Last week, I introduced you guys to the idea of Earnings Management, and showed you a very basic example of it. This week, as I promised, I’ll discuss the Motives, Means and Opportunity of Earnings Management.
Let’s start with the Motives. In order for a group of managers for a company to benefit from Earnings Management, there must be two conditions that hold in any scenario. The first is that the unmanaged earnings is projected to be different from some ideal target that the managers have set for the time period. It could be both too low or high, and the target would be based on the ideal number for stakeholder expectations and contractual requirements. The second is that the managers would benefit from using managed earnings to make their reported earnings look better than the unmanaged earnings. For example, it would have to make stakeholders react less positively or negatively to the reported earnings of the company.
Now that we know about the motives, we can move on to the means of it. How do the managers manipulate their earnings? The methods are divided largely into two categories, with the first being Accrual-based earnings management. Accrual-based earnings management techniques include aggressive revenue or expenses recognition policies, which means looser or tighter restrictions on what counts as revenue or expenses, and changes in accounting choices or estimates. The second is real earnings management, which is a set of changes in operational decisions (e.g. delay R&D expenses, overproduce inventory).
So when can these managers get away with it? Once again, for managers to have the opportunity of earnings management, two conditions must hold. The first is that the expected benefits of managing the earnings for the set time period is larger than the cost. Although it may seem very obvious, it is very important that these extra steps do not cost the company too much, as ‘borrowing’ earnings from the future could be very costly. The second is that the stakeholders will not be able to see through the earnings management techniques that the managers used and back out unmanaged earnings. The managers have to be very careful in their methods of managing their numbers so that they aren’t too obvious to detect.
Although there is no universal equation that leads to the perfect earnings management technique every time, a little bit of it could go a long way for the company’s managers. However, as stakeholders, it is important that we also develop an eye for detecting such methods and manipulations so that we can use them to our own advantages.
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