Introduction
The earnings management is a question of great significance for accounting since it has important implications for setting standards and regulations. However, there are certain aspects to be considered, when studying the academic evidence of earnings management in the sphere of accounting and finance. In order to address these issues, one needs to define the earnings management in accounting and standards setting, to analyze the earning management incentives, and to differentiate the ways to test distribution of reported earnings and accruals.
Defining Earnings Management
There are a number of approaches to defining the specific criteria of the earnings management. The occurrence of earnings management is associated with the different means of judgment. Judgment is used in presenting financial reports or structuring the lists of the transactions of a certain company with the purpose of creating a misleading impression (Schipper 92). It is commonly applied either for giving the wrong impression about the company’s situation to the stakeholders or for attempting to affect the contractual or other outcomes of the company. The latter may often depend on the impression created by the numbers and figures in the financial reports.
However, it is problematic to outline the precise definition of the several aspects of the description of the earnings management. First of all, judgment can occasionally be required for completing the financial report. When reporting the anticipated future economic events and estimated figures that cannot yet be precisely calculated, the specialist that completes the report is supposed to use their judgment.
Therefore, it is hard to define, whether the estimated numbers were presented objectively or in the favor of the company that might want to affect the impression from the report. Thus, only the judgment concerning the objective earnings that are to be reported is included in the definition of the earnings management.
Also, the judgment in financial reporting is used for restructuring the information in order to make it more clear and comprehensible for the users. And it is hard to recognize whether that restructuring can intermediately affect the impression about the financial prospects and performance of the company. Therefore, the most objective and precise criterion is the intentional misleading, in which some information is undisclosed or presented in the manner that would make it incomprehensible or harder for the users to draw their own conclusions. Otherwise, when the earnings management is used on a small scale with the only purpose of making the reports more informative and presentations more productive, there is no necessity of altering the standards of financial reporting.
Earnings Management Incentives
It is challenging, for the researchers, to determine the criteria of how to recognize whether the earnings management took place since it requires the analysis of the earnings before the financial report was drawn. The incentives that tend to affect the scale at which the earnings management takes place may include “capital market expectations and valuation, contracts written in terms of accounting numbers; and antitrust or other government regulation” (Healy and Wahlen 370).
Capital market motivations include the expectation and valuation aspects. It is common practice for the investors and stakeholders to analyze the company’s performance on the basis of the accounting valuation (Jones 194). Therefore, the perspective of the earnings management is tempting for the managers in order to create the impression of the company’s short-term stable performance. It also creates an incentive of managing earnings for the better performance at the stock market and potential appeal to new stakeholders. Among the accruals that are managed in this case, there are loan loss reserves and claim loss reserves (Hirst and Hopkins 48).
The contractual incentive occurs when the data from accounting reports is used for monitoring, regulating and renewing the contracts. This type of earnings management needs the attention of the standards setters because it can intermediately lead to the resource allocation (Smith and Warner 154).
In the case of the governmental or industry-related regulations, the incentive is dictated by the possibility of avoiding anti-trust or other restrictions. This area is highly controlled by the standard setters because, on the larger scale, it can create a financial turmoil in the whole industry.
Distribution of Reported Earnings and Accruals
The reported earnings are most likely to be the subject of the earnings management when the company has to declare loss. However, it is difficult to find out that the company was experiencing losses if the information is not properly reflected in the accounting reports and accruals. Some types of unexpected components of the accruals tend to be associated with the earnings management, including “loan loss provisions for banks, claim loss reserves for property-casualty insurers, and deferred tax valuation allowances” (McNichols and Wilson 9). Nevertheless, the methods of testing the distribution of earnings management among the accruals need further investigation.
Conclusion
In conclusion, the main criterion for defining the earnings management is the intentional restructuring the information in the financial reports in order to mislead the stakeholders, investors, contractors, or governmental bodies. Such practices should be monitored by the standards setters since they are dangerous for the economy on many levels. The area that requires further investigation is defining tests for discovering the earnings management in the accruals.
Works Cited
Healy, Paul M., and James M. Wahlen. “A review of the earnings management literature and its implications for standard setting.” Accounting horizons 13.4 (1999): 365-383. Print.
Hirst, D. Eric, and Patrick E. Hopkins. “Comprehensive income reporting and analysts’ valuation judgments.” Journal of Accounting Research 36 (1998): 47-75. Print.
Jones, Jennifer J. “Earnings management during import relief investigations.” Journal of accounting research (1991): 193-228. Print.
McNichols, Maureen, and G. Peter Wilson. “Evidence of earnings management from the provision for bad debts.” Journal of accounting research (1988): 1-31. Print.
Schipper, Katherine. “Commentary on earnings management.” Accounting horizons 3.4 (1989): 91-102. Print.
Smith, Clifford W., and Jerold B. Warner. “On financial contracting: An analysis of bond covenants.” Journal of financial economics 7.2 (1979): 117-161. Print.