What Is Earnings Management?

Earnings management is the use of accounting techniques to produce financial statements that present an overly positive view of a company's business activities and financial position. Many accounting rules and principles require that a company's management make judgments in following these principles. Earnings management takes advantage of how accounting rules are applied and creates financial statements that inflate or "smooth" earnings.

Understanding Earnings Management

Earnings refers to a company's net income or profit for a certain specified period, such as a fiscal quarter or year. Companies use earnings management to smooth out fluctuations in earnings and present more consistent profits each month, quarter, or year.

Large fluctuations in income and expenses may be a normal part of a company's operations, but the changes may alarm investors who prefer to see stability and growth. A company's stock price often rises or falls after an earnings announcement, depending on whether the earnings meet or fall short of analysts' expectations.

Management can feel pressure to manage earnings by manipulating the company's accounting practices to meet financial expectations and keep the company's stock price up. Many executives receive bonuses based on earnings performance, and others may be eligible for stock options when the stock price increases.

Many forms of earnings manipulation are eventually uncovered either by a certified public accountant (CPA) firm performing an audit or through required Securities and Exchange Commission (SEC) disclosures.

Examples of Earnings Management

One method of manipulation when managing earnings is to change to an accounting policy that generates higher earnings in the short term.

For example, assume a furniture retailer uses the last-in first-out (LIFO) method to account for the cost of inventory items sold. Under LIFO, the newest units purchased are considered to be sold first. Since inventory costs typically increase over time, the newer units are more expensive, and this creates a higher cost of sales and a lower profit.

If the retailer switches to the first-in first-out (FIFO) method of recognizing inventory costs, the company considers the older, less-expensive units to be sold first. FIFO creates a lower cost of goods sold expense and, therefore, higher profit, so the company can post higher net income in the current period.

Another form of earnings management is to change company policy so more costs are capitalized rather than expensed immediately. Capitalizing costs as assets delays the recognition of expenses and increases profits in the short term.

Assume, for example, company policy dictates that every item purchased under $5,000 is immediately expensed and costs over $5,000 may be capitalized as assets. If the firm changes the policy and starts to capitalize all items over $1,000, expenses decrease in the short-term and profits increase.

Special Considerations

A change in accounting policy must be explained to financial statement readers, and that disclosure is usually stated in a footnote to the financial statements. The disclosure is required because of the accounting principle of consistency.

Financial statements are consistent if the company uses the same accounting policies each year. This is important because it allows the financial statement user to easily identify variations when looking at the company's historical trends. The fact that a change in policy must be explained and that all of a company's accounts are laid bare in its financial statement means that careful readers will likely discover the earnings management strategy. The problem is that not everyone has the time to go over reports in full or the knowledge to understand everything that is written.

The Bottom Line

Investors should always do their homework before investing in a stock. That means analyzing the company’s financial report to get a true picture of how it is doing. Don’t just fixate on the headline numbers the company wants you to read or trust that analysts or somebody else will do the job on your behalf. Go through everything yourself and do it with a skeptical eye.