25 Jul Understanding Earnings Management – Thakur Chabert
Earnings management implies the use of accounting techniques to generate financial statements that render an exceedingly positive outlook of a company’s business activities and financial situation. Several accounting rules and principles necessitate that a company’s management makes judgments in pursuing these principles. Earnings management takes benefit of how accounting rules are applied and generates financial statements that increase or “smooth” earnings.
Earnings are the company’s net income or profit for a particular period, for instance, a fiscal quarter or year. Companies employ earnings management to smooth out instabilities in earnings and present more steady profits each month, quarter, or year. Huge fluctuations in income and expenses might be a normal element of a company’s operations, but the changes might alarm investors who favor seeing constancy and growth. A company’s stock price frequently increases or drops after an earnings announcement, relying on whether the earnings meet or fall short of analysts’ anticipations.
Earnings Management can feel strain to administer earnings by manipulating the company’s accounting practices to congregate financial expectations and keep the company’s stock price up. Numerous executives obtain bonuses rooted in earnings performance, and others may be entitled to stock options when the stock price enhances. Various forms of earnings manipulation are ultimately uncovered either by a CPA firm making an audit or via required SEC (Securities and Exchange Commission) disclosures.
Examples of Earnings Management
One technique of manipulation when managing earnings is to alter an accounting policy that creates higher earnings in the short term. For instance, suppose a furniture retailer uses the last-in, first-out (LIFO) system to account for the cost of inventory items traded. Under LIFO, the newest units bought are deemed to be sold first. Since inventory costs characteristically boost over time, the newer units are more costly, and this generates a higher cost of sales and a lesser profit. If the retailer changes to the first-in, first-out (FIFO) method of distinguishing inventory
costs, the company deems the older, less-costly units to be sold first. FIFO generates a lower cost of goods sold expense and, consequently, higher profit thus the company can post a higher net income in the present period.
A different form of earnings management is to modify company policy so more costs are capitalized instead of expensed right away. Capitalizing costs as assets holdups the acknowledgment of expenses and increases profits in the short term. Suppose, for instance, company policy utters that every item bought under $5,000 is instantly expensed and costs over $5,000 might be capitalized as assets. If the firm alters the policy and begins to capitalize all items over $1,000, expenses reduce in the short-term and profits boost.
Factoring in Accounting Disclosures
A modification in accounting policy, nevertheless, should be explained to financial statement readers, and that disclosure is generally affirmed in a footnote to the financial statements. The disclosure is necessary because of the accounting principle of consistency. Financial statements are steady if the company uses the same accounting policies every year because it facilitates the financial statement user to effortlessly discover variations when looking at the company’s historical trend. Consequently, any policy change should be explained to the financial report reader. Consequently, this type of earnings manipulation is generally revealed.
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