What Is Earnings Management?

Earnings management is the use of accounting techniques to produce financial statements that present an overly positive view of a company's business activities and financial position. Many accounting rules and principles require that a company's management make judgments to follow these principles. Earnings management takes advantage of how accounting rules are applied and creates financial statements that inflate or smooth earnings.

Understanding Earnings Management

Earnings are a company's 澳洲幸运5官方开奖结果体彩网:net income or profit for a certain specified period, such as a fiscal quarter or year. Companies use earnings management to smooth out fluctuations in earnings and present more consiste🧸nt ꩲprofits each month, quarter, or year.

Large fluctuations in income and expenses may be a normal part of a company's operations, but the changes may alarm investors who prefer to see stability and growth. A company's stock price often rises or falls after an 澳洲幸运5官方开奖结果体彩网:earnings announcementꦗ, depending on whether the earningܫs meet or fall short of analysts' expectations.

Management can feel pressure to manage earnings by manipulating the company's accounting practices to meet financial expectations and keep the company's stock price up. Many executives receive bonuses based on earnings performance, and others may be eligible for 澳洲幸运5官方开奖结果体彩网:stock options when the stock price increases.

Many forms of earnings manipulation are eventually uncovered either by a 澳洲幸运5官方开奖结果体彩网:certified public accountant (CPA) firm performing an audit or through required 澳洲幸运5官🍸方开奖结果体彩网:Securities a💝nd Exchange Commission (SEC) disclosures.

Special Considerations

A change in accounting policy must be explained to financial statement readers, and that disclosure is usually stated in a footnote to the financial statements. The disclosure is required because of the 澳洲幸运5官方开奖结果体彩网:accounting principle of consistency.

Financial statements are consistent if the company uses the same accounting policies each year. This is important because it allows the financial 🥃statement user to easily identify variations when looking at the company's historical trends.

The fact that a policy change must be explained and that all of a company's accounts are laid bare in its financial statement means that careful readers will likely discover the earnings management strategy. The problem is that not everyone has the time to go over reports in full or the knowledge to understand everything that is written.

How to Spot Earnings Management

You should do your research and due diligence whenever you invest your money. But how can you tell if a company smooths its income? There are several ways you can spot earnings management when you analyze a company's financial statements. The following are some of the red flags:

• An increase in earnings only in the last 澳洲幸运5官方开奖结果体彩网:fiscal quarter of the year.
• The company's revenue increases without any boost in its cash flows. 澳洲幸运5官方开奖结果体彩网:Revenue recognition is a common example, where a company accounts for revenue before sales occur rather than waiting for when the transactions are complete.
• There is no corresponding relationship between an asset's net worth and its 澳洲幸运5官方开奖结果体彩网:depreciation. Companies that manipulate depreciation by increasing the useful life of an asset. This reduces the impact depreciation has on their net income.

Examples of Earnings Management

Generate Higher Earnings

One method of manipul💝ation when managing earnings is to change to an accounting policy that generates higher earnings in the short term.

For example, assume a furniture retailer uses the 澳洲幸运5官方开奖结果体彩网:last-in first-out (LIFO) method to account for the cost of 澳洲幸运5官方开奖结果体彩网:inventory items sold. Under LIFO, the newest units purchased are considered tꦉo be sold first. Since inventory costs typically increase over time, the newer units are more expensive, and this creates a higher cost of sales and a lower profit.

If the retailer switches to the 澳洲幸运5官方开奖结果体彩网:first-in first-out (FIFO) method of recognizing inventory costs, the company considers the older, less-expensive units to be sold first. FIFO creates a lower 澳洲幸运5官方开奖结果体彩网:cost of goods sold (COGS) expense and, therefore, higher profit, so the company can post higher net income in the current period.

Capitalize More Costs

Another form of earnings management is to change company policy so more costs are 澳洲幸运5官方开奖结果体彩网:capitalized rather than expensed immediately. Capitalizing costs as assets delays the recognition of expenses ಞand increases profits in the short term.

Assume, for example, company policy dictates that every item purchased under $5,000 is immediately expensed and costs over $5,000 may be capitalized as assets. If the firm changes the policy and starts to capitalize all items over $1,000, expenses decrease in the short term and profits increase.

The Bottom Line

Investors should always do their homework before investing in a stock. That means analyzing the company’s financial report to get a true picture of how it is doing. Don’t just fixate on the headline numbers the company wants you to read or trust that analysts🐎 or somebody else will do the job on your behalf. Go through everything yours🐓elf and do it with a skeptical eye.