Earnings management

Hello. Janis Weber here, and I am covering some topics about financial accounting and trying to inspire you to want to do a further study in the topic.

Before I delve into my topic, let me introduce myself. I am an accounting educator at the moment, but I have had a career in accounting that also spans public accounting as a CPA in public practice. I've enjoyed working with accounting both in academia and in the actual public practice. But I hope that I can inspire you to want to study more about accounting through these topics. Today, we're going to be talking about earnings management, which is an interesting angle. It's not directly related to the mechanics of accounting, but it is a critical element that I feel that anyone that looks at financial statements should be aware of.

Earnings management happens because management has some form of pressure that they're feeling to make their financial statements look better. This earnings management, I'm not trying to say that it's always bad to use earnings management, but often it becomes a negative thing because there's so much abuse in the area of earnings management. I will try to present three things. I'll talk about triggers that motivate a company to implement earnings management, and then I'll move on to some of the methods that are used to do earnings management. Then I'm going to talk about the danger of using earnings management if it's not done appropriately. First, earnings management triggers. What would make a company want to manage their income rather than just reporting the transactions as normal? A company could feel pressure, and that is generally, as far as I know, the main reason that companies implement earnings management procedures. The pressure could come from inside their company or from external forces. I'll talk about internal and external expectations that could trigger earnings management from the company. First, on the internal angle, you'd have a company that might set an aggressive revenue or profit goal, and everyone in the company is trying to make that goal. There's a lot of pressure if the goal's not made. There's a temptation to try to make an adjustment to make it happen. That's one thing that might happen internally. Then the other one is their employees sometimes, and managers are given incentives to meet a certain goal of income or of sales. They might have an incentive of bonus salary, or stock options, or some other perk that would only be received if they met these goals. Of course, the pressure's on, and that is the internal. Those are the two internal most prevalent, probably, forces that cause the earnings management. Then, on the external, these are huge. The external pressure on a company is very great. The analysts in the stock market give recommendations to investors about whether they should or should not invest in a company. Missing an analyst forecast can negatively affect the stock price drastically. The company is trying to meet the analyst expectations even though those analysts are not inside the company, and don't actually know what the company's economic situation or prospects are fully, at least, they know some about the company, but they don't know as much as the internal management people. But still their opinion is taken very seriously by stockholders. The analysts' expectations can greatly increase management's urge to do some adjustment to their financial statement. Then the investors are constantly watching activity from the company to see the strength of the asset and liability match, to see the equity that's there and also to watch the sales and the net income of the company, looking for trends of progress at all times, of course. If things don't turn out to be as strong as they expected or as strong as the analysts expected, the shareholders could lose confidence in the company, of course. Then that might trigger them to sell or a prospective shareholder might not buy the stock if the financial statements were not looking good. Then the next one, of course, the creditor is someone that you have to present financial statements to and there's a temptation from management to try to make their financials look as strong as possible for those creditors, because it could affect whether or not they get a loan or a line of credit, and also the repayment terms would be more favorable if the financial statements are looking strong. All these expectations are pressuring management to do something to make the financial statements look better. Even if it's not the right thing, management might be tempted to do something.