Earnings are normally regarded as one of the most powerful indicators of a company’s business activities. Earnings management refers to the use of different accounting techniques with the aim of producing financial reports that tend to present an extremely positive view of an organization’s financial position and business activities. Most of the accounting principles and rules require the firm’s management to make different judgements.
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Research shows that earnings management tend to take advantage of ways in which accounting rules are normally applied as well as creates specific financial statements that tend to inflate revenue, total assets and revenue.
The different reasons for carrying out earnings management are normally diverse, and tend to range from the intention of satisfying analysts’ expectations to having incentives for purposes of realizing bonuses. In addition, firms carry out earnings management with the intention of maintaining a competitive position within a financial market. There are different motives behind earnings management (Dhole, Manchiraiu & Suk, 2016). This include: stock market incentives, political costs, concealing of private information, personal interests, management contract motivations, regulatory motivations as well as lending contract motivations. Firstly, there is stock market incentives. Research shows that the specific interaction between stock markets and accounting numbers reaction may push the management of a firm towards carrying out of an earnings management. Moreover, investors mostly rely on the forecast and views of stock market analysts with the aim of putting together a specific portfolio containing successfully potential firms. Beating or meeting the forecasts made by analysts seems to be of adequate significance for organizations to take part in earnings management (Da Cunha & Piccoli, 2017).
Therefore, meeting of the analysts’ expectations tends to be vital because companies that beat or meet expectations often enjoy greater returns. Researchers claim that missing of earnings benchmark usually has numerous negative implications for the various stock returns. Therefore, for a company to be able to beat or meet the different forecasts, managers mainly turn to earnings. The second motive are the personal incentives. There are various reasons other than the different financial motives for a CEO to manage the earnings of a company. For instance, a new chief executive officer may trend downwards to earnings management during the year of change and trend upwards earnings management during the years that follow. Research also shows that retiring Chief Executive Officers tend to use upwards earnings management with the intention of leaving in style as well as keeping their seat on the company’s board (Versano & Trueman, 2017).
The third motive for earnings management is referred to as internal motives. These motives are normally not linked to the external stakeholders of a firm such as unions, government and shareholders. However, they are considered intra-company. In addition, within an organization, it might be useful for the one to engage in altering of financial returns or restructuring transactions in a manner that avoids budget ratcheting or tends to meet the various financial standards. Therefore, managers will opt to use what is considered as income-decreasing unexpected accruals especially when the different earnings innovations are regarded as transitory (Vladu, 2015). Those firms that are using standards that are externally determined such as fixed standards, peer group standards or the specific cost of capital are often less likely to smooth earnings when compared to those companies that mainly use internal standards including subjective standards, prior year and budget goals. Another motivation of earnings management is known as management compensation contact.
One of the theories known as management compensation theory or the bonus plan hypothesis tends to contend that managers are usually motivated in using earnings management with the intention of improving their compensation. This is because management bonuses are in most cases tied to a company??™s earnings. Therefore, it is projected that earnings management is normally used for the purposes of increasing income. This means that the organizational managers are most likely to select reports accruals that tend to defer income often when awards on the cap of bonus were arrived at because they had no more profit from extra earnings. Hence, they are better off if they increase income for the coming year at that specific point (Versano & Trueman, 2017). For instance, researchers have revealed that banks that are close to the minimum capital requirements tend to use different earnings management techniques including overstatement of loan provisions, understanding of the loan write-offs as well as recognizing of the abnormal realized gains on the different investment portfolios.
Another motivation of earnings management is lending contracts motivations. The hypothesis of debt covenant is usually based on facts that creditors tend to impose specific restrictions on the dividends payments, share buybacks as well as the issuing of extra debt mostly in terms of the reported accounting ratios and figures with the purpose of ensuring there is the repayment of a company’s borrowing (Henry, Weimin & Jian, 2013). Therefore, the theory is that organizations who have huge debts have the incentive of managing earnings for purposes of not breaching their covenants. Regulatory motivation is another motivation.
Different industries and in particular insurance, utility and banking are normally monitored for purposes of compliance with different regulations that are linked to accounting ratios and figures. Insurance and banks specifically are in most cases subject to different requirements that they have adequate assets or capital for purposes of meeting their liabilities. Therefore, such regulations may end up giving managers of the company various incentives for using earnings management (Katmon & Farooque, 2017). In addition, banks that are close to the minimum capital requirements normally use earnings management techniques including overstatement of loan provisions, realizing abnormal realized gains as well as understanding of the loan write-off on their specific investment portfolios, ostensibly with the purpose of not breaching the various regulatory requirements.
Methods used to manage earnings
Firstly, there is cookie jar reserve method. This method tends to deal with various estimations of the future events. Reports from GAAP reveal that management needs to estimate as well as record obligations that needs to be paid in future due to transactions or events in the present fiscal year which is based on the basis of accruals. However, there are always doubt that surrounds the process of estimation due to the fact the future is never certain at all times. Therefore, there is never a correct answer. This means that the management should select a distinct amount based on GAAP. As a result, there is a huge chance of taking advantage of the earnings management. Based on the cookie-jar technique, a corporation will try overestimating expenses during the present period with the purpose of managing earnings (Dye, 2017). Therefore, in cases where the actual expenses may turn out lower compared to the estimates, the difference may be put inside a cookie jar so that it can be used at a later date when the organization requires a boost in earnings so as to meet predictions.
The different examples of estimations for purposes of managing earnings include: allowances and sales returns, estimation of bad debts, estimation of write downs, write-downs, termination of pension plans as well as the estimation percentage of the completion time for long term contracts and many others. Secondly, there is big bath technique. Despite the fact that this is a rare occurrence, in some cases corporations may end up restricting debt, writing-down assets, as well as changing or closing down a company’s operating segment. In such cases, expenses are normally unavoidable. Whenever the management records estimate a charge against the earnings for the specific cost of the implementation of the change, then it has the ability of negatively affecting the specific cost of share price.
However, the share price may end up going up rapidly if the specific charge for related operational and restricting changes is normally viewed in a positive manner. Based on this particular technique, if a company’s manager has to report news that are bad such the loss incurred from substantial restricting, then he or she is better of reporting all the information at once (Kayame, 2017). The third method of asset management is identified as the big bet on the future. Whenever an acquisition takes place, the specific corporation that is acquiring the company is normally said to have a huge bet on its future. Under the GAAP regulations, the acquisition of a firm should be reported as being a purchase. This in turn tends to leave two opportunities open for the earnings management. Firstly, an organization may consider writing off the continuing research and development costs against the various current earnings made in the acquisition year.
This in turn tends to protect the organization’s future earnings from such charges. As a result, when such costs are incurred in the future, then it is not a must for them to be reported. This means that future earnings will end up receiving a boost. Secondly, a company can claim the different earnings of the newly acquired organization (Mankin, Jewell & Rivas, 2017). Therefore, when the acquired firm is consolidated with the particular parent organizational earnings, then instantaneously they receive a boost in their current annual earnings. This means that through the acquisition of another firm, the parent organization tends to buy a boost that is guaranteed in the future or current earnings through the big bet technique. Another method of earnings management is identified as flushing out the investment portfolio. For a company to achieve strategic alliance as well as invest their extra funds, it should buy the shares of another organization. The two different forms of investment include: available for sale securities and trading securities.
The actual losses or gains from sales particularly in the market value of different trading different securities that are reported as part of operating income. Therefore, a manager can end up managing its earnings via different techniques. Firstly, there is timing of sale of specific securities that are believed to have gained value. The organization can sell a portfolio security which has a gain that is unrealized and can then report the gain as part of the operating earnings when required. Secondly, there are timing sales of different securities that are known to have lost value. Whenever a manager wants to reveal lower earnings then one can sell the security that tends to have unrealized loss and in turn report the loss in terms of operating earnings (Njah & Jarboui, 2013). Thirdly, there is the change of holding intent, write-down impaired securities. This is because management may manage earnings via change of its holdings from those available all the way to sale securities. This in turn would end up having an effect of moving unrealized loss or gain on the security or forming the income statement.
Lastly, there are write-down impaired securities. Research shows that securities that tend to have an evidently long term reduction in the fair market value may be written down to the particular reduced value irrespective of their classification in the portfolio. Another method of earnings management is known as throw out a problem child. Research shows that to increase the earnings of the company in the future period, the organization may sell the particular subsidiary that is not performed well. For instance, the subsidiary known as the problem child may end up being thrown out (Dhole, Manchiraiu & Suk, 2016). Earnings may be managed by selling the subsidiary, exchanging the stock in one of the equity methods subsidiaries as well as spinning off the subsidiary.
In addition, it is possible for the company to swap its stock in one of the equity methods subsidiary instead of having any recordable loss or gain. Introducing new standards is another earnings management method. New regulations and rules are usually introduced inside the GAAP as a result of changing demand on the specific business environment. Accounting principles may be modified in a manner that will not end up changing the earnings. Research shows that when a specific accounting standard has been adopted it tends to take approximately two to three years with the purpose of adopting the specific standard.
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