Mechanics of earnings management

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This section explains the mechanics of earnings management. Areas that offer maximum opportunities for earnings management include revenue recognition, inventory valuation, estimates of provisions such as bad debts expense and deferred taxes, and one-time charges such as restructuring and asset impairments. This section does not provide examples of every conceivable method of managing earnings.In this section, we describe two major methods of earnings management income shifting and classificatory earnings management.

Income Shifting

 Income shifting is the process of managing earnings by moving income from one period to another. Income shifting is achieved by accelerating or delaying the recognition of revenues or expenses. This form of earnings management usually results in a reversal of the effect in one or more future periods, often in the next period. For this reason, income shifting is most useful for income smoothing. Examples of income shifting include the following:

• Accelerating revenue recognition by persuading dealers or wholesalers to purchase excess products near the end of the fiscal year. This practice, called channel loading, is common in industries such as automobile manufacturing and cigarettes.
• Delaying expense recognition by capitalizing expenses and amortizing them over future periods. Examples include interest capitalization and capitalization of software development costs.
• Shifting expenses to later periods by adopting certain accounting methods. For example, adopting the FIFO method for inventory valuation (versus LIFO) and the straight-line depreciation (versus accelerated) can delay expense recognition.
• Taking large one-time charges such as asset impairments and restructuring charges on an intermittent basis. This allows companies to accelerate expense recognition and, thus, make subsequent earnings look better.

Classificatory Earnings Management

Earnings are also managed by selectively classifying expenses (and revenues) in certain parts of the income statement. The most common form of this classificatory earnings management is to move expenses below the line, meaning report them along with unusual and nonrecurring items that usually are given less importance by analysts. Managers attempt to classify expenses in the nonrecurring parts of the income statement as these examples illustrate:

• When a company discontinues a business segment, the income from that segment must be separately reported as income (loss) from discontinued operations. This item is properly ignored in analysis because it pertains to a business unit that no longer impacts the company. But some companies load a larger portion of common costs (such as corporate overhead) to the discontinued segment, thereby increasing income for the rest of the company.
• Use of special charges such as asset impairments and restructuring charges has skyrocketed (almost 40% of companies report at least one such charge). The motivation for this practice arises from the habit of many analysts to ignore special charges because of their unusual and nonrecurring nature. By taking special charges periodically and including operating expenses in these charges, companies cause analysts to ignore a portion of operating expenses.

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