Introduction
Financial statements provide useful information to a wide range of users. These users include shareholders, owners, investors, suppliers, managers, government and creditors etc. Many users rely on the information from financial statements to make decisions. Therefore, financial statements should be relevant, provide faithful representation, comparability, verifiability, timeliness and understandability. However, there are different evidences of managers manipulating the earnings for various reasons. “Earnings management is the choice by a manager of accounting policies, or real actions, affecting earnings so as to achieve some specific reported earnings objective” (Scott, 2012, p. 423). Managers play an important role in the company because they have control over the accounting policies, thus, the managers can manipulate the income. There are different viewpoints about earnings management. Some people think it will protect the company’s interests to allow the managers to manage the earnings, and others oppose it.
There is a good side and bad side of earnings management, and each side of earnings management will lead to different outcome. This paper is going to present some of the motives why managers use various method to manage the income, explain the benefits and costs of allowing managers to manage earnings for the companies.
Motives of Earnings Management
There are reasons and motives for managers engage in earnings managements. Many studies presented that mangers would manage earnings for personal interests, companies’ interests or both interests. Scott (2012) summarized the earnings management methods as taking a bath, income minimization, income maximization and income smoothing. Managers u...
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Munter, P. (2001, January 17). SEC sharply criticizes “earnings management” accounting. The journal of corporate accounting and finance. Retrieved from http://www.csus.edu/indiv/l/lundbladg/ACCY%20113/113_WA/SEC%20Sharply....pdf
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Scott, W. R. (2012). Financial accounting theory (6th ed.). Toronto, ON: Pearson.
Management accounting in organisation is very important for decision-making and to make the business more efficient and therefore increasing its profits. Is the process of preparing accounts that can help managers to make day-to-day and short-term decisions, by providing them with accurate and timely key financial and statistical information...
Is the current economic environment forcing managers into a difficult position? The slowing of the general economy or industry-specific economic conditions decreases sales while increasing bad debts and obsolete inventory. The operating performance decline is amplified by the reversals of prior-period accruals based on recent experience. The original accounting estimates were made under very different economic conditions. As the economy or industry slows, managers may find it increasingly difficult to meet the earnings objectives set during the boom times.
Marshall, D.H., McManus, W.W. & Viele, D.F. (2011). Accounting: What the numbers mean (10 ed). New York, NY: The McGraw-Hill Companies, Inc.
... tempted to falsely inflate earnings is to take away their personal gains, if the company's stocks go up. I believe that when upper level management has too much incentive based on personal financial gain, which is directly based on the performance of the company; it compromises their judgments. I think that upper level management should not be allowed to receive stock options or to even own stock in the company as the financial statements would provide a neutral, bias-free report. Management would have no reason to "cook the books." I also feel that any management who still decides to falsify documents needs to be held more accountable for their actions and receive tougher punishments. I think that these strict guidelines would help the people in the United States and people all over the world feel more confident in investing their money into the stock market.
Marshall, M.H., McManus, W.W., Viele, V.F. (2003). Accounting: What the Numbers Mean. 6th ed. New York: McGraw-Hill Companies.
Management/Preparers of financial statements may have a number of factors that motivate them to manage earnings aggressively. The ultimate motive for earnings management, however, is to aesthetically enhance the performance of a company in the eyes of its stakeholders (Essays, UK,
Garrison, R. H., Noreen, E. W., & Brewer, P. c. (2010). Managerial Accounting. New York: McGraw Hill/Irwin.
Earnings management occurs when a manager, or managers, use his or her judgment, in financial reporting, to alter the company’s financial reports. The manager purposefully structures the transaction(s) to favorably alter the financial statements and mislead stakeholders about the company’s economic performance or, to influence contractual outcomes, which depend on the reported accounting numbers (Brown, 2015).
According to the conceptual framework, the potential users of financial statements are investors, creditors, suppliers, employees, customers, governments and agencies, and the general public (Financial Accounting Standards Board, 2006). The primary users are investors, creditors, and those who advise them. It goes on to define the criteria that make up each potential user, as well as, the limitations of financial reporting. The FASB explicitly states that financial reporting is “but one source of information needed by those who make investment, credit, and similar resource allocation decisions. Users also need to consider pertinent information from other sources, and be aware of the characteristics and limitations of the information in them” (Financial Accounting Standards Board, 2006). With this in mind, it is still particularly difficult to determine whom the financials should be catered towards and what level of prudence is necessary for quality judgment.
Financial reporting quality is related to the overall quality of the financial statements including disclosures which depict the fair presentation of the firm. Whereas in low financial reporting quality accounting figures are distorted or changed in such a way that their economic underlying reality is not correctly exhibited. For instance if the depreciable life of an asset is estimated in such a way which contradicts with its real economic life then it can be said that financial reporting quality is affected. In many cases there are alternatives available in the accounting standards or estimation and judgment is involved of the management. However, management can exploit these alternatives or judgments to change figures according to their desired outcome. For instance if management want to show lower earnings they can choose alternatives between inventory valuation methods (LIFO in case of rising prices) or lower depreciable lives. Management is usually in a position to manipulate figures because they are the ones who are responsible for preparing financial statements. American ...
Reichelstein, S. (2000). Providing Managerial Incentives: Cash Flows versus Accrual Accounting. Journal of Accounting Research, 38(2), 243.
Marshall, D. H., McManus, W. W, & Viele, D. (2002). Accounting: What the Numbers Mean. 5th ed. San Francisco: Irwin/McGraw-Hill.
Schipper, K 1989, ‘Commentary on Earnings Management’, Accounting Horizons, Vol September, pp. 91-103, retrieved 2nd January 2014, EBSCOHost database.
If we look at the contribution of Accounting to Financial Economic Thought, the initial idea of an individual, a firm or an economy is obtained on the basis of Financial Accounting information provided. An in-depth understanding of the financial accounting information provided will guide the decisions towards an optimal resource allocation.
Marshall, D., McManus, W., & Viele, D. (2004). Accounting: What the numbers mean. [University of Phoenix Custom Edition e-text]. New York, NY: McGraw-Hill Companies.