What is Earnings Management?

Earnings management is the use of accounting trickery to make a company’s financial results appear better than is really the case. This done by taking advantage of the accounting standards to either inflate a firm’s reported profits or to make these figures look less variable. The intent behind earnings management is to make earnings attain a specific target, even if the underlying performance of the business differs from this result.

Reasons for Earnings Management

There are several reasons why a company might engage in earnings management, which includes the following items:

Generate consistent earnings. Earnings management is especially common in publicly-held companies, because their investors base their stock valuation analyses on a reliable track record of consistent increases in earnings.
Achieve bonus plans. The requirements of management’s bonus plans can drive them to manage earnings, in order to maximize their bonus payouts.
Battle short sellers. Senior management might use earnings management to force short sellers out of their positions. When a positive earnings report drives up the stock price, short sellers are forced to abandon their short sale positions, given the risk of incurring major losses.

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Earnings Management Techniques

There are several ways to manage earnings. For example, managers could lower the capitalization limit, so that lower-cost expenditures are capitalized as fixed assets, rather than being charged to expense as incurred. Another possibility is to switch from the last in, first out method of valuing inventory to the first in, first out method, which tends to reduce the cost of goods sold during inflationary periods. Yet another option is to reduce the amount of recognized bad debt expense by shrinking the allowance for doubtful accounts.

How to Detect Earnings Management

Earnings management typically involves a change in accounting policy, which should be disclosed in the footnotes that accompany an organization’s financial statements. Consequently, a detailed analysis of the footnotes can reveal the existence of earnings management.