Some Issues About Earnings Management

Some issues about earnings management

Before we consider the meaning of earnings management, we should firstly think about the reasons why this topic deserves our discussion. Actually, earnings management is a pivotal issue in the modern finance management. In nowadays commercial society, managers often make full use of earnings management to achieve the expected figures in the balance sheet or the income statement for different purposes.

Managers have a lot of reasons to do it. If managers use earning management to increase profits of their companies, they can get more bonuses when managerial compensation contracts are done. Besides, managers can choose earnings management to disguise the truth that they make less effort for the benefits of companies than they are required or expected to. Of course, managers on some occasions activate earnings management not only for themselves. There is a significant correlation between figures in financial statements and market reaction, which leads management to earnings management. Specifically, if a company’s performance reflected on the financial statement does not meet analysts’ forecasts, the share price of the company may suffer from a sharp decrease and thus confidence for bankers to lend money to the company may soon collapse. The value of the company may then be damaged and the cash flow is threatened without the use of earnings management. Last but not least, earning management can act as a tool of signaling inside information to outsiders. By publishing steady and increasing earnings over several periods, outsiders may be more easily to determine the situation of the company and the securities market can react accordingly if the market is efficient.

As a result, we can draw the definition of earnings management from different purposes of earnings management and what managers really do about the earnings management. Earnings management, also known as earnings manipulation, is an accounting sleight of hand that managers use to meet earnings expectations. This is achieved by altering information and financial reports (Goel & Thakor, 2003) . To illustrate, earnings management contains two choices: accounting choice and real actions.

Earnings management has various kinds of patterns to apply for. And we can classify them as four main patterns: taking a bath, income minimization, income maximization and income smoothing . Taking a bath means that a company prefer to enlarge the deemed loss on one year in order to add the possibility of profit for coming years. Income minimization, though similar to taking a bath, does not go so far as taking a bath. On the other hand income maximization is to maximize the reported net income. And we can get the idea from the literate word “smoothing” of income smoothing, which makes the profits on the financial statements being relatively constant over periods.

Managers sometimes use real activities