnings growth profile”6.

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Earnings Management to meet analysts’

forecasts:

There are many capital markets and managerial incentives for firms to meet

or beat earnings expectations. Firstly, there is a market premium to exceed the

earnings predictions. Firms that meet or beat earnings forecasts receive a market

premium and an additional returns premium for specific earnings surprise, and

firms that beat forecasts have an added returns premium over the firms that do not

meet forecasts. This shows that the stock market rewards companies that beat

earnings expectations, and undoubtedly provides companies with the added

motivation to not just meet, but to exceed the expectations.

Secondly, managers would want to overcome earnings predictions to

increase the present value of their stock options. When reported income is between

the minimum reported and the maximum reported income to receive a specific

bonus, managers might want to increase the reported earnings to maximize their

compensation. In a similar way, beating earnings expectations will lead to more

significant stock prices as compared to just meeting the predictions, and managers’

bonuses are normally related to stock price. Moreover, given that the executives’

decision level is shorter than that of companies’, this enables risk-averse managers

the motivation to exceed earnings expectations to boost stock prices in order to

enlarge the present value of their executive bonus.

Thirdly, managers of companies prior to selling stocks on their own

accounts have an incentive to direct financial analysts’ expectations downwards

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before earnings declaration, and later beat these under-valued expectations at

earnings announcement in favour to obtain the most significant share price during

stock sale on their personal accounts. Adding to that, market rewards firms for the

magnitude above which expectations are exceeded, hence managers of companies

have the encouragement to overcome the expectations to obtain the most

significant share price after earnings publication.

Last but not the least, firms may obtain additional market bonus from having

a track record of regularly exceeding earnings expectations. As documented by

Kasznik and McNichols, “firms that consistently meet market expectations

command a higher market premium over and above their market fundamentals”7.

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Conclusion:

It can thus be understood that earnings management is a strategy used by the

management of a company to deliberately manipulate the company's earnings so

that the figures match a pre-determined target. It has many effects such as

implications on firms’ investment decisions, to avoid losses, and on ethical issues,

only to name a few. Although there are many different implications and methods

used by managers for earnings management, income smoothing is one of its most

important and complex, and it is also the driving force behind managing earnings

to meet a pre-specified target. However, Abusive earnings management is

considered by the Securities and Exchange Commission (SEC) to be a material and

intentional misrepresentation of results and for any excessive use of income

smoothing, the SEC may issue fines.

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Reference:

1. “There is no standard, universally accepted definition for any of these terms.

People use them in different degrees of appreciation to cover a wide variety

of activities, many perfectly legal. This tends to blurs the distinction

between the entirely legal earnings management and illegally cooking the

books” Article Name: What is Earnings Management,

http://www.swlearning.com/pdfs/chapter/0324223250_1.PDF

2. “The main motivator for earnings management is greed” by Bitner

http://arno.unimaas.nl/show.cgi?fid=19848, Article Name: Ethics and

Management, pg 4

3. “if investors cannot trust the numbers, the investment world may well price

equities to offer not merely a risk premium but also a credibility premium”

by Arnott http://arno.unimaas.nl/show.cgi?fid=19848, Article name: Ethics

and Management, pg 4

4. “earnings management and manipulation as the greatest threats to ethics in

accounting” by Merchant and Rockness, http://arno.unimaas.nl/show.cgi?

fid=19848, Article Name: Ethics and Management, pg 4

5. “Earnings management occurs when managers use judgment in financial

reporting and in structuring transactions to alter financial reports to either

mislead some stakeholders about the underlying economic performance of

the company or to influence contractual outcomes that depend on reported

accounting practices.” By Healy and Wahlen,

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http://www.saycocorporativo.com/saycoUK/BIJ/journal/Vol3No1/Article_4.

pdf, Article Name: Income Smoothing, real Earnings Management and long-

run stock returns.

6. “For example, the Federal Home Loan Mortgage Corporation was found by

the government to have illicitly altered the volatility mark on its put

swaptions in order to achieve a smoother earnings growth profile”

http://www.saycocorporativo.com/saycoUK/BIJ/journal/Vol3No1/Article_4.

pdf, Article Name: Income Smoothing, real Earnings Management and

long-run stock returns, Page 56.

7. “firms that consistently meet market expectations command a higher market

premium over and above their market fundamentals” by Kasznik and

McNichols http://www.kellogg.northwestern.edu/accounting/papers/jimmy

%20lee.pdf, Article Name: Earnings Management to just meet analysts’

forecasts, page 4