Question

In recent years, publicly traded companies are under pressure to meet or beat the analysts' consensus earnings estimates in their quarterly reports because the market will punish those that fail to deliver expected earnings. Thus, managers tend to utilize many methods to improve reported profitability that are cosmetic in nature and do not affect "real" operating performance to meet market expectations. These methods are referred as earnings management (commonly called" cooking the books"). Managers have different motivations to engage in earnings management, and they usually defend their actions including the following arguments: (1) Increasing stock price by managing earnings benefits stockholders; no one is hurt by these actions, (2) Earnings management is a temporary fix; such actions will be curtailed once "real" profitability improves, as managers expect. So, what are the affected parties in schemes above to manage profits to prop up stock price? Do the ends of earnings management justify the means? What governance structure you think to curb earnings management and increase the reporting quality? Please discuss.

Answer 1

Earnings management may be defined as management decision making and reporting intended to achieve stable and predictable financial results. A large number of companies are using earnings management to maintain steady earnings growth. In other words, earnings management is a strategy used by the management of a company to deliberately manipulate the company’s earnings so that the figures match a predetermined target. This practice is carried out for the purpose of income smoothing. An accounting expert can manipulate earnings in several ways within the boundaries of accounting standards. It can be said unethical but not always illegal. Earnings management is firms’ strategic tool for maximizing firm value and reducing risks.

Affected parties include:

1. Firms, especially failing firms, for signalling or concealing private information and for large tax avoid when accounting numbers are the basis for tax calculation.

2. CEOs and CFOs and managers to improve their compensation.

3. Creditors often impose restrictions on the payment of dividends, share buybacks and the issuing of additional debt in terms of reported accounting figures and ratios, in order to ensure the repayment of the firm’s borrowings. Hence, the hypothesis is that firms who have a lot of debt have an incentive to manage earnings so that they do not breach their debt covenants.

4. The banking, insurance and utility industries are monitored for compliance with regulations linked to accounting figures and ratios. Banks and insurance firms especially are often subject to requirements that they have enough capital or assets to meet their liabilities. Such regulations may give managers incentives to use earnings management.

Earnings management is a tool for satisfying self-interest of the managers. But, it can be used for the welfare of the stakeholders, if it is ethically used. So, to get the optimum benefit of earnings management, steps should be taken to improve corporate governance. Accounting standards should be revised and set in such ways, that there remain no loopholes for manipulating earnings. Auditors should be more careful in detecting earnings manipulation and their independence should be ensured. Finally, the consciousness and the morality of the stakeholders can turn this malpractice into a good one if the motivations behind the earnings management are free from evil intentions.

Please understand and use this answer as a reference and rewrite in your own words.