Earnings Management

Introduction to Earnings Management

• Definition: The strategic use of accounting techniques to
produce financial reports that paint a desired picture of a
company's financial health.
• Ethical Concerns: Earnings management exists on a spectrum
from legal earnings smoothing to outright financial fraud.
• Relevance: Affects investor confidence, stock prices, and
corporate governance.
Types of Earnings Management
• Income Smoothing: Adjusting revenues and expenses to
reduce earnings volatility.
• Big Bath Accounting: Writing off large expenses in a single
period to make future periods look better.
• Cookie Jar Reserves: Overstating expenses in good years to
create reserves for bad years.
• Aggressive Revenue Recognition: Recording sales before
they are actually earned.
• Off-Balance Sheet Financing: Hiding liabilities using special
purpose entities (SPEs).
Motivations for Earnings Management
• Meet or beat analyst expectations.
• Influence stock prices and market perception.
• Enhance executive compensation (bonuses, stock options).
• Avoid violating debt covenants.
• Reduce political scrutiny and tax obligations.
Techniques Used in Earnings
Management
1.Revenue Manipulation
1. Channel stuffing (pushing excess inventory to distributors).
2. Recording fictitious sales.
2.Expense Manipulation
1. Capitalizing expenses that should be recorded immediately.
2. Delaying expense recognition.
3.Asset Valuation Tricks
1. Overstating goodwill and intangible assets.
2. Manipulating depreciation schedules.
4.Liability Management
1. Keeping liabilities off the balance sheet using SPEs.
2. Underreporting pension obligations.
Earnings management technique
Revenue Manipulation Techniques Expense Manipulation Techniques
1. Aggressive Revenue Recognition: 6. Capitalizing Operating Expenses: Moving
Recognizing revenue before a sale is complete regular operating expenses to capital
(e.g., recognizing long-term contracts upfront expenditures to spread the cost over several
instead of spreading revenue over time). years.
2. Channel Stuffing: Forcing distributors to buy 7. Deferring Expenses: Delaying necessary
more inventory than they can sell to inflate expenses (e.g., maintenance, R&D, marketing)
short-term revenue. to make the current period look more
profitable.
3. Bill-and-Hold Transactions: Recording
revenue for products that have been invoiced 8. Reclassifying Expenses: Moving expenses
but not yet shipped to customers. to non-operating costs to make operating
income look stronger.
4. Round-Tripping Transactions: Selling an
asset and buying it back later at the same 9. Underestimating Bad Debt Reserves:
price, artificially boosting revenue. Recognizing full revenue from customers who
may not pay, reducing reported expenses.
5. Recording Fake Sales: Fabricating
transactions that are later reversed but still 10.Pension and Post-Retirement Benefits
boost short-term earnings. Manipulation: Adjusting expected return
assumptions on pension assets to reduce
reported liabilities.
Earnings management techniques
Liability & Asset Valuation Tricks Cash Flow Manipulation
11.Off-Balance Sheet Financing: Using 15.Artificially Boosting Free Cash Flow:
Special Purpose Entities (SPEs) to hide Delaying payments to suppliers or
debt (e.g., Enron’s infamous use of accelerating collections from customers to
SPEs). show stronger cash flow.
12.Overstating Inventory Values: Reporting 16.Misclassifying Cash Flows: Shifting
inflated inventory levels to reduce cost of financing cash flows (e.g., short-term
goods sold (COGS) and increase profits. loans) into operating cash flow to make
operations appear healthier.
13.Manipulating Goodwill & Asset
Impairments: Avoiding impairment 17.Timing Loan Drawdowns: Drawing on
charges on overvalued goodwill and credit lines before reporting dates to
intangible assets to keep reported inflate cash balances.
earnings higher.
14.Understating Liabilities: Hiding
obligations such as lease commitments,
pending lawsuits, or deferred
compensation.
Earnings management techniques
Stock & Shareholder Manipulation
18.Stock Buybacks to Inflate EPS:
Using share repurchases to
artificially reduce the number of
shares outstanding, making
earnings per share (EPS) look
better even if net income remains
unchanged.
19.Changing Share-Based
Compensation Treatment:
Adjusting the way stock-based
compensation is recorded to
impact expenses and net income.
Earnings Management vs. Fraud
• Earnings Management: Exploiting accounting flexibility within
legal boundaries.
• Fraud: Intentional misrepresentation or falsification of financial
statements.
• Boundary Line: When earnings management crosses into
fraud, regulatory bodies like the SEC take enforcement actions.
Detection and Prevention
• Red Flags for Investors & Auditors:
• Large one-time adjustments.
• Frequent changes in accounting methods.
• Sudden revenue spikes near quarter-end.
• Regulatory Measures:
• Sarbanes-Oxley Act (SOX) to enhance financial transparency.
• Stricter auditor oversight and independent board governance.
• Best Practices:
• Strong internal controls.
• Ethical corporate culture.
• Transparent financial disclosures.
Examples: Apple – Ethical Revenue
Deferral
• Earnings Management Type: Revenue deferral for subscription-
based products.
• What Apple Did:
• Apple recognizes a portion of iPhone revenue over time instead of all at
once.
• AppleCare and service-related revenue are recognized gradually to reflect
the delivery of services.
• Impact on Financials:
• Smooths revenue over multiple quarters, reducing volatility.
• Helps Apple maintain steady growth rather than showing sharp fluctuations in
earnings.
• Why It’s Ethical:
• Aligns with GAAP and IFRS standards.
• Provides investors with a clearer picture of long-term revenue.
General Electric (GE) – SEC Accounting
Fraud Case (2018)
• Earnings Management Type: Aggressive revenue recognition and
underreporting liabilities.
• What GE Did:
• Used accounting tricks to inflate cash flow by billions.
• Misclassified long-term obligations as short-term to improve liquidity ratios.
• Impact on Financials:
• Reported earnings appeared stronger than reality, misleading investors.
• Stock price declined nearly 75% after investigations.
• SEC Penalty:
• In 2020, GE agreed to pay a $200M fine for failing to disclose material
financial risks.
Tesla – Non-GAAP Adjustments &
Controversies
• Earnings Management Type: Non-GAAP earnings adjustments and
deferred expenses.
• What Tesla Did:
• Reports “Adjusted EBITDA” that excludes stock-based compensation costs.
• Deferred some expenses to improve quarterly earnings results.
• Uses regulatory credit sales to artificially boost net income in weaker
quarters.
• Impact on Financials:
• In 2021, Tesla reported a $5.5B profit, but nearly $1.5B came from selling
regulatory credits, not core business operations.
• Analysts debate whether Tesla’s earnings reflect its true profitability.
• Why It’s Controversial:
• Non-GAAP measures can mislead investors if not properly disclosed.
Enron – The Ultimate Earnings
Management Scandal (2001)
• Earnings Management Type: Off-balance-sheet financing and revenue
inflation.
• What Enron Did:
• Created Special Purpose Entities (SPEs) to hide debt.
• Recorded anticipated future profits as current revenue.
• Manipulated energy market pricing through its trading operations.
• Impact on Financials:
• In 2000, Enron reported $100B in revenue, but much was fabricated.
• Bankruptcy wiped out $74B in shareholder value, and thousands of employees lost
pensions.
• Legal Consequences:
• CEO Jeff Skilling sentenced to 24 years in prison.
• Led to the creation of the Sarbanes-Oxley Act (SOX) to prevent accounting fraud.
Microsoft – Conservative Accounting
(1990s)
• Earnings Management Type: Income smoothing through reserve
accounting.
• What Microsoft Did:
• Deliberately underestimated revenue growth.
• Over-reserved for potential losses during strong years, then released
reserves in weaker periods to stabilize earnings.
• Impact on Financials:
• Created artificially stable growth that reassured investors.
• Avoided extreme earnings fluctuations, keeping stock price stable.
• Why It’s Ethical (But Controversial):
• Not illegal but raised concerns about transparency.
• SEC later questioned Microsoft’s accounting, leading to more disclosure
requirements.
On the Role of Information
The role of finance
• Allocation of resources
Market failure
• Market mechanism/finance fails to allocate resources efficiently
• Examples
• Market power (e.g. monopoly)
• Missing/incomplete markets
• Inequality
• Crises
• De-merit goods

• Lost opportunities
• Financial loss
How to get an edge in the markets?
• Core problem – Information
• Information asymmetry: when one side of the market knows
more than the other
• Perspectives
• Investor (asset manager, institutional investor, real investor)
• Company owners
• Company managers
South Sea Company Bubble (1720)
• A company for carrying out an undertaking of great advantage,
but nobody to know what it is.
Market for used cars
• Buying a used car
• Fiat Barchetta
• Search the web (in the Netherlands, use Zomoto.nl)
• Look for Fiat -> Barchetta
• Minimum price EUR3,000 and a minimum mileage of 20,000 km
• 160 results meet the search criteria
• Prices vary from EUR3,200 to EUR22.950
• Age varies from 1995 to 2005
• Mileage varies from 26,590 km to 256,000 km
• Sorting on mileage
• a lot of cars have a mileage from ~54,000 km to ~75,000 km
• Why would so many people offer a car in that range?
• Fiat owners forum (where owners ask others for help on various
issues), and this is the wise comment of one of them.
• It appears that the ‘cam belt’ needs frequent replacement. As one
owner advises:
• When buying second hand : change belt
• If +3 years old : change belt
• If +60,000 km : change belt
• In addition, it appears you need to replace the ‘variator’ or ‘variable
valve timing’ (VVT) every once in a while. If you do not do this in
time, you run the risk of ruining your entire engine.
• Given this knowledge (and assuming you are not a mechanic), how
do you start searching?
• Lemon car • Plum car
 Sample
size =
100
50
50 plums
lemons
 Seller’s price Buyers are
expectations willing to pay

Lemons=€10 Lemons<€12
Plums=€2000 Plums<€2400
00 00
• If quality can be verified -> no problem
• Price for lemons €1000-€1200
• Price for plums €2000-2400

• BUT
• Sellers are always better informed -> INFORMATION
ASYMMETRY
• Buy:
lemons (€1200), plums (€2400)
• If there is an equal probability to get either a lemons or a plum,
then the buyer would be willing to pay
½ (1200) + ½ (2400) = 1800
• Lemon car • Plum car
Adverse selection
• At €1800 only lemons are offered for sale

• Consequences
• MARKET FAILURE
• Lemons drive good cars out of the market
• Zero cars sold
Solutions
• Hire a car expert
• Thorough screening, inspection
• Reputable car marketplace that
certifies good cars
• Insurance, deductible,
guarantees
• Incentives

• Reduce information
asymmetries
• Reduce uncertainty
Market failure under asymmetric information

The Market for “Lemons”: Quality Uncertainty and the Market

Mechanism
George Akerlof, 1970, The Quarterly Journal of Economics

2001 co-laureate of Nobel Prize in economics

Information and financial markets
• Cars • Company securities
• Sellers • Founders/managers
• Buyers • Investors
Information and financial markets
• Hire a car expert • Advisor (third party expert, gate
keeper)
• Thorough screening, inspection • Due diligence
• Reputable car marketplace that • Transaction venue (certification,
certifies good cars vouching, ratings)
• Insurance, deductible, guarantees • Sunk capital, fees, ratings,
• Incentives contracts
• Signaling • Corporate governance
• Roadshow, exposure

• Reduce information asymmetries

• Reduce uncertainty • Transparency (confidentiality)
• Reputational capital, risk
management
Financing private companies
• Information asymmetry (and adverse selection) is one of many
frictions that need to be resolved in order to obtain external
financing
• Many more exist
• Agency problems
• Moral hazard
• Conflicts of interests
• Risk shifting
• Asset transfer/stripping
• Private benefits
• …
Market based solution for raising capital
• The role of financial intermediation
• Allocate capital to its most productive use
• Value
• Match/synergies/investment case, risk-return profile
• Appropriate solution for companies depends on
• Size
• Stage
• Strategic goals
• Other considerations
• Economies of scale
 The Model Simplified
Information
sharing

Alternative Assets 3. Market data, pricing Investors

1. Deliver standardized information 2. 1. Bank and Financial

Fund Stakes LP’s
Submit Institutions –
IOI / Affiliates
Bid Funds 2. Strategic
Equity Assets 3. Angel groups
Exchange 4. Family offices
Strategic 5. Asset managers
Execution Investors 6. Advisors and
Corporate Credit 1. Asset screening and information disclosure service providers
2. Investor database Advisors 7. Funds of Funds
3. Bookbuilding and pricing indication 8. Foundations
4. Liquidity benchmarking 9. High net-worth
Individuals

1. Documentation
Designated Advisors 2. Placement
3. Closing
Takeaways
• Information is crucial
(including soft and hard information)

• Solutions exist to reduce adverse selection problems

• Professional investment requires efficient infrastructure

Nature of information
Information and semantics
• Data
• Information
• Knowledge
• Wisdom

• Perception
• Relativity of information
Information
• Hard
• Soft

• Public
• Private
Stochasticity and Randomness
Outcomes
• Path-determined vs. path-dependent
Theory of information
• Signaling

• Screening

• Monitoring

• Vouching

• Verification

• Costly commitment
Credibility
• Costly signaling

• Authenticity

• Repeated games

• Validation
Disclosure mechanism
• Positive vs. negative
disclosure

• Omissions

• Comply or explain
Adverse selection
Moral hazard
Information and manipulation
• Obfuscation

• Information packaging

• Fuzzy logic in truth

• Plausible deniability

• Relativity
Obfuscation
• Strategic disclosure vs. voluntary disclosure

• Information overload

• Timing

• Selective disclosure

• Risk disclosure
Lying with Statistics
• Cherry picking

• Timeframe picking

• Segment distortion, misleading comparisons

• Misleading averages

• Empirical evidence
Base rate fallacy
• Base rate fallacy, or base rate neglect, is a cognitive error
whereby too little weight is placed on the base, or original rate,
of possibility (e.g., the probability of A given B). In behavioral
finance, base rate fallacy is the tendency for people to
erroneously judge the likelihood of a situation by not taking into
account all relevant data. Instead, investors might focus more
heavily on new information without acknowledging how this
impacts original assumptions.
Window dressing
Incomplete contracts
• Ax ante trust with sanctions

• Ex post enforcement

• Contracts as a backstop or pro-active tool

Omissions or What you see is not what
you get
• Market wizard
Insider trading
• Purpose

• Enforcement

• Value
Auditors
• Limitations
Risk and Corporate
Governance
Risk
• Nature of risk
• Different dimensions of risk
Risk and Uncertainty
• Risk vs. uncertainty
• Parameters
• Knowns and unknowns
Manifestations of risk
• Future outcomes
• Can risk and uncertainty be measured practically?
Randomness
• Oversized impact of randomness
• Perceptions of randomness
Risk Optimization vs. Management
• Cross-section
• Across time

• Maximization of outcome
• Minimization of risk

• Survival

• Destruction
Unknown unknowns
• Unknowable outcomes
• Managing the unknowns
Ergodicity
• Surviving in financial
markets
Trust
• High vs. low trust
• Enforcement vs. pre-emption
Risk and Governance Theory
• Stakeholder theory
• Stewardship theory
• Resource dependence
• Behavioral perspectives
• Institutions
Risk Transfer
• Transferring risk to another party
Risk Shifting
• Risks are imposed on others without their full knowledge or
consent
Agency Theory and Risk Shifting
• Asset management incentives
• Hiding risks in asset management
Asset Substitution
• Shifting risks across assets
Risk in Distressed Situations
• Survival optimization
• Risk distribution and payoff
• Rational choice to gamble in distress
Excessive Risk-Taking
• Agency problem of overvalued equity
Excessive Risk Aversion
• Desirable risks
• Aversion to productive risks
Obfuscation of Risk
• Transparency
Metrics
Value at Risk
• the maximum expected loss over a given time horizon at a
specified confidence level
Stress Tests and Scenario Analysis
• Hypthetical models
Risk-adjusted measures
• E.g. risk-adjusted return on capital
Others
• Beta
• Cost of capital
• Credit risk models
• Operational models
• Economic value added
Risk Optimization
Risk optimization
• Diversification
• Hedging
• Insurance
• Capital allocation
• Buffers
• Early warning systems

• Governance structure
Best Practices
• Enterprise Risk Management Frameworks (e.g. COSO)
• ISO 31000 Risk Management Guidelines
• Chief risk officer
• 3 lines of defense (operational, risk management, internal audit)
• Governance codes
• Regulation
Governance Practices
• Board risk oversight
• Risk appetite statement
• Incentives
• Transparency
• Independent review