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Earnings Management Definition, Methods, Laws Case Study

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Updated: Jul 21st, 2020

Definition

The earnings management is a broad subject that has many aspects. The wide definition presents it as a certain set of managerial choices aimed at achieving some of the company’s objectives (Arya, Glover and Sunder 112). Therefore, the best way of defining it is to try to recognize its types and constituencies. The earnings management can vary in its compliance with the set standards of accounting. According to this criterion, it can be white, gray, and black (Ronen and Sadan 340).

The purpose of the white earnings management is to make the financial reports more clear, comprehensive, and informative by means of restructuring the information in a more convenient order. The gray earnings management is more opportunistic than the white one; it is in pursuit of the economic efficiency and gain for the company that provides the report. However, despite the dubious intentions, it exists within the boundaries of the compliance with the standards. Therefore, it is risky but opportunistically efficient. Meanwhile, the black earnings management deals with creating an intermediately misleading impression about the company’s finances.

Considering the fact that the earnings management occurs when the judgment is needed in the financial report, another criterion for definition is the intention of the accountant (Schipper 92). The intention of creating an informative report results in white earnings management. Meanwhile aim to mislead the readers and misrepresent the company’s situation is the black earnings management. Therefore, the earnings management depending on its purpose can be beneficial, neutral, and pernicious.

The Methods to Manage Earnings

There are a number of various means of applying the earnings management (Ronen and Yaari 31). The most common methods to manage earnings include choosing the type of treating and dealing with the financial reports, according to the GAAP, deciding whether to adopt any new standards, defining the items in the financial report as those that are above or below the line of operating earnings. The methods of the narrower spectrum include structuring the financial transacting for concluding new contracts and lease agreements and timing the recognized revenues (Easton, Eddey and Harris 17). Finally, there are methods for managing the transparency and the informative potential of the financial reports, such as disregarding or subtracting minor expenses.

The intermediate means to manage earnings include documenting contingent sales as the self-explanatory ones, restructuring transacting in a “channel stuffing” way, virtual “bill-and-hold” transaction, and violating the regulation of the quarter cutoffs, the recognition of the revenues before the payment or goods were received, or the transaction was finished.

Managing GAAP Earnings through Pro Forma Earnings

Whereas GAAP earnings are classified as the earnings in cash that need to be documented, one means of the earnings management, is to report them as so-called pro forma earnings. The pro forma earnings are commonly non-cash, and one-time, non-recurrent type of earnings. Therefore, they may be disclosed by the company for the purposes of presenting their financial performance in a different way. Usually, such ways of earnings management refer to misrepresent the stock-compensation charges, gains and losses, the costs of merging between two or more companies, etc. Given the fact that documenting the GAAP earnings as pro forma non-cash earnings, leads to creating the misrepresenting impression about the company’s performance and misleading the stakeholders and partners, it is classified as a type of black pernicious earnings management, and such practice is condemned by the standards setters and accounting regulators.

The Players of the Accounting Scene

The reported earnings play a crucial role in the company’s presentation. Therefore, there are many figures on the accounting scene who directly or indirectly influences the way the financial reports are drafted, and whether they comply with the standards. Firstly, the management team and the board of directors of the company made a crucial decision about the level of the company’s disclosure and discretion according to GAAP and IRS regulations. However, apart from the company itself, there are users of the reports, including investors, employees, lenders, consumers, competitors of the company, government regulators, etc. Also, there are independent gatekeepers, such as analysts, investment bankers, media and other agents that can influence the financial situation on the accounting scene.

Alongside all those agents, there are different regulations and constrains that define the financial environment. One of the influences on the accounting scene in the twenty-first century is The Sarbanes-Oxley Act.

The Sarbanes-Oxley Act

The Public Company Accounting Reform and Investor Protection Act signed in 2002, is most commonly recognized as The Sarbanes-Oxley Act. The main motivations for drafting the Sarbanes-Oxley Act were the hazardous effects of the pernicious earnings management to the economy and the increased risks of the economic meltdown (Kolev, Marquardt and McVay 159). In the US, there was a crisis episode, known as the technological bubble that involved black earnings management to misrepresent the high-tech industry. Given the dangers of this practice, the standards of earnings management needed to be revised. However, there are some concerns about the Act since it increases the severity of governmental regulation of the market.

Conclusion

Earnings management is an operation of presenting the information in financial reports with the use of judgment. It can be beneficial, neutral, and pernicious, depending on its purpose and intention. There are some severe regulations of methods and forms of earnings management, most of which are listed in the Sarbanes-Oxley Act.

Works Cited

Arya, Anil, Jonathan C. Glover, and Shyam Sunder. “Are unmanaged earnings always better for shareholders?” Accounting Horizons 17.1 (2003): 111-116. Print.

Easton, Peter D., Peter H. Eddey, and Trevor S. Harris. “An investigation of revaluations of tangible long-lived assets.” Journal of Accounting Research 1.2 (1993): 1-38. Print.

Kolev, Kalin, Carol A. Marquardt, and Sarah E. McVay. “SEC scrutiny and the evolution of non-GAAP reporting.” The Accounting Review 83.1 (2008): 157-184. Print.

Ronen, Joshua, and Simcha Sadan. “Accounting classification as a tool for income prediction.” The Journal of Accounting, Auditing, and Finance 1.2 (1981): 339-353. Print.

Ronen, Joshua, and Varda Yaari. Earnings management. New York, NY: Springer US, 2008. Print

Schipper, Katherine. “Commentary on earnings management.” Accounting Horizons 3.4 (1989): 91-102. Print.

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