What Is Earnings Management?

What is Earnings Management?

Having a concrete understanding of what earnings means will improve the understanding of what earnings management means.  Earnings are how much profit a company makes during a specific period. In the future, a company’s profit plays a great part in determining a stock’s price.

There are a lot of earnings management issues in a capital marketing environment. Earnings management can something led to accounting and financial reports frauds, when it is carried to the extreme. In this case, SEC (Securities and Exchange Commission) may issue fines to the company as a form of punishment. Financial reports show the performance and condition of a company, which allows making decisions on the next step in the company’s favor.  Decisions making on situations in respect to management such as if the company should invest, disinvest, and/or change pricing. Every company has to deal with the issues of maintaining integrity of their financial systems and protecting their assets.  

Earnings management is making accounting choices related to some objectives other than transparency. Transparency means designing the financial reports to portray a transparent clear picture of the economic activities of the business. Investors are interested in transparency in regard to financial reports in an accounting point of view.

When a public company is covered by analysts, they build expectations about that company’s performance over the next few years. Analysts will make earnings forecast, usually earnings per share for a company. Some companies will provide official guidance to analysts, but others do not. Some companies will even make some range of potential earnings forecast that they think they may achieve themselves. On the other hand, some companies may not formally state anything about their performance. However, analysts except companies to provide some guidance so if their earnings forecast are off, especially if the earnings forecast is too high somehow the company let them know about it. This is because analysts dislike earnings disappointments and they will punish companies for it since they feel that the company doesn’t have enough information to help them not be wrong on the down side with their earnings forecast. So, analysts discount their future earnings potential which result in unusually large decreases often times in stock prices following earnings disappointments.

The important question is what makes companies and management manipulate earnings? There are so many reasons behind why companies try to fake the picture of their financial position and business activities.

Reasons:

• To meet financial analysts’ earnings forecast.
• To raise the stock price.
• To receive compensation based on earnings performance.
• To smooth net income to look like the company’s earnings are increasing. etc.

There are many techniques used to manage and manipulate earnings:

Cookie Jar Reserves Technique

A company may use the Cookie Jar Reserves technique to reserve or put money aside during a good year to use during a bad year to make its profitability seem smoother. Also, it is to ensure the company’s ability in always meeting its targeted forecast. So, basically the Cookie Jar Reserves technique is away for a company to mislead investors. Therefore, for this very reason Cookie Jar Reserves is forbidden by SEC and US Securities.