Earnings Management: Causes, Techniques, and Transparent Financial Reporting
Author: Mintz, Steven
Source: The Aspen Institute Center for Business Education's Corporate Governance and Accountability Project
Year: 2006
Abstract:
This Teaching Module was prepared by Dr. Steven Mintz, Professor and Area Chair, Cal Poly, San Luis Obispo, as part of the Aspen Institute Center for Business Education's Corporate Governance and Accountability Project.
Earnings management occurs when managers use judgments to purposefully alter operating results to mislead stakeholders into thinking the company is doing better than it really is or to gain a personal advantage. Various techniques can be used such as prematurely recognizing revenue, deliberately delaying expenses, changing estimates to inflate earnings, and improperly disclosing financial information. The motivation for earnings management can be to:
• Meet financial analysts' estimates of earnings that leads to performance-based compensation
• Raise the stock price thereby enhancing the value of stock options
• Smooth net income making it appear that the earnings are increasing at a steady rate
• Make it look as though future earnings are higher than they really are by establishing "cookie jar reserves" (inflated expenses) in the current year that can be drawn on in future years
These techniques impair the accuracy, reliability, and transparency of financial reports and can lead to dysfunctional decision making. The external auditors and the audit committee of the board of directors are responsible for ensuring that internal controls exist to support strong governance systems that prevent these financial abuses from occurring. The objectives of this module are three-fold:
1. To help students understand how basic accounting techniques such as depreciation estimates, allowance for bad debts, and inventory adjustments can be used to manage earnings.
2. To help students recognize the factors that can lead to earnings management.
3. To help students understand why the accounting scandals at Enron and WorldCom led to the Sarbanes-Oxley Act and the resulting increase in the oversight of management by external auditors and the audit committee.
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