Analysis implications of earnings management

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Because earnings management distorts financial statements, identifying and making adjustments for it is an important task in financial statement analysis. Still, despite the alarming increase in earnings management, it is less widespread than presumed. The financial press likes to focus on cases of earnings management because it makes interesting reading. This gives many users the incorrect impression that earnings are managed all the time. Before concluding a company is managing earnings, an analyst needs to check the
following:

• Incentives for earnings management. Earnings will not be managed unless there are incentives for managing them. We have discussed some of the incentives, and an analysis should consider them.
• Management reputation and history. It is important to assess management reputation and integrity. Perusal of past financial statements, SEC enforcements, audit reports, auditor change history, and the financial press provides useful information for this task
• Consistent pattern. The aim of earnings management is to influence a summary bottom line number such as earnings or key ratios such as the debt-to-equity or interest coverage. It is important to verify whether different components of income  (or the balance sheet) are consistently managed in a certain direction. For example, if a company appears to be inflating earnings through, say, revenue recognition policies while simultaneously decreasing earnings through an inventory method change, it is less likely the company is managing earnings
• Earnings management opportunities. The nature of business activities determines the extent to which earnings can be managed. When the nature of business activities calls for considerable judgment in determining financial statement numbers, greater opportunities exist to manage earnings

Evaluating Earnings Quality
Earnings quality (or more precisely, accounting quality) means different things to different people. Many analysts define earnings quality as the extent of conservatism adopted by the company a company with higher earnings quality is expected to have a higher price-to-earnings ratio than one with lower earnings quality. An alternative definition of earnings quality is in terms of accounting distortions a company has high earnings quality if its financial statement information accurately depicts its business activities. Whatever its definition, evaluating earnings quality is an important task of accounting analysis.

Steps in Evaluating Earnings Quality. Evaluating earnings quality involves the following
steps:

• Identify and assess key accounting policies. An important step in evaluating earnings quality is identifying key accounting policies adopted by the company. Are the policies reasonable or aggressive? Is the set of policies adopted consistent with industry norms? What impact will the accounting policies have on reported numbers in financial statements?
• Evaluate extent of accounting flexibility. It is important to evaluate the extent of flexibility available in preparing financial statements. The extent of accounting flexibility is greater in some industries than others. For example, the accounting for industries that have more intangible assets, greater volatility in business operations, a larger portion of its production costs incurred prior to production, and unusual revenue recognition methods requires more judgments and estimates. Generally, earnings quality is lower 
• Determine the reporting strategy. Identify the accounting strategy adopted by the company. Is the company adopting aggressive reporting practices? Does the company have a clean audit report? Has there been a history of accounting problems? Does management have a reputation for integrity, or are they known to cut corners? It is also necessary to examine incentives for earnings management and look for consistent patterns indicative of it. Analysts need to evaluate the quality of a company’s disclosures. While disclosures are not substitutes for good quality financial statements, forthcoming and detailed disclosures can mitigate weaknesses in financial statements.
• Identify and assess red flags. One useful step in evaluating earnings quality is to beware of red flags. Red flags are items that alert analysts to potentially more  serious problems. Some examples of red flags are:

Poor financial performance desperate companies are prone to desperate means.
Reported earnings consistently higher than operating cash flows.
Reported pretax earnings consistently higher than taxable income.
Qualified audit report.
Auditor resignation or a nonroutine auditor change.
Unexplained or frequent changes in accounting policies.
Sudden increase in inventories in comparison to sales.
Use of mechanisms to circumvent accounting rules, such as operating leases and
receivables securitization.
Frequent one-time charges and big baths.

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