Earning Management

It is known that the ability to generate profit in the future plays a very crucial role in determining the company's current stock price. "Earnings" is the most important item in the financial statement and a rise in earnings can increase the company's value, build up market expectation to the company and create a higher level of reputation [1]. That is why the management of a company deliberately manipulate its earnings in order to make the figures match pre-determined targets, as what we call "Earnings management". By employing accounting policy choice and real actions, the management is able to "manage" earnings.

It is necessary to point out that earnings management is not everything illegal and unethical. It can be reasonable and legal management decision making and reporting intended to achieve stable and predictable financial results. For example, under GAAP, companies should estimate sale return and allowance to match with revenue. Since normally, there is substantial uncertainty during the estimation process, GAAP permit a range of estimation. Instead of the reasonable estimation, management may select the upper limit of the estimation range in order to record more sales return in current period and less in future. As a result, they potential get an earnings boost. It is legitimate, but it has the potential to reduce the usefulness and transparency of the information.

On the other hand, earnings management which involves intentionally recognizing or measuring transactions in the wrong accounting period or recording fictitious transactions will be considered as fraud. It is the acceptability of an accounting policy under GAAP that draws the line distinguishing reasonable earnings management (including aggressive accounting) from illegitimate fraud. Let's think about the example above again. What if the company records the sales returns and allowance way out the range of the estimate? Or what if the