The Pros And Cons Of Earnings Management

Earnings Management is the concept where through the use of accounting methods under the generally accepted accounting principles (GAAP) standard set by FASB, companies are able to skew the results on their financial statements to look more favorable, create a positive view of the company’s financial standing and operation. Paul Rosenfield, a CPA who was the director of the AICPA accounting standards, says that GAAP is a system that has two flaws in regard to earnings management; realization and allocation. The first flaw, realization, is a flaw because under GAAP allows for assets and liabilities such as purchases, payments, sales, etc. to be changed to the advantage of the company. For example a company may change the cost flow assumption

External financing such as the use of loans would have a lower interest rate for companies that have a better financial standing and so companies exploiting the flaws would receive better external financing opportunities than if they didn’t exploit the flaws. In a scholarly article written by Dechow, Sloan and Sweeny they found factors that would have firms be tempted to manipulate earnings to reap the benefits. These factors are in which the company is more likely to; have a board of directors be dominated by management, have a CEO that’s also the chairman of the board, have a CEO that was the company’s founder and less likely to have an audit committee and an outside

These changes would make the company’s net worth much higher than it actually is which would encourage shareholders to invest more in that company because it seems to be doing very well. The fraud triangle is the motivations of people who commit fraud and these factors are opportunity (when people are in a position which would give them the ability to commit fraud), pressure (when people feel the need to commit fraud due to some sort of internal or external factor like debt) and rationalism (when people commit fraud due to faulty logic such as they need money now but will pay back later).
Earnings Management and Fraud both have similar definitions in which they are done to put the company in a more positive view of financial standing. The difference is that earnings management is legal through the flaws under GAAP that allows companies to be able to do so. Fraud is not legal and at times is bluntly changing numbers instead of changing the method of getting the number like it is done in earnings management. But there is a very fine line between these two as a company managing their earnings could easily do a bit more to commit fraud instead of just managing their earnings