After a long 4-week break, I sort of had to force myself to get back into the rhythm of studying finance, because I practised experiential entrepreneurship for my senior project. It wasn’t an entirely separate topic, but was very different in the method of learning that I had to actually experience the situations rather than learn it through videos online. Anyways, this week’s topic was Earnings Management.
Earnings Management, by definition, is the act of managers using self selection and judgement in writing their financials statements for the firm and structuring transactions to ‘mislead’ some share/stakeholders about the financial performances of the firm or gain an advantage in a contractual outcome that depends on reported accounting numbers. However, this isn’t outright cheating or fraud. None of the numbers that are reported are made up or fraudulent. It’s just the way in which the managers decide to present their numbers and what numbers they decide to actually present to the stakeholders of the company.
To detect Earnings Management, three things have to be looked at: Motive, Means and Opportunity. Motive is the reason that the managers feel the need of using Earnings Management, Means is the changes that the managers make when manipulating their earnings, and Opportunity is the timing that the managers are able to get away with the manipulation. An example of Earnings Management would be changing the ‘Bad Debt Expense’ percentage to report higher earnings. If unmanaged earnings of a company was expected to be $20,000 and the manager wants it to be $21,000, he could change the Bad Debt Expense percentage, which is based on an expectation that 1% of credit sales ($200,000) to customers won’t be collected, to 0.5% so that he would be able to create a managed earnings of $1,000 to add to the unmanaged earnings. The reported earnings to stakeholders would be the unmanaged earnings + managed earnings, which would be $20,000 + $1,000 = $21,000.
Next week, I’ll talk more about the motives, means and opportunity of earnings management.