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EarningsManagementandEarningsQuality1.WhatisEarningsManagement?(BryanHall’sWebpage)Earningsmanagementisdefinedbyaccountingliteratureas“distortingtheapplicationofgenerallyacceptedaccountingprinciples.”ArthurLevitt,theoldSECChairman,definedearningsmanagementas“practicesbywhichearningsreportsreflectthedesiresofmanagementratherthantheunderlyingfinancialperformanceofthecompany.”Earningsmanagementisoftendefinedastheplannedtimingofrevenues,expenses,gainsandlossestosmoothoutbumpsinearnings.Inmostcases,earningsmanagementisusedtoincreaseincomeinthecurrentyearattheexpenseofincomeinfutureyears.Forexample,companiesprematurelyrecognizesalesbeforetheyarecompleteinordertoboostearnings.Earningsmanagementcanalsobeusedtodecreasecurrentearningsinordertoincreaseincomeinthefuture.Theclassiccaseistheuseofcookiejarreserves,whichareestablished,byusingunrealisticassumptionstoestimateliabilitiesforsuchitemsassalesreturns,loanlosses,andwarrantyreturns.Managersengageinincomesmoothingactivitiesbecausetheyknowthatvolatileearningsstreamstypicallyleadtolowermarketvaluations.Manysuccessfulmanagementteamsbelievethatthestrategictimingofinvestments,sales,expenditures,andfinancingdecisionsisanimportantandnecessarystrategyformanagerscommittedtomaximizingshareholdervalue.Investorsaredissatisfiedwiththemanagementofearnings;however,investorsbecomeenragedwhenquarterlyorannualearningsforecastarenotmetbyfirms.Therefore,investorsandthepublicviewminorearningsmanagementasacceptableandaneverydaybusinesspractice.Inresponsetopubliccomplaintsandconcernforearningsmanagement,theSEChasissuedbulletinstohelppreventearningsmanagement.2.ThePublicPerceptionofEarningsManagementEarningsmanagementhasanegativeeffectonthequalityofearningsifitdistortstheinformationinawaythatitlessusefulforpredictingfuturecashflows.WithintheConceptualFramework,usefulinformationisbothrelevantandreliable.However,earningsmanagementreducesthereliabilityofincome,becausetheincomemeasureisbiased(upordown)and/orthereportedincomethatisnotrepresentationallyfaithfultothatwhichitissupposedtoreport(e.g.,volatileearningsaremadetolookmoresmooth).Thetermqualityofearningsreferstothecredibilityoftheearningsnumberreported.Companiesthatuseliberalaccountingpoliciesreporthigherincomenumbersintheshort-run.Insuchcases,wesaythatthequalityofearningsislow.Similarlyifanonrecurringgainincreasesincome,butthegainisobviouslynotsustainable,thenthequalityofearningsisconsideredlow.Forthemarketstoworkefficiently,itisvitalthatinvestorsbeabletotrusttheearningsnumbersofthecompaniesinwhichtheyhavechosentoinvesttheircapital.Recentstudieshaveshownthattheinvestingpublicbelievesthattheoccurrenceofearningsmanagementisbothwidespreadandpervasiveinthefinancialstatementsofcorporationsworldwide.However,itisinterestingtonotethattheinvestingpublicdoesnotnecessarilyviewminorearningsmanagementasunethical,butinfactasacommonandnecessarypracticeintheeverydaybusinessworld.Itisonlywhentheimpactofearningsmanagementisgreatenoughtoaffecttheinvestors’portfoliothattheyfeelfraudhasbeencommitted.3.TheImpactofEarningsManagementPublicperceptionaboutthewidespreadoccurrenceofearningsmanagementisaffectingthepublic’sconfidenceinexternalfinancialreporting.Thepracticeofearningsmanagementdamagestheperceivedqualityofreportedearningsovertheentiremarket,resultinginthebeliefthatreportedearningsdonotreflecteconomicreality.Investorsrelyonfinancialinformationprovidedbythecompanytomaketheirinvestmentdecisions,andwheninvestorsbelievetheyarebeinggivenmeaninglessinformationtheybecomewaryoftrustingthecompaniestheyhaveinvestedin.Investors’apprehensionwilleventuallyleadtounnecessarystockpricefluctuation.Asinvestorslosefaithinreportedearnings,theyareforcedintoaguessinggameconcerningtheactualfinancialpositionofacompany.Thisuncertaintyultimatelyhasthepotentialtounderminetheefficientflowofcapitaltherebydamagingthemarketsasawhole.4.IncentivestoManageEarningA.EXTERNALFORCES•AnalystForecasts-Companiesareunderextremepressuretomeetanalysts’earningsestimatesinordertopreventlargedropsintheirstockprice.•Debtmarketsandcontractualobligations-Companiesdependonachievingcertainearningsfigurestoobtainaccesstodebtmarkets,oreventomeettheircurrentdebtcovenantsandothercontractualobligations.•Competition-Thereispressureinhighlycompetitiveindustriestostayatthetopoftheindustryintermsofrevenueormarketshare.Companiesmaywanttomanagethesefigurestostayabovecompetitors.B.INTERNALFACTORS•Potentialmergers-Ifthecompanyishopingtoenteramerge,astrongfinancialpositionwillmakeitlookmuchmoreattractivetoothercompanies.•ManagementCompensation-Stockoptionandbonusprogramsthataretiedtoearningsperformancewillprovideincentiveformanagerstomanipulateearningsnumberstoboosttheirowncompensation.•Planningandbudgets-Sometimescompanieswillestablishunrealisticplansandbudgetstopushmanagerstooverachieve.Thiscanprovidepressureformanagementtoboostearningstomeetthecompany’sownexpectations.•Unlawfultransactions-Somecompaniesevenuseearningsmanagementtocoveruptheirownunlawfultransactionssuchasembezzlement,fraud,misappropriation,andbribery.