What is Earnings Management?
Financial manager or Management of a company chooses to exhibit only things in their financial reports which project their company in good status in view to gain profit from that. Earnings management is a bad thing as most of the calculation of profit showed in the reports will be either fake or prepared on the basis of uncertain future judgments.
There are many types of earnings management based on the size of the company and its financial status, the below list is commonly used types.
#1 – Cookie Jar Reserves
Cookie jar reserves come under the technique of aggressive accounting as it deals with creating a big reserve in the profit year and drawing down 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 their reports but the company will make it even worse by writing off all bad debts, overvaluation of assets depreciation, restructuring costs, other expenses in the same year to show more loss and evade tax.
#3 – Expense and Revenue Recognition
It can be also called “Income Smoothing” This comes under fraudulent accounting as the company records its expenses before it incurs or not showing the profit, sales when earns. They can even accelerate the sales showing extra revenue or they don’t recognize a bad debt in the current year and shifts it to next year as it reduces this year’s profit.
Earnings Management Examples
Let’s consider if a company is having $20,000 as bad debts and it is not recoverable, so it has to be written off during this financial year but the financial manager says to show $10,000 as debtors and write off the balance in next financial year as this year profit is low. This comes under the type of expense and revenue recognition as expense in not recognized correctly to inflate profit.
The market is not stable due to external factors like high pricing low demand etc a company can face loss. The CEO of the company asks to show all the losses in the same year like unrecoverable debts, depreciation, high reserve, 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 BATH type of earnings management.
Earnings Management Techniques
There are three types of techniques in earnings management they are;
- Aggressive & Abusive Accounting – This 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 accounting refers to writing off all the expenses and losses in the same year if the company is made a high profit and to evade from tax.
- Fraudulent Accounting – If revenue, 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 Principles).
The purpose of earnings management cannot be bad always; there can be some good reasons also. Generally, it is bad as it is done for the purpose of Personal gain from such activity like earning commission from obtaining a contract from a false report or increasing the stock value it 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 loss.
How to Detect Earnings Management?
The Healy model (1985) is used to calculate the estimation of discretionary accruals that are 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 earnings management is shown above, there are other methods as well.
Earnings management can be good as well as bad, it is considered as good when there is no personal intention. It is bad for the company if the company is using this 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, types along with examples and purposes. You can learn more about from the following articles –
- Quality of Earnings Examples
- Calculate Pro-Forma Earnings
- Unappropriated Retained Earnings Meaning
- Calculate Diluted EPS
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