Earning 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.

There are a number of areas on the earnings statement that provide management with opportunities for influencing the outcome of reported earnings.

Eli Lilly is a profitable company and is one of the top pharmaceutical firms. The company has faced losses in the year 2008 but appears to have been recovering strongly. While Lilly has much lower earnings than its competitor, Pfizer, Lilly’s ROA and ROE are substantially higher than Pfizer. However, Lilly’s earnings fell by 14.2% in the year 2011, and ROA and ROE also fell during the period. Its P/E ratio fell substantially since 2008 due to the market’s lack of optimism about Lilly’s future. Lilly’s management is under considerable pressure to reverse the declining trend. Thus, management would have incentives to manipulate the areas of accounting that require judgment call like revenue recognition policies and valuation allowances to boost in earnings in 2011.

Does it matter what your competitors are doing? Step back and consider management’s incentives and choices. What is the motivation to manage 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.

On the other hand, share price is more sensitive that net income sooner to certain events such as acquisitions and mergers or R&D. This sensitivity makes share price a better device for calculating compensation. Share price however is not as precise as net income since it can be affected by events such as changes in the economy’s interest rates or terrorist attacks that has nothing to do with manager effort.

Introduction. The authors studied the earnings management and its manipulation techniques that executives use to obtain preferred financial results. The regulatory changes promoted an aggressive financial reporting. The pressure of mandatory reforms and financial markets affect CFO’s personal financial interests and interest of corporation that the management can manipulate with. The authors investigated the influence of incentive conflict and earnings management ethics on financial reporting (p. 506). The main objective of research is to comprehend the earnings management structure, earnings management ethics, and examine methods to minimize CFO’s harmful effects on earnings.

Introduction. The author studies accounting methods, earnings management, and financial reporting to examine the ethicalness of judgments. Management’s ethics play a key role in earnings management activities and financial reporting. The researcher questions if the accounting profession and businesses build the line of tolerable and prohibited earnings management practices (pp. 285 -286). The main objective of research is to examine ethically related judgments through earning management activities. Management plays different ethical roles to achieve expectations. The author raises concern on changes in ethical concepts when management has personal interest in company earnings. The study is important because it investigates the role of management and stakeholders in earnings management processes, and situations, under which the judgement becomes more favorable (pp. 286 -287). The author considers two problems: 1) unethical accounting activities lead to fraud, and 2) complexity of ethical decisions due to personal gain.

In Bradshaw and Sloan’s (2002) article, there are several evidences show that market participants like analysts, investors and managers are stressing on the Street earnings. Street earnings is favoured by the majority because it provides additional useful and relevant information and makes the firm look better since it generates higher value. GAAP (Generally Accepted Accounting Principles) earnings is the traditional measurement based on regulations and it is not relevant in predicting future cash flows. Examples of earnings in the wild market are Street earnings and non-GAAP earnings. Following the trends of using non-GAAP earnings, it is a good way to let the free market to create an efficient corporate financial reporting even there are

Earnings management “ occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers” (Healy and Wahlen).

Evaluating earnings is very important as it gives an idea of the bank’s ability to maximize revenue and control expenses, and allows a bank to fund growth, cover losses, maintain adequate capital levels and pay dividends. It also represents the quality of a bank’s profitability and its competence to upkeep the quality of the banks and the quality and source of its earnings. The quality of earnings refers to if earnings can and will continue to support the needs of the banks and if they are coming from core earning sources or non-recurring events and are they sustainable. Earnings of JP Morgan Chase and Sagicor is done over a four year period, starting in 2011 and ending in 2014, as this is needed to understand the trend of changes amongst the two companies. Ratios used to analyse the two companies’ earnings are:

a) The earnings (net income) are considered as the most critical financial figure in the financial statements as it indicates the profitability of the company. All benefits for shareholders including both the capital gains and dividends are closely related with the earnings. In other words, the performance of the company and the management can be largely evaluated by the earnings figure. Due to the importance of earnings, it is not surprising the management is keen to improve the figure via all possible ways including legal and illegal approaches. The earnings management can be defined as using reasonable and legal means to achieve stable and optimised financing results (Burgstahler & Dichev 1997).

A similar study by Accenture/Economist Intelligence Unit reported a significant gap between potential and actual practice.3 These indications of a slowing pace of management accounting change may be due to a range of factors. In some cases, new management accounting tools aren’t adapted to organizational strategy or structure and can’t be used. And in some cases, innovation has failed due to implementation-related factors. However, the main problems aren’t technical or structural; they lie in the need for a better management of the management accounting process itself.