EarningsManagementandEarningsQuality1.WhatisEarningsManagement?(BryanHall’sWebpage)Earningsmanagementisdefinedbyaccountingliteratureas“distortingtheapplicationofgenerallyacceptedaccountingprinciples.”ArthurLevitt,theoldSECChairman,definedearningsmanagementas“practicesbywhichearningsreportsreflectthedesiresofmanagementratherthantheunderlyingfinancialperformanceofthecompany.”Earningsmanagementisoftendefinedastheplannedtimingofrevenues,expenses,gainsandlossestosmoothoutbumpsinearnings.Inmostcases,earningsmanagementisusedtoincreaseincomeinthecurrentyearattheexpenseofincomeinfutureyears.Forexample,companiesprematurelyrecognizesalesbeforetheyarecompleteinordertoboostearnings.Earningsmanagementcanalsobeusedtodecreasecurrentearningsinordertoincreaseincomeinthefuture.Theclassiccaseistheuseof"cookiejar"reserves,whichareestablished,byusingunrealisticassumptionstoestimateliabilitiesforsuchitemsassalesreturns,loanlosses,andwarrantyreturns.Managersengageinincomesmoothingactivitiesbecausetheyknowthatvolatileearningsstreamstypicallyleadtolowermarketvaluations.Manysuccessfulmanagementteamsbelievethatthestrategictimingofinvestments,sales,expenditures,andfinancingdecisionsisanimportantandnecessarystrategyformanagerscommittedtomaximizingshareholdervalue.Investorsaredissatisfiedwiththemanagementofearnings;however,investorsbecomeenragedwhenquarterlyorannualearningsforecastarenotmetbyfirms.Therefore,investorsandthepublicviewminorearningsmanagementasacceptableandaneverydaybusinesspractice.Inresponsetopubliccomplaintsandconcernforearningsmanagement,theSEChasissuedbulletinstohelppreventearningsmanagement.2.ThePublicPerceptionofEarningsManagementEarningsmanagementhasanegativeeffectonthequalityofearningsifitdistortstheinformationinawaythatitlessusefulforpredictingfuturecashflows.WithintheConceptualFramework,usefulinformationisbothrelevantandreliable.However,earningsmanagementreducesthereliabilityofincome,becausetheincomemeasureisbiased(upordown)and/orthereportedincomethatisnotrepresentationallyfaithfultothatwhichitissupposedtoreport(e.g.,volatileearningsaremadetolookmoresmooth).Thetermqualityofearningsreferstothecredibilityoftheearningsnumberreported.Companiesthatuseliberalaccountingpoliciesreporthigherincomenumbersintheshort-run.Insuchcases,wesaythatthequalityofearningsislow.Similarlyifanonrecurringgainincreasesincome,butthegainisobviouslynotsustainable,thenthequalityofearningsisconsideredlow.Forthemarketstoworkefficiently,itisvitalthatinvestorsbeabletotrusttheearningsnumbersofthecompaniesinwhichtheyhavechosentoinvesttheircapital.Recentstudieshaveshownthattheinvestingpublicbelievesthattheoccurrenceofearningsmanagementisbothwidespreadandpervasiveinthefinancialstatementsofcorporationsworldwide.However,itisinterestingtonotethattheinvestingpublicdoesnotnecessarilyviewminorearningsmanagementasunethical,butinfactasacommonandnecessarypracticeintheeverydaybusinessworld.Itisonlywhentheimpactofearningsmanagementisgreatenoughtoaffecttheinvestors’portfoliothattheyfeelfraudhasbeencommitted.3.TheImpactofEarningsManagementPublicperceptionaboutthewidespreadoccurrenceofearningsmanagementisaffectingthepublic’sconfidenceinexternalfinancialreporting.Thepracticeofearningsmanagementdamagestheperceivedqualityofreportedearningsovertheentiremarket,resultinginthebeliefthatreportedearningsdonotreflecteconomicreality...
