Discuss (using academic and practical evidence) different earnings management types (30
marks)
(721 words)
Earnings are the most important item in financial statements. They indicate the extent to
which a company has engaged in value-added activities. Earnings management (EM) is
defined as the reasonable and legal management decision making and reporting intended to
achieve stable and predictable financial results. The Economist suggested that EM is ‘’a
pervasive phenomenon’’; the prices of S&P 500 stocks have consistently been enhanced by
EM. However, the SEC criticised EM as having adverse consequences for financial reporting.
Two main types of EM are real earnings management (REM) and accrual-based earnings
management (AEM).
REM refers to managers’ opportunistic timing and structuring of operating, investment and
financing transactions to affect reported earnings in particular direction. This usually results
in sub-optimal business consequences and imposes a real cost on the firm. Managers exploit
their discretion in operating decisions and adjust real activities to overstate earnings and
avoid losses. This leads to unusually low cash flow from operations, unusually high
production costs and discretionary expenses.
AEM refers to managers’ opportunistic use of the flexibility allowed under GAAP to change
reported earnings. AEM is not aimed at changing underlying cash flows. Sources of
accounting discretion include revenue recognition, financial asset/ liability recognition,
goodwill etc.
Compared to AEM, REM is easier to apply but is less likely to draw auditor or regulatory
scrutiny. Most real actions are indistinguishable from mostly salient business specific
decisions that are hard to detect. Managers trade-off is between AEM and REM on rational-
basis depending on costs-benefits associated with each other. The 2 types are complements
because REM precedes AEM and AEM is used when REM does not meet certain EM
objectives. Companies switched from AEM to REM after the passage of SOX in 2002.
3 main motivations for EM are capital market incentives, managerial incentives, and debt
and other liability-alike contracts. Investors view earnings as stock value relevant data that
is more informative than cash flow data. The use of accounting information by investors and
financial analysts to help value stocks can create an incentive for managers to manipulate
earnings in an attempt to influence short-term stock price performance and hit earnings
benchmarks. Thus, managers not only help maintain stock liquidity (investor interest),
increase stock prices, enhance company reputation, and get better terms of trade; but also
maximise their bonus compensation and secure their jobs. Researches showed that failure
to meet analysts’ consensus estimates results in pay cuts for the CEO, thus, almost all
interviewed CFOs admitted to smooth earnings. Moreover, EM provides accounting
information for debt, managerial and industry-specific (joint ventures, trade relations)
contracts. A motivation for EM is the need to maintain the levels of certain accounting ratios
due to debt covenants. The risk of breaching contractual agreements in loan/debt contracts
marks)
(721 words)
Earnings are the most important item in financial statements. They indicate the extent to
which a company has engaged in value-added activities. Earnings management (EM) is
defined as the reasonable and legal management decision making and reporting intended to
achieve stable and predictable financial results. The Economist suggested that EM is ‘’a
pervasive phenomenon’’; the prices of S&P 500 stocks have consistently been enhanced by
EM. However, the SEC criticised EM as having adverse consequences for financial reporting.
Two main types of EM are real earnings management (REM) and accrual-based earnings
management (AEM).
REM refers to managers’ opportunistic timing and structuring of operating, investment and
financing transactions to affect reported earnings in particular direction. This usually results
in sub-optimal business consequences and imposes a real cost on the firm. Managers exploit
their discretion in operating decisions and adjust real activities to overstate earnings and
avoid losses. This leads to unusually low cash flow from operations, unusually high
production costs and discretionary expenses.
AEM refers to managers’ opportunistic use of the flexibility allowed under GAAP to change
reported earnings. AEM is not aimed at changing underlying cash flows. Sources of
accounting discretion include revenue recognition, financial asset/ liability recognition,
goodwill etc.
Compared to AEM, REM is easier to apply but is less likely to draw auditor or regulatory
scrutiny. Most real actions are indistinguishable from mostly salient business specific
decisions that are hard to detect. Managers trade-off is between AEM and REM on rational-
basis depending on costs-benefits associated with each other. The 2 types are complements
because REM precedes AEM and AEM is used when REM does not meet certain EM
objectives. Companies switched from AEM to REM after the passage of SOX in 2002.
3 main motivations for EM are capital market incentives, managerial incentives, and debt
and other liability-alike contracts. Investors view earnings as stock value relevant data that
is more informative than cash flow data. The use of accounting information by investors and
financial analysts to help value stocks can create an incentive for managers to manipulate
earnings in an attempt to influence short-term stock price performance and hit earnings
benchmarks. Thus, managers not only help maintain stock liquidity (investor interest),
increase stock prices, enhance company reputation, and get better terms of trade; but also
maximise their bonus compensation and secure their jobs. Researches showed that failure
to meet analysts’ consensus estimates results in pay cuts for the CEO, thus, almost all
interviewed CFOs admitted to smooth earnings. Moreover, EM provides accounting
information for debt, managerial and industry-specific (joint ventures, trade relations)
contracts. A motivation for EM is the need to maintain the levels of certain accounting ratios
due to debt covenants. The risk of breaching contractual agreements in loan/debt contracts
