Managing Earnings or Cooking the Books

History is full of instances where management have used their financial reporting discretion to camouflage poor performance or create the illusion of spectacular growth by employing accounting irregularities. These irregularities may be named as aggressive accounting, earnings management, income smoothing, fraudulent financial reporting or creative accounting practices. While they may vary in the degree to which they misreport financial results, they have similar effects; financial statements which serve as a foundation for decision makers are incorrect, improper, and worse, misleading.

The subject of “creative accounting” (also referred to as “earnings management”) was dramatically brought to the attention by Arthur Levitt, former Chairman of the Securities and Exchange Commission, in a September 1998 speech at New York University. Mr. Levitt’s talk was titled “The Numbers Game”, and in it he provided current examples of “creative accounting” and also challenged “the broad spectrum of capital market participants, from corporate management to Wall Street analysts to investors, to stand together and reenergize the touchstone of financial reporting system: transparency and comparability.” Since this speech, the SEC and other authorities all over the world have launched a number of initiatives aimed at reducing creative accounting.

What is Earnings Management?

Earnings (sometimes called “net income” or “bottom line”) are the most important element of financial statements. Increased earnings are the indication of increased company value while decreased earnings could be a significant indicator of a decrease in that value. Given the importance of earnings, it is no surprise that company management has a vital interest in how earnings are reported in financial statements. Therefore, it is also no surprise that they will need to understand the impact of their accounting choices so that they make the best decision for the company.

I have checked the definition of earnings management from different sources for this article. For example; in accordance with C. Mulford and E. Comiskey, earnings management is the active manipulation of accounting results for the purpose of creating an altered impression of business performance. As stated in many sources, earnings management may also be defined as “reasonable and legal management decision making and reporting intended to achieve stable and predictable financial results”, therefore, earnings management should not to be confused with illegal activities to manipulate financial statements and report results that do not reflect economic realities. These types of activities, popularly known as “cooking the books” involve misrepresenting financial results.

Motivations for Managing Earnings

There is a reasonable amount of research, in addition to evidence, indicating that companies manipulate financial reporting outcomes in response to a wide range of factors including the desire to meet or beat shareholders’ earnings expectations, incentives to maximize compensation tied to earnings outcomes, capital market pressures for superior growth or avoiding debt covenant violation.

Closer Look to Earnings Managements

The aggressive accounting is the choice and application of accounting principles in a forceful and intentional fashion, in an effort to achieve desired results, typically higher current earnings, whether the practices followed are in accordance with generally accepted accounting principles or not. Aggressive accounting practices are labeled as fraudulent financial reporting when fraudulent intent has been alleged in an administrative, civil, or criminal proceeding.

Like aggressive accounting, earnings management entails an intentional effort to manipulate earnings. However, the term earnings management typically refers to steps taken to move earnings toward a predetermined target, such as one set by management, a forecast made by analysts, or an amount that is consistent with a smoother, more sustainable earnings stream. As such, earnings management may result in lower current earnings in an effort to “store” them for future years. Income smoothing is a subset of earnings management targeted at removing peaks and valleys from a normal earnings series in order to impart an impression of a less risky earnings stream.

The creative accounting practices are practices that might be used to adjust reported financial results and position to alter perceived business performance. As such, aggressive accounting, both within and beyond the boundaries of generally accepted accounting principles, is considered to be included within the collection of actions known here as creative accounting practices. Also included are actions referred to as earnings management and income smoothing. Fraudulent financial reporting is also part of the creative accounting practices.

Earnings Management within the Boundaries of GAAP

There are no authoritative listings of actions that could be considered earnings management. Rather, those suggested usually are identified simply by considering areas of flexibility within GAAP and anecdotes based on experience. A sampling of possible earnings management techniques or accounting activities that might be used for earnings-management purposes is provided in the Exhibit.

Items listed in the Exhibit are routine accounting activities that are an essential part of the implementation of GAAP. While the activity is required in the implementation of the requirements of GAAP, each of these areas has a characteristic in common: the need to exercise varying degrees of estimation and judgment. It is this feature, among others, that former SEC chairman Levitt no doubt had in mind when he declared that “Flexibility in accounting allows it to keep pace with business innovations. Abuses such as earnings management occur when people exploit this pliancy. Trickery is employed to obscure actual financial volatility.”

For example, consider item dealing with determining the allowance for uncollectible accounts. There is some evidence that companies may use the adjustment for bad debt expenses to manage earnings. An earnings shortfall might be avoided simply by booking a somewhat lower bad debt adjustment. The degree of uncertainty in making such an accrual is great, and it would be difficult to demonstrate that the adjustment was understated.

Item dealing with restructuring accruals, has received considerable attention as a possible earnings management tool. The pattern is to overstate the restructuring accrual and then reverse a portion of it into earnings if needed to reach an earnings target. As with the loss accrual, the degree of uncertainty and the need for the exercise of considerable judgment makes it very difficult to demonstrate that the charge is overstated.

Earnings Management Activities

• Determining the allowance required for uncollectible accounts or loans receivable
• Judging the need for and the amount of inventory write-downs
• Estimating the amount of a restructuring provision
• Determining the presence of impaired assets and any necessary loss accrual
• Estimating the stage of completion of percentage-of-completion contracts
• Estimating the likelihood of realization of contract claims
• Determining the allowance required for warranty obligations or any claims
• Deciding the extent to which various costs such as advertising, software development, production costing etc. should be capitalized
• Changing depreciation methods, (e.g., accelerated to straight-line)
• Changing the useful lives used for depreciation purposes
• Determining or changing the amortization periods for intangibles
• Deciding on the valuation allowance required for deferred tax assets
• Estimating write-downs required for certain investments
• Estimating environmental obligation accruals
• Making or changing pension actuarial assumptions
• Determining the portion of the price of a purchase transaction to be assigned to acquired in-process research and development

Is Earnings Management Good or Bad?

The critical point here is that steps taken to manage earnings can range from the employment of conventional GAAP flexibility to behavior that goes well beyond GAAP boundaries and into the dark realm of fraudulent financial reporting.

The question is when does playing the numbers become fraud? If carried too far, efforts to manage earnings result in misstatements or omissions of material amounts or proper disclosures so this may be considered as “cooking the books”. The actions are intended to deceive the users of the financial statements. The terms “accounting irregularities” and “fraudulent financial reporting” often are used to describe such activities.

Beyond the boundaries of conventional GAAP, according to Mr. Levitt, is a “gray area where the accounting is being perverted, where managers are cutting corners, and where earnings reports reflect the desires of management rather than the underlying financial performance of the company.” Presumably, a black area lies beyond the gray. Movement from gray to black raises the likelihood of action which is bad.