Earnings Management

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Earnings Management
High-quality accounting occurs when managers measure and report firm performance and financial position with very little measurement error or bias. However, management’s influence over accounting practice can result in earnings management, low accounting quality, and the need to adjust financial data to better reflect its economic information content. Earnings management connotes different things to different users of the term. Healy and Wahlen provide the following definition of earnings management Earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reporting accounting numbers.

Note that the definition includes managers’ choices, judgments, and estimates that are necessary but that mask the underlying economic performance of a firm. In addition, structuring transactions may also be used as an earnings management tool. For example, managers might delay maintenance to increase reported income. This is often referred to as real earnings management because, although no estimates or judgments were involved, a real decision to delay maintenance was undertaken to influence a decision maker’s understanding of the earnings signal for future profitability.

Detecting earnings management is difficult, because managers can exercise judgment in financial reporting in many ways. Moreover, earnings management is often intended to create the appearance of fundamental economic growth (for example, increasing sales and earnings).

Incentives to Practice Earnings Management
Managers may engage in earnings management if choices and estimates allowed in U.S. GAAP or IFRS benefit them personally or if doing so leads to benefits for the firm andits stakeholders. Examples of reasons for earnings management are:

•  Managing earnings upward might increase the manager’s compensation under compensation contracts based on earnings or stock prices.
•  Managing earnings upward might enhance job security for senior management by influencing the outcomes of transactions that affect corporate control, such asproxy fights and takeovers.
• Managing earnings upward might allow the firm to obtain debt financing at a lower cost by appearing more profitable or less risky, avoid violation of debt covenants, or influence the effects of other binding constraints from accounting-based contracts.
•  Managing earnings upward might influence short-term share price performance and increase the economic benefits to the firm from engaging in initial publicand seasoned equity offerings and using firm shares in acquisitions.
• Managing earnings upward prior to managers’ sale of their personal ownershipinterests (insider selling) might increase share prices and maximize manager gains from the sale.
• Managing earnings upward might influence stock prices positively (or delay stock price declines) by meeting or beating the market’s expectations for earnings, managers’ own earnings forecasts, and prior period’s earnings, and might also maintain a smooth earnings time-series to cause the firm to appear less risky.
•  Managing earnings downward might discourage entry into the industry by potential competitors.
•  Managing earnings downward might reduce the probability of antitrust actions against the firm or other regulatory interventions or political interference related to tax issues, capital requirements (e.g., for banks, thrifts, and insurers), and import relief.
• Managing earnings downward might suppress stock prices and thus yield favorable terms when taking a company private.
•  Managing earnings downward prior to managers’ insider share purchases might decrease share prices and maximize manager gains from future share sales.
•  Managing earnings downward might cause negative current consequences but will create opportunities to reverse earnings management in future periods.

Deterrents to Earnings Management
Managers may be deterred from engaging in earnings management for the following reasons:

• Capital markets and regulators such as the SEC penalize firms identified as flagrant earnings managers.
•  Firms and managers who are perceived as practicing aggressive earnings management will lose their reputation for being honest and trustworthy among capital market participants and stakeholders. When it is revealed that a firm has managed earnings, its stock price usually falls dramatically and firm managers are often punished or fired.
• Legal consequences can result from aggressive earnings management and fraud.
• Securities regulations and stock exchanges require annual audits by independent accountants. Auditors can monitor particularly aggressive actions taken by management to influence earnings, although an auditor’s power to thwart actions taken within the bounds of U.S. GAAP or IFRS is limited.
• The ongoing scrutiny of financial analysts and investors serves as a check on earnings management. Security analysts typically follow several firms in an industry and have a sense of the corporate reporting ‘‘personalities’’ and strategies of various firms. The frequency, timeliness, and quality of management’s communications with shareholders and analysts signal the forthrightness of management and the likelihood of earnings being highly managed

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