Earning Management: A Study

Ms. Surbhi Chhabra*

ABSTRACT
Earnings management (EM) is not a technical term in accounting or finance. However, it occurs when i) Firm management has
the opportunity to make accounting decisions that change reported income, and ii) Exploits those opportunities. Earnings
management is the use of accounting techniques to produce financial reports that present an overly positive view of a
company's business activities and financial position. Many accounting rules and principles require company management to
make judgments. Earning management takes advantage of how accounting rules are applied and creates financial statements
that inflate earnings, revenue or total assets. Earnings are the powerful indicators of the firms' business activities. Since a
company's stock is measured by the present value of its future earnings, investors and analysts look to earnings to determine the
attractiveness of a particular stock. It directly affects the overall integrity of financial reporting and significantly influences
resource allocation in an economy. The objective of this paper is to help academic researchers, regulators, and investors better
understand issues surrounding earnings management. Extent and type of earnings management depends on several factors like
stock market incentives, personal incentives, political & regulatory motives. The main objective of this study is to focus on
techniques, motives and control of earnings management
Keywords: Earnings Management, Accounting Technique, Firm Performance, Types of Earning.
INTRODUCTION
Earnings management is the practice of managerial actions that are reflected in a company's financial reports either
to give the impression of smooth periodic or annual earnings, to show high profits in a given year at the 'expense' of
lowering reported earnings in the future or to show low profit in a given year so that in future years reported profits
will be higher. In some cases, management uses various accounting methods in order to convey private information
to financial report readers. Management of earnings may mislead stakeholders about the true financial performance
of the company. If management gains anything from managing earnings, one must ask whether such gains are at the
expense of anybody.
The study explores the relationship between the practices of earnings management, firm performance. The prevalence
of earnings management in India can be explained by some local factors: flexibilities provided by Indian regulatory
bodies; unclear lines that can differentiate fraud and aggressive accounting (earning manipulation); weak market
competition; information asymmetry; investors' lack of awareness about the accounting concepts; and the high
emphasis

OBJECTIVES OF THE STUDY

The main objective of this study is to focus on techniques and control of earnings management. In the light of this
main objective, the specific objectives of the study are as follows:
1. To know about earnings management, and
2. To study the techniques are applied to manage the earnings.

METHODOLOGY
This research is based on secondary sources. Secondary sources of information include academic
Journals, books and websites. In this paper earnings management and techniques that are used to manage the
earnings are analyzed to maximize the personal benefit.

* Assistant Professor in Commerce, SGGJ Girls College Raikot, Punjab University, India

Earning Management: A Study l 40

LITERATURE REVIEW
The study of earnings management dates back to Healy's (1985) study titled "the effect of bonus schemes on
accounting decisions." Since that time, different authors conducted studies on earnings management. While some
authors (Sloan, 1996; Fairfield et al., 2003; Fama and French, 122 international research journal of finance and
economics, Issue 116 (2013) 2006; cooper et al., 2008; and Chu, 2012) have tested the relationship between earning
management and firm value, other authors (Teoh, Welch, and Wong, 1998; Othman and Zeghal, 2006; Huddart
and Louis, 2009; li, 2010; Cohen et al., 2011; Mashadi et al., 2012; and Gholami, Nickjoo, and Nemati, 2012) have
tested the relationship between earning management and firm value. Although empirical studies in developed
economies have found that earning management and firm value affect the market price of shares, there has not been
much research conducted on developing countries (Ogundipe, Idowu, and Ogundipe, 2012).
According to roman (2009), "earnings management occurs when firm management has the opportunity to make
accounting decisions that change reported income and exploit those opportunities". He also stated that accounting
for business operations requires judgment and estimates. For example, one can't measure revenue without estimating
when customers will pay, how many will not pay, how many will return goods for refund and costs to the seller for
fulfillment of warranty or maintenance promises. Many writers restrict the term "earnings management" to the
selection of estimates that achieve an earnings target and would not use the suggest that certain factors such as debt
covenant constraints, compensation plan provisions, political costs, the need to issue equity capital, insider trading,
etc. Provide managers with incentives to manage earnings. Several researches found different managerial incentives
for earnings management.
Defond and Jiambalvo (1994) find that sample firms accelerate earnings prior to lending covenants, and Holthausen,
Larcker and Sloan (1995) observed that managers manipulate earnings downwards when their bonus are at their
maximum. Healy (1985) also documented similar evidence. Another set of studies focus on top managers' job
security and their incentives to manipulate earnings when the managers are faced with a possibility of losing their
respective jobs.
Watts and Zimmerman (1986), the use of earnings management is widely debated and actively researched. Schipper
(1989) defines EM as "purposeful intervention in the external financial reporting process, with the intent of obtaining
some private gain". Healy and Wahlen (1999) also define EM as a Managers' 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…"(p.368). Mulford and Comiskey (2002) define EM as "…active manipulation of earnings towards a pre-
determined target". All these definitions focus on the legal accounting and economic choices that may be used to
influence reported earnings.

TECHNIQUES AND EFFECTS OF EARNING MANAGEMENT

The Big Bath
This form of income manipulation can be thought of as part of income smoothing. What it usually does is effectively
accelerate expenses and losses into a single year with already poor results so that future income looks better and
smoother. Even though the FASB has issued fairly recent statements to reduce the magnitude for taking a big bath,
companies can, and do, still use this technique. Examples may include recognizing losses on assets that have a fair
market value below the current book, or carrying, value.
Creative Acquisition Accounting
As the number of acquisitions has decreased (since the late 1990s) and with the advent of SFAS nos. 141 and 142, this
doesn't seem to be as much of a problem as it once was. Still, when a company has made an acquisition or acquisitions
during the year, the transactions should be looked at closely to see exactly how they were accounted for and what
effect the treatment has on current, and will have on future, earnings.

41 l Splint International Journal of Professionals I ISSN : 2349-6045 I Vol.-III, Issue-11, November 2016
Cookie Jar Reserves
The cookie-jar technique deals with estimations of future events .these can go along with the big bath and are a form
of income smoothing. Earnings are managed under this method by selecting the period in which a revenue or
expense item is taken. This is usually done for expenses that are based on estimates. If a company is having a
particularly good year and next year's results are uncertain, they can over-accrue some reserves in the current year
and then have the ability to under-accrue them in the next year if needed. By doing so, they effectively inflate the
following year's income at the expense of this year's. Income, thus, appears smoother, and the company may be able
to publicly forecast higher profits for the following year even if their business isn't actually going to do any better in
the following year. This may temporarily be good for the stock price, but it isn't
Materiality
This method may not be a big deal to small companies since nearly everything is material and, hence, should be
accounted for. But for large, publicly traded companies with revenues and assets in the billions of rupees, they can
potentially get away with millions of rupees worth of misstatements and merely write them off as being "nonmaterial"
in nature. Auditors are primarily concerned with material misstatements. Materiality has the potential to allow
companies to slightly fudge their numbers, just enough to get them to where the analysts forecasted.
Revenue Recognition
Sort of the flip-side of cookie jar reserves, improper revenue (or expense) recognition can lead to inflated financial
statements now at the expense of future earnings. Some companies that have dabbled with this earnings management
technique then have to inflate revenue in the next period even more to make up for the shortfall caused by the prior
period's acceleration of revenue. It becomes a never-ending game of covering up for the previously improperly
recorded revenue and can fairly easily lead to outright fraud. Several of the bigger scandals of the past few years have
been the result of companies improperly, and/or prematurely, recording revenues in order to meet or exceed
forecasts, only to have the house of cards eventually come tumbling down, resulting in massive restatements to the
prior financial statements, new management, new auditors, and very low stock prices (if not bankruptcy).
Big bet on the Future Technique
When an acquisition occurs, the corporation acquiring the other is said to have made a big bet on in future. Under
generally accepted accounting principles (gap) regulations, an acquisition must be reported as a purchase. This leaves
two doors open for earnings management. In the first instance, a company 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.
Flushing - the Investment Portfolio
To achieve strategic alliance and invest their excess funds, a company buys the shares of another company. Two
forms of investment are trading securities and available for sale securities. 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. When available for sale securities are sold, any loss
or gain is reported in operating income. A manager can manage its earnings through various techniques which are:
i. Timing sales of securities that have gained value: the company can sell a portfolio security that has an
unrealized gain and can report the gain as operating earnings if it is required.
ii. Timing sales of securities that have lost value: if the manager wants to show lower earnings then he can sell
the security that has an unrealized loss and report the loss in operating earnings. iii. Change of holding intent,
write-down "impaired securities: management can manage earnings through change of its holdings from
available to sale securities to trading securities and vice versa. This would have the effect of moving any
unrealized gain or loss on the security to or from the income statement.

Earning Management: A Study l 42

iv. Write-down "impaired securities: securities that have an apparent long term decline in fair market value can
be written down to the reduced value regardless of their portfolio classification.
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" subsidiary may be "thrown out". Earnings can be managed through sell the subsidiary, exchange the
stock in an equity method subsidiary and spin off the subsidiary.
Introducing New Standard
New rules and regulations are introduced in gap due to changing demand of business environment. Accounting
principles can be modified in a way that will not change the earnings. When a new accounting standard is adopted
it takes two to three years to adopt the standard. Voluntary early adoption may provide an opportunity to manage
the earnings. A company can take the advantage of manage expense on a cash basis.

CONTROL OF EARNING MANAGEMENT (EM)

One way to control earnings management (by accounting techniques) is setting more rigorous Accounting standards.
However, this may have the unwanted effect that manager's turn to 'real
Earnings management', which consists of abnormal, suboptimal, business practices in order to change reported
earnings. Given the weak legal system and the lack of accounting and capital market infrastructure in transitional
economies, emerging economies are particularly likely to face severe problems in monitoring managers' accounting
decisions. The introduction of international accounting standard and practices in the market has been shown to
increase market liquidity; reduced transaction cost, and improved pricing efficiency. It is still an open question as to
whether the adoption of international accounting standards improves the quality of accounting information, thereby
reducing the level of earnings management. Firms adopting IAS are less likely to smooth earnings, less likely to
manage earnings upwards to avoid reporting a loss, and more likely to recognize loss timely than non adopting firms
Scott (2012) recognizes a variety of EM Patterns, which are as follows:
1. Taking a bath: when a loss cannot be prevented (e.g. during organizational stress or reorganizations) man-
agers are more willing to take a huge loss for current period which will result in a higher future profits.
2. Income minimization: manage earnings downwards to minimize profit (e.g., for political visible firms).
3. Income maximization: manage earnings upwards to maximize profit (e.g., for debt Covenants)
4. Income smoothing: manage earnings in such a way to reduce volatility of earnings to a minimum (e.g., to
receive a constant remuneration or to signal or disclose inside information to the market.)

CONCLUSION
Earnings management is the attempt to smooth the path of earnings over time by using various accounting strategies
to shift earnings from one quarter to another. This is not to be confused with attempts to inflate earnings by dubious
accounting methods (think Enron, for example). The primary reason to engage in earnings management is to make
the stream of earnings seem more predictable and less volatile. The belief is that the stock market rewards a steadily
growing and predictable earnings stream rather than a volatile one. Whether this belief is true or not may be worthy
of investigation but it is taken as gospel. Wall Street equity analysts build models to forecast earnings. Firms' guide
analysts subject these days to fair disclosure rules in the U.S. the market punishes negative earnings surprises, so the
key is not to miss on the downside. Internal targets are another reason that a company may choose to use earnings
management techniques. Often times, the company has set its own internal goals, such as departmental budgeting,
and wants to be sure to meet those goals. No department wants to be the one to blow the proposed budget, so
earnings management techniques are used to balance this out.

43 l Splint International Journal of Professionals I ISSN : 2349-6045 I Vol.-III, Issue-11, November 2016
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Earning Management: A Study l 44

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