Essay On Earnings Management

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Recommended: Good earnings management

The main basis of this definition involves the interests of management towards stakeholders and contractual outcomes. Earnings management decisions rely on the intent of the managers, which can include reflecting the financial results positively to investors or for the firm to meet contractual obligations. Earnings management is the manipulation, through a selection of accounting policies, to achieve a desired financial reporting result. Accruals can be classified as matching financial activities of a firm to the time that they are incurred rather than when cash is received. Earnings management that manipulates these types of transactions is what essentially composes accrual-based earnings management. Companies can engage in this type of management by increasing or decreasing income by creating accruals, which are often referred as non-discretionary accruals. (2)

There are various techniques which managers can utilize to engage in accrual based earnings management. The basis of accrual-based earnings management is to do with managerial decisions associated with accounting principles that can alter earnings in the current or future period. Accruals created to manipulate these changes in earnings are often referred to as non-discretionary accruals. There are some techniques that allow managers of firms to encompass this method and some examples include revenue recognition, operating expense timing and unrealistic assumptions to estimate liabilities.

Revenue recognition focuses on prematurely recognizing revenue in order to boost current earnings for the period. Recognizing revenue is a method that a manufacturing company can use by recognizing sales before their completion in order to increase revenues reported in that period, ...

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...rnings downwards so that potential future compensation plans can be realized. (8) study states that firms where managers qualify for bonus plans have dramatically smoother earnings changes than those that do not. It also shows that firms with a qualified bonus plan use discretionary accruals to reach earnings targets significantly more than those without a qualified bonus plan.

Another important motivation for firms to engage in earnings management involves debt covenants. This motivation is based on restrictions involved with earnings that are imposed on firms by creditors. Firms have an incentive to avoid violating such restrictions, as in doing so may results in higher interest rates on debt or even immediate debt repayments. (10) study suggests that managers do actively engage in accrual-based earnings management in order to avoid violation of debt covenants.

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