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
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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
As Chapter 10 questions, if further evidence continues to surface that capital markets do not always behave in accordance with the efficient market hypothesis, then should we reject the research that has embraced the EMH as a fundamental assumption? In this regard we can return to earlier chapters of this book in which we emphasised that theories are abstractions of reality. Capital markets are made of individuals and as such it would not (or perhaps, should not) be surprising to find that the
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.
This case study is the first of a two-part Earnings Management Case. The purpose of Part
Earnings management is the use of accounting techniques, such as change in accounting policies and accounting estimates, with an objective to create an optimistic outlook (sometimes overly optimistic) of a company’s business activities and financial position. Although to some it may seem like it is earnings fraud, earnings management actually took benefit from the flexibility and the legitimateness (within the framework of Generally Accepted Accounting Principles (GAAP)) of accounting rules to manipulate revenue and expenses recognition.
Grahama, Harvey and Rajgopalc (2004) interviewed over 400 executives, revealing that executives assign a high level of priority in meeting target earnings as it builds credibility with the market and multiplies the positive effect, confirming previous research. The executives also believed failing to meet the targets would result in a severe market reaction and that directors sacrifice economic value to avoid these effects, avoiding a potentially larger economic loss. This can also be said of achieving or beating expectations, where the potential economic gain from the multiplied positive market effect can easily outweigh the economic sacrifice. Equipped with these justifications, over 80% of those surveyed admitted they were willing to sacrifice economic value and use RM to meet expectations. Moreover, the executives acknowledged that RM is more widespread and favoured to the manipulation of accounting methods,
I enjoyed the conversation on GAAP and earnings management relating to the case “Be Careful What You Wish For: From the Middle”. The conversation was brief, but got me thinking on the ethics of earnings management. GAAP accounting is to reflect in good faith the company’s actual financial status and present reality as is. It is not to present a manipulated set of numbers that paint a pretty picture. GAAP requires recording of revenue when there is persuasive evidence of an arrangement, assurance of collectability, a fixed or determinable price, and delivery. If Sarah recognizes revenue before delivery, she would violate GAAP and partake in channel stuffing. It would not be earnings management.
Earnings Management: An Examination of Ethical Implications, Fraud, and the Related Impacts to Stakeholder Interests
It was Myron Gordon’s articles that made a significant contribution to the income smoothing topic, in which he provided the rationale for early smoothing studies that launched the era of hypothesis testing in modern academic literature. Gordon wrote two articles in 1960 and 1964 but he was mostly renowned for his article in 1964. Gordon’s [1964] article was more dynamic and straightforward than his previous article as he provided a more ‘explicit’ treatment of the combination of his ideas based on income smoothing. Initially Gordon argues the proposal of income smoothing as a criterion for accounting choice by regulators. But the main significance in Gordon’s article was how income smoothing could impact on stockholder satisfaction. (Gordon, M.1964)
Investors and analysts have a tendency to rely too heavily on the record of past earnings growth (La Porta et al. 1997). According to Lakonishok, Shleifer & Vishny (1994) popular strategies like 'extrapolating past earnings growth too far into the future' or 'assuming a trend in stock prices', 'overreacting to good or bad news', or 'simply equating a good investment with a well-run company
The concept of earnings management is not a new thing. Its practice is actually very common among most companies. Managing earnings is not all necessarily bad. However, there is a fine line that shouldn’t be crossed. Corporate managers are under extreme pressures when it comes to meeting forecasted results. There are various factors that contribute to these pressures: external, company culture, and personal. Corporate management may use various transactions to help “make the numbers”. But, it is when the line between practical methods
I end up this discussion by emphasizing that the basic procedure to find a market response is to associate some measure of market return on securities with some measure of the information content of the financial statements. I then review the 1968 Ball and Brown study. Since their methodology takes some getting used to for students who have not seen it before, I stick fairly closely to the coverage in Section 5.3, although the article itself could usefully be assigned as reading by instructors who wish to consider BB’s procedures in greater depth. I concentrate on explaining how BB operationalized the measurements of market return and information content of net income. Figure 5.3 is useful in this regard. The figure also ties nicely back to the efficient securities market theory of Chapter 4, and the discussion in Example 3.3 of the dichotomization of factors affecting share price into market-wide and firm-specific factors (Example 3.3 is optional reading, however). I go on to review briefly the ERC research outlined in Section 5.4, as an example of an important direction in which the Ball and Brown methodology has developed. I concentrate on persistence as an explanatory variable for the ERC since this concept is
Professor Messod Beneish created the Beneish M-score Model in 1999 in his research entitled The Detection of Earning Manipulation. He identified that earnings management is important for financial statement users to assess current economic performance, to predict future profitability, and to determine firm value (Jansen et al, 2012)
Creative accounting is also called “Earnings management” which is known as the manipulation of financial information. The term can be defined in many ways. Initially we define it as 'a process whereby accountants use their knowledge of accounting rules to manipulate the figures reported in the accounts of a business ' (Naser, 1993, p.59).