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 following these principles. Earnings management takes advantage of how accounting rules are applied and creates financial statements that inflate earnings, revenue, or total assets.

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.

Management can feel pressure to manage earnings by manipulating 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 (Securities and Exchange Commission) disclosures.

One method of manipulation when managing earnings 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. Under LIFO, 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 of recognizing inventory costs, 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.

Through earnings management, another form of manipulation is to change company policy so more costs are capitalized rather than expensed immediately. Capitalizing costs as assets delays the recognition of expenses and increases profits in the short term. Assume, for example, company policy dictates that every expense under $1,000 is immediately expensed and costs over $1,000 may be capitalized as assets. If the firm changes the policy and starts to capitalize far more assets, expenses decrease in the short term and profits increase.

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 statements. 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.