What is Earnings Management?

Earnings management refers to deliberate intercession by the management in reporting to deceive the stakeholders on the company’s economic & financial position or with the personal intention to gain income from contracts with these manipulated financial reports.

The financial manager The financial manager or management of a company chooses to exhibit only things in their financial reports that project their company in good status to gain profit from that. Earnings management is bad as most of the calculation of profitCalculation Of ProfitThe profit formula evaluates the net gain or loss of an organization in a particular accounting period. It is computed as the difference between the total sales revenue and the overall expenses incurred by the company.read more showed in the reports will be either fake or prepared based on uncertain future judgments.

Types

There are many types of earnings management based on the size of the company and its financial status; commonly used models are as below:

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#1 – Cookie Jar Reserves

Cookie jar reserves come under the technique of aggressive accounting. It deals with creating a significant reserve in the profit year and drawing downDrawing DownA drawdown is defined as the percentage of decline in the value of a security over a period before it bounces back to the original value or beyond. It is expressed as the difference between the highest, i.e., the peak value of that asset, and the lowest, i.e., the trough value of the same.read more when the company faces a bad year, or bad debts can be underestimated in a year to show the company is making a profit.

#2 – The Big Bath

When a company is facing a bad period due to external factors it will affect its profit, it has to show it in its reports, but the company will make it even worse by writing off all bad debts, overvaluation ofDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. read more assets depreciationAssets DepreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. read more, restructuring costsRestructuring CostsRestructuring Cost is the one-time expense incurred by the company in the process of reorganizing its business operations. It is done to improve the long term profitability and working efficiency. This expenditure is treated as the non-operating expenses in the financial statements.read more, other expenses in the same year to show more loss and evade tax.

#3 – Expense and Revenue Recognition

It can also be called “Income Smoothing” This comes under fraudulent accounting as the company records its expenses before it incurs or does not show the profit and sales when earned. They can even accelerate the sales showing extra revenue, or they don’t recognize a bad debtBad DebtBad Debts can be described as unforeseen loss incurred by a business organization on account of non-fulfillment of agreed terms and conditions on account of sale of goods or services or repayment of any loan or other obligation.read more in the current year and shifts it to next year as it reduces this year’s profit.

Earnings Management Examples

Example #1

If a company has $20,000 as bad debts and it is not recoverable, it has to be written off during this financial year. Still, the financial manager says to show $10,000 as debtors and write offWrite OffWrite off is the reduction in the value of the assets that were present in the books of accounts of the company on a particular period of time and are recorded as the accounting expense against the payment not received or the losses on the assets.read more the balance in the next financial year as this year’s profit is low. It comes under the type of expense and revenue recognition as an expense is not recognized correctly to inflate profit.

Example #2

The market is not stable due to external factors like high pricing, low demand, etc. a company can face losses. The company’s CEO asks to show all the losses in the same year, like unrecoverable debts, depreciation, high reserves, etc., as already the company is in a loss. So that the next financial year will be profitable, this is an example of The BIG BATHBIG BATHBig Bath is a manipulative accounting in the books of accounts where the company manipulates the income in a bad year by degrading the income further, reporting even more loss than it is so that the upcoming period or year looks better and makes future results look good and attractive.read more type of earnings management.

Earnings Management Techniques

There are three types of techniques in earnings management they are;

  • Aggressive & Abusive Accounting – refers to the aggressive escalation of sales or revenue recognition. Abusive accounting includes cookie jar, big bath, etc., to show there is a high profit that year.Conservative Accounting – Conservative accountingConservative AccountingThe conservatism principle of accounting guides the accounting, according to which there is any uncertainty. All the expenses and liabilities should be recognized. In contrast, all the revenues and gains should not be recorded, and such revenues and profits should be recognized only when there is reasonable certainty of its actual receipt.read more refers to writing off all the expenses and losses in the same year if the company makes a high profit and evades tax.Fraudulent Accounting –  If revenue and losses are not shown in the reports to deceive stakeholders, or if high profit is shown to earn contracts, it comes under fraudulent accounting. It also violates the GAAP (Generally Accepted Accounting PrinciplesGenerally Accepted Accounting PrinciplesGAAP (Generally Accepted Accounting Principles) are standardized guidelines for accounting and financial reporting.read more).

Purpose

The purpose of earnings management cannot always be wrong; there are also some good reasons. Generally, it is bad as it is done for Personal gain from such activity as earning commission from obtaining a contract from a false report or increasing the stock value in the market by showing the company is highly profitable. A good reason can be moving the money for next year’s so that the company will be showing consistent profit instead of fluctuating between profit and lossProfit And LossThe Profit & Loss account, also known as the Income statement, is a financial statement that summarizes an organization’s revenue and costs incurred during the financial period and is indicative of the company’s financial performance by showing whether the company made a profit or incurred losses during that period.read more.

How to Detect Earnings Management?

The Healy model (1985) is used to calculate the estimation of discretionary accruals used in earnings management.

  • Where: NDA = Estimated non-discretionary accruals TA = Total accruals scaled by lagging assets t = 1, 2… T refers to years included in the period of estimation; t = year in the event period.

One method of detecting earningsEarningsEarnings are usually defined as the net income of the company obtained after reducing the cost of sales, operating expenses, interest, and taxes from all the sales revenue for a specific time period. In the case of an individual, it comprises wages or salaries or other payments.read more management is shown above; there are other methods as well.

Conclusion

Earnings management can be good and bad; it is considered good when there is no personal intention. It isn’t good for the company if it uses these techniques to inflate its profit, as it can`t be done in the long term, or it will affect the company in the long run.

This has been a guide to What is Earnings Management & its Definition. Here we discuss the techniques of earnings management and types along with examples and purposes. You can learn more about it from the following articles –

  • Formula for Operating EarningsEarnings CallLikert ScaleCalculate Pro-Forma Earnings