Earnings Management: Meaning, Methods, Example And Risks

Key Takeaways
 

• Earning management is using an accounting method which gives you profits and positive points about your company by creating financial statements.
   
• Investors should analyse their financial statements before investing in a new company. 
   
• When a company wants to match earnings to pre-determined target earning management can help in this.

Bonus tip - Do you know? Finance teams now closely check Q4 differences, year-end adjustments, and one-time entries to control and monitor earnings management.

Earnings is simply companies income or profit that they earn in a specific period of time like year or monthly. If analysts want to know the value and scope of that particular company's stock, they see earnings. When a company does not earn much, its stock prices are less than other companies whose earnings are more. Companies use earning management for adjusting financial reports to show profit. When companies' earnings are announced, prices of stocks can be up or down depending on the situation of earnings.

Earning management can be difficult because in this method companies have to manipulate accounting practices. The reason for this is to see if the company is meeting financial expectations or not. 

Example:

There is a company called XYZ selling  electronics . A specific target is set for each month. In December, the company recorded growth, it sold targeted amounts of electronics. But it was visible that the company will not do this better in January. So the company delayed reporting and noted December's some sole items and added them into the January record. In this way the profit of December and January appeared better. In this method the company did not change business or methods. It just changed the timing. 

Highlights of the earning management 

Earning management is a very important topic especially in corporate accounting. 

The main goal for earning management is to present the best performance of the company to the stockholders. There are some widely known earning management methods:

Accrual-Based Earnings Management 

This method is used when revenue is known not when payment is received. In this type the whole report can not be changed. This gives real analysis of companies finances because it includes expenditures. It used to alter outcomes by using accounting entries like depreciation, bad debts, or revenue recognition. There are four types of accrual- based earnings Deferred revenue, Accrued revenue, Prepaid expenses, and Accrued expenses.

Real Earnings Management 

In real earnings management , companies do not change numbers or delay them instead the company changes its whole operation.  In real earnings management the company keeps numbers as it is and tries to change function. If a company's target has not been achieved before the financial year ends, the company sells items at a discounted price. So that company can show higher profit. But in this method the company had to change the method of work. Also, the company eliminates the cost of some functions like advertisement and employee training. 

Big Bath accounting 

In big bath accounting companies always show big losses in the current year in order to show profit in future. If a company is currently doing badly then it decides to add more loss in it. It helps avoid dragging them into the future. It uses techniques like Goodwill impairments and Massive asset write-offs to do this. By doing this the company can show significant growth in next year. 

This method is used when a new CEO steps up in a company to show profit in future or when company already knows about the future loss. This method can be performed under IFRS rules, this is not illegal still it is considered as unethical because it misleads investors.

Cookie Jar reserves

In this method, companies do changes in the current year when the profit is high. Companies do not show the Total profit of the year instead create large warranty provisions and overestimate bad debt expenses. Companies do this intentionally to reduce profit even if it is doing well. In short, companies save these profits to use later. In future if a company experiences loss or less profit that time it can release this reserves. This is a good option if the company wants to show stable and consistent profit. 

income smoothing

The income accounting company mentions its expenses and revenues in different periods. If in a specific year the profit is much better than previous, the company saves for the future to show a smooth income of the company. Companies do this to attract investors because they prefer businesses that show predictable growth. But there are some drawbacks of this technique like it can hide business problems which results in high risk.

History of earning management 

The history of earning management is revolutionary, earlier it was income smoothing but now transferred to mathematical detection models and stricter global regulations.

Conclusion 

Earning management is a method which company managers use to show reported profits according to their interest. Some practices are legal but some can mislead investors. Investors, auditors, and regulators should always analyse financial statements.

FAQs 

How do companies "manage" their earnings?

Companies sometimes manage their statements by showing sales early or late, expenses more or less. 

Is Earnings Management legal or is it fraud?

If earning management is done with accounting rules then it is legal. But if a company manipulates statements with dishonesty then it is illegal. 

Why is Earnings Management considered "unethical" if it's legal?

Earning management is considered unethical because it hides real companies' performance from investors and focuses on short-term image improvement.

How to evaluate GAAP vs. Adjusted Earnings? 

You can evaluate GAAP by including all the expenses.