Earnings Management
What Is Earnings Management?
Earnings management is the utilization of accounting strategies to create financial statements that present an excessively positive perspective on a company's business activities and financial position. Many accounting rules and principles expect that a company's management make decisions in following these principles. Earnings management exploits how accounting rules are applied and makes financial statements that blow up or "smooth" earnings.
Grasping Earnings Management
Earnings alludes to a company's net income or profit for a certain period, like a fiscal quarter or year. Companies use earnings management to streamline variances in earnings and present more steady profits every month, quarter, or year. Large vacillations in income and expenses might be a normal part of a company's operations, however the changes might caution investors who like to see stability and growth. A company's stock price frequently rises or falls after a earnings announcement, contingent upon whether the earnings meet or fall short of experts' expectations.
Management can feel pressure to oversee earnings by controlling the company's accounting practices to measure up to financial assumptions and keep the company's stock price up. Numerous executives receive bonuses in view of earnings performance, and others might be eligible for stock options when the stock price increases. Many forms of earnings manipulation are ultimately uncovered either by a CPA firm performing an audit or through required SEC (Securities and Exchange Commission) disclosures.
Significant
The Securities and Exchange Commission (SEC) has squeezed charges against managers who participated in fraudulent earnings management. The SEC additionally expects that the financial statements of publicly traded companies be certified by the Chief Executive Officer (CEO) or Chief Financial Officer (CFO).
Instances of Earnings Management
One method of manipulation while overseeing earnings is to change an accounting policy that produces higher earnings in the short term. For instance, expect a furniture retailer utilizes the last-in, first-out (LIFO) method to account for the cost of inventory things sold. Under LIFO, the most up to date units purchased are viewed as sold first. Since inventory costs ordinarily increase over the long run, the fresher units are more costly, and this makes a higher cost of sales and a lower profit. Assuming the retailer changes to the first-in, first-out (FIFO) method of perceiving inventory costs, the company considers the more seasoned, more affordable units to be sold first. FIFO makes a lower [cost of goods sold](/machine gear-pieces) expense and, hence, higher profit so the company can post higher net income in the current period.
One more form of earnings management is to change company policy so more costs are capitalized as opposed to expensed right away. Promoting costs as assets defers the recognition of expenses and increases profits in the short term. Accept, for instance, company policy directs that each thing purchased under $5,000 is quickly expensed and costs more than $5,000 might be capitalized as assets. If the firm changes the policy and begins to capitalize all things more than $1,000, expenses decline in the short-term and profits increase.
Considering in Accounting Disclosures
A change in accounting policy, in any case, must be clarified for financial statement readers, and that disclosure is typically stated in a footnote to the financial statements. The disclosure is required as a result of the accounting principle of consistency. Financial statements are predictable assuming the company utilizes similar accounting policies every year since it permits the financial statement client to effectively distinguish varieties while checking the company's historical trend out. Consequently, any change in policy must be cleared up for the financial report reader. Therefore, this type of earnings manipulation is generally revealed.
Features
- Companies use earnings management to introduce the presence of steady profits and to smooth earnings' changes.
- One of the most famous ways of controlling financial records is to utilize an accounting policy that creates higher short-term earnings.
- In accounting, earnings management is a method of controlling financial records to work on the presence of the company's financial position.
