Real and Accrual Based Earnings Management

2092 Words9 Pages
Advanced Accounting Theory Final Paper
April 28, 2014

Real and Accrual Based Earnings Management
1.1 Introduction The most important item in the financial statements of a company is earnings. Earnings indicate the amount of value-added activities a company has engaged in over a period of time, as well as assist in the direction of resource allocation in capital markets. Just as the eyes are the window to the soul, earnings are the window to a company’s value. Increasing earnings represent an increasing company value, while the opposite can be said about decreasing earnings. Seeing how important earnings are to a company’s value, it comes to no surprise that management has a strong incentive to report earnings in their maximum
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These techniques are defined briefly as follows:
Big Bath: a technique where a one-time charge is taken against income to reduce assets, resulting in lower future expenses. The write off allows the asset to be reduced or removed from the financial statements, ultimately resulting in a lower net income in that year. The idea is to take a “big bath” to wash the books, resulting in an increased net income for future years. An example would be if a manager shifted profits forward by prepaying expenses, or delaying the realization of revenues.

Creative Acquisition Accounting: when a company allocates a large portion of an acquisition price as being “in process”. An example would be using R&D as a large one-time write off charge.

Cookie Jar Reserves: a technique where a company portray unlikely assumptions when they are calculating estimates for loan losses, warranty costs, or sales returns for example. Accruals are hidden away in the ‘cookie jar’ during good times and the jar is empty during bad times.

Immaterial Mis-sapplications of Accounting Principles: when a company records errors within a defined percentage ceiling and rationalizes the implied ‘errors’ on the profits being too small to be material to increase earnings.

Premature Recognition of Revenue: when companies
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