Techniques, Motives and Controls of Earnings Management
Introduction
Earnings management is recognized as attempts by management to influence or manipulate
reported earnings by using specific accounting methods (or changing methods), recognizing one-
time non recurring items, deferring or accelerating expense or revenue transactions or using other
methods designed to influence short term earnings. So, Earnings management can be defined as the
accounting policies or the accruals control, chosen by the management of enterprises to make the
earnings reach the expected level under the pressure from the relevant stakeholders and the
constraints of generally accepted accounting principles (GAAP). In addition to the choice of
accounting policy and the control of accruals, the means of earnings management have also included
lobbying for the regulatory organization to modify the accounting principles and the manipulation of
profit figures in the fiscal report.
The most successful and widely used earnings management techniques can be classified into twelve
categories. Here some of the most common categories are described below:
i. “Cookie jar reserve” technique: The cookie-jar technique deals with estimations of future events.
Under the cookie-jar technique, the corporation will try to overestimate expenses during the current
period to manage earnings. If and when actual expenses turn out lower than estimates, the
difference can be put into the "cookie jar" to be used later when the company needs a boost in
earnings to meet predictions.
ii. “Big Bath” Techniques: If the management record estimated charge (a loss) against earnings for
the cost of implementing the change then it will negatively affect the cost of the share price. But the
share price may go up rapidly if the charge for restructuring and related operational changes is
viewed as positively. So managers are expected to inform about the loss incurred all ant once and
finish it.
iii. “Big Bet on the Future” technique: The acquiring company in acquisition can write off continuing
R&D costs against current earnings in the acquisition year, protecting future earnings from these
charges. This means that when the costs are actually incurred in the future, they will not have to be
reported and thus future earnings will receive a boost.
iv. “ Flushing” the investment portfolio: To achieve strategic alliance and invest their excess funds, a
company buys the shares of another company. . Actual gains or losses from sales or any changes in
the market value of trading securities are reported as operating income where as any change in
market value of available for sale securities during a fiscal period is reported in “other
comprehensive income components” at the bottom of the income statement, not in operating
income.
v. “Throw out” a problem child: To increase the earnings of future period, the company can sell the
subsidiary which is not performed well i. e. “the problem child”. The existing shareholders become
the owner of the problem child by distributing or exchanging the shares of a subsidiary with the
current shareholders. As a result, no gain or loss is normally reported on a spin off.
vi. Introducing new standard: New rules and regulations are introduced in GAAP due to changing
demand of business environment. Voluntary early adoption may provide an opportunity to manage
the earnings. A company can take the advantage of manage earnings by changing the time an
accrual basis rather than cash basis those are recorded as expense on a cash basis.
vii. Write off of long term operating Assets: The cost of long term operating assets used or consumed
is recorded as an amortization It is not necessary to record depreciation or amortization expense if
the long term operating asset changed to non operating assets and thus increase earnings.
viii. Sale/leaseback: A company can enhance the earnings of the financial statement by selling a long
term asset that has unrealized gain or losses. According to IAS 17, losses occurring in a
sale/leaseback transactions are recognized on the seller’s book immediately and gain are amortized
over the period if it is capital lease or proportion of the payment is operating lease.
ix. Operating versus non operating Income: Non operating earnings will not affect future earnings
where as operating earnings are expected to continue in the near future. The manager can manage
its earnings when making decisions about items which falling into areas.
x. Early Retirement of Debt: Management can manage the earnings by selecting the fiscal period of
early retirement of debt. A gain or loss is occurred when the company makes the early payment of
cash which is different from the book value of long term debt such as bonds. This gain or loss is
recorded as an extraordinary item at the bottom of the income statement which boost the earnings
of that period.
xi. Use of Derivatives: Derivatives offer a lot of opportunities for manager to manage earnings.
Derivatives can be used to protect against some types of business risk, such as: interest rate
changes.
xii. Shrink the ship: Companies do not have to report any gain or loss for repurchase of their own
shares on the income statement because no income is recognized on the transaction and thus
increase their earnings.
Motives behind earnings management:
The reasons for Earnings management are diverse and range from the intention to satisfy analysts’
expectations to incentives to realize bonuses or to maintain a competitive position within the
financial market. Prior researches identified different categories of incentives:
i. Stock market incentives:The interaction between accounting numbers and stock markets reaction
can indeed push management towards earnings management. Investors often rely on the views and
forecasts of stock market analysts to put together a portfolio of potentially successful firms.
i. Signaling or concealing private information : Failing firms engage in earnings management and
alter their annual accounts to conceal their financial struggle without immediately measuring the
consequences on stock price or CEO compensation.
ii. Political costs: Firms can also manage reported earnings by changing financial statements in order
to influence shareholders’ opinions and decisions.
iii. Personal incentives There might be other than financial motives for the CEO to manage earnings.
Retiring CEO’s use upwards earnings management to leave in style and keep a seat on the board.
iv. Internal motives: Related to motives within the company. Within a company, it might also be
useful to alter financial reports or to structure transactions in such a way that budget ratcheting is
avoided or performance standards are met.
v. Management compensation contract motivations :The management compensation theory, also
known as the bonus plan hypothesis contends that managers are motivated to use earnings
management to improve their compensation, as management bonuses are often tied to the firm’s
earnings.
vi. Lending contracts motivations: the hypothesis is that firms who have a lot of debt have an
incentive to manage earnings so that they do not breach their debt covenants. Banks used loan loss
provisions to manage earnings.
vii. Regulatory motivations: Banks and insurance firms especially are often subject to requirements
that they have enough capital or assets to meet their liabilities. Such regulations may give managers
incentives to use earnings management.
How to control Earning Management
The US Securities and Exchange Commission (SEC) announced that it would promote international
compatibility by allowing foreign companies to access US capital markets while reporting under
IFRS . Moreover, if accounting standards as well as governmental scrutiny do not completely
eliminate earnings management then auditors should be confronted with attempts to alter financial
reports.
Conclusion:
Earnings management is a tool for satisfying self interest of the managers. But, it can be used for the
welfare of the stake holders, if it is ethically used. So, to get the optimum benefit of earnings
management, steps should be taken to improve corporate governance.
