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Earnings management refers to the act of manipulating the process of financial reporting in order to achieve certain desired outcomes (Jones, 2015). Managers use several earnings management practices that include income minimization, income maximization, taking a bath, and income smoothing (Scott, 2015). In many cases, accountants use various accounting techniques to create a positive illusion of a companys activities and financial status. The business practice usually takes advantage of the flexibility of accounting rules and principles (McKee, 2005). Earnings management can be either positive or negative depending on how it is used. Its application can be evaluated from two main perspectives namely financial reporting and contracting.
In the case of financial reporting, the practice can be used to protect a businesss financial status by concealing losses in order to meet a companys projected earnings for a certain period (Scott, 2015). This can help a company to prevent damage reputation and please shareholders. In addition, it can prevent drastic changes in share price that can affect a company negatively. Some managers use earnings management to protect their company by recording excessive writeoffs and including total earnings rather than net earnings (Jones, 2015). Engaging in these practices show that many mangers do not trust that the securities markets are efficient. Earnings management can also be used to manipulate shareholders and investors by reporting a stream of a companys growing earnings over a certain period of time. Therefore, it is used to disseminate a companys inside information to investors (Scott, 2015). Income smoothing and streamlining the financial status of a business are some of the positive uses of earnings management.
Earnings management can be applied to protect a company from rigid and incomplete contracts when it is evaluated form a contracting perspective (Ronen & Yaari, 2008). Rigid and incomplete contracts have negative consequences that can affect a company adversely. Despite offering protection, extreme earnings management can affect a company negatively. It can reduce the usefulness of a companys financial reports and statements to investors if the practice is kept a secret by management (Scott, 2015). Investors might make poor investment decisions based on misleading and inaccurate information contained in financial reports. On the other hand, the practice lowers managers willingness to work hard and become committed to their work. This happens because earnings management offers them an opportunity to smooth their compensation over time (Ronen & Yaari, 2008). This lowers their compensation risk and enables them to achieve their bottom line objectives.
Earnings management has significant implications on public policy because the practice can be used by many companies to engage in fraudulent reporting (McKee, 2005). In an effort to appease and please shareholders as well as attract investors, many companies use earnings management to improve the financial standing of their companies (Riahi-Belkaoui, 2003). Minimizing and maximizing earnings as well as income smoothing can have negative implications especially to investors and shareholders because they provide misleading financial information that does not represent the actual financial status of a company (Ronen & Yaari, 2008). Protecting the welfare of shareholders and investors should the main priority for managers and accountants. On the other hand, companies can misuse the practice and cause severe financial ramifications. Many businesses have collapsed or filed for bankruptcy because they applied certain techniques of earnings management to hide their financial problems (Riahi-Belkaoui, 2003).
Earnings management can be a good or bad practice depending on how a company uses it. It is good if it is used to prevent violations of debt contracts, drastic share price drops, and loss of company reputation. It is bad if it is used to manipulate shareholders, attract investors by concealing companys financial problems, and conceal losses that could have severe financial implications in future.
References
Jones, S. (2015). The Routledge Companion to Financial Accounting Theory. New York, NY: Routledge.
McKee, T. E. (2005). Earnings Management: An Executive Perspective. New York, NY: Thomson.
Riahi-Belkaoui, A. (2003). Accounting: By principle or Design? New York, NY: Greenwood Publishing Group.
Ronen, J., & Yaari, V. (2008). Earnings Management: Emerging Insights in Theory, Practice and Research. New York, NY: Springer science & Business.
Scott, W. R. (2015). Financial Accounting Theory (7th ed). New York, NY: Pearson.
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