This paper discusses the motives behind earnings management and explains some of the methods used by firms to manage their earnings. Earnings management has been defined differently by a number of scholars. It is important to note that there is a thin line between fraud and earnings management. Hamid, Hashim and Salleh citing the works of Brown, Perols and Lounge and Erickson, Hanlon and Maydew noted the difference in the definitions that are offered by the scholars. According to Perols and Lounge organizations will engage in fraud due to the constraints on earnings management. The research found out that the firms that had engaged in earnings management will be more likely to be involved in cases of fraud. Brown and Erickson et al noted that the difference between earnings management and fraud is that earnings management is usually within the scope of the generally accepted accounting principles (GAAP) while fraud is outside of the boundaries of GAAP.
Earnings management has been defined as the manipulation of the financial statements and reports by the managers so that the firms can earn extra profit. It has also been defined as the action where the management of the organizations apply their own self-assessment in the communication of the financial information and transactions to modify the financial data for two main reasons: 1) influencing contractual businesses that solely rely on the financial information or 2) providing the stakeholders with a wrong impression about the financial position of the firm.
Inhaltsverzeichnis (Table of Contents)
- Motivations for earnings management
- Methods of earnings management
Zielsetzung und Themenschwerpunkte (Objectives and Key Themes)
This text aims to discuss the motivations behind earnings management and explain the methods used by firms to manage their earnings. It explores the fine line between earnings management and fraud, highlighting the differences in definitions and interpretations among scholars. The text also examines the impact of earnings management on organizational operations and the various techniques employed to manipulate financial statements.
- Motivations for Earnings Management (e.g., contracting, debt avoidance, remuneration)
- The Distinction Between Earnings Management and Fraud
- Methods of Cosmetic and Real Earnings Management
- Consequences of Earnings Management on Firm Operations
- Examples of Earnings Management in Practice (e.g., Tesco case study)
Zusammenfassung der Kapitel (Chapter Summaries)
Motivations for earnings management: This section delves into the various reasons why firms engage in earnings management. It begins by highlighting the significant impact of past accounting scandals, such as Enron and WorldCom, which underscored the importance of understanding the motives behind such practices. The text then examines several key motivations, including contractual pressures, such as the need to meet targets in lending agreements and management compensation contracts. It explores how these contracts can incentivize earnings management to protect the firm's financial position and maintain positive relationships with stakeholders. The text further discusses the role of debt covenants in influencing earnings management, explaining how firms might manipulate financial reporting to avoid penalties or renegotiations of debt agreements. Finally, it touches upon the role of remuneration, job security, and pressure from external parties, such as financial analysts, in driving firms to engage in earnings management practices in order to meet expectations and maintain market stability. Examples such as the Tesco case are used to illustrate the real-world implications of these motivations.
Methods of earnings management: This section details the techniques firms use to manage their earnings. It distinguishes between cosmetic and real methods, explaining how cosmetic methods do not affect cash flow but manipulate reported figures through practices like adjusting depreciation, inventory valuations, or delaying asset impairment. Several specific techniques are examined, including the "cookie jar reserve" method, where firms overestimate expenses in one period and use the excess to boost earnings in future periods. The "big bath" method, where losses are reported at once to improve future performance, is also explained. The text then examines techniques related to acquisitions, such as claiming acquired firm earnings or writing off R&D costs, and the use of subsidiary sales or spin-offs to influence reported earnings. The impact of these methods on the firm’s overall financial picture and implications for stakeholders are discussed. This section emphasizes the nuanced and sometimes complex means through which organizations can manipulate their financial reports to present a specific image of their performance.
Schlüsselwörter (Keywords)
Earnings management, fraud, GAAP (Generally Accepted Accounting Principles), financial reporting, motivations, methods, cosmetic earnings management, real earnings management, debt covenants, remuneration, contracting, financial analysts, Tesco case study, cookie jar reserve, big bath method, acquisitions, subsidiaries, accounting scandals.
Frequently Asked Questions: A Comprehensive Guide to Earnings Management
What topics are covered in this text about earnings management?
This text provides a comprehensive overview of earnings management, covering motivations for earnings management, methods employed by firms, the distinction between earnings management and outright fraud, and the consequences of such practices. It examines various techniques used to manipulate financial statements, the impact on firm operations, and includes real-world examples such as the Tesco case study.
What are the key motivations behind earnings management?
Firms engage in earnings management for various reasons, including meeting targets in lending agreements (contractual pressures), avoiding penalties related to debt covenants, securing better remuneration for management, maintaining positive relationships with stakeholders, and meeting the expectations of financial analysts. The desire to protect the firm's financial position and maintain market stability are also significant motivators.
What are the different methods used for earnings management?
The text distinguishes between cosmetic and real earnings management. Cosmetic methods manipulate reported figures without affecting cash flow (e.g., adjusting depreciation, inventory valuations, or delaying asset impairment). Real methods involve actual changes in firm operations. Specific techniques discussed include the "cookie jar reserve" method, the "big bath" method, manipulating earnings through acquisitions, and utilizing subsidiary sales or spin-offs.
What is the difference between earnings management and fraud?
The text explores the fine line between earnings management and fraud, acknowledging the varying definitions and interpretations among scholars. While both involve manipulating financial reporting, fraud is intentional misrepresentation with the intent to deceive, whereas earnings management may involve less intentional misrepresentation or involve bending the rules within generally accepted accounting principles (GAAP).
What are the consequences of earnings management on firm operations?
The text examines the impact of earnings management on a firm's overall financial picture and its implications for stakeholders. It highlights the potential for misleading investors, damaging relationships with creditors, and impacting the firm's long-term financial health. The potential legal and reputational risks associated with detected earnings management are also implied.
What real-world examples are used to illustrate earnings management?
The text uses the Tesco case study as a prominent example to illustrate the real-world implications of earnings management motivations and methods. It also references past accounting scandals, such as Enron and WorldCom, to emphasize the importance of understanding the motives behind such practices.
What are the key terms and concepts discussed in the text?
Key terms include earnings management, fraud, GAAP (Generally Accepted Accounting Principles), cosmetic earnings management, real earnings management, debt covenants, remuneration, contracting, financial analysts, cookie jar reserve, big bath method, acquisitions, subsidiaries, and accounting scandals.
What is the overall purpose of this text?
The text aims to provide a clear and structured understanding of earnings management, its underlying motivations, the methods employed, and the consequences for firms and stakeholders. It seeks to differentiate between acceptable accounting practices and fraudulent activities, offering insights into the complexities of financial reporting.
- Citation du texte
- David Onditi (Auteur), 2017, Financial Reporting on Earnings Management, Munich, GRIN Verlag, https://www.grin.com/document/499803
