A History Of Earnings Management

When analysts question a firm’s earnings quality, it raises concerns regarding under or over aggressive accounting practices that may be allowing the firm to manipulate the earnings. Earnings quality is defined as the strength of the current earnings in being used to predict future earnings and cash flows. Since earning quality is indicative of future performance, analysts are more likely to address issues that have substantial impact on the earnings quality. An issue arises when the nature of the earnings is questioned. While permanent earnings are part of normal operations, any irregular, one time earnings can skew the earnings, making the firm look more profitable than it is. This is due to the inability to recreate similar one-time transactions that will give rise to such numbers. Investors prefer predictable

Understandably, there are a variety of ways in which a company can manage their earnings, and if accomplished successfully, the results can be highly profitable. Not all techniques are fraudulent, as effective earnings management is considered good for business and shareholders. Income smoothing is a specific example of permissible earnings management that involves controlling fluctuations in net income to make earnings less variable over a given period of time (Goel & Thakor, 2003). Smoothing is acceptable as long as it adheres to the restrictions of U.S. GAAP, which maintains that all revenues and expenses are accounted for in a defined fashion. There are a lot of incentives in figuring how to effectively smooth income, as substantial value can be created through the successful arrangement of financial transactions. Management is able to make more intelligent decisions with regards to the future of the firm if the earnings are able to match the forecasts. One instance this is seen is when management is faced with the decision to smooth total income or

Such an intense focus has been placed on quarterly earnings as an indication of a company’s success by everyone from analysts to executives that ethics have for the most part been thrown out the window, sacrificed to the all important number, i.e. earnings per share. This is the theory in Alex Berenson’s book “The Number: How the Drive for Quarterly Earnings Corrupted Wall Street and Corporate America.” This number has become part of a game to be played, a figure to be manipulated – beat the number and Wall Street all but throws a parade, miss it and a company’s stock may be abandoned. Take into account the incentives that executives have to beat the number and one can find plenty of reasons to manage earnings.

Unfortunately, all those efforts have not been vindicated because of the following reasons: Accounting did not cause the recent corporate scandals such as Enron and WorldCom. Unreliable financial statements were the results of management decisions, fraudulent or otherwise. To blame management’s misdeeds on fraudulent financial statements casts accountants as the scapegoats and misses the real issue. Reliable financial reports rely to a certain extent on effective internal controls, but effective internal controls rely to a large extent on a reliable management system coupled with strong corporate governance. when management deliberately or even unlawfully manipulates business processes in order to achieve desirable financial goals and present untruthful financial reports to the public, accounting systems are abused and victims rather than perpetrators.

Companies often try to keep accounting earnings growing at a relatively steady pace in an effort to avoid large swings in earnings from period to period. They also try to manage earnings targets. Reflect on these practices and discuss the following in your discussion post.

The retained earnings general ledger account is adjusted every time a journal entry is made to an income or expense account

The financial crisis of the early 2000s left many investors and stockholders nervous about the accuracy of financial statements issued by public companies. The financial crisis resulted after many previously successful companies suddenly tanked due to restatement of their financials. These companies include Enron, Tyco, Sunbeam, Rite-Aid, Xerox and WorldCom amongst others (Kieso, 2014, p. 17). How could many previously successful companies suddenly go belly-up? The evidence was to be seen, these companies had used malicious accounting techniques to hide massive amounts of debts and increase their assets without having to show them accurately in a fair and honest way on their financial statements.

Before 2002, shocking scandals in the stock markets generated substantial losses to investors and, for a time, the United States economy was in near chaos. Enough evidence of impropriety, financial statements, market analysts, politicians and company executives, emerged to increase investor skepticism for a long time (Larson, Thompson and Walters, 2004). The primary focus of this problem was the concerns regarding the ethical behavior of business enterprises and the effectiveness of accounting and auditing norms (Larson et al. 2004). The Sarbanes-Oxley Act of 2002 was signed into law by President George W. Bush to enhance the public's confidence in the accounting profession (Larson et al., 2004). This Act, considered one of the most noteworthy

The accounting system we use today started in Venice in renaissance period over 520 years ago. The trade business increased hugely during this time and all the financial recordings had to be written down to help people see how their business is doing. During that time in 1494 the first book about was published in accounting by Luca Paciolli and was called “The Collected Knowledge of Arithmetic, Geometry, Proportion and Proportionality”. He was called “The father of Accounting” and most of his described principles have been used up until this day.

Company operates in the Industrial Sector – Services, and Industry – Regional Airlines. According to the Standard Industrial Classification System (SIC), company belongs to the industry group 451: Air

As stated in Exhibit 3, Earnings management is the managerial use of discretion to influence reported earnings. Within the accrual accounting system, managers have significant discretion with their firms’ accounting choices. Management has the ability to make choices that can opportunistically lead to higher or lower reported earnings. Richard 's and Ira Zar’s (CFO) actions would not change if these results were the result of GAAP flexibility because he violated the rules of accounting, the conceptual framework principle of neutrality in numerous ways to report the financial results that CA did under false pretenses. It would be one thing if CA garnered these results through legitimate business decisions versus using accounting tactics like changes in accounting estimates or outright fraud as in the use of the 35 day Month. The purpose of which was solely to allow CA to meet or exceed analysts’ estimates.

Even the small profits reported by Enron in 2000 were eventually determined to be only a illusion by court-appointed bankruptcy examiner Neal Batson. Batson’s report reveals that over 95% of the reported profits in these two years were attributed to Enron’s misuse of MTM and other accounting techniques. But while financial analysts could not be expected to know that the company illegally manipulated the earnings, the reported profit margins in 2000 were so low and were declining so steadily that they should have merited ample skepticism from analysts about the company’s profits.

Yes, it is clearly unethical to intentionally understate earnings since the management makes representations that the financial statements are complete and accurate. It is obvious that intentionally understating earnings is done to allow the company to later overstate earnings by using falsified reserves to cover the inadequate current period earnings.

* With a focus on net income, managers could be incentivized to maximize ROE at the expense of other stakeholders, particularly bondholders. For instance, managers may fuel earnings growth by over-levering the company to benefit from tax shields in order to increase the value spread.  In addition, there are many other ways in which managers can manipulate earnings, for example, by slowing down depreciation charges or selling off assets to realize extraordinary gains.

As the scandals came to light, mistrust of financial reporting in general grew. One article in the Forbes magazine noted that “repeated disclosures about questionable accounting practices have bruised investors’ faith in the reliability of earnings reports, which in turn has sent stock prices tumbling” (Forbes). Imagine trying to carry on a business or invest money if you could not depend on the financial statements to be honestly prepared. Information would have no credibility. There is no doubt that a sound, well-functioning economy depends on accurate and dependable financial reporting. United States regulators and lawmakers were very concerned that the economy would suffer if investors lost confidence in corporate accounting because of unethical financial reporting.