Earnings Management: Definition and Examples

Earnings management refers to the deliberate manipulation of a company’s financial statements to meet specific financial targets or portray a desired image of financial health. Companies may use accounting practices like adjusting revenue recognition, altering expense timing, or restructuring costs to smooth earnings, meet analyst expectations, or influence stock prices. While some forms of earnings management are legal and fall within the flexibility of accounting standards, excessive or deceptive practices can mislead stakeholders and potentially violate regulations.

Key Takeaways

• Earnings management refers to a company’s deliberate use of accounting techniques to make its financial reports look better.
• Earnings management can occur when a company feels pressured to manipulate earnings in order to match a pre-determined target.
• Excessive earnings management can lead a company to misrepresent facts on its financial statements, which can cause the Securities and Exchange Commission (SEC) to impose fines and other punishments.
• Different types of earnings management include moving earnings from one reporting period to another in order to paint a better picture or manipulating the balance sheet to hide liabilities and inflate earnings.

Understanding Earnings Management

Before diving into what earnings management is, it is important to have a solid understanding of what we mean when we refer to earnings. Earnings are the profits of a company. Investors and analysts look to earnings to determine the attractiveness of a particular stock. Companies with poor earnings prospects will typically have lower share prices than those with good prospects. Remember that a company’s ability to generate profit in the future plays a very important role in determining a stock’s price.

That said, earnings management is a strategy used by the management of a company to deliberately manipulate the company’s earnings so that the figures match a pre-determined target. This practice is carried out for income-smoothing. Thus, rather than having years of exceptionally good or bad earnings, companies will try to keep the figures relatively stable by adding and removing cash from reserve accounts (known colloquially as “cookie jar” accounts).

Types of Earnings Management

Here are a few ways companies can manage their earnings. Note that there may be areas below that are still legal and within the bounds of what is acceptable treatment.

Accrual-Based Earnings Management

Accrual-based earnings management involves manipulating accounting entries to alter reported financial outcomes without changing actual business activities. This method uses discretionary accruals, such as recording revenue prematurely or deferring expenses, to create a more favorable profit picture. While these practices are often within the flexibility of accounting standards, they can mislead stakeholders if they are done to intentionally cross over accounting periods (i.e. report revenue in one period instead of another).

Real Earnings Management

Real earnings management focuses on altering actual business operations to meet financial targets, impacting cash flow and operational decisions. Examples include offering large discounts to boost short-term sales, delaying expenses like advertising, or overproducing inventory to lower the cost of goods sold. These strategies, also not always illegal, can compromise long-term business health for immediate financial gains.

Big Bath Accounting

Big bath accounting involves recognizing significant losses or write-offs in a single period to clean up the financials and make future periods look more profitable. Companies often use this strategy during already poor-performing years, writing down assets or restructuring operations. While it resets the financial baseline, it can distort the true performance of the period. The company might temporarily be too aggressive in writing costs off.

Cookie Jar Reserves

Cookie jar reserves involve creating excessive reserves during profitable periods and using them in less profitable times to smooth earnings over time. For example, a company might overstate liabilities or allowances and reverse them later to boost earnings when needed. This approach can help stabilize earnings but often lacks transparency while also not properly reflecting what is actually happening from period to period.

Income Shifting

Income shifting manipulates the timing of revenue and expenses to influence financial results across reporting periods. This can involve deferring revenue to future periods or accelerating expenses into the current period to reduce taxable income or smooth earnings. Although this method may comply with accounting rules, it can create misleading financial statements if done excessively or fraudulently.

Earnings Management vs. Fraud

Earnings management and fraud are two distinct concepts in financial reporting. They can sometimes overlap. Companies may engage in earnings management to meet analysts’ expectations, smooth income over time, or align with internal targets. When it is done to intentionally mislead the market or investors, it is considered fraud.

Fraud refers to intentional manipulation or misrepresentation of financial information. Fraudulent activities often involve overstating revenues or hiding liabilities – much like earnings management practices.

The key difference between earnings management and fraud lies in intent and transparency. While earnings management may involve aggressive but permissible accounting practices, fraud involves deliberate deception and misstatement of facts. Companies that engage in earnings management usually follow generally accepted accounting principles (GAAP). It’s when practices are taken too far that it’s considered fraudulent.

Earnings Management and Sarbanes-Oxley

The Sarbanes-Oxley Act of 2002 was a significant legislative response to corporate scandals such as Enron (discussed below). This act introduced stringent requirements for financial reporting, including enhanced internal controls, more rigorous auditing standards, and increased transparency.

Section 404 of the Sarbanes-Oxley Act, for example, mandates that companies assess and report on the effectiveness of their internal controls over financial reporting. The act also holds CEOs and CFOs personally responsible for the accuracy of their company’s financial statements, with penalties for fraudulent reporting. These changes were designed to curb earnings management practices that veered into manipulation and foster a more trustworthy financial environment.

Despite these regulations, the challenge of monitoring earnings management persists, as companies often find ways to operate within the boundaries of the law. The SEC uses tools like mandatory periodic filings like the 10-K and 10-Q to gauge ongoing performance and financial reporting of public companies. In addition, the SEC continually updates its guidance on accounting standards, working with organizations like the Financial Accounting Standards Board (FASB) to address emerging issues in earnings management.

Examples of Earnings Management

One example of earnings management is when a company adopts an accounting procedure that makes it appear the company is generating higher earnings over a short-term time period. The widely publicized collapse and bankruptcy of energy giant Enron Corporation in December 2001 is an example of this.

The company used fake holdings and off-the-books accounting principles to manipulate its balance sheet. The purpose of this was to hide the company’s liabilities and inflate earnings. With the company’s balance sheet looking better, Enron was able to project better financial health. By reporting higher revenue, it was able to reflect higher profitability (even though a lot of that revenue had technically not yet been earned yet).

Investors can sometimes glean important insights into changes in a company’s accounting and reporting practices by reviewing the footnotes of the financial statements, which is where a company must disclose such changes.

Detecting Earnings Management

Financial statement manipulation comes in a variety of forms. Investors who know what to look for can sometimes detect earnings management by performing a financial statement analysis of a company’s quarterly and annual reports.

Here are some signs a company might be using earnings management techniques to distort its financial statement figures:

• Claiming revenue growth that doesn’t come with a corresponding growth in cash flows.
• Reporting increased earnings that only occur during the fiscal year’s final quarter.
• Expanding fixed assets beyond what is considered normal for the company and/or industry.
• Exaggerating an asset’s net worth by neglecting to use the correct depreciation schedule.

What Is Earnings Management?

Earnings management refers to the use of accounting techniques to influence financial reports. Companies may adjust their earnings to meet analysts’ expectations or smooth out fluctuations, though these practices must comply with accounting standards.

Is Earnings Management Legal?

Yes, earnings management is legal as long as it stays within the bounds of generally accepted accounting principles.

How Does Earnings Management Impact Financial Statements?

Earnings management can distort a company’s financial health by making it appear more profitable or stable than it truly is. This can mislead investors and other stakeholders while also hiding accurate information from regulatory agents.

Why Do Companies Engage in Earnings Management?

Companies may engage in earnings management to meet investor expectations, secure financing, smooth out earnings volatility, or avoid triggering regulatory or covenant breaches. These practices help maintain market confidence, though they can distort the company’s true financial health.

The Bottom Line

Given that earnings management can skew a company’s true financial picture, it’s important that investors perform as much due diligence as possible before making an investment decision. Although the different methods used by managers to smooth earnings can be very confusing, the important thing to remember is that the driving force behind managing earnings is to meet a pre-specified target (often an analyst’s consensus on earnings). As the great Warren Buffett once said, “Managers that always promise to ‘make the numbers’ will at some point be tempted to make up the numbers.”