Earnings management

Earnings Management, Mohammad Jafariramsheh July 2011 Introduction In order to discuss earnings management and what its effects are on business and whether or not it's a good thing, we must first understand what earnings management really is. Earnings are one of the most important things in the financial statement. Increased eranings represent a rise in company value, while decreased earnings indicate a decline in that value. Regarding the importance of earnings, there is no wonder that the company managers are highly intrested in how earnings are reported. In the companies where managers attempt to alter and misrepresnt the financial performance or the true income and assets in order to present a more favorabale image of the company, earinings managemnet occurs. Generally, incentives for earnings management include explicit contract such as bonus plans, and debt covenants, implicit contract, capital markets and need for external financing, the political and regulatory process, and some specific circumstances such as earnings decreases or losses. Earnings management may lead to misrepresentation of financial information as a result of conflicting interests between the agent and principle. The paper discuss earning management concept and the question “ Is earnings management good or bad?”. Literature Review Much of the literature about earnings management presents some information about the most important questions asked by standards setters, involving whether earnings management is commonplace and ordinary or occurs infrequently and rarely, which accruals are the focus of earnings management and what are the effects on resource allocation decisions. This information is necessary to evaluate the pervasiveness of earnings management and the integrity and truthfulness of financial reports. The focus in the past research of earnings management has been mainly on finding whether earnings management exists and when. Researchers have examined a wide range of measures of earnings management and samples from firms where the motivations to manage earnings are expected to be high. Studies have shown that earnings management does exist and it occurs for different reasons. These reasons include influencing capital market expectations and valuation, to increase management’s compensation, to avoid violating contracts written in terms of accounting numbers, and to reduce regulatory costs and some other reasons that will be discussed in the next parts. Research has approved that earnings management as a problem needs more attention by standards setters and regulators, but before these they can try to fix the situation, they will need to do a broad research to determine which accounting standards are being managed, the frequency and impact of earnings management, and what factors limit earnings management. Although we are known that earnings management exists, it is difficult to report and document it. The main reason being that to prove that earnings have been managed researchers must first determine what earnings should have been before the effects of earnings management. One approach that has been used is to identify conditions in which managers’ incentives to manage earnings are high. It is clear that earnings management is still a new topic that it is only beginning to be explored. Future research will not focus simply on whether or not earnings management exists, but will expand the questions to include the dimensions and frequency of the earnings management and the effect that earnings management has on stock prices and resource allocation. Analysis and Findings Earnings management is the process by which management can potentially manipulate the financial statements to represent what they wish to have happened during the period rather than what actually happened (Scott 2009). Earnings management occurs in corporations where managers attempt to present a more favourable financial picture of the company performance through discretionary accruals (Aini, Takiah, Pourjalali & Teruya, 2006). Managers use flexible accounting principles to manage earnings (Davidson III, Jiraporn, Kim & Nemec, 2004). Previous studies on earnings management mainly focus on identifying incentives for managers of listed companies to manage earnings (Bauwhede, Willekens & Gaeremynck, 2003). Incentives for earnings management include explicit contract such as bonus plans (Gaver, Gaver & Austin, 1995) and debt covenants (DeFond & Jiambalvo, 1994), implicit contract (Bowen, DuCharme& Shores, 1995), capital markets and need for external financing (Teoh, Welch & Wong, 1998a), the political and regulatory process (Han & Wang, 1998) and some specific circumstances such as earnings decreases or losses (Burgstahler & Dichev, 1997). Earnings management may lead to misrepresentation of financial information as a result of conflicting interests between the agent and principle. Two of the most important researches and articles about earnings management are done at the end of 1990s and current decade by Schipper at 1989 and Healy and Wahlen at 1999. “the process of taking deliberate steps within the constraints of generally accepted accounting principles to bring about a desired level of reported earnings.”( Schipper, 1989) And Schipper defines earnings management from accounting numbers view as: “…a purposeful intervention in the external financial reporting process, with the intent of obtaining some private gain (as opposed to, say, merely facilitating the neutral operation of the process).”…”A minor extension of this definition would encompass ‘real’ earnings management, accomplished by timing investment or financing decisions to alter reported earnings or some subset of it.” Schipper’s definition of earnings management was limited to the external financial reporting process. Schipper also believes that in a view of accounting numbers as information, earnings management in other words can be expressed as disclosure management as a result of managed earnings is the intervened external financial reporting. ‘Earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers’ (Healy and Wahlen, 1999, p.365). Healy and Wahlen’s definition of earnings management further structure managers’ intention to guide the external view to mislead the shareholders about firms’ financial performance. Healy and Wahlen defined three different incentives for earnings management: capital market expectations and valuations, contracts written in terms of accounting numbers and antitrust or other government regulation. They concluded that research has not been able to help standard setters in their attempts to control earnings management nor to provide evidence on the extent and scope of earnings management practices. In this part, some points about good and bad side of earnings management according to Scot(2009) and Hanna(1999) will be described. Good Side of Earnings Management Contract-based arguments(Scot 2009) ,[object Object]

Contract violation is costly, earnings management may be low-cost way to work around.Investor-based arguments(Scot 2009) To communicate inside information to investors ,[object Object]

Discretionary accrual management as a way to credibly reveal management’s inside information about earnings expectations.

Manager foolish to report more earnings than can be maintained.

Manage reported earnings to an amount management expects will persist.The Bad Side of Earnings Manegement Financial Reporting Perspective(Hanna 1999) ,[object Object]

Implies manager not penalized for non-core charges, such as writedowns, provisions for restructuring.

But current non-core charges increase core earnings in future years, through lower amortization and absorption of future costs.Recommendation To the Auditing Standards Board: ,[object Object]

Earnings management

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Earnings management