Earnings management is the practice of inappropriately managing the earnings number reported in the company's income statement, and is quite different from the process of managing the company's underlying business. The Panel on Audit Effectiveness, established by the Public Oversight Board in response to a concern expressed by the Securities and Exchange Commission (SEC), found no single definition of the term, but cited several examples, including this from attorney Michael R. Young:
There are two types of managed earnings. One type is simply conducting the business of the enterprise in order to attain controlled, disciplined growth. The other type involves deliberate manipulation of the accounting in order to create the appearance of controlled, disciplined growth when, in fact, all that is happening is that accounting entries are being manipulated [italics in original]. (Panel on Audit Effectiveness, 2000)
In an interesting overview article, Patricia Dechow and Douglas Skinner suggested that there is a fine distinction between fraudulent accounting and earnings management: Both involve the intent, by reporting management, to distort their company's earnings picture, but fraudulent accounting does so by violating generally accepted accounting standards (GAAP) while earnings management does so within GAAP. (Technically, fraud requires scienter—proof of an intent to injure. It is a legal determination, and would be subject to an analysis of all surrounding circumstances.)
INTENSIFIED PRESSURES FOR EARNINGS MANAGEMENT
In a landmark 1998 speech, the then chairman of the SEC, Arthur Levitt, Jr., said:
While the problem of earnings management is not new, it has swelled in a market that is unforgiving of companies that miss their [earnings] estimates. I recently read of one major U. S. company that failed to meet its so-called "numbers" by one penny and lost more than six percent of its stock value in one day.… the different pressures and expectations placed by, and on, various participants in the financial community appear to be almost self-perpetuating.
Also in that speech, the chairman suggested this slippery slope:
- Analysts ask managements of the companies they follow for guidance, as they project future earnings for the company and projections are influential in analysts' recommendations.
- Investors use those research reports in their decisions.
- The management people running those companies try to meet the analysts' earnings projections to (i) maintain their credibility with the analyst community, and (ii) maintain the relative price of the company's stock.
- Where the normal operations of the business do not produce earnings equal to the investment community's expectations, managements are pressured to find ways to manage the reported earnings.
- Auditors, who want to retain their clients, bend under their own set of pressures to let this process continue.
APPROACHES TO MANAGING EARNINGS
Many strategies are used by companies to manage earnings in ways that are inappropriate. These are strategies that have as their outcome the achievement of predetermined earnings figures. Only a few of the most popular will be discussed here.
Decisions Solely to Meet Earnings Goal
Perhaps the simplest way to manage earnings is to control the expense spigot. Even the most lean company can find discretionary expenses that can be trimmed to help meet the earnings target for a period. Advertising, research, staff training, or maintenance programs can be deferred, at least in the short run. There is a great temptation to cut these programs "in the short run" on the assumption that business will pick up in subsequent periods and the deferred programs can then be resumed.
In well-run companies, managements are focused on the long-run success of the entity, and they avoid temptations to enhance, artificially, the results for any single quarter or year.
Making Necessary Judgments to Meet Earnings Goal
Opportunities for earnings management are inherent in accrual accounting. Under the accrual method, management is asked to look beyond the simple cash inflows and outflows the company experienced during a period and give a more nuanced picture of the company's operations. But the application of accrual accounting requires some difficult judgments. For example:
- Revenues are recorded when the sale transaction is complete, not when the customer makes payment, but management must then estimate what proportion of those credit sales will not be collected in the future.
- When the company pays cash for a fixed asset, that cash outflow is allocated as an expense over future years; but management must then estimate how many years will be benefited from the acquisition.
- If the company is sued, management must estimate the likelihood that the suit will result in an assessment against the company, and how much that assessment is likely to be.
The financial community has agreed that an accrual-based measure of earnings, subject to these judgments, is a much better measure of business success than a simple measure of cash results. The increase in information in an accrual-based income statement is largely the result of the exercise of managements' judgments.
In well-run companies, managements exercise those judgments, issue by issue, without regard to the effect those judgments have on the entity's reported earnings. To make sure that those judgments are free from bias, well-run companies outline—in formal policies and written accounting manuals—the processes to be followed in developing accrual judgments. Earnings management occurs when the decision makers skew issue-by-issue judgments, perhaps skirting their own policies, with an objective of forcing the earnings to a predetermined number.
Changing Accounting Principles to Meet Earnings Goal
The opportunity to manage earnings is also inherent in U.S. accounting standards. For many reasons, the financial community has agreed that it was better if the standards to be followed in preparing financial statements—and measuring earnings—were set by community consensus, rather than by government fiat. That notion of an underlying consensus is embedded in the name given to that body of standards—GAAP.
Understandably (and perhaps unfortunately), that consensus approach has allowed different accounting rules to be available for similar transactions. There are, for example, at least three different generally accepted ways to account for the cost of inventory items; there are also at least three different generally accepted ways to allocate the cost of a fixed asset over its useful life.
In well-run companies, management selects among the alternative accounting standards the one that most closely reflects the underlying relevant economic factors. Earnings management occurs when those making decisions select among the allowable alternatives of a particular generally accepted accounting standard the one that will result in earnings that meet the predetermined number.
FULL DISCLOSURE IS A KEY DEFENSE
Most financial and accounting personnel accept at least the semistrong version of the efficient market hypothesis—that is, an understanding that the financial marketplace will incorporate all available information in the prices it sets for stocks, it will do so promptly, and without regard to the source of that information.
Even if the final net income number on a company's income statement has been enhanced by earnings management, the efficient market hypothesis holds that analysts and other readers of the financial statements will correct for that overstatement, preparing an adjusted or pro forma income statement backing out the items that artificially benefited the reported results. That will be true only so long as information about the artificial enhancements is fully disclosed. Information about earnings management can be disclosed to the readers of the income statement in several ways:
- The impact of material, unusual events or transactions should be highlighted as separate line items in the income statement (Accounting Principles Board Opinion 30)
- The footnotes to the financial statements should describe the earnings impact of any changes in accounting policy, or changes in estimates (Financial Accounting Standards Board Statement No. 154)
- The management's discussion and analysis (MD&A) segment of SEC filings should "Describe any unusual or infrequent events or transactions or any significant economic changes that materially affected the amount of reported income" and "The discussion and analysis shall focus specifically on material events … that would cause reported financial information not to be necessarily indicative of future operating results" (U.S. SEC Regulation S-K)
A company's management might argue that they had good reasons for changing the process they had followed in establishing reserves, or even for offering sales incentives at the end of a period. Such moves cannot be—and should not be—constrained under the flexibility that is inherent in accrual accounting systems. The market should not be deceived so long as the effect of those adjustments is fully detailed in the notes or the MD&A. But without full disclosure, the enhanced income statement may well present a misleading picture of the company's operations. An income statement, enhanced by earnings management without adequate disclosure, may well be a fraudulent income statement.
A HIGH-INTEGRITY FINANCIAL ORGANIZATION IS THE BEST DEFENSE
As Levitt said, the pressure to practice earnings management is not new—what is new is the intensity of that pressure. With the passage of the Sarbanes-Oxley Act of 2002, the community has established some contrapressures: strengthening the hand of the board of directors and the audit committee; enhancing the professionalism of outside auditors; and requiring fairness sign-offs by the chief executive officer (CEO) and the chief accounting officer. Those regulations may help keep the pressures in balance, and reduce the incidence of earnings management.
But in the end, fair financial reporting depends on the integrity of the company's financial team. Every CEO needs a well-respected accountant at his or her side, to help temper the temptation within the company to manage earnings. Every company needs a high-integrity chief accounting officer who is prepared to say, "No, we shouldn't give in to the pressure—I can't let our company go down that path."
American Institute of Certified Public Accountants. (1973). Reporting results of operations. Accounting Principles Board Opinion No. 30. New York: Author.
Dechow, Patricia M., and Skinner, Douglas J. (2000). Earnings management: Reconciling the views of accounting academics, practitioners and regulators. Accounting Horizons, 14 (2), 235–250.
Financial Accounting Standards Board. (1978, November). Statement of financial accounting concepts no. 1. Norwalk, CT: Author.
Financial Accounting Standards Board. (2005, May). FASB statement 154: Accounting changes and error corrections—A replacement of Accounting Principles Board (APB) opinion no. 20 and FASB statement no. 3. Norwalk, CT: Author.
Levitt, Arthur, Jr. (1998, September 28). The "Numbers game." Speech given at New York University Center for Law and Business. Also, reprinted in The CPA Journal, December 1998.
McKee, Thomas E. (2005). Earnings management: An executive perspective. Mason, OH: Thomson.
Panel on Audit Effectiveness. (2000). Earnings management and fraud. In Report and Recommendations. Stamford, CT: Author.
U.S. Securities and Exchange Commission. (2004). Regulation S-K, Section 229.0 Retrieved February 15, 2006, from http://www.sec.gov/divisions/corpfin/forms/regsk.htm
Robert J. Sack