The Effect Of Excessive Em On Decision Making

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Earnings management (EM) refers to the act of affecting how outcomes of business activities are presented, by altering between different accounting policies, redistribution of discretionary earnings and expenses and manipulating real business activities without exceeding Generally Accepted Accounting Principles (GAAP) (Walker, 2013). In recent years, EM has become a much more prevalent topic for discussion as an increasing number of firms use the technique to achieve management targets and therefore maximise shareholder wealth. Over-performing EM usually results in fraud. This essay aims to evaluate the extent to which investors should consider the effects of excessive EM in decision making with regards to FTSE 100 firms. This will be…show more content…
In this scenario, the announcement of earnings can influence the price the new investors pay, hence the money the old generation receives. One of the other plausible consequences for investors from the implementation of EM is the reduction in volatility of share prices (Barton et al., 2010). Markarian and Gill-de-Albornoz (2012) state that there is a correlation between stable stock values and earning management, more in particular income smoothing, which constitutes in “moderating year-to-year fluctuations in income by shifting earning from peak years to less successful ones”. Graham et al. (2005) report in a study that 97% of firms evaluated indicated they smoothed incomes, rather than reporting real operating performance, to lower investors’ beliefs regarding firm-level risk, as it is claimed to be less costly (Cohen & Zarowin, 2010). Studies show that income smoothing succeeds in conveying information about future profitability (Turcker & Zarowin, 2006) and Pastor and Veronesi (2003) argue that there is a direct proportionality between stock return volatility and insecurity about future profitability. Thereby the stability of share prices is a consequence of income smoothing. On the other hand, there are also drawbacks of using EM methods. Accounting data is of vital importance to many stakeholders in a business and, as “managers have the opportunity to shape financial reports in
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