Earnings Management

Earnings management is an accounting process whereby managers manipulate reported earnings to obtain some private gain. As an indicator of opportunistic managerial behavior, investors and regulators are both concerned with the deliberate use of generally accepted accounting procedures to arrive at a desired level of reported earnings. However, the term earnings management now has a wider connotation and embraces every kind of striving in earnings manipulation. The purpose may be to increase management's compensation, or to meet earnings forecasts, but employment practices such as “revolving door,” where a company hires senior finance executives such as a chief financial officer (CFO) or controller from its current external audit firm are also studied under the canopy of earnings management. The practice is also associated with managers using their discretion in financial reporting to smooth earnings, to reduce [Page 545]the likelihood of violating lending agreements, and to window-dress financial statements prior to initial public offerings (IPOs).

While earnings management is used to provide private benefits to managers, it is the firm that bears the cost of conducting it. Traditional literature has thus focused on investigating the nature and significance of unexpected accruals. More recent work has instead looked at the distribution of reported earnings for abnormal discontinuities such as declines in earnings. There are many interesting examples of how earnings are manipulated upward by changes in current asset and liability items such as accounts receivable and payable. These include bringing forward credit sales or deferring recognition of expenses. Managers may report accruals that defer income when the earnings target in their bonus plan is not met. When firms cap bonuses, managers may also defer income when that cap is reached. Other accrual options or accounting method choices that are susceptible to abuses of management's reporting judgment include banks' use of loan loss provisions, insurers' use of claim loss reserves to meet regulatory requirements, and IPO firms' use of bad debt provisions or income-increasing depreciation policies to increase the offer price.

Managers are compensated on the basis that they will act in the interest of firm owners. There are a large number of studies that find that managers use incentive pay plans to increase their payouts. One particular example is earnings-based bonus awards. Managers maximize the value of their bonus award by increasing (or decreasing) reported earnings. In some situations, payouts from a bonus pay plan are made only when earnings exceed a specified threshold or “hurdle” rate. Depending upon the total cash flows from operations and nondiscretionary accruals, managers then have the incentive to select the level of discretionary accruals that maximizes the expected value of their bonus award.

Weak corporate governance practices are also associated with managers' incentives to use discretionary accruals to maximize their compensation. This is the case when manager compensation is tied to stock price performance through options. Chief executive officers (CEOs) and top executives can then profitably exercise their stock options by exaggerating firm earnings that support higher stock prices. When job security is a paramount concern, managers could engage in smoothing earnings, thereby reducing the likelihood of dismissal. Managers may also attempt to develop a favorable reputation of their competence by managing earnings that show a steady growth in firm performance.

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