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Earnings management is bad when it becomes abusive. There are several cons of the earning management. Schipper (1989) and Healy and Wahlen (1999) state that earnings management is the alternation of firms' reported economic performance by insiders. It will mislead some stakeholders or influence contractual outcomes. Earning management is used to reduce outsider interference and protect insiders' private control benefits. For instance, insiders can use their discretion in financial reporting to inaccurately reflect firm performance and consequently weaken There are five earnings management techniques that will threaten the integrity of financial reporting outsiders' ability to govern the firm.
Firstly, big bath is the strategy of manipulating a company's income statement to make poor result look even worse. The big bath is often implemented in a bad year to enhance artificially next year's earning. The big rise in earnings might result in a larger bonus for executives. That is a disadvantage of applying earning management because new CEOs sometimes use the big bath so they can blame the company's poor performance on previous CEO and take credit for the next year's improvements. For example, company who has low current year earnings were more likely to record large extraordinary losses while companies with unusually high earnings were more likely to record large extraordinary gains. Firms with low earnings will under report earnings by the maximum amount possible in order to take a big bath. When earnings are not low, the company will act to smooth earnings rather than take a big bath.
Second is creative acquisition accounting. The allocation to expense of a greater portion of the price paid for another company in an acquisition in an effort to reduce acquisition-year earnings and boost future-year earnings. For instances, accountant applies acquisition-year expense charges which include purchased in-process research and development and an overly aggressive accrual of costs required to effect the acquisition. Therefore, company can decrease the acquisition-year earnings in order to show a good performance during the future year earnings. That is the disadvantage of earning management because it cannot perform accurate figures I in the financial statement.
Third, earnings management creates the problem of "Cookies jar" reserves. Accounting practice that inflates provisions for expected expenses and later reverses them to boast earnings in many cases at very convenient times. This is traditionally abused when companies want to push reserves into future earnings. For instances, company use reserves to cover the estimated costs of taxes, litigation, bad debts, job cuts, and acquisitions. In good year, company stores reserves in the balance sheet, so that it can place them on the income statement when management needs extra income to show good result.
In addition, earning management abuses the materiality concept. Earning management abuses often stem from misuse or misunderstanding of the proper application of the materiality concept For example, accountant tends to deliberately recording errors or ignoring mistakes in the financial statements under the assumption that their impact is not significant.
Lastly, earning management records improper revenue recognition. Recording revenue before it is earned. For example, improper sales cut off, consignment sales recorded as revenue, back to back swaps (One firm "sells" an asset at a gain to another organization and agrees, in turn, to purchase assets from the "buyer" during either the current accounting period or a subsequent period. Both firms inflate earnings by recording gains on the assets transferred to the other party). Assume that an entity tend to response to higher costs, in order to meet current-period sales targets or for any other reason. It will increase prices at the beginning of the next quarter, thereby stimulating some customers to purchase unusually high quantities before the end of the current quarter. If the sales meet all the criteria for revenue recognition, the entity should recognize the sales when the product is shipped, possibly resulting in an effective and legitimate management of earnings. However, there is an unusual right-of-return privilege and there is no basis for estimating the returns that will take place, the transaction essentially becomes a conditional sale, and recognizing the revenue when the product is shipped violates GAAP and misstates the financial statements. If the right-of-return privilege has been concealed from the auditor as part of a scheme to increase reported earnings, the financial statement misstatement involves fraudulent financial reporting.
Creative accounting is directed towards information in the financial statements concerned with either profitability or the level of indebtedness. Lets us consider some "creative" devices. Earning management creates problems. The company can increase using percentage of completion basis of accounting in order to anticipate revenues and profits from uncompleted contracts. Therefore, company can inflate reported profits and the growth rate of those profits.
There are various "creative" devices to reduce a group's reported indebtedness. For example, arrange for the borrowings to be made by or transferred to a related company which is not fully consolidated in the group's financial statements. The group's interest in this company will be accounted for on the basis of the equity method, whereby a single figure representing the group's share of the company's a net asset will appear in the group's consolidated balance sheet. Thus, the related company's borrowings do not appear in the consolidated financial statements, being netted off in arriving at the single figure of the group's share of its net assets. If full consolidation is applied, this netting off does not take place, and the related company's borrowings are included in the total group indebtedness shown in the consolidated balance sheet.
The disadvantages of the earning management are the error that the management misstatement of the financial statement whether is intentional or unintentional. The misstatement will arise from fraudulent reporting and misappropriation of assets. The fraudulent financial reporting involves intentional misstatement or omissions of amount in the financial statement will consider as manage earnings.
In this case study, the auditor will find it very hard to use the Generally Accepted Auditing Standards (GAAS) to audit the company financial statement because of managers using the different methods to smooth earnings makes it very complex and confused to meet the pre-specified targets. This is because the GAAS doesn't provide the sufficient guide line to implement the concept of professional skepticism and the management will usually judged as processing integrity. If the GAAS dismiss collusion as impossible or difficult to detect, it will cause the auditors hard to determine the authenticity of document. However, most of the financial statement frauds will involve the collusion and falsified document. Therefore earnings management opens doors to occurrence of fraudulent activities thereby imposing a disadvantage. In addition, it also imposes difficulties to audit as mentioned and this affects the true and fairness of the financial statements.
The fraudulent earnings management is the reporting of earnings or cash flow figures that do not reflect the true underlying performance and trend, or that provide a poor guidance for the future earnings or cash flow. Besides that, it also can affect the company long-term targets or long-term earnings because it is the company main objectives. The example concern that the business manager who is exceeding the expectation and invest the "excess" profits into an entrepreneurial initiative. The company will get the higher profit during the subsequent period but the current profit would be lower than achievable and the next year's profit would be possibly been overstated. This action would consider as fraudulent behavior or managerial mistake.
Besides that, the manager shows the earnings management likely to follow the high earnings forecast than low earnings forecast. It will cause the shareholder may not find it optimal to prohibit earnings management. It also can impact the firm's to report total asset and equity as well as their goodwill, intangible assets, property plant and equipment, long term debt and current asset and liabilities.
The other disadvantages of earnings management is the company have break away from GAAP earnings by reporting pro forma earnings. Non-GAAP earnings exclude items that are classified as either "non-recurrent" or "non-cash" such as restricting costs, amortization of goodwill. The financial reporting have record the non-cash items such as depreciation and amortization expenses, stock compensation-related charges, merger costs, research and development, extraordinary items and adjustment for number of shares used to calculate EPS. This item in the financial statement will make the affect for the management when doing the decision-making for the future planning and objective.