Earnings management, in

accounting Accounting, also known as accountancy, is the measurement, processing, and communication of financial and non financial information about economic entities such as businesses and corporations. Accounting, which has been called the "languag ...

, is the act of intentionally influencing the process of

financial reporting Financial statements (or financial reports) are formal records of the financial activities and position of a business, person, or other entity. Relevant financial information is presented in a structured manner and in a form which is easy to un ...

to obtain some private gain.Schipper, Katherine. 1989. “Commentary on Earnings Management.” ''Accounting Horizons'' (December): 91–102. Earnings management involves the alteration of

financial reports Financial statements (or financial reports) are formal records of the financial activities and position of a business, person, or other entity. Relevant financial information is presented in a structured manner and in a form which is easy to un ...

to mislead stakeholders about the organization's underlying performance, or to "influence contractual outcomes that depend on reported accounting numbers."Healy, Paul M., and James Wong. Wahlen. 1999. “A Review of the Earnings Management Literature and Its Implications for Standard Setting.” ''Accounting Horizons'' 13 (4): 365–383. Earnings management has a negative effect on

earnings quality Earnings quality, also known as quality of earnings (QoE), in accounting, refers to the ability of reported earnings (net profit/income) to predict a company's future earnings. It is an assessment criterion for how "repeatable, controllable and ...

, and may weaken the credibility of

. Furthermore, in a 1998 speech

Securities and Exchange Commission The U.S. Securities and Exchange Commission (SEC) is an independent agency of the United States federal government, created in the aftermath of the Wall Street Crash of 1929. The primary purpose of the SEC is to enforce the law against market ...

chairman

Arthur Levitt Arthur Levitt Jr. (born February 3, 1931) is the former Chairman of the United States Securities and Exchange Commission (SEC). He served from 1993 to 2001 as the twenty-fifth and longest-serving chairman of the commission. Widely hailed as a c ...

called earnings management "widespread". Despite its pervasiveness, the complexity of accounting rules can make earnings management difficult for individual investors to detect.

Occurrence and response by regulators

Earnings management is believed to be widespread. A 1990 report on earnings management situations stated that "short-term earnings are being managed in many, if not all companies", and in a 1998 speech, Securities and Exchange Commission (SEC) chairman

called earnings management a "widespread, but too little-challenged custom". In a 2013 essay, Ray Ball, while opining that

accounting research Accounting research examines how accounting is used by individuals, organizations and government as well as the consequences that these practices have. Starting from the assumption that accounting both measures and makes visible certain economic ...

was not reliably documenting earnings management, wrote: "''Of course'' earnings management goes on. ..People have been tried and convicted." A 2020 report indicated that earnings management was the most common type of accounting fraud the SEC has taken action against under its whistleblower program. The SEC has criticized earnings management as having adverse consequences for financial reporting, and for masking "the true consequences of management's decisions". It has called on standard-setters to make changes to

accounting standards Publicly traded companies typically are subject to rigorous standards. Small and midsized businesses often follow more simplified standards, plus any specific disclosures required by their specific lenders and shareholders. Some firms operate on th ...

to improve

financial statement Financial statements (or financial reports) are formal records of the financial activities and position of a business, person, or other entity. Relevant financial information is presented in a structured manner and in a form which is easy to un ...

transparency, and has called for increased oversight over the financial reporting process. The SEC has also pressed charges against the management of firms involved in

fraud In law, fraud is intentional deception to secure unfair or unlawful gain, or to deprive a victim of a legal right. Fraud can violate civil law (e.g., a fraud victim may sue the fraud perpetrator to avoid the fraud or recover monetary compens ...

ulent earnings management.

Motivations and methods

Earnings management involves the manipulation of company earnings towards a pre-determined target. This target can be motivated by a preference for more stable earnings, in which case management is said to be carrying out ''income smoothing''. Opportunistic income smoothing can in turn signal lower risk and increase a firm's market value. Other possible motivations for earnings management include the need to maintain the levels of certain accounting ratios due to

debt Debt is an obligation that requires one party, the debtor, to pay money or other agreed-upon value to another party, the creditor. Debt is a deferred payment, or series of payments, which differentiates it from an immediate purchase. The ...

covenants, and the pressure to maintain increasing earnings and to beat analyst targets. Earnings management may involve exploiting opportunities to make accounting decisions that change the earnings figure reported on the

financial statements Financial statements (or financial reports) are formal records of the financial activities and position of a business, person, or other entity. Relevant financial information is presented in a structured manner and in a form which is easy to un ...

. Accounting decisions can in turn affect earnings because they can influence the timing of transactions and the estimates used in financial reporting. For example, a comparatively small change in the estimates for uncollectible accounts can have a significant effect on

net income In business and accounting, net income (also total comprehensive income, net earnings, net profit, bottom line, sales profit, or credit sales) is an entity's income minus cost of goods sold, expenses, depreciation and amortization, interest, a ...

, and a company using last-in, first-out accounting for

inventories Inventory (American English) or stock (British English) refers to the goods and materials that a business holds for the ultimate goal of resale, production or utilisation. Inventory management is a discipline primarily about specifying the shap ...

can increase net income in times of rising prices by delaying purchases to future periods.

Detecting earnings management

Earnings management may be difficult for individual investors to detect due to the complexity of accounting rules, although

ers have proposed several methods. For example, research has shown that firms with large

accruals Accrual (''accumulation'') of something is, in finance, the adding together of interest or different investments over a period of time. Accruals in accounting For example, a company delivers a product to a customer who will pay for it 30 days l ...

and weak governance structures are more likely to be engaging in earnings management. More recent research suggested that linguistics-based methods can detect financial manipulation, for example studies in 2012 found that whether a subsequent irregularity or deceptive restatement occurred is related to the linguistics used by top management in earnings conference calls.

References

{{Good article Management accounting Accounting research Accounting systems Financial reporting

Occurrence and response by regulators

Motivations and methods

Detecting earnings management

Further reading

References