Earnings Management Paper

Earnings management paper.

This paper discusses “whether and/or when a company should manage its earning (and why or why not)”. First a brief definition of earnings management will be given with the different patterns of earnings management.  Afterwards the paper deals about concrete applications (and the underlying motivations) of earnings management  and their likeliness. Only the possible and relevant good earnings management cases will be discussed briefly. Finally a conclusion will be made whether if bad earnings management is irreversible and what can be done.

Definition Earning management:

Patterns Earnings Management. There are different patterns in Earning management that are recognizable. The first one is bath. The second one is income minization. The third one is income maximization and the last one income smoothing.

“The contract-based motivation”. The first motivation worth to mention to manage earnings for a company is the contractual motivation. By managing earnings, a firm tries to obtain some flexibility concerning rigid and incomplete contracts. This contract-based argument is, in my opinion certainly a valid argument because it’s related with important principles of contract law. Moreover, there are circumstances where managing earnings can be a remedy to mitigate the application of new accounting standards (that were enacted after the contracting date). If not, the contract could be violated, which would have costly consequences. A good example are the debt covenant contracts (“the debt covenants hypothesis” of Dichev & Skinner (2002) )^[1]: new accounting standards (e.g.: with reduction of net-income/increase liabilities as a result) may increase the probability of a debt covenant violation. Such contract violations are extremely costly for a firm, and managing the earnings could be the solution for a low-cost way to work around. In those situations, a firm should (and should be allowed to) manage its earnings because the new circumstances were, certainly in case of enactment of new accounting standards, not foreseeable around the time the contract was concluded. Another example that strengthens the case of “good earnings management” is the bonus plan hypothesis^[2]. Considering a sudden change in accounting standards, the management incentive plans could not be adapted in the short run with the result that the accounting policy changes could affect the levels and/or variablilty of bonuses. Therefore an efficient contractual behavior (by the firm, their managers,…) could be possible (and even highly desirable) with earnings management, and is for that reason a good side of earnings management. Undoubtedly, this has to be within reasonable range, meaning in  best interests of contracting parties and shareholders.