Earnings management is the accounting practice of intentionally influencing the reporting of financial information to achieve some gain (Ahadiat & Hefzi, 2012). The process can be accomplished by manipulating financial reports to mislead stakeholders on the performance of the organization. For a long time, the ethics of reporting financial information has been a matter of interest. For instance, when a company uses its reserves for deferred maintenance, it greatly misleads the investor and other stakeholders on the real financial image of the enterprise. Indeed, the practice of earnings management is so widespread yet rarely challenged. In addition to its ethical underpinnings, earnings management has adverse effects for financial reporting. In most cases, it masks the real results of the management’s decisions. The motivation behind earnings management is essentially to create the image of more stable earnings for the company (Ahadiat & Hefzi, 2012). Similarly, the practice is carried out to maintain some levels of the accounting ratios and relay a picture of increasing earnings[Need an essay writing service? Find help here.]
How Earnings Management Works
Earnings management is achieved through practices that are designed to produce a given level or earnings. DeFond and Park (1997) and Greenfield et al. (2008) observe that managers have both business and personal reasons to display impressive results or at least some satisfactory performance to the stakeholders (as cited in Ahadiat & Hefzi, 2012, p. 245). However, through factors such as increased competition and recession, realizing or sustaining the desired performance can be impossible.
Given such circumstances, managers choose to apply accounting principles to manipulate business operations to attain the desired outcome. The Generally Accepted Accounting Principles (GAAP) offer managers a great deal of choices in making decisions on financial reporting (Ahadiat & Hefzi, 2012, p. 246). GAAP operate on the expectation that professional judgmental and integrity will guide the accountant in selecting the standards that will best fit the financial situation of the firm. Ahadiat and Hefzi (2012) further write that GAAP contributes to the practice in two ways; the amount of expenses to record and the amounts of revenue to be recognized in an accounting period. GAAP also sets the standards which allows accountants to use their reasoning in transactions. The practice is treated in the same manner in the United States and in countries that use International GAAP. Accounting results may also be manipulated by changing the timing of some transactions. For instance, transactions involving repairs of manufacturing facilities can be delayed. Such operating decisions can also include granting salespersons more incentives. Although GAAP offers guidelines on preparing financial statements, it does not give directions on how or when earnings management can cross ethical borders (Ahadiat & Hefzi, 2012). It should be realized that ethics is an important matter in accounting. The practice of accounting and its related activities can affect the lives of many people connected to the organization. The collapse of large corporations such as Enron due to accounting malpractices created the need for more professionalism in the practice (Markham, 2006).
One of the most common approaches in earnings management is the use of deferred maintenance. It occurs when the management seeks to alter the costs of expenses by delaying maintenance and repair activities (Ahadiat & Hefzi, 2012). While in most cases these manipulations are generally legal, they often raise ethical questions. The concern arises since differing maintenance costs obscure the real earnings of the company. Many financial executives consider differing maintenance costs as a means of achieving analysts forecast (Ahadiat & Hefzi, 2012). This manipulation reduces the value of the firm but helps to meet the short term goals of the managers. Manipulating real activities lessens the value of the organization since current decisions can negatively affect future cash flows. Accrual manipulation of this manner is likely to draw scrutiny from regulators. In many efficient companies, managers exercise judgments without regard to the firm’s reported earnings. [“Write my essay for me?” Get help here.]
Markham (2006) mentions that cookie jar reserves are used as an income smoothening technique. In this regard, expenses are solely based on estimates. In case a company overestimates its expenditures, it can decide to use part of the expenses of the current accounting period to save for future periods. By recording more expenses in the current accounting period, it enables the company to record less in the coming periods (Roychowdhury, 2006). Consequently, the management establishes a kind of “cookie jar reserve” that can be tapped for later use. As such, under the cookie jar technique, the corporation can intentionally try to overestimate its current expenses as a means of managing earnings (Markham, 2006). Estimation of earnings in this manner can relate to sales returns, estimating inventory, estimating warranty costs, and determining the rate of completing long-term projects. According to accounting rules, companies should recognize their expenses in tandem with the revenue associated with the same expenses (Markham, 2006). For instance, when a corporation offers an item with a warranty, the future warranty costs must be estimated and recognized at the same time the sale is made. When sales are made on credit, bad-debt estimates must be acknowledged immediately. So, in case the company overestimates the expenses in the current accounting period, it will not need to do the same in the future accounting periods.
To control earnings management through deferred maintenance, there is a need for stricter accounting standards. However, this can also have the effect of management applying “real earnings management” to influence reported earnings (Roychowdhury, 2006). On a positive front, the use of deferred maintenance as a means of earnings management can be ethically used to serve the welfare of the stakeholders. The adverse effects of this practice have led to many parties calling for its identification and deterrence.
In light of accountants’ training and experience, accounting manipulation creates many ethical debates. In reference to earnings management, the underlying moral concern is whether the financial manipulation leads to distortions that ultimately mislead the consumers of the information (Ahadiat & Hefzi, 2012). In most cases, the accounting manipulations lead the stakeholders into making wrong assessments on the financial and economic performance of the organization. As a result of such incorrect evaluations, the stakeholders’ interests can be damaged. Accountants have a duty and responsibility to disclose all relevant information that can be expected to influence the decisions of the reader. The constant pressure for short-term growth in organizations seems to diminish these ethical values. In many cases, as accountants rise in an organization, their ethical sensitivity weakens (Ahadiat & Hefzi, 2012). In some cases, accountants with loose ethical standards are likely to get promotion since they serve the interests of the management better with respect by portraying a positive image of the organization through financial statements. It is, therefore, important for accountants to exercise a high degree of ethical responsibility on earnings management. Manipulated earnings reflect negatively on the image and performance of accountants. Organizations can organize ethics seminars and workshops to create awareness on the need for ethical practices. [“Write my essay for me?” Get help here.]
Earnings management is therefore seen as a process of meeting the short-term interests of managers on a company’s performance. While it can ethically be used to further the welfare of the stakeholders, it is rarely applied in that manner. Practices such as deferred maintenance are simply used to manipulate financial information to communicate wrong information to the stakeholders. It, therefore, creates many ethical questions especially on the professionalism of accountants.
Ahadiat, N. & Hefzi, H. (2012). An investigation of earnings management practices: Examining generally accepted accounting principles. International Journal of Business and Social Science, 3(14), 245-251
Markham, J. (2006). A financial history of modern U.S. corporate scandals: From Enron to reform. Armonk, NY: M.E. Sharpe.
Roychowdhury, S. (2006). Earnings management through real activities manipulation. Journal of Accounting and Economics, 42(3), 335-370.