What is Earnings Management?
Earnings management is a euphemism for methodologies in accounting that follow the letter of generally accepted accounting practices, but are not necessarily in keeping with the spirit of those practices. Sometimes referred to as creative accounting, earnings management is an attempt to present the financial information in the most positive light, usually by downplaying any negative elements to the point that they are extremely difficult to detect. This questionable practice is sometimes used to attract investors, keep current investors happy, and in general project an image of the business that is not the complete truth.
One of the aspects of earnings management that allow the practice to be somewhat successful in misrepresenting the true nature of a financial situation is that the information that is presented is generally correct. However, that information is presented without taking into account any other relevant facts that would provide a more balanced and accurate picture of the status of the company. For example, the company may release a document to investors that hails the fact that unit sales were up by 25% in the most recent quarter, while failing to mention that that the upswing in sales was due to a price drop that essentially left the level of generated revenue unchanged from the previous quarter.
The more successful instances of earnings management focus on telling just the right amount of truth in the form of isolated facts, while downplaying or omitting other data that would allow investors and others to understand the actual financial status of the business. This creates a situation where the accounting records are technically complete, and do contain entries for all financial transactions. However, the issue of where in the accounting records those entries are posted, and thus how they are presented, is subject to questioning. Only by conducting an audit with the aid of an outside accounting firm can these types of accounting irregularities be identified.
In recent years, earnings management has come under closer scrutiny by investors and by government regulatory agencies. The use of this practice has led to situations where investors ultimately lost a great deal of money, since they made investments based on the manipulated information supplied to them. As a result of recurring instances of this type of creative accounting, many governments are taking steps to refine regulations related to business accounting and accountability, making it somewhat harder to utilize loopholes in the current processes to offer investors and others a partial and overly-optimistic perception of the true financial situation.
Of course what they did was not simply fail to present the “complete picture”; they took liberties to paint some expenses as if they were assets and managed to turn a loss into a profit.
When it was exposed, it rocked the company (which eventually filed for bankruptcy) and the CEO is now spending time in prison, where he belongs. I realize that this is not expense management as explained here, but it’s not that far off in my opinion.
Once you start manipulating the facts, be it ever so slightly, it won’t be long before you start making things up completely out of whole cloth. If you ask me what pressures accountants to do such improper things, it starts from the top down, and everyone is trying to make the investors happy.
@David09 - In your example, however, there was no attempt at earnings management to avoid decreases and losses. The company flat out told you that they had shrunk margins. I think frankly they are under increasing pressure to do so, because of tighter SEC regulations.
Even if they hadn’t, astute analysts would have dug into the numbers to reveal the true nature of what was going on. Afterwards they would tell the whole world that margins would have shrunk and the effect would be the same.
The definition of earnings management is a good one, but I think it overemphasizes the naiveté of today’s investors. Take the example it gives about an increase in revenue that doesn’t mention the price reduction in the product.
Most investors and analysts would actually pick up on this. If you’re growing your top line sales but you’re cutting your prices then what you’re really doing is shrinking your profit margins.
Just about everyone understands this. I learned it too the hard way, as an investor. I bought a stock in a company that was doing well. Then all of a sudden they released a quarterly report where they announced an increase in sales, but a decrease in margins. The stock fell like a rock and I sold it much later, licking my wounds all the way down.
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