Incentives to practice earnings management

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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 and its 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 as proxy 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 public and seasoned equity offerings and using firm shares in acquisitions.
•  Managing earnings upward prior to managers’ sale of their personal ownership interests (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. Although deterrents exist, the existence of incentives to practice earnings management indicates that you are best served by increasing your analysis of accounting quality when these incentives are present

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