Accounting: The Language of Business - Vol. 2 (Intermediate: Part 46)

Suppose that throughout your childhood you were good with numbers. Other kids used to copy your homework. You figured store discounts faster than your parents. People came to you for help with such things. So you took accounting and eventually became a tax auditor for the IRS. What an embarrassing job, right? You feel you should be writing poetry or doing aviation mechanics or whatever. But then you realize that tax collecting can be a calling too.

James Hillman

Statements of Net Income and Comprehensive Income (Part D)

by

Charles Lamson

Motivations for Earnings Management. The flexibility to accounting standards gives management the ability to manipulate its reported earnings to meet company objectives. One of managers' overriding goals for the earnings presentation is to meet or exceed analysts' earnings forecasts. Financial analysts are trained to analyze a company, summarize relevant financial information for investors, and provide an opinion about whether investors should buy or sell stock in a company. In addition, financial analysts publish forecasts of a company's sales and earnings. If the company's actual earnings fall below this forecast, the market will most often react negatively, causing a drop to stock price.

For example, the share price of Nike Inc. declined about 7% when it released its sales for the second quarter of fiscal 2016 of $8.24 billion. Although this sales figure was a 6% increase from prior periods, the analysts forecasts were $8.27 billion (fortune.com). If Nike had reported sales higher than $8.27 billion its share price likely would not have decreased. Thus, although it didn't do so, Nike had an incentive to manage revenues upward to beat analysts' forecasts.

Managers are also motivated to manage earnings to:

1. Beat benchmarks such as prior quarter earnings or earnings from the same quarter of a prior year.

2. Avoid reporting a loss.

3. Present a firm's earnings as a smooth, upward trend.

4. Increase their own compensation when bonus plans are based on the net income (or stock price) of the firm.

In a survey of over 400 executives, 85.1% of those surveyed agreed that the earnings from the same quarter and the prior year is an important benchmark. In this same survey, 73.5% noted that analysts' forecasts were an important benchmark, and 65.2% indicated that avoiding a loss is important. Finally, 54.2% stated that earnings from the prior quarter is an important benchmark (John Graham, Campbell Harvey, and Shiva Rajgopal "The Economic Implications of Corporate Financial Reporting," Journal of Accounting & Economics. 2005, pp. 3-73).

In another study, researchers found evidence suggesting that 8% to 12% of companies that would have reported small earnings decreases instead exercise discretion in order to report small increases in earnings (David Burgstahler and Elia Dichev, "Earnings Management to Avoid Earnings Decreases and Losses," Journal of Accounting & Economics, 1997, pp. 99-126). The same study found evidence suggesting that 30% to 44% of companies that would have reported a small loss instead exercised discretion in order to report a small profit.

Earnings Management Techniques. Managers employ earnings management techniques when actual earnings are either lower or higher than expected.

When low earnings are expected, the big bath earnings management technique involves increasing a net loss to allow the firm to show increased net income in the future. Managers can intentionally report very low or negative earnings in a period by accelerating the recognition of expenses, into current period earnings or delivering revenue recognition to the future reporting. This then allows them to report higher earnings in future periods than they would otherwise have reported because they have shifted expenses back to the prior period or shifted revenues to the future.

When earnings are higher than expected in the current period, managers may elect to reduce earnings to create cookie jar reserves. Cookie jar reserves are used in future periods to increase earnings as needed, possibly to exceed analysts' forecasts. For instance, managers could recognize an overstated warranty expense when earnings are high, thus increasing warranty expense and the warranty liability and reducing reported earnings. In later years, managers have a sufficient warranty liability and may not need to increase the accrual. Therefore, management can report lower warranty expense and increase reported earnings in that period. 

For example, let's assume that the management of Wilson Retailers prepares an income statement for the year ended 2018 and realizes that earnings will exceed analysts' forecasts by $150,000. The company may choose to increase the estimate of warranty liability by an additional $125,000, thus increasing warranty expense by that amount. Wilson will still exceed the analysts' forecasts, but only by $25,000. In future years, the company has $125,000 as a "reserve." Therefore, if management determines that the company is going to miss analysts' 2019 forecast by an amount less than or equal to $125,000, they can reduce their warranty liability, report little or no warranty expense, and thus increase that income.

Earnings Management in Practice. A survey of auditors provides a summary of the approaches management uses to manipulate earnings. The most common approach is through the manipulation of expense and losses (52% of the occurrences of an earnings management attempt) followed by the manipulation of revenues (22% of the occurrences) and opportunities around business combinations (13% as illustrated in Exhibit 5.2) (Mark Nelson, John Elliott, and Robin Tarpley, "How Are Earnings Managed? Example from Auditors, Accounting Horizons, Supplement 2003, pp. 17-35 ).

EXHIBIT 5.2 Earnings Management Approaches Used in Practice

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 175-176*

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