Critically discuss earnings management

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Earnings Management, in exchange listed companies, is not fraud but a case of caveat emptor for investors.


Earnings management is controversial issues [A1]among investors and company’s management[A2], Nowadays, listed company’s [A3]managements [A4]face a lot of pressure to push the firm’s stock prices as high as possible, maximizing the shareholder’s wealth as well as ensuring their own benefits. Hence, the [A5]earnings management has been used to meet this achievement. However, some said [A6]the earnings management is a fraud, and it is criticized for misleading, and deceiving the authentic company’s information to the stakeholders, as many recent cases, like Enron and WorldCom, were collapsed [A7]accused of the uses of the earnings management.

Definition of Earning Management

Earnings management is defined as the management of a firm uses its own acumens to decide the most beneficial accounting treatments applied to the firm [A8](Healy and [A9]Wahlen, 1999, cited by Dechow & Skinner, 2000). Indeed, earnings management highly corresponds with accruals accounting basis[A10]. It offers management a window to defer or alter the material transactions in order to avoid the unexpected impacts to stock value (Dechow et al, 2000). There are plenty of approaches can [A11]be used by management to mitigate the negative effects to [A12]the company’s market value. For instance, booking[A13] the profits of next year in advance, eliminating the operation cost through capitalization, and deferring expenditures to following period, in order to camouflage the company’s true performance of current year (Dharan, 2003). However, to what extent that the earnings management would become inappropriate? [A14]It is explicitly by the Securities and Exchange Commission (SEC) that the earnings management is only acceptable when it is within the guidelines laying down by General Accepted Accounting Principles (GAAP), and anything beyond the scope of GAAP would be in case of fraudulence. According to SEC, fraudulent accounting incurred is always pertinent to management using over-aggressive earnings management ways to deal with the firm’s accounting transactions (Dechow et al, 2000). Additionally, William &[A15] Gerry (2003) believe that fraudulent earnings management is to distort the sensitive information, covering the genius financial position of the company by the ways of using different inappropriate accounting approaches. Therefore, not all the cases are constituted the [A16]fraud, but when the managements exploit the over-aggressive and improperly [A17]methods to tackle with the financial transactions.

Reasons & Problems of using Earning Management

The earnings management is said to be the approaches that steadies the firm’s stock prices without fluctuations, since fluctuated stock price may have an adverse effect to the company’s operation cash inflow (Boissay, Frank & Gropp, 2008), and the potential opportunities to attract new capital. Moreover, stock prices are determined by various factors, but a vast majority of determinants are subjected by the market. Dechow et al (2000) stated that a firm’s stock price will be fallen unequally and substantially, if the firm’s performance does not align with the market’s anticipation. It can be seen that managements have strong reasons to exploit the earnings management to meet the market expectation. Furthermore, the company’s incentive scheme was held to be the one of the main force that directors exploit the earnings management. Nowadays, many companies link its market performances with the bonus of the managements, resulting managements abusing of the earnings management in order to maximize their personal’s wealth by holding the company’s stocks or share options as part of their compensation (Gaver, Gaver & Austin, 1995). It is seemed that using the earnings management may benefit all the parties. However, the company’s managements would change periodically, and the company’s growth is simply shifted from the future. When the market realizes the true financial position of the company, it is possible that its stock price would be dropped substantially, and the shareholders would be the major victim eventually.

Argument of using Earning Management from the view of Caveat Emptor

Some arguments of earnings management revolves the Caveat Emptor, which refers to a buyer has responsibility and duty to scrutinize all potential problems of the product before purchasing, and hence, they have no rights to claim damages from sellers afterwards. However, it is problematic that the earnings management is difficult to discover as company’s managements would try to suppress the negative information to public (Lo, 2007). Since the asymmetric information existed between the managements and investors, therefore, financial reports of listed companies are required to be audited before delivering in many countries, ascertaining the information provided is complied [A18]with the relevant accounting standards. Nowadays, investors evaluated [A19]the company’s results are heavily rely on the audited reports as it is impossible for investors to monitor the day-to-day operation of a company. However, In the case of Enron collapse, the auditor, Arthur Andersen, was failure to fulfil their obligations to protect the benefits of the stakeholders. There was an obvious conflict of interest between the Andersen and Enron. On the one hand, Enron paid Andersen for auditing its financial reports. On the other hand, Enron also paid a huge amount of consultant fee to Andersen, in returning of their opinions to circumvent the loopholes of the accounting standards in order to achieve the mystery growth [A20](Arnold & De Lange, 2004). Moreover, the credit rating agencies and the company’s managements themselves have the strong motivations to exacerbate the veil between the investors and the firm. In order to sustain the stock prices, companies would pay to credit rating agencies to rank their company as the best quality investments (Frost, 2007, cited by Demirtas & Cornaggia, 2013). Undoubtedly, this practice would lure people and even the giant fund houses to buy those highest rating securities, plus the company’s directors compensations are related with the company’s performances. All cumulative, it can be found that the instinctive problem of Caveat Emptor [A21]is the conflict of interest. The beneficial parties would try to hide the unfavourable information disseminating to investors. As a result, people are unlikely to access the potential problems of their investments, and not able to make a reasonable decision.

Regulation and Prevention of Earnings Management in the U.K. and U.S.

Accounting standards and Auditing are the prevalent and saying to be the efficient ways to prevent the creating accounting. However, the effects of these two methods for preventing from frauds are seemed to be inefficient. Accounting standards are the set of rules that provides a frame to a company when they are preparing the financial statements, and hence, investors can comprise the different companies under the same frame. Every listed company in the U.K. and the U.S. is required to present their financial reports according with the UK General Accepted Accounting Practice and US General Accepted Accounting Principles respectively (Pricewaterhousecoopers, 2010). It seems to be the best way to prevent accounting fraud incurred, if company followed all the guidelines set. However, the line between appropriate using earnings management and overly aggressive way is difficult to define (William et al, 2003), since many future benefits inflow are purely decided by the judgement of the directors. The U.K. GAAP emphasises on the concept of “True and fair view” [A22]presented into the financial report, while the U.S GAAP do not require. However, this term is arguable as it is too subjective, since different person have dissimilar explanations and perceptions of this term (Amat, Blake & Oliveras, n.d.), and therefore, it can be seen that U.K. would have more flexibility for management using earnings management rather than U.S. Other than the accounting standards, auditors play a significant role of prevention the fraud of using earnings management. The absence of the auditor’s diligence to fulfil their professional duties may be responsible the fraudulent earnings management occurred. In responding to the financial scandals in the very beginning of 21st century, the US governments [A23]enacted the Sarbanes-Oxley Act aiming to enhance quality of the financial statements (Coglianese, Healey, Keaing & Micheal, 2004), re-building the market’s confidence towards the audit firms. Nevertheless, the outcome of the Act was disappointed[A24]. According to Mckenna (2012), auditors refuse the blames of the frauds which they were not able to detect by saying that they were innocent and deceived by the managements as well as investors. Moreover, auditors were seldom to give negative opinions to the problematic companies as those auditors are paid enormous fees for auditing and consulting. Furthermore, the account standards are greatly influenced by the major beneficial party audit firms (Healy & Palepu, 2003). Therefore, a lot of principles and rules set to regulate the management’s behaviours towards earnings managements may be undermined as well as the independence of the auditors themselves.


In the [A25]conclusion, earnings management cannot be said to be radically frauds [A26]to some extent as it can be found that its have positive and negative effects towards stakeholders. On the bright side[A27], shareholders and managements are both gaining the appreciation of the stock price rising. On the down side, the conflict of interests between managements and stakeholders may lead the managements exploit the earnings management for personal gaining and being reckless of the consequences. Since the asymmetric information involved, Caveat emptor may not be held for managements to shift the criticism to shareholders as they do not observe company’s financial states properly before investment.

References :

Amat, O., Blake, J., & Oliveras, E. (N.d.). The struggling Against Creating Accounting: Is “True and Fair View” Part of the Problem or Part of the Solution?. Retrieved from

Arnold, B., & De Lange, P. (2004). Enron: an examination of agency problems. Critical Perspectives on Accounting, 15(6), 751-765. Retrieved from

Boissay, F., Frank, M. Z., & Gropp, R. E. (2008). The Effect of Stock Market Fluctuations on Corporate Cash Flows. Retrieved from

Coglianese, C., Healey, T. J., Keating, E.K., & Micheal, M. L. (2004). The Role of Government in Corporate Governance. Retrieved from

Demirtas, K. O., & Cornaggia, K. R. (2013). Initial credit ratings and earnings management. Review of Financial Economics. 22(2013), 135-145, Retrieved from

Dechow, P. M., & Skinner, D. J. (2000). Earnings management: Reconciling the views of accounting academics, practitioners, and regulators. Accounting Horizons, 14(2), 235-250. Retrieved from

Dharan, B. G. (2003). Earnings Management with Accruals and Financial Engineering. Retrieved from

Gaver, J. J., Gaver, K. M., & Austin, J. R. (1995). Additional evidence on bonus plans and income management. Journal of Accounting and Economics, 19(1), 3-28. Retrieved from

Healy, P.M. & Palepu, K.G. (2003). The Fall of Enorn, Journal of Economic Perspective, 17(2), 3-26.

Lo, K. (2007). Earningss management and earningss quality. Journal of Accounting & Economics, 45(2-3), 350-357. Retrieved from

Mckenna, F. (2012). Ten years after Sarbox, time for an audit of the auditors. Retrieved from

Pricewaterhousecoopers. (2000). International Accounting Standards – Similarities and Differences – IAS, US GAAP and UK GAAP. Retrieved from

William, R. O., & Gerry, H. G. (2003). Maynard Manufacturing: an analysis of GAAP-based and operational earnings management techniques. Strategic Finance, 85(1), 50. Retrieved from

[A1]We would probably refer to earnings management as a singular concept, so this would be “a controversial issue”.

[A2]Again, consider your use of plurals here. We might say “a company’s management” or simply “company management”.

[A3]We would possibly rearrange this to read “the management of listed companies”

[A4]This word is always singular. Watch out for this elsewhere.

[A5]Again, I don’t think you would need a definite article before this word.

[A6]Your reader may ask “who said this?”. Can you provide a source to support this?

[A7]We might say “like the collapse of X and X”.

[A8]Is this a direct quote? If so, I recommend making this clear.

[A9]Be consistent with your use of “and” or “&” in citations.

[A10]As a non-specialist, I’m not entirely sure what you are trying to say here. Do you need to explain your reasoning about how this is the case, or perhaps why it is relevant at all?

[A11]We might add the word “which” or “that” before “can” to help this sentence flow a little more.

[A12]We might say “on” rather than “to”.

[A13]What do you mean by this word?

[A14]It is best to avoid posing questions in academic writing, if possible. It is a little informal, and it implies that you are speaking directly to your reader. If you intend to discuss this topic here, you could instead phrase this as a statement.

[A15]It is best to use the word “and” in the general body of your essay (rather than within a bracket).

[A16]No definite article required, because you are discussing a general concept here.

[A17]We would say “improper”

[A18]We would say “complies with”

[A19]“evaluating” is the participle form.

[A20]I’m not quite sure what you mean here by “mystery”.

[A21]Does this term need to have capital letters? It may be worth checking this.

[A22]Is this a direct quote? If so can you indicate where this comes from?

[A23]There is only one US Government, and you need to capitalise the G.

[A24]Can you clarify what you mean here? Disappointing? Not as intended?

[A25]You can delete this article, because you are talking about the general conclusion to this essay (rather than the specific section entitled “conclusion”). Also, I recommend adding the phrase “it has been argued” (or something similar) at some point in your conclusion, to make it clear that you are summarising your main arguments. Otherwise, it may seem a little unclear to your reader.

[A26]Can you clarify what you mean here?

[A27]This is quite an informal phrase. We might simply say “on the positive side” instead.