Earnings management is the practice of making certain accounting decisions that can lead to a desired level of company earnings, or profits. Because earnings can have a strong effect on a company’s stock price or on management’s compensation, various incentives exist for a company to manage its earnings. Some types of earnings management comply with generally accepted accounting principles, or GAAP, which are the rules a company must follow in its financial reporting. Other methods can be unethical or illegal.
Acceptable Earnings Management
A company sometimes makes choices about which methods or policies it uses to keep records and generate financial statements. A company may choose certain policies or methods that maximize earnings and comply with GAAP. For example, accounting regulations may require a company to adopt a new accounting method within three years that will cause its earnings to decrease. The company may wait until the end of the third year to adopt the new method so that its earnings remain higher until that time.
Some types of earnings management may allow a company to comply with regulations but could be considered unethical. Accountants have flexibility to estimate numbers and make assumptions for certain accounting calculations. An accountant may exploit this flexibility by tailoring some of these estimates and assumptions to increase earnings. For example, accountants must estimate an asset’s salvage value and useful life to calculate its depreciation expense. An accountant might estimate figures that are slightly inaccurate and that result in a low depreciation expense to inflate the company’s earnings.
Fraudulent and Illegal Methods
Some methods that a company uses to manage its earnings are fraudulent and illegal. For example, a company can intentionally disregard GAAP to increase its earnings. It might report revenue for a transaction earlier than it should or report certain expenses later than it should. A company also might report revenue for transactions that never took place or from customers that do not exist. These types of earnings management practices can potentially wipe out stockholders’ investments in a company when they are discovered.
An investor should thoroughly read a company’s quarterly and annual reports and financial statements before making an investment. Companies disclose information about their accounting practices in the notes to their financial statements that describe their calculations for certain financial statement figures. Reading this information and learning about a company’s business and industry can help you identify potentially deceptive earnings management practices.
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